We recently discussed how Wayfair has committed to building a next-day fulfillment network for home goods. The more inventory that Wayfair warehouses in its CastleGate network, the higher the product availability, faster the delivery times, and higher the conversion rate. The company believes owning the full supply chain is one of the most important drivers of repeat buying, a metric that is fundamental to Wayfair’s unit economics.

However, Wayfair reported Q4 2021 results last week and the numbers tell a slightly different story: the absolute volume of inventory delivered through CastleGate declined in 2021. Also, as a percentage of sales, CastleGate accounted for 18% of large parcel volume in 2018 and only 19% in 2021.

We've been researching Wayfair's supply chain services to understand why the uptake of CastleGate has been relatively slow by suppliers and how this could change over time.

Last week, we interviewed two former Wayfair executives who were involved in building CastleGate forwarding, Wayfair’s digital freight forwarding service, and CastleGate fulfillment, Wayfair’s warehousing network, and hosted an investor dialogue to explore Wayfair’s strategic positioning.

Historically, the furniture industry has followed a drop-shipping model where the retailer owns no inventory and merely facilitates the sale between suppliers and end customers. Asian suppliers work with third-party freight forwarders to organise the ocean freight, drayage, and custom clearance in the origin and destination ports. This is the ‘first-mile’ of the supply chain.

Once the product reaches the supplier’s US warehouse, the product is listed in a retail channel for end-customers to purchase. Post-sale, LTL trucking firms operate the middle-mile of the supply chain by collecting the parcels from suppliers and delivering to a UPS or Fedex hub for the last mile journey. In some cases, there can be multiple LTL trucking legs to ship the product across the US.

Wayfair has built a vertically-integrated supply chain solution to reduce the cost of each stage of the process:

It doesn’t take a rocket scientist to figure out what the motivation of these platforms are, whether it be Amazon, Wayfair or Shopify. The motivation is that you’ve got to keep the cost down. If it’s a type of a relationship where the seller brings it in, you sell it and you turn around and buy it, there’s a wholesale markup. If you can’t control any of the miles – but the first mile in my case – and if you can’t keep transportation costs down, especially in today’s environment, the wholesale cost goes up. That means your sale price goes up – or it doesn’t – and it all flows to the bottom line. - Former VP, CastleGate Logistics at Wayfair

For the first-mile, Wayfair is a NVOCC-licensed forwarder that can negotiate volume and pricing directly with ocean carriers. Suppliers can not only get better ocean freight pricing, but Wayfair also saves a lot of hassle for them:

What’s the value? First of all, we’re buying from volume versus the little guy. Secondly, it was a no-brainer for the seller to use this first-mile service, because they didn’t have to do anything anymore. They didn’t have to worry about tracking a container on the water, making sure it gated in. They didn’t have to worry about the customs clearance process, because we’d manage that, as well. They also didn’t have to worry about the dray and the appointments at the warehouse. They didn’t have to worry about anything. - Former VP, CastleGate Logistics at Wayfair

CastleGate forwarding should be even more important today when even some smaller NVOCC’s are struggling to get ocean freight capacity.

First of all, especially for the little sellers, I’ve had multiple ocean carriers tell me that they will not sign any contracts for less than 2,000 or 2,500 containers, this year. One said they were not signing any new customers this year. Ocean carriers are not doing named accounts at all. If you’re not an existing named account, from the past, you’re not getting a named account. - Former VP, CastleGate Logistics at Wayfair

The bigger the volume, the more negotiating power Wayfair has to guarantee space and pricing. The first-mile savings can have a significant impact on the final price to the customer:

if it’s $20,000 to move that container because it’s got to be drayed and there are all the other costs we just talked about, from port to door, and somebody else can do it for $10,000, that’s impactful. If there are 50 sofas, that’s $200. - Former VP, CastleGate Logistics at Wayfair

If we can fit 50 sofas in a 40ft container that costs $20,000 including drayage in the spot market, the total ocean freight unit cost is $400 per sofa.

Given Wayfair negotiates directly with carriers at large volume, if it secures a container rate at $10,000, this saves $200 per sofa. At an average sofa price of $1,500, this is a 13% cost saving that can be passed back to the customer. Even if we normalise the container rates to $10,000, Wayfair could achieve ~6-8% lower unit cost per sofa.

This is just the potential first-mile savings.

Wayfair also runs a middle-mile and last-mile delivery network. The company believes it can reduce the touches in the large parcel supply chain 50%. If the breakage rate is ~1% per touch, this could improve the breakage and return rate by 3%.

Wayfair Q4 2019 Presentation
Wayfair Q4 2019 Presentation

The combination of cheaper ocean freight rates and lower breakages drive a better customer experience which turns more inventory for suppliers and drives more revenue for Wayfair.

It seems like a great deal for all parties. Yet, even with today's supply chain challenges, CastleGate penetration hasn't materially improve over the last 3 years.

What could really be limiting CastleGate penetration?

This is what Overstock’s CEO believes:

Our supply chain continues to be a competitive advantage. As a reminder, our supply chain is broad and distributed with a vast partner network that reduces single-source risks, shipping bottlenecks and supply chain kinks. Unlike some of our competitors, we don't pressure our partners to lock up inventory in our distribution centers. As a result, we tend to give favorable priority in pricing on inventory, particularly during periods of high demand and low supply - Overstock CEO, Q4 21 Earnings

Maybe the suppliers don’t want to commit their inventory to Wayfair exclusively? After all, CastleGate products are forward positioned in Wayfair’s warehouses and made exclusively available to Wayfair’s customers. Suppliers still own the inventory but it is effectively stuck in Wayfair’s channel and can’t be marketed elsewhere. If it doesn’t sell, it just sits in a CastleGate warehouse because there is not enough margin to ship the product elsewhere.

Limiting products to one channel is a risk for suppliers, especially those that own US drop-ship warehouses. If large suppliers can get space on carriers via 3PL’s, storing product in their own warehouse and enjoying the flexibility to sell in all channels seems like an optimal solution.

Maybe this means only smaller, Asia-based suppliers without a US warehouse footprint are the best targets for CastleGate services?

Could this mean CastleGate attracts relatively smaller suppliers that produce lower quality products?

Also, positioning inventory in CastleGate is even less attractive during a pandemic when inventory is tight and furniture demand is sky high. Over the last 2 years, Walmart, Target, and other direct buyers were willing to take the inventory risk and pay suppliers upfront for furniture to meet the high demand. This is what the Former Head of Fulfillment Engineering at Wayfair explained to us last month:

The one big problem CastleGate deals with is the cashflow question. If I am the supplier of this chair and I’ve got 1,000 right now, that just came out of my factory and Target came along and offered to buy 800 of them, I’m going to ship a container to Target, maybe get a smaller margin than I would from Wayfair, but I get the cash now. With Wayfair, I have to wait until it sells before I recoup my investment. There are a bunch of programs, within CastleGate, to incentivize them to do that. - Former Head of Global Fulfilment Engineering at Wayfair

Suppliers maintain the inventory risk and arguably take on more distribution risk by limiting the inventory to one channel. During periods of such high demand, Walmart and Target can pay upfront and companies like Overstock also provide suppliers with more flexibility. The drop-ship model certainly doesn’t offer the best experience for end customers, but it seems more attractive to the largest suppliers.

Maybe there was a counter-intuitive market over the last 18 months where even with limited container supply and $20,000 rates, suppliers had enough demand to sell inventory upfront or at the highest margin via their own drop-ship warehouses.

There could also be a marketing challenge for CastleGate Services. On last quarter’s earnings call, Niraj explains how CastleGate penetration was potentially limited due to a complex pricing structure that will be simplified this year:

[CastleGate pricing] was very clinical and it was very technically correct, but it was complicated. The ocean freight cost x the drayage cost, the brokerage fee is this, the cargo insurance is that, the induction charge depending on the location is this, the consolidation fees are that. So it was very complicated to understand your costing. What we did is we basically simplified it. We said, "Hey, look. Move the goods into CastleGate upstream. Induct them into our consolidation operation. Here's what you're going to pay," and they think of it as covering that ocean freight drayage, that inbound cost that they would have otherwise paid someone else. - Wayfair CEO, Q4 21 earnings

Although CastleGate adoption has been slow, the company is building two new fulfilment centres this year to meet capacity expectations. This was Niraj last quarter:

About the 2 fulfillment centers, one is just outside of Baltimore and one is just outside of Chicago. And the one in Baltimore has just recently opened. And the one in Chicago will open later in the year..at this point, we do not need to build it out for locations. So we're building it out at this point for capacity. We have an estimate of how much capacity we need, and we're building them out in order to handle that capacity. - Wayfair CEO, Q4 21 earnings

Wayfair’s CFO comments were even more interesting on this point:

We do expect to have increasing penetration of goods flowing through our CastleGate network…We have forward visibility on that with ocean freight. As CastleGate penetration grows, that gives us the confidence in our 27% to 28% gross margin targets” - Wayfair CFO, Q4 21 Earnings

The increased demand for Wayfair’s forwarding services is a leading indicator for CastleGate Fulfillment penetration. Also, over 90% of large parcels flow through Wayfair’s middle mile and 75% through the last-mile.

We can see the impact CastleGate has on Wayfair's unit economics below:

Source: In Practise, Wayfair 10-K
Source: In Practise, Wayfair 10-K

Wayfair saw a step-change in gross margin from ~24% in 2016 to ~29% today. From 2014 - 2020, the unit cost per shipped parcel decreased from $37 to $30 but increased again to $37 last year due to the spare capacity in the network.

However, it's interesting that Wayfair's 2021 gross margin only declined 70bps in 2021. We would've expected more deleverage given revenue declined 5% and fulfilment square footage slightly expanded. This was partly offset by the product gross margin which expanded 50bps to 43.7% and has improved by nearly 500bps in the last 3 years. This could be driven by product mix or simply greater economies of scale procuring inventory post-covid.

Either way, if CastleGate adoption does increase as management expect, the lower fulfillment costs and higher merchandising margins will propel Wayfair's gross margin comfortably above 30%.

It's hard to cut through the post-covid noise to understand the growth outlook for Wayfair and many other e-commerce companies. However, one thing we can't deny, is that Wayfair is focused on building the best customer experience in the home category. With committed founders leading the company, this could prove to be hard to beat in the long-run.

It has become very clear the role that logistics plays in providing an optimal e-commerce experience. And what you hear companies talk about advanced logistics, the only companies that you really hear talk about it a lot are Walmart, Target, Home Depot, Amazon and us. Without advanced logistics, it's very hard to provide that optimal experience. And frankly, it's very hard to control one of the major cost inputs. We feel very good about where we are. As the results play out, you're going to see that our ability to kind of keep being an outsized winner in the category is going to be very strong. - Wayfair CEO, Q4 21 Earnings