Wayfair Inc. (W) Q2 2016 Earnings Report, Transcript and Summary

Good morning. My name is Stephanie and I will be your host operator today. At this time, I would like to welcome everyone to the Wayfair Q2 2016 Earnings Release and Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. I would now like to introduce Julia Donnelly, Head of Investor Relations at Wayfair.

Good morning and thank you for joining us. Today, we will review our second quarter 2016 results. With me are Niraj Shah, Co-Founder, Chief Executive Officer and Co-Chairman; Steve Conine, Co-Founder and Co-Chairman; and Michael Fleisher, Chief Financial Officer. We will all be available for Q&A following today’s prepared remarks. I would like to remind you that we will be making forward-looking statements during this call regarding future events and financial performance, including guidance for the third quarter of 2016. We cannot guarantee that any forward-looking statement will be accurate, although we believe that we have been reasonable in our expectations and assumptions. Our 10-K for 2015 and our subsequent SEC filings identify certain factors that could cause the Company’s actual results to differ materially from those projected and any forward-looking statements made today. Except as required by law, we undertake no obligation to publicly update or revise these statements whether as a result of any new information, future events or otherwise. Also please note that during this call, we will discuss certain non-GAAP financial measures as we review the Company’s performance. These non-GAA financial measures should not be considered replacements for and should be read together with GAAP results. Please refer to the Investor Relations section of our website to obtain a copy of our earnings release which contains descriptions of our non-GAAP financial measures and reconciliations of non-GAAP measures to the nearest comparable GAAP measures. This call is being recorded and a webcast is available for replay on our IR website. Now, I would like to turn the call over to Niraj.

Thanks, Julia, and thank you all for joining this morning. We are pleased to report our second quarter results and share with you some exciting initiatives we have underway. We generated net revenue of $787 million in Q2, up 60% year-over-year and $756 million in our Direct Retail business, up 72% year-over-year. This represents Direct Retail dollar growth of $315 million versus Q2 2015, making this the third quarter in a row with the Direct Retail business has added over $300 million in revenue year-over-year. As we have noted in the past, we believe that we are taking a third to 40% of the U.S. online dollar growth in our categories. There is a secular shift underway as consumers shift home purchases away from brick and mortar stores and toward online purchases. We believe that the strength of our offering including vast product selection, beautiful visual merchandising, helpful customer service and quick shipping and delivery have positioned us as beneficiaries of that trend and allowed us to take such a significant share of the dollars as they move online. The key part of our value proposition is our ability to deliver home products to the customer quickly and conveniently. I’d like to update you on some of the strategic initiatives that we began to pursue over 18 months ago to improve and expand our domestic transportation and logistics infrastructure. Our business model has always been somewhat of a hybrid model, giving the customary seamless branded first party experience while leveraging a drop-ship model where we have leading selection yet take little to no inventory. We believe this model allows us to focus on the things we are good at, merchandising, marketing, sales and service, all underpinned by great technology, while allowing our suppliers to focus on what they are good at, product design and development, sourcing and manufacturing. The area of the physical value chain where we and our suppliers meet is domestic logistics. The domestic warehousing and its integration into transportation and delivery to the customer, an area where we have historically invested in backend technology integration with our suppliers to enable a seamless customer experience. With the scale we now have, we are optimizing the warehousing transportation, logistics part of the value chain in order to meet and exceed customer expectations. It’s important to note that after product cost, we have three cost lines that are roughly of the same proportion of cost today, advertising, which is to get customers; operational expenses, which are mainly driven by the team that is building the business; and transportation. Transportation expense is the only cost that can be optimized and lowered on a per order basis while benefitting all participants in the value chain Wayfair, our suppliers and most importantly our customers. Today, the majority of our product is shipped individually from a supplier’s warehouse to the customer, whether that product is a small table lamp where the last mile delivery can be by FedEx or UPS to the customer’s door or a large sectional sofa that must be delivered by a local trucking company brought into the customer’s home, unpackaged and sometimes assembled. Under our CastleGate program that began in earnest in early 2015, we are forward positioning our supplier’s highest volume products in our warehouses so that we can ship these products from our warehouse directly to the customer often with a next day or two-day delivery guarantee. With CastleGate, we effectively act as a third-party logistics provider to our suppliers, taking no ownership of inventory and receiving fees from suppliers for inventory management and fulfillment services. But this program is much more strategic than a simple third-party logistics provider. As I noted earlier, the benefits of the CastleGate program accrue to the customer, to our suppliers and to Wayfair. Customers are delighted by the next day or two-day delivery guarantee, on the site, which is possible both due to the strategic locations of our warehouses that can reach a vast majority of the U.S. population with a one or two-day ground shipping and due to the way in which our warehouses are operated and integrated into the transportation network. Suppliers benefit from the dramatically increased sales volume for their products as a result of the next day or two-day delivery guarantee, and they generally experience comparable warehousing costs and inventory turns as they see in their existing warehouses. Wayfair benefits not only from the incremental sales volume and increased customer satisfaction but also from reduced transportation costs, as we leverage the strategic locations of our warehouses and the volume of shipments coming from these warehouses. We also experience reduced damage rates as we take more direct control and reduce the number of touch points for an order. After launching in 2015 and entering 2016 with approximately 1 million square feet of warehouse space, we are now operating approximately 3 million square feet of warehouse space across multiple facilities in Kentucky, Utah and Southern California, with additional facilities in New Jersey and the United Kingdom coming on line this quarter. While a small portion of our revenue flows through these warehouses today, it is ramping very quickly, as we aggressively onboard suppliers and lease additional warehouse space to meet the backlog of demand from suppliers who are interested in participating. We are also beginning to take more direct control of our large item delivery experience for products that are too bulky to be delivered through FedEx and UPS. Historically, this portion of our catalog represents 25% to 30% of our revenue. These very large deliveries have always been a customer pain point in our industry with long delivery times, high damage rates and half day long delivery windows. We used to outsource the delivery of these very large items to a single, national, white-glove company. But in 2011, we began directly contracting with line haul carriers, pool point operators and last mile delivery agents in order to reduce costs and improve the customer experience. Just as we took steps in 2011 to leverage our scale and take more direct control, we are now taking further steps by optimizing our line haul trucking and shifting to full truckloads and operating our own pool points cross docks and last mile delivery facilities. Similar to CastleGate, this allowed us to speed up delivery times for customers, reduce cost per order over time and reduce touch points and damage rates. We also improved the service level we provide to customers by incentivizing delivery personnel based on customer feedback and applying our technology expertise to enable convenient features, such as scheduling delivery in cart upon check-out, which Steve will describe in more detail. In October 2015, we opened our first last mile delivery operation as a Wayfair lease facility and operated by Wayfair employees. We focused on honing the operation. And now that we have made significant strides in customer experience and operational efficiency, we are working on adding to the service levels and rolling this out across the country. Today, we are operating five of our own last mile delivery facilities, all in top 20 U.S. markets. And while it is still early days, the results are very encouraging with improving customer experience survey results. We intend to continue taking direct control of our line haul trucking pool points and cross docks and expect to have a total of eight metropolitan areas operating with our own last mile delivery facilities by Q1 2017 and double that by the end of 2017. I’ll now turn the call over to Steve to discuss some of the technological underpinnings of this expanded distribution network. Afterwards, I’ll give an update on our international business and on some of the strategic investments we are making.

Thanks, Niraj, and good morning, everyone. Managing the complexities of our logistics infrastructure would not be possible without our custom developed technology. Like all parts of our business, our logistics network was developed with technology and data at its core, and with a focus on optimizing for the home category where products come in a wide range of sizes and shapes, and can be bulkier, heavier and some times more fragile. We think there is a lot of opportunity to take our technology and data and transform the large item delivery experience for the customer. One recent new feature we added to our site is the ability for customers to schedule delivery of certain large items, such as the bedroom set or a large patio set at the time of purchase upon checkout. Rather than placing an order, receiving an estimated ship day and then subsequently receiving an email schedule of delivery date, a week or so later when the order is in transit, we allow customers to select their delivery date and time window right on the site as they complete their purchase. While the customer sees it a stress free convenient way to preplan their delivery, behind the scenes there is a lot more going on to enable this experience. Our technology takes a delivery location and product location to determine the eligibility and early as possible delivery date and then interfaces with the software of our last mile delivery facilities to provide the available delivery window to the customer. To improve the accuracy of the timeline, we leverage our ever-growing volume of big data around product ship times and supplier lead times. Customers then have the ability to adjust the delivery window to accommodate and change in their schedules from the site or from the mobile app. We’re also applying complex algorithms in our CastleGate program to enable our next day or two-day delivery promise for our smaller parcel products, which can range in size from propellers to queen size of upholstered headboards. Customers can filter their search results on our site to only shop products with the next day or two-day deliver promise. For every product on our website that offers that promise, our technology needs to know the real-time CastleGate inventory, the customer delivery location and the locations and utilization of the trucks in our network. We forecast the cubic feet availability per truck on a continuous basis, and utilize data around store cut offs each day at all possible hubs. Our algorithms predict how much space we need to reserve on trucks for our next day or two-day guarantee, and how much other product going in the same direction can fit, which allows us to maximize our guarantee and coverage and our truck utilization and cost efficiency. These integration and partnership with FedEx and UPS are also required in order to optimize around carrier source schedules to increase efficiencies and reduce cost and to bypass local carrier hubs and inject product directly into four carrier hubs. All of this data allows us to decide in real time what delivery promise we can make for each individual customer on every possible product. Over time, our teams of engineers and data scientists will continue innovating to make our delivery experience faster and even more convenient for the customer. One product feature we’re working on is real time mobile app tracking of delivery trucks from Wayfair’s last mile facilities on their way to customer’s home. This would allow us to provide a shorter more accurate delivery window and an Uber like experience to the customer. This is just one of many examples of future product features our team of over 700 engineers is working on today to enhance the customer experience and generate more repeat purchases in the future. I’ll now turn the call back over to Niraj.

Thanks Steve. I’d now like to update you on the performance of our international business. As a reminder, we’ve operated sites in the UK since 2008, and Germany since 2009. But in 2014 and 2015, we began laying additional ground work in Europe to deepen the product catalog and build out the supply chain. We have served Canada through our U.S. site since 2008 but in early 2016, we launched the wayfair.ca site that’s targeted specifically at the local Canadian market. With a solid offering in place in the UK and Canada, we began to ramp advertising spend in these two countries in 2016 to fuel customer acquisition and brand awareness. I am pleased to report that our international business continued to show strong growth in Q2, reaching $54 million or 7% of total net revenue. Of total international growth, international Direct Retail growth was 170% year-over-year, excluding the impact of the Australian business that we divested last year. While we continue to monitor the recent political events in the UK, our long-term vision for that business has not changed. Our German business is in earlier stage as we deployed resources there later than in the UK. Our Canadian business benefits from the logistics infrastructure we have in the United States. And we are now able to serve approximately 40% of the Canadian population with a two-day delivery as we ship an average of five trucks each day from our Kentucky warehouses. With a nearly $250 billion addressable market in Western Europe and a relatively underserved Canadian market, we continue to be excited about the market opportunity we have in the UK, Germany and Canada, and our ability to leverage the technology, ad spend and logistics playbook we have developed in the U.S. over many years. You will hear more about this in a minute from Michael, but I did want to talk a bit about some of the mid-term and long-term investments we are making in our international business and our transportation and logistics network and in our core business with new product and service offerings such as wedding registry and the home improvement categories. These initiatives do not contribute meaningfully to revenue today but they do weigh on gross margin, they deleverage ad spend and in particular, they increase OpEx as we hire employees to staff the teams dedicated to these initiatives. For example, there are approximately 1,000 people focused on ramping up these new initiatives that would provide meaningful revenue and profit generation in the future but today do not contribute meaningfully to revenue and certainly significantly hurt profit. If you add up the compensation expense for these people and other operating expenses associated with these initiatives, such as rent versus new still heavily underutilized facilities, the run rate annual cost is in excess of $100 million in operating expense, the vast majority of which is people. These initiatives also involve investment in the gross margin and ad spend lines but we have delivered consistent gross margin and leveraging and ad spend on an aggregate basis because of the strength of the core underlying U.S. business which masks the drag on the overall P&L. If you add the gross margin investment and ad spend investment tied to these initiatives to the over $100 million in operating expense, the aggregate cost would be in access of our total adjusted EBITDA losses. Steve and I have said since we went public that as substantial owner operators, we will run the business in a way that continues to focus on the extraordinary long-term opportunity. What that means is that we will make the right long-term investments as long as they show progress. As an example, when we went public, we said we would invest heavily in ad spend and then would be leveraging ad spend as a percentage of revenue as we saw the payback on those new customers. We’ve now delivered consistently on that since the beginning of 2015. Today, we feel the same way about our investments in our international business, our logistics infrastructure and our new product and service offerings. We began most of these initiatives in 2015, at the end of the second quarter 2016. We now feel that we have largely finished staffing them. With the OpEx headcount investment in place, we’re excited about the future flow-through of profitability in 2017 and beyond, as revenue and contribution margin from these initiatives begin to overtake the OpEx headcount investment and flow through to the bottom line. We’ve never been more bullish about the long-term opportunity for our business and the potential benefits in 2016, 2017 and beyond of all of the initiatives we have underway. I will now turn the call over to Mike.

Thanks Niraj, and good morning everyone. As always, I will highlight some of the key financial information for this quarter now, with more detailed information available in our earnings release and an updated set of charts in our investor presentation, which can be found on our IR website. In Q2, our total net revenue increased 60% year-over-year to $786.9 million. As in recent quarters, this growth was driven by our Direct Retail business, which increased 71.6% over Q2 2015 to $755.7 million. Our other business, which primarily includes revenue from our retail partners, but also includes revenue from our small media business and CastleGate logistics program, decreased as expected 39.2% over Q2 2015 to $31.3 million as we continue to ramp down our retail partner business. As Niraj mentioned, this quarter, the Direct Retail business, increased $315 million versus Q3 last year. We’re pleased to have maintained this momentum, even as we reach a larger scale and increasingly comp of a larger base of revenue. This growth has been fueled by the U.S., where we believe we’re taking between a third and 40% of the U.S. online dollar growth in our categories, and benefiting from higher brand awareness and repeat purchases. As I’ve discussed in past quarters, providing guidance can be difficult in a high growth business, where you also need the consumer to show up every day and make purchases. This quarter, we beat the top end of our revenue guidance but not by as much as we have in previous quarters. One of our challenges in striking revenue guidance is forecasting next quarter’s performance in the context of the dramatic sequential acceleration of growth from last year, on top of which we are now comping. As a reminder, the Direct Retail quarterly revenue comps in 2015 increased from 63% in Q1 to 81% in Q2 to 91% in Q3. Interestingly, if you look at the two-year stack for Direct Retail growth, which many of you do in your analysis and reports, it has been extraordinarily consistent with a range of 145% to 155% for the last six quarters. This quarter’s Direct Retail growth of 71.6% is right in line with that range, with a two-year stack of 152%. As I mentioned last quarter, we were not guiding for Q2 to create an outsized beat, but rather to be prudent, particularly in light of an exceptionally strong June of 2015. These accelerating comps and the two-year stack, impact how we’re thinking about Q3 and Q4 2016, which I’ll describe more in a few minutes. In Q2 2016, our earlier stage international business in Europe and Canada also exhibited strong growth. Though still relatively small, international direct revenue increased 170% versus Q2 2015, excluding the impact of other revenue from our international retail partners and the impact of our Australian business that we divested last year. Our total net revenue growth remains incredibly high on an absolute basis. And we have been able to continue delivering this growth while maintaining compelling underlying unit economics. We’ve consistently held gross margin in the mid-23s to 24% since we went public. And the second quarter of 2016 represents the sixth quarter in a row where we have demonstrated year-over-year ad spend leverage, despite the funding of substantial new advertising investments in our international business. Our gross profit for the quarter, which is net of all product costs, delivery and fulfillment expenses was $188.5 million or 24% of total net revenue and was slightly above our near-term target margin in the mid-23s. The remaining financials I will share on a non-GAAP basis excluding the impact of equity-based comp and related taxes, which totaled $11.3 million in Q2. For a reconciliation of GAAP to non-GAAP reporting, please refer to our earnings release on our Investor Relations website. Customer service and merchant fees were 3.8% of net revenue for the quarter. Though there will be some quarterly fluctuations, we generally expect this expenses to be variable. Advertising spend was $94.4 million in the quarter or 12% of net revenue compared to 12.5% in Q2 last year. This represents year-over-year ad spend leverage of 50 basis points in the quarter and was similar to the leverage we saw in Q1. Ad spend efficiencies are driven by our increasing mix of orders from repeat customers because we spend less on advertising to get our existing customers to buy again then to acquire a new customer. The pace of our year-over-year ad spend leverage moderated in the first half of 2016 when compared to the pace of our ad spend leverage in 2015 because ad spend leverage in the U.S. is being partially offset by increasing advertising investments in Europe and Canada to fuel new customer acquisition. We expect the remainder of 2016 to show very modest leverage year-over-year as we continue to invest in our international markets. We added approximately 598,000 net new active customers this quarter, bringing LTM total active customer count to 6.7 million customers, up 65% year-over-year. LTM net revenue per active customer increased to $404, up 13.2% year-over-year. We also saw continued strong repeat purchase behavior with 58% of orders coming from repeat customers, a new high watermark, and LTM orders per active customer at 1.7, up from 1.67 a year ago. Our merchandising, marketing and sales spend on a non-GAAP basis was $38.1 million or 4.8% of net revenue, compared to $20.6 million or 4.2% of net revenue in Q2 last year. Non-GAAP operations, technology and G&A expense was $64 million for the quarter, or 8.1% of net revenue, compared to $33.1 million, or 6.7% of net revenue in Q2 2015. These two expense items consist primarily of headcount expenses and their increase reflects the accelerated pace of hiring we had in the back half of 2015 and the first half of 2016 to keep up with revenue growth and to invest in the new initiatives, Niraj discussed earlier. In the second quarter, we added 794 net new employees for a total of 5,398 employees as of June 30, 2016, up 89% versus June last year. Of the 5,398 employees we now have, approximately 670 of them or 12% are located in Europe. The majority of the compensation expense for the new hires during the first half of 2016 resides in the merchandising, marketing, and sales, and operations technology and G&A expense line. As we noted on prior calls, accelerated hiring we saw in the first half of 2016, has been a catch-up period, as our recruiting team ramped up. We believe we’re now well-staffed for our strategic initiatives and expect to hire at a slower pace in the back half of the year. Adjusted EBITDA for the quarter was negative $24.9 million or negative 3.2% of net revenue compared to our guidance of negative 3.2% to negative 3.6% and compared to negative $5 million or negative 1% of net revenue in the same quarter a year ago. The increase in our adjusted EBITDA loss margin versus Q2 last year, was driven primarily by increased operating expense as a result of the hiring in the U.S. and Europe I just described, and to a lesser extent by unutilized facilities costs as we ramp up our logistics infrastructure. As I noted before, the unit economics of our business continue to remain strong with solid gross margin, year-over-year ad spend leverage, increasing mix of orders from repeat customers and increasing revenue per active customer in the second quarter, even as we grew active customer count to 6.7 million and continue to demonstrate extraordinarily high top line growth. These strong underlying unit economics enable investments in several key strategic areas of our business, which initially drag on gross margin, deleverage ad spend and particular increase operating expenses. As Niraj noted, these investments are driving our overall EBITDA loss and are being offset by the continued success and contribution of the underlying U.S. business. I would like to take a minute to elaborate on each one individually and how it impacts our financials. We described during our last call how our investments in our international business weigh significantly on our P&L in terms of gross margin, ad spend and OpEx. In logistics, we believe our growing infrastructure will drive revenue uplift as we increase customer satisfaction and to link customers with a next day or two day-delivery guarantee nationwide, but there is also a headwind to revenue as we take new sales tax nexus in the states where our warehouses, pool points, cross stocks and delivery depots are now located. We have now taken nexus in nine states, and 40% of our revenue in the second quarter was therefore subject to sales tax. On the cost side, our efforts to ramp up our infrastructure should in the medium to longer term reduce cost per order as we benefit from more scale efficiencies. But there was some drag initially as we ramp volume to full efficiency levels and ramp up new warehouse space in step functions and there the rent and occupancy cost of unutilized square footage. For new product and service offerings such as wedding registry which we plan to launch later this year, we’re incurring compensation expense as we hired new product, marketing and engineering personnel in advance of any revenue generation. The goal of all of these investments is to return future incremental revenue growth, increase customer satisfaction service levels, lower our cost per order and therefore lead to incremental profitability in the future. We will continue to closely monitor these investments as we always do to ensure that we are seeing the proper ROI and customer response. Non-GAAP free cash flow for the quarter was negative $19.4 million based on net cash from operating activities of $24.9 million less capital expenditures of $44.3 million. As expected, CapEx spending was 5.6% of net revenue this quarter, driven by ongoing investments in our data centers and technology infrastructure, and equipment purchases and improvements for leased warehouses within our expanding supply chain network. While CapEx as a percentage of net revenue ran a bit higher this quarter, we continue to expect full year 2016 CapEx to be approximately 4% of net revenue. It’s also worth noting that our expanding supply chain network is primarily asset light, meaning we lease warehouses and don’t own any trucks as opposed to taking these assets on to our books. Our warehouse facilities are also optimized for bulky products that are often not conveyable, meaning the level of equipment purchases and automation is relatively low on a per square foot basis, keeping CapEx costs lower. Our inventory level was $17.4 million or 0.6% of LTM sales compared to 0.7% last quarter. Non-GAAP diluted net loss per share was negative $0.43 or negative $0.57 on a GAAP basis on 84.8 million weighted average common shares outstanding. As of June, 30, 2016, we had approximately $353.5 million of cash, cash equivalents and short and long-term investments. Now, let me give our guidance for the third quarter. As I mentioned earlier, we are comping off extraordinarily high Direct Retail growth from Q3 last year of 91%. And it’s my goal to create guidance that is thoughtful and prudent. For Q3, we are forecasting direct revenue between $790 million to $815 million, which year-over-year represents a revenue increase of $245 million to $270 million and a growth rate of 45% to 50%. These growth rates seem appropriate in light of this steep acceleration of our growth last year, and the relatively consistent two-year stack growth, we’ve seen over the last year. As I’ve done in the past, to provide transparency, please note that our quarter to date Direct Retail revenue growth is currently comping in the mid to high-50s. We forecast other revenue to be between $30 million to $35 million, down 39% to 29% year-over-year as we continue to deemphasize the retail partner portion of this business. This equates to total net revenue of $820 million to $850 million. We forecast adjusted EBITDA margin of negative 4.25% to negative 4.75% for Q3. Our continued losses at these levels are driven primarily by our ongoing aggressive investment in our international business and the other OpEx headcount and related investments, Niraj and I have described earlier on the call. We’re now caught up on our hiring to staff these many initiatives and that headcount in both our international business and U.S. business is a critical investment in the future long-term growth of Wayfair. We have always said that will make the investments necessary to take advantage of the long-term opportunity created by the significant accelerating shift online in our category. Small moments in our revenue forecast, have an outsized impact on our EBITDA margins, as we are not rescaling our investments which are all mid to longer term in nature. We do expect to continue showing good unit economics, with gross margin continuing in the mid-23s, solid contribution margin and some ad spend leverage, albeit much smaller due to the continued ramp of our international investments. OpEx cost as a percentage of net revenue will continue to rise in Q3, with the full run rate impact of our first half, catch-up hiring and then should show good sequential leverage in Q4. We continue to target breakeven adjusted EBITDA in Q4, so this will be highly dependent on the level of revenue growth we guide next quarter for Q4. Stating the obvious, since we’re targeting breakeven and our cost structure based on our investments to somewhat set in place, small incremental revenue growths have the potential to drive Q4 either just over or under the breakeven level. We will update you on this next quarter but nothing has changed in both our long term focus on making the right investments in the business and our desire to drive the business to free cash flow positive and EBITDA breakeven and profitability in the near to mid-term. For modeling purposes for Q3 2016, please assume equity-based compensation related tax expense of $15.7 million, average weighted shares outstanding of 85.1 million and depreciation and amortization of approximately $16 million. Now, let me turn the call over to Niraj, before we take your questions.

Thanks Michael. Before we wrap up, I’d just want to reiterate one concept that Michael mentioned. We’re running the business today with very consisting gross margins and contribution margin. With an approximate contribution margin on incremental revenue of 20%, we’ve used these incremental contribution dollars, which are large because of our large dollar growth, to make the important investments that we’ve been discussing today, in the international market markets, in our distribution and logistics network, and in new product and service offerings. The assets primarily in the form of people and real estate to drive those initiatives are largely in place now. And our continued strong growth at massive scale will continue to deliver large contribution dollar flow-through and create leverage, particularly in the OpEx line as we move into Q4 and 2017. I could not be more excited about how our business is resonating with customers. As we’ve always done, we will continue to make the right investments to deliver an exceptional experience across the board to our growing audience of new and repeating Wayfair customers. Now, having our teams fully staffed against these initiatives, we are excited to execute on our plans and deliver for our customers and drive solid financial performance. We’d now be happy to take your questions. So, I’ll turn the call over to the operator.

Thank you. Ladies and gentlemen, we will now conduct a question-and-answer session. [Operator Instructions] Your first question comes from the line of Neely Tamminga with Piper Jaffray. Your line is open.

Good morning. This is Kayla Wesser on for Neely. As we think about new customer acquisition, just wondering if you could talk more about some of your new strategies like registry and loyalty, and more specifically in terms of timing of rollout and maybe key attributes of the programs? And any sense on if these programs are being requested by your current customers? Thanks.

Thanks, Kayla. This is Niraj. So, in terms of the new things you mentioned; so, a few different things in there. Our loyalty program, we revamped that with the launch of the private label credit card last fall in August, September timeframe of 2015, and that’s gotten off to a really nice start. So, we’ll give you an update on that in the near future, but that continues to ramp and we’ve been working on version 2 of that -- and not a revamp but additional set of things are going roll out pretty soon. In terms of the registry, we -- the soft launch for that is actually coming up shortly and that will fully launch in the early fall, which I think we’ve mentioned. And there are lot of the things we’re doing for customers to allow them to basically grow their share of wallet us are things that we’ve mentioned in the past around seasonal décor decorative, the home improvement categories, and those are initiatives we’ve been working on for a while that kind of continue to roll out as we speak. So, all these things are sort of in play now. And one of the things we tried to mention on the call was that all of these efforts were started in 2015 or before. And so, we’ve been at these for a while and we’re exciting about the time period now as that they are actually all starting to reach market. So, we sort of expect to see exciting things come from them as we move forward.

Your next question comes from the line of Seth Basham with Wedbush Securities. Your line is open.

Thanks a lot, and good morning. My question is around orders per active customer. And we saw that network increase on an LTM basis but year-over-year in a quarter it was down. As you invest in all these initiatives to improve share of wallet as you just mentioned, how are you thinking about orders per active customer going forward?

We would expect orders per active customer over time to go up. The main metric we really look at is the dollars per active customer but the two are pretty closely related because our strategy is not to prioritize AVO over orders, it’s really to prioritize total customer share of wallet which really means you need to drive orders. So, expectation is that you should see that number rise. As you know that’s a slow number to move either up or down, because of the way it lags the current events. And so, our expectation is basically that it’ll continue to go up, albeit slowly.

Okay, that’s helpful. As it relates to AOV specifically, we saw really strong growth once again this quarter. Can you give us a sense of the drivers behind that improvement and how we should think about AOV going forward?

Yes. So AOV, the thing about AOV is it’s really an outcome. And so, AOV gets driven by a few different things, but the primary thing AOV gets driven by is basically category mix shift. And so, I mentioned seasonal décor and decorative accents, as those scale and take some share from the total, they’ll pull down AOV, while the home improvement categories which are some of the earlier categories of the emerging ones that started to grow will pull up AOV. And then, you have some things like our international business, which in general today would pull down AOV. So, you have this mix shift of different businesses and the mix shift of categories within business that makes that number move around. This is a little bit of wide -- we were talking about the average orders per customer a minute, AOV times that at the dollars per customer per year, and that’s kind of why you keep going back to the dollars per customer per year metric.

Your next question comes from the line of Matt Fassler with Goldman Sachs. Your line is open.

Couple of questions, first of all, when you talk about your two-year stack for Direct, it has been stacking quite consistent, 156 I believe in Q1, 152 in Q2. The high-end of your range [technical difficult] of the either range Direct would imply a little bit of deceleration in this two year stack. So, how should we think about that in terms of the management of the underlying business and what might be transpiring the op [ph] compares?

Yes. I think Matt that’s just us being sort of thoughtful and prudent. Obviously, it’s really tough when you’re trying to forecast against what was a massive acceleration in growth rate last year, on an already big base. And so obviously, we have the data where we’re at quarter-to-date, and as I said that’s sort of in the mid to high 50s. But at the same time I got a sort of straight guidance and knowing that I’ve still got chunk of a quarter left in front of me, and I’m working against an increasingly tough comp as the revenue accelerated throughout the quarter. So, it’s really just trying to be thoughtful about guidance setting within that context.

Got it. And then, second question, you spoke about the investments you made in people, you talked about the initiatives that you’re engaging in although thoughtful, do you think of these as essentially revenue driving over time, or in essence revenue preserving or franchise enhancing in that way. So, do you see a return on, I guess, those operating expense dollars, the same way you very closely measured and delivered on returns on your ad expense dollars?

Yes, thanks Matt. This is Niraj. I would tell you to think about them as revenue driving. So, the way to think about them is you have things like new categories or offerings like registry and home improvement, which are easier to see how those are revenue driving or internationally you see revenue driving. But, when you think about the logistics investments, they basically -- the primary thing they do is they improve lifetime value and they drive up conversion rate. And both of those are very revenue driving activities. And so, I think you have to think of everything we’re doing is revenue driving. And the thing I would say is the difference between like preserving enterprise value or defensive moves and offensive moves are largely a function of time in the sense that if you think about what the customer wants and you are very aggressive about it early, you effectively not only get the benefit of the customer reaction to that which is revenue driving but you build the most then forces others to fall behind, they then do it to try to preserve their revenue, they try copy you but it’s very hard to catch up. So, the nuance between the two I think is maybe slightly smaller than you might think of first flush.

Your next question comes from the line of Oli Wintermantel with Evercore ISI. Your line is open.

Yes, good morning guys. I had a question regarding the EBITDA guidance for the next quarter. It looks like it’s a bigger step down in the third quarter year-over-year versus we saw it just in the second quarter. Can you maybe give us some insight into what drives that; is that more on the international side; more on the U.S. side, or what is driving it?

Yes. Hey, Oli; it’s Michael. I would say it’s really driven by both, but primarily the starting point is the continued international investment. As we noted on the call, we have 670 people in Europe now; obviously that’s a substantial investment against what is still a small albeit very fast and increasingly growing revenue base. So, I think piece number one in terms of sort of thinking about where our losses are coming from is certainly the international business. The second is as Niraj spoke about on the call, we are making some substantial investments in our distribution and logistics infrastructure here in the U.S. and that has a cost as well, as well as all these new areas that we’re investing in, the home improvement categories, registry et cetera. So, I think the place you’re going to see it is you’re going to see it increase in the OpEx line and particularly you’re going to continue to see growth on a dollar basis from Q2 to Q3 in the OpEx line. And then you’ll really start to see the leverage in that line in Q4 as we start to slow the pace of hiring in the back half of the year when we are really sort of catching up and more aggressively hiring focusing all of those categories in the first half of the year. Then, you’ll see it effectively deleverage in Q3 and then leverage in Q4.

If I can just chime in for a minute on that question, Oli. So, just a couple of points. If you look at the OT G&A and MMS lines added together, which are basically the OpEx line really driven by headcount in particular and you see this quarter is at 11.4% of revenue. If you look at a year ago, it was 9.4% of revenue. So, it went up 200 basis points. Now, if you look at what happened last year, you’ve seen in Q3, it actually went down from 9.4 to 8.6, so it went down 80 basis points. And at the time we mentioned that hiring was slower than we were hoping to have it, and we talked a lot about it. Well, do you think to be able to hire people you want? We said, we will. We have a pretty infrastructure in place. And then couple of quarters later, quarter later we mentioned that we now have infrastructure in place. Well, the point is what you see now is you see that we’ve hired all these folks. In this quarter we hired a net new 794 people. And so, we’ve hired all these folks, you see that line and deleverage and what is basically reflecting is that we’ve hired OpEx folks at a rate faster than revenues hired but it’s not against the revenue, it’s against the initiatives which were basically having [ph] future revenue. So, what would happen is that that line which in the third quarter of last year was 8.6% went down from the second quarter, this year, now we’ve hired all these folks but they are now on payroll, it won’t -- now they are going to be paid for full quarter. So, it’s not going to go down right away, it will go down now over time as the revenue continues to grow. But to Michael’s point, we’re not continuing to ramp up hiring, so not just because it’s against the revenue but also because the rate the hiring slows. So, these initiatives which are really about the future, which I mentioned a $100 million for the OpEx, OpEx is really the people and some of the rents, but these investments have a huge deleveraging effect on gross margin and on ad cost. If you added all of that together, the cost in these initiatives is very, very large. If you go down to this list of the little over dozen initiatives, they are actually very, very substantive in what they will do from a competitive advantage standpoint, what they will do for future revenue, what they do for lifetime value, all of these spaces. So, we’re thrilled about them. What you’re seeing is a consequence of sort of the full cost of the all them now hitting, and you’re not seeing the benefit of many of them yet. However, not time last, [ph] but you’re seeing that they are now starting to roll out. So, we’re very excited about the kind of near to mid future but there is big opportunities here when we think about -- as Michael mentioned, the vast majority of this internationally, we think about the magnitude of that effort and then, after that you scale and you think about the logistics network and then magnitude of that and then you think about sort of category expansions, it does add up.

That’s helpful, thanks. And just quickly on the gross margin line, it was 23.8 in the third and fourth quarter, that’s right in line with your near-term guidance. Is that a prudent assumption for the second half at all?

Yes. I think we continue to target mid-23s, and we sort of said mid-23s to mid 24, we came in a little high this quarter. But also remember, Q4 is the holiday period, typically a place where sort of everyone gets sharper on price and therefore margin tightens up.

Your next question comes from the line of John Blackledge with Cowen and Company. Your line is open.

Just a couple of questions. So, for the CastleGate initiative, could you discuss the conversion rates or items that are available for delivery in one or two days versus comparable items that are available at later delivery dates? And then what percent of small parcel inventory is available in one to two-day delivery at this point? And then, I have a follow-up.

Sure. So, on the conversion rate lift, that’s not something we publically disclose but there is a meaningful conversation rate lift, when we promise that fast delivery on these larger bulkier items. In terms of the percent of our business that is going through the fast delivery network, I would basically describe it today’s high single digit percentage of our revenue is flowing for that network and we believe we’re now in a position to ramp it quite quickly.

And just a quick follow-up, Michael, could you give us a sense of the second quarter EBITDA in the U.S. and international and also ad expense in the U.S. and international, and when will you break out U.S. and international results? Thank you.

We did see greater ad leverage in the U.S. We’re not giving the specific details, because we’re not going to sort of keep doing that. But we did see greater ad leverage in the U.S., obviously offset by the investment in the international business. I think using the back of the envelop math we’ve given everybody in previous quarters; you can look at almost all of the losses this quarter as being tied to the international business. And it’s not hard to get there when you sort of add in the operating cost of that business plus the lower gross margin, lower contribution margin and less than lower -- higher ad spend. And in terms of sort of breaking out, I think we recognize that everybody has a great interest in sort of better understanding the international U.S. split, at the same time it still represents 7% of the business albeit one that’s growing very quickly. And so we’re carefully considering sort of what’s the right time and the right format to give additional detail.

Your next question comes from the line of Michael Graham with Canaccord. Your line is open.

Hi, thank you. Your old framework that we had been discussing around margin progression in the out years was sort of a couple of hundred basis points of expansion per year. You’ve got a lot of investing going on. I’m wonder if you have any comment on that just philosophically; you took a step backwards in profitability in Q3; would you be willing to do that in the future? And then related to that, the two things that could extend this framework of investing beyond what you’re talking about are more products and geographies beyond, and I am just wondering if you can comment on how you’re thinking about those possibilities.

Sure. Let me start with the expansion categories and geographies. On categories, we’re very focused on just being a home player. So, when we talk about our categories, we talk about furniture, décor, and we talk about the finished parts of home improvement which are like plumbing and lighting, flooring, these are the categories that our consumer, that she is picking herself, not things for the builder, we talk about house-wares and kitchen. So, we’re not terribly interested in expanding that list. So, if you think about the ones that we have talked that we’re pushing into, they are effectively just flushing out that list, but we’re not really looking to change that list, if that makes sense. So, don’t look forward to us entering media or parallel or these adjacent categories. We’re very focused on home and within the construct of what I just described. In terms of geographies, we’re very much focused on the four countries we operate in today. So the United States and Canada, North America and in Europe it’s the UK and Germany. And those are very large markets that have a lot of opportunity. And as they continue to scale up, it will open up for other geographic opportunities, which are adjacent. But to be honest, right now, we’re focused entirely on those forward geographies. So, I would think about kind of the near-mid-term oriented around that construct where we believe there is a huge amount of opportunity in those geographies with the home offering and that’s absolutely what we’re focused on. In terms of the margin expansion question that you started with, the way I would describe it, the way I believe that we’ve always said is that we’re very focused on getting to free cash flow positive, which is the way operated the business for the first decade, which is why Steve and I were able to effectively own the portion we own today, and we believe that’s a really good way to function. And so, the fact that over the last few we raised a lot of investment capital, build the brand and we’re operating at a loss, that’s not a place we really want to be. And so, we’re very focused on getting free cash flow positive, EBITDA positive and self funding our growth. That said, we’re very interesting and being very ambitious in capturing what we believe to be a very large opportunity that we don’t believe will last forever. So, in that sense, we’re certainly anything that is prudent in the confines of the strategy we have around the categories, the markets we’re interested [ph] in we’re certainly going to pursue. And so, our ideal strategy is to pursue that while generating our own investment capital and not having to do that by raising outside capital, which is obviously very dilutive. So, in terms of the rate of margin expansion, what we say is very focused on getting to this free cash flow positive, EBITDA positive place. And we expect that the expansion of margin will continue because the amount of flow-through contribution margin exceeds our ability to invest it. But we said that while we’re very focused on getting back to where our self funding, we’re less focused on the time period it takes to get from there to the targeted long-term EBITDA, because we expect that to be impacted by investment opportunities, some of which are hard to predict the timing of which today. But despite that, we don’t expect to be able to spend he flow-through EBITDA on wide investments. So we expect it to continue to flow through, thus increasing our EBITDA percentage, which is why Q1 of 2014 we were at negative 7% EBITDA and even with this headcount ramp that we just talked about, which took us down on EBITDA percentage, we think we’re going to swing back out from that fairly quickly in the not too distant future. So, that’s the way I would kind of define. When we talk about gross margin expansion, we always talked about private label ramping, which is something that’s ramping nicely. We talked about transportation cost efficiencies. Our logistics network is a driver of that. We just gave you a pretty good update on that. And we talked about buying power from volume. And even, there were some comments about how our growth is decelerating and we’re comping up 90% growth, frankly growth will decelerate and frankly the rate we’re growing at scale [ph] we’re growing growth at, growth will decelerate. I’d just remind you, the market is only growing in 12, 15, something percent depending on where you believe our market growing at, the overall market is growing few percent. We think, even if this growth decelerates “we’re going to still be growing at a very excess growth rate to continue to take significant share and while preserving that flow through contribution margin 20%.” I know that’s longer answer than you’re looking for, but I was hoping to tie it altogether.

That was the exactly what I was looking for. Thank you, Niraj.

Thanks. Operator, I think we have time for maybe one more question.

Certainly. Your last question comes from the line of Chris Horvers with JP Morgan. Your line is open.

I just want to understand, as you put back the two-year stack in the different business, can you talk about what the experience then in the U.S. and then is there a U.S. only? And then, is there a point in time, that you can look out to say, international business is X percent of revenues today, but once it gets to a certain scale that backs actually then the two-year stack to a higher level? Thanks.

Yes, Chris, I think we -- obviously, we’re not -- we’ve given you the international growth; it’s obviously on a small base. This was a 170% that we try to do the math to exclude the partner business as well as the Australian business that we divested to see how to sort of clean math, which you’ll need because that detail isn’t in the Q. And so -- but it’s obviously still a small pieces of the whole. The U.S. business continues to chug along at a sort of a substantial growth rate, because it’s vast, vast majority of the business. I do think that if some point in time that business has very long legs, we’re tiny compared to the market opportunity. You’ll remember roundly, the Western European market is $250 billion like the U.S. business. So, there is a ton of room to go versus the $50 million business we have there today. So, I think the opportunities exist to scale and then be a meaningful sort of accelerating growth contributor exists but it’s got a long way to go to sort of get to the scale we can outstrip what continues to be extraordinary growth on a massive base of the U.S. business.

I think that’s a good summary. We mentioned that the direct international business grew 170% in the quarter, and despite that it ticked up to 7% sales. So, can see the relative size of it, it’s going to be a drag. I think the way to think about it is, if you think about these things independently, and I know you guys ask hey, at some point, can you give us the full segment financials and what have you, so would be helpful. And we’re aware of that. You have these different exciting growth things going on, you’ve got these international businesses where you can’t treat it as one thing, you are really need to think about Canada separate from the UK, separate from Germany. In the U.S., you have wayfair.com which is our dominant brand in the U.S. but you have other brands Joss & Main and AllModern, and they are all on different growth trajectories. And so, there is a lot of things going on that all add together to give you this aggregate growth number. And that’s why you can see these different trends in terms of how it’s going to play out over time being perhaps a little more volatile than if you’re kind of steadily growing at a few percent a year off the expansion of new units being added that are fairly predictable. But the opportunity is I think much lower because of the disruptive nature of the internet and the fact that at the speed at which the share is changing hand. So, we’re certainly very focused on that. We obviously run the business in a very granular way to make sure that each individual effort and the funding we’re giving it is paying off. And then, when you add it up, these patterns that to be fair kind of hard from the -- you have I would say to model out precisely, but there are certainly very exciting growth things underway that we expect to see flow into results over time.

Great, thanks everybody for joining the call today. And we look forward to talking to you next quarter.

Bye, guys.

This concludes today’s conference call. You may now disconnect.