Spruce Point's short report on WIX: 13 points I disagree with

April 20, 2017

Yesterday a renowned short-seller called Spruce Point Capital (SP for short) published a short report on Wix. I'm very familiar with Wix: I covered it as a buy-side analyst at Putnam and Putnam became a shareholder just over a year ago on my recommendation (I have no idea if the firm has held the position since my departure three months ago). I'm delighted that I've since become a VC, so I'm able to write this piece publicly. Full disclosure, I sold my personal shares in Wix a bit over a week ago, before I knew about this report, due to valuation concerns after the recent run-up.  As such, I have no personal financial incentive to defend the company. I find it frustrating, though, when short-sellers fail to present both sides of an investment case and try to force-fit reality into the narrative of a "shocking expose." Investors considering whether to sell/short Wix after reading this report deserve a more balanced view. 

 

Before I comment on the specific claims, it is important to remember that the work companies like Spruce Point do is crucial to the functioning of the financial system. We need good shorts investigating irregularities, exaggerated claims and irrational exuberance, and in the long term everyone benefits from their work through more accurate asset pricing.

 

That said, there are many errors in this piece, some of which reflect a misunderstanding of Wix’s business model or misleading innuendo. The very best short reports are laser focused on a single key issue and present compelling evidence on it. As usual for short reports (and court cases) where there is no such smoking gun, SP has thrown the kitchen sink at Wix instead, making it hard to respond to each point in a timely way. I'll try to cover as many of the points I disagree with as I can here:

 

1) Spruce Point (SP) claims that Wix was an early mover in freemium, and it is now becoming more competitive. In fact, while Wix was an early mover, there is little evidence the space is becoming more competitive (lists of competitors don't count). The largest freemium competitors, Weebly and Squarespace, are both growing more slowly than Wix (Weebly's headcount is actually shrinking). GoDaddy is starting to enter the space, but has historically not run a freemium model and has built its brand around domains. Wix’s competitive position in the marketplace is arguably stronger than ever today. Many of the purported "competitors" SP cites like Adobe are so far up-market from Wix as to be irrelevant for any serious analysis. 

 

2) SP claims Wix’s 85% gross margins, low capex and "negative churn" are collectively too good to be true. The margin profile makes perfect sense if you understand that Wix’s business is effectively selling web-hosting (a notoriously high gross margin business) and other high-margin add-ons. GoDaddy's equivalent segments are at similar margins (dragged down by its lower margin domains business) and many public software companies boast 75%+ gross margins, including New Relic, Atlassian, Ansys, and Aspen Tech. On capex, Wix uses cloud vendors Amazon Web Services (AWS) which obviates the need to build expensive datacenters. Many competitors build their own datacenters. On negative churn, almost every public SaaS company has dollar net retention over 100%. Wix does present churn differently from other software companies and it is legitimate to question if this is the right way to think about the business, but the company has showed data indicating that for a given cohort of registered users the number of paying accounts generally does not decline over time. This fits my own experience (as a Wix user long before I researched the stock), in that I have built multiple different websites over the past four years on the platform, deactivating some only to spin up others (including this blog!).

 

3) SP claims the SEC has issued comment letters to Wix questioning its Adj. EBITDA presentation. This is true, but the missing context is that every SMB web services company, including GDDY and EIGI, were using the same Adj. EBITDA presentation. Further it is moot point as free cash flow should be the real focus for investors, not Adj. EBITDA, as any short seller would surely agree. 

 

4) SP points out that Wix’s early venture backers have exited. This is not remotely surprisingly or relevant, Wix has been public for over three years and few venture firms will hold public company shares for that long. Either SP doesn't understand this dynamic, or they are deliberately giving readers the wrong impression. 

 

5) SP says Wix’s share price has exploded under "curious circumstances." In fact, Wix smashed consensus expectations through 2016, showing stronger than expected free cash flow and re-accelerating growth at the same time, rare feats for a high-growth tech company. It was also remarkably inexpensive to start with.

 

6) SP points out that the street has used the wrong share count to value Wix. Shame on the street if true, but there is nothing surprising in Wix’s share count: all unprofitable companies I've ever analyzed (and I covered SaaS stocks, so there were quite a few) use the lower of their basic share counts as the denominator in EPS when earnings are negative. This is a standard practice to avoid making losses appear smaller on a per share basis. Almost every public SaaS company will have a similar step-change in reported diluted shares outstanding when it becomes profitable. Wix does have more antidilutive shares than most, but not by an egregious amount. Any investor worth their salt has already taken this into account, and kudos to SP for highlighting it to those who haven't. Other public companies that will have a similar situation with a greater than 20% increase in share count include: APTI, PFPT, CSOD and BOX. Many others will see mid-teens reported share count increases when they break to profitability, though again this should be well understood by anyone who reads financial statements. 

 

7) SP claims Wix is giving fully diluted share count guidance "for the first time." In fact, the fully diluted share count has been disclosed in each annual 20F. It is showing up in guidance because the guidance indicates profitability, per the point above. This is not a revelation.

 

8) SP points out that analysts have failed to value Wix on its restated Adj. EBITDA. This is a nonsensical claim for SP to make. First, Wix should be valued on free cash flow anyway, not adjusted EBITDA (blame the sell-side for that). Second, the adjustment is nothing more than a presentation: analysts use EBITDA as a proxy for free cash flow. Companies like Wix that are building up significant deferred revenue balances have higher current period free cash flow than their GAAP income statement suggests. The SEC asked companies like Wix to remove deferred revenue from reported Adj. EBITDA so that the metric would be consistent across all companies, but that doesn't mean that analysts should apply the same multiples on a new lower Adj. EBITDA number. Nothing about Wix’s actual business changed- just the presentation. Why should the valuation change?

 

9) SP claims new entrants are gaining share faster. This is the slide that convinced me that SP doesn't understand Wix’s business. Wix is not an enterprise content management system or high-end online store provider. Wix does not compete directly with Magento, Drupal, Joomla, Shopify, Opencart, or Adobe. Wix targets the very low end of the market and is a closed platform (not open source) that includes hosting. It is absolutely crucial to understand the many distinctions here if you want to understand Wix’s model.

 

10) SP claims Wix provides little cost of revenue disclosure: This is a very simple business from a COGS perspective. Wix’s variable costs are web hosting, customer support (which they are stingy with, as SP points out) and domain name registration costs. What is there to hide? 

 

11) SP claims Wix’s mix of short/long term deferred revenue merits scrutiny. The vast majority of subscriptions are one year subscriptions, and Wix has only recently introduced longer-term subscriptions.

 

12) SP claims Wix’s user growth is slowing. It is true that active user growth is slowing, but this is only one lens to evaluate the business (in fact SP itself claims in an earlier slide that registered users are "almost meaningless to evaluate the business." I agree. The conversion rate from a registered user to a paying user varies enormously by geography (higher in the US and other developed countries, lower elsewhere). My data shows that Wix has been increasing sales & marketing spend in the US, attracting fewer users at a higher conversion rate. Regardless, I agree with SP that this is not the best way to evaluate the business. When someone calls a metric irrelevant in one breath and cites its slowdown as evidence the business is falling apart, they clearly aren't presenting a balanced view. 

 

13) SP's values Wix by comparing it to slower growing/legacy peers on a price/sub and EV/Rev basis. I'm flummoxed why either of these is the right valuation technique to use here, other than that they fit nicely with the narrative SP is trying to push. SP compares a high growth company with four slower growth companies, three of which are growing just mid-single digits Y/y. It also compares Wix to GoDaddy on an EV/Sales basis, despite Wix’s far better gross margins. I challenge SP to consider what Wix’s free cash flow margin can look like in a few years should it spend less aggressively on sales and marketing to fuel growth, and then compare it to peers on that basis.

 

My view: SP seems to fundamentally misunderstand why Wix is special relative to the "peer companies" it cites (and to be clear, I own GoDaddy stock, even after selling my Wix shares). Small business web services is a famously tricky category, which is still dominated by local web development shops. The key business driver for Wix is the conversion rate from a free user to a paid user, which is closely related to whether a user can build, unassisted, a website they are proud of and willing to pay to show the world. By investing enormously in ease of use of the website builder (including Wix ADI, a disruptive innovation) as well as building a dominant brand, Wix has become the default choice for small business owners to build sites themselves in much of the world. Higher conversion rates flow through the model, allowing Wix to spend more than others acquiring users and reinvest the proceeds in branding and further UI improvements, such as verticalizations like Wix restaurants and Wix Music. Like GoDaddy, which has achieved huge share of the domain registration business, Wix is the dominant player in the freemium website market, one of two "on-ramps" that small business owners use to start their online web presence. Whether or not Wix is fairly valued for this market position and its financial results is a fair question- and one I don't feel that I have an answer to after the recent share price appreciation, much as I admire what the company has built. Still, it is a question best considered with a balanced view, not a slanted one that mixes genuine concerns with flawed claims.

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