Wayfair Inc (W) 2016 Q2 法說會逐字稿

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.

(Operator Instructions)

I would 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 make 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 in 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-GAAP 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 web site to obtain a copy of our earnings release, which contains descriptions of our non-GAAP financial measures, 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 web site. Now I'd like to turn the call over to Niraj.

Thanks, Julia. 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 under way. 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 where 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 1/3 to 40% of the US online dollar growth in our categories. There is a secular shift under way, 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 has positioned us as beneficiaries of that trend, and allowed us to take such a significant share of the dollars as they move on line.

A key part of our value proposition is our ability to deliver home products to the customer quickly and conveniently. I would 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 customer a seamless branded first-party experience, while leveraging a drop-ship model where we have leading selections, 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 back-end technology integration with our suppliers to enable a seamless customer experience. With the scale we now have, we are optimizing the warehousing, transportation, and logistics part of the value chain in order to meet and exceed customer expectations.

It's important to note that after product costs, we have three cost lines that are roughly of the same proportion of costs 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 benefiting all participants in the value chain: Wayfair, our suppliers, and most importantly, our customers.

Today the majority of our product is shipped individually from the 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 2015, we are forward-positioning our suppliers' 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 accrued 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 US 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 on-board 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 out-source 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 carriers, 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 costs 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 of 2015, we opened our first last-mile delivery operation that is 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 the own last-mile delivery facilities, all in top-20 US markets. While it is 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 will now turn the call over to Steve to discuss some of the technological underpinnings of this expanded distribution network. Afterwards, I will give an update on our international business, and on some of the strategic investments we are making.

Thanks, Niraj. 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 sometimes 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 a bedroom set or a large patio set at the time of purchase upon check out. Rather than placing an order, receiving an estimated ship date, and then subsequently receiving an e-mail to schedule the 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 a stress-free convenient way to pre-plan their delivery, behind the scenes there is a lot more going on to enable this experience. Our technology takes the delivery location and product location to determine eligibility and earliest possible delivery date, and then interfaces with the software of our last-mile delivery facilities to provide the available delivery windows to the customer.

To improve the accuracy of the time line, 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 a change in their schedules from the site or from their mobile app.

We are 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 throw pillow to queen-size upholstered headboards. Customers can filter their search results on our site to only shop products with a next-day or two-day delivery promise.

For every product on our web site 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 for 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 guaranteed coverage, and our truck utilization and cost efficiency.

Deep integration with FedEx and UPS are also required in order to optimize around carrier sort schedules, to increase efficiencies and reduce cost, and to bypass local carrier hubs, and inject product directly into forward 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 are working on is real-time mobile app tracking of delivery trucks from Wayfair's last-mile facilities on their way to the customer's home. This would allow us to provide a shorter, more accurate delivery window, and an Uber-like experience for 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 will now turn the call back over to Niraj.

Thanks, Steve.

I would 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 groundwork in Europe to deepen the product catalog, and build out the supply chain. We have served Canada through our US site since 2008, but in early 2016 we launched the Wayfair.ca site that is 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 an earlier stage, as we deployed resources 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 under-served 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, add spend, and logistics play book we have developed in the US over many years. You will hear more about this in a minute from Michael.

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 de-leverage 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 will 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 for new still heavily under-utilized 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 leverage and ad spend on an aggregate basis because of the strength of the core underlying US 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 excess 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 there would be leverage in ad spend as a percentage of revenue as we saw the pay-back on those new customers. We have 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, and at the end of the second quarter of 2016 we now feel that we have largely finished staffing them. With the op-ex head count investment in place, we are 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 head count 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 under way.

I will now turn the call over to Michael.

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 web site.

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-medium 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 are pleased to have maintained this momentum, even as we reach a larger scale and increasingly comp off a larger base of revenue. This growth has been fueled by the US, where we believe we are taking between 1/3 and 40% of the US 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, in 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 out-sized 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 are thinking about Q3 and Q4 2016, which I will 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-23%s to 24% since we went public. 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 23%s.

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 web site.

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 expense to be variable. Advertising spend was $94.4 million in the quarter, or 12% of net revenue, compared to 12.5% in Q2 of last year. This represents year-over-year ad spend leverage of 50 basis point 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 than 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 US 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 moderate 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-water mark; 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 $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 head count 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 lines.

As we noted on prior calls, the 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 are 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 US and Europe I just described, and to a lesser extent by un-utilized 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 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, de-leverage ad spend, an in 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 US 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 investment in our international business weighs 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 delight customers with a next-day or two-day delivery guarantee nationwide.

There is also a head wind to revenue, as we take new sales tax nexus in the states where our warehouses, pool points, cross-docks, 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 costs per order, as we benefit from more scale efficiencies. There is some drag initially, as we ramp volume to full efficiency levels, and ramp up new warehouse space in step functions, and bear the rent and occupancy cost of un-utilized 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 and service levels, lower our costs 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, plus 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%. 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 the steep acceleration of our growth last year, and the relatively consistent two-year stacked growth we have seen over the last year.

As I have 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 50%s. We forecast other revenue to be between $30 million to $35 million, down 39% to 29% year over year, as we continue to de-emphasize 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 head count and related investments Niraj and I have described earlier on the call. We are now caught up on our hiring to staff these many initiatives, and that head count in both our international business and US business is a critical investment in the future long-term growth of Wayfair.

We have always said that we will make the investments necessary to take advantage of the long-term opportunity created by the significant accelerating shift online in our category. Small movements in our revenue forecast have an out-sized impact on our EBITDA margins, as we are not re-scaling 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 23%s, solid contribution margins, and some ad spend leverage, albeit much smaller, due to the continued ramp of our international investments. OpEx costs 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 break-even adjusted EBITDA in Q4, though this will be highly dependent on the level of revenue growth we guide next quarter for Q4. Stating the obvious, since we are targeting break-even and our cost structure based on our investments is somewhat set in place, small increments of revenue growth have the potential to drive Q4 either just over or under the break-even 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 break-even and profitability in the near- to mid-term. For modeling purposes for Q3 2016, please assume equity-based compensation and 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 just want to reiterate one concept that Michael mentioned. We are running the business today with very consistent gross margins and contribution margins. With an approximate contribution margin on incremental revenue of 20%, we have used these incremental contribution dollars, which are large because of our large dollar growth, to make the important investments that we have been discussing today -- in the international 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. Our continued strong growth at massive scale will continue to deliver large contribution dollar flow-through, and recreate 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 would now be happy to take your questions, so I will turn the call over to the operator.

Thank you.

(Operator Instructions)

Your first question is from the line of Neely Tamminga with Piper Jaffray.

Good morning, this is Kayla Wesser on for Neely.

As we think about new customer acquisition, wondering if you could talk more about some of your new strategies like registry and loyalty, and more specifically in terms of timing of roll-out and maybe key attributes of the programs? Any sense on if these programs are being requested by your current customers? Thanks.

Thanks, Kayla. This is Niraj.

In terms of the new things you mentioned -- 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 time frame of 2015. That's gotten off to a really nice start. We'll give you an update on that in the near future. But that continues to ramp, and we've been working on version two of that -- or not a revamp, but an additional set of things that will roll out pretty soon.

In terms of the registry, the soft launch for that is coming up shortly, and that will fully launch in the early fall, which I think we've mentioned. Then a lot of the things we are doing for customers to allow them to basically grow their share of wallet with us are things that we've mentioned in the past, around seasonal decor, decorative accents, the home improvement categories. Those are initiatives we have been working on for a while that continue to roll out as we speak.

All these things are in play now. One of the things we tried to mention on the call was that all of these efforts were started in 2015 or before, so we've been at these for a while. What's exciting about the time period now is that they're actually now all starting to reach market. We expect to see exciting things come from them as we move forward.

Your next question is --

I think we can.

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

Thanks a lot, and good morning.

Hello, Seth.

My question's around orders per active customer. We saw that metric increase on an LTM basis, but year over year in the 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?

Yes, thanks, Seth.

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. Our strategy is not to prioritize AOV over orders; it's really to prioritize the total customer share of wallet, which really means you need to drive orders. The 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 event. Our expectation is basically that it will 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. AOV -- the thing about AOV is, it's really an outcome. AOV gets driven by a few different things, but the primary thing AOV gets driven by is basically category mix shift. I mentioned seasonal decor and decorative accents. As those scale and take some share from the total, they'll pull down AOV. The home improvement categories, which are some of the earlier categories of the emerging ones that started to grow, will pull up AOV.

Then you have some things like our international business, which, in general today would pull down AOV. You have this mix shift of different businesses and the mix shift of categories within businesses that makes that number move around. This is a little bit of why we talked about the average orders per customer a minute ago; AOV times that is the dollars per customer per year. That's why I keep going back to the dollars per customer per year metric.

Understood. Thank you very much and good luck.

Thanks, Seth.

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

Thanks a lot, and good morning. A couple of questions.

First of all, when you talk about your two-year stack for direct, it has in fact been quite consistent -- 156, I believe in Q1, 152 in Q2. The high end of your range, or the entirety of your range for direct would imply a little bit of deceleration in this two-year stack. How should we think about that in terms of the momentum in the underlying business? And what might be transferring beyond compares?

Matt, I think that's just us being 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. Obviously, we have the data where we're at quarter to date. As I said, that's in the mid to high 50%s. But at the same time, I've got to strike guidance, and knowing that I still got a big chunk of the quarter left in front of me; and I'm working against an increasingly tough comp as the revenue accelerated throughout the quarter. It's really 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, all of it [thoughtful]. Do you think of these as essentially revenue-driving over time? Or are they in essence revenue-preserving or franchise-enhancing in that way? Do you see a return on those operating expense dollars the same way you very closely measured and delivered on returns on you ad expense dollars?

Yes, thanks Matt, this is Niraj.

I would tell you to think about them as revenue-driving. 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 international -- easier to see how it's revenue driving. When you think about the logistics investment, they basically -- the primary thing they do is they improve lifetime value, and they drive up conversion rate. Both of those are very revenue-driving activities. I think you could think of everything we're doing as revenue driving.

The thing I would say is, the difference between 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're 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 a moat that then forces others to fall behind. They then do it to try to preserve their revenue -- they try to copy you; but it's very hard to catch up. The nuance between the two is maybe slightly smaller than you might think at first blush.

Got it. Thank you so much.

Thanks, Matt.

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 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 US side? Or what is driving it?

Yes. Hello, 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.

I think piece number one, in terms 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 logistics infrastructure here in the US. 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.

I think the place you're going to see it is, you're going to see it increase in the OpEx line. Particularly, you're going to continue to see growth on a dollar basis from Q2 to Q3 in the OpEx line. Then you'll really start to see the leverage in that line in Q4, as we slow the pace of hiring in the back half of the year, when we were really catching up and more aggressively hiring folks in all of those categories in the first half of the year. I think you'll see it effectively de-leverage in Q3, then leverage in Q4.

If I could chime in for a minute on that question, Oli.

Just a couple points. If you look at the OTG&A and MMS lines added together, which are basically the OpEx line, really driven by headcount in particular, you see this quarter's 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. If you look at what happened last year, you see in Q3 it actually went down from 9.4% to 8.6%, so it went down 80 basis points. At the time, we mentioned that hiring was slower than we were hoping to have it. We talked a lot about, well, do you think you'll be able to hire the people you want. We said we will, we just didn't have the recruiting infrastructure in place, da da da. Then a couple quarters later, or a quarter later, we mentioned that we now have the infrastructure in place.

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. We've hired all these folks. You see that line de-leverage. What it's basically reflecting is that we've hired OpEx folks at a rate faster than revenue is hired; but it's not against the revenue, it's against the initiatives, which were basically harbingers of future revenue. What will 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're now on payroll. It won't -- now they're going to be paid for a full quarter, but it's not going to go down right away. It will go down now over time as the revenue continues to grow. To Michael's point, we're not continuing the ramp of hiring. It goes down not just because it's against the revenue, but also because the rate of hiring slows.

These initiatives, which are really about the future, which I mentioned $100 million for the OpEx -- OpEx is really the people and some of the rent. But these investments have a huge de-leveraging effect on gross margin and on ad cost. If you added all of that together, the cost for these initiatives is very large. But if you go down through this list of a little over a dozen initiatives, they're actually very substantive, and 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 things. We're thrilled about them. What you're seeing is the confluence of the full cost of all of them now hitting, and you're not seeing the benefit of many of them yet. However, enough time's elapsed that you're seeing that they're now starting to roll out.

We're very excited about the near to mid future, but there's big opportunities here. When you think about, as Michael mentioned, the vast majority of this is international. When you think about the magnitude of that effort, and then after that in scale you think about the logistics network and the magnitude of that, and then you start thinking about some of these category extensions, it does add up.

That's helpful, thanks.

Quickly on the gross margin line, it was 28 -- 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, then, as well?

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

Got it. Thanks very much.

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

Great, thank you. Just a couple questions.

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

Sure. On the conversion rate lift, that's not something we've publicly disclosed. But there is a meaningful conversion 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, it's -- I would basically describe it today as a high-single-digit percentage of our revenue is flowing through that network, and we believe we're now in a position to ramp it quite quickly.

Okay, that's great. A quick follow-up.

Michael, could you give us a sense of the second-quarter EBITDA in the US and international? And also ad expense in the US and international? When will you break out US and international results? Thank you.

Yes. We did see greater ad leverage in the US. We're not giving the specific detail, because we're not going to keep doing that. But we did see greater ad leverage in the US, obviously offset by the investment in the international business.

I think, using the back-of-the-envelope 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. It's not hard to get there when you add in the operating costs of that business plus the lower gross margin, lower contribution margin, and less than lower higher ad spend.

In terms of breaking out, I think we recognize that everybody has a great interest in better understanding the international-US split. At the same time, it still represents 7% of the business, albeit one that is growing very quickly. We're carefully considering what's the right time and the right format to give additional detail.

Thank you.

Thanks, John.

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

Thank you.

The old framework that we had been discussing around margin progression in the out years was a couple hundred basis points of expansion per year. You've got a lot of investing going on. I'm wondering if you have any comment on that philosophically. You took a step backwards in profitability in Q3. Would you be willing to do that in the future?

Then related to that, the two things that could extend this framework of investing beyond what you're talking about are more product and geographies beyond Europe. I'm wondering if you can comment on how you're thinking about those possibilities?

Sure. Let me start with the expansion of categories and geographies. In categories, we are very focused on being a home player. When we talk about out categories, we talk about furniture and decor, we talk about the finished parts of home improvement, which are like plumbing, lighting, flooring. These are the categories that our consumer, that she's picking herself, not things for the builder. We talk about housewares and kitchens. We're not terribly interested in expanding that list. If you think about the ones that we have talked about that we're pushing into, they're effectively fleshing out that list. But we're not really looking to change that list, if that makes sense. Don't look forward to us entering media or apparel 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 -- the United States and Canada in North America, and in Europe it's the UK and Germany. Those are very large markets. They have a lot of opportunity. As they continue to scale up, it will open up other geographic opportunities which are adjacent. To be honest, right now our focus is entirely on those four geographies. I would think about the near mid term oriented around that construct, where we believe there's a huge amount of opportunity in those geographies with the home offering. 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 -- what I believe that we've always said is that we're very focused on getting to free cash flow-positive, which is the way we operated the business for the first decade, which is why Steve and I were able to effectively own the portion we own today. We believe that's a really good way to function. The fact that over the last few years we raised a lot of investment capital to build the brand, and were operating at a loss -- that's not a place we really want to be. We're very focused on getting back to free cash flow-positive, EBITDA-positive, and self-funding our growth.

That said, we're very interested in being very ambitious in capturing what we believe to be a very large opportunity that we don't believe will last forever. In that sense, we're certainly -- anything that is prudent in the confines of the strategy we have around the categories we're interested in and the markets we're interested in, we're certainly going to pursue. Our ideal strategy is to pursue that while generating our own investment capital, and not having to do that by raising outside capital, which obviously is very dilutive.

In terms of the rate of margin expansion, what we said is, we're very focused on getting to this free cash flow-positive, this EBITDA-positive place. 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 we're self-funding, we're less focused on the time period it takes to get from there to the target 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.

Despite that, we don't expect to be able to spend the flow-through EBITDA on wise investments, so we expect it to continue to flow through, thus increasing our EBITDA percentage, which is why in Q1 of 2014 we were at negative 7% EBITDA. Even with this headcount ramp that we just talked about, which took us down on an EBITDA percentage, we think we're going to swing back up from that fairly quickly in the not-too-distant future. That's the way I would define it.

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. We talked about buying power from volume, even where there were some comments about how our growth is decelerating. When you're comping off 90% growth, frankly growth will decelerate. Frankly, at the rate we're growing and at the scale we're growing at, growth will decelerate.

I'll remind you, the market's only growing 12%, 15%-something, depending on what you believe online's growing at. The overall market's only growing a few percent. We think even as this growth decelerates, quote-unquote, we're going to still be growing at a very excess growth rate, and continue to take significant share, and while preserving that flow-through contribution margin of 20%. I know that's a longer answer that you were looking for, but I was hoping to tie it all together.

No, that was 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 JPMorgan. Your line is open.

Thanks, good morning, guys.

I wanted to understand, as you peel back the two-year stack in the different businesses, can you talk about what the experience has been in the US? Then is there a -- US only. Then, is there a point in time that you can look out and say, international business is X percent of revenues today, but once it gets to a certain scale, that could actually bend 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. It was 170% that we tried to do the math to exclude the partner business, as well as the Australian business that we divested, just so you have the clean math which you will need, because that detail isn't in the Q. But it's obviously still a small piece of the whole. The US business continues to chug along at a substantial growth rate, because it's the vast majority of the business.

I do think that at some point in time that business has very long legs, right? We're tiny compared to the market opportunity. You'll remember roundly the Western European market is $250 billion, like the US business. There's a ton of room to go versus the $50 million business we have there today. I think the opportunities for scale and then be a meaningful accelerating growth contributor exists; but it's got a long way to go to get to the scale where it can out-script what continues to be extraordinary growth on a massive base of the US business.

I think that's a good summary of it. We mentioned that the direct international business grew 170% in the quarter, and despite that, it ticked up to 7% of sales. You can see the relative size of it is 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 have said, hey, at some point can you give us the full segment of financials, and what have you. Obviously that 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 even treat it as one thing. You really need to think about Canada separate from the UK, separate from Germany. In the US you have Wayfair.com, which is our dominant brand in the US, but you have other brands -- Joss & Main and AllModern -- and they're all on different growth trajectories.

There's a lot of things going on that all add together to give you this aggregate growth number. 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 steadily growing at a few percent a year off the expansion of new units being added that are fairly predictable. The opportunity is, I think, much larger, because of the disruptive nature of the internet and the fact that -- the speed at which share's changing hands.

We're certainly very focused on that. We obviously run the business in a granular way to make sure that each individual effort and the funding we're giving it is paying off. Then when you add it up, you have these patterns that, to be fair, are hard. From the data that you have, I would say they model out precisely. But there's certainly very exciting growth things under way that we expect to see flow into results over time.

Thank you.

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.