SNAPSHOTCompany – Williams-SonomaTicker – WSM (NYSE)Industry – Retail: Home DecorMarket Cap - $3.7 billion: Mid-capBUSINESS & INDUSTRYFifty years ago, Chuck Williams opened up a store in Sonoma, CA aptly naming it Williams-Sonoma. Today, Williams-Sonoma has grown into a multi-channel portfolio of retail stores focusing on “enhancing customer's lives at home.” During that time W-S acquired or created several other brands including Pottery Barn and all its spin offs (e.g. Potter Barn Kids, Pottery Barn Bed + Bath, & PBteen), Hold Everything, and West Elm. At the beginning of 2006, WSM operated 570 retail stores represented by 254 Williams-Sonoma, 188 Pottery Barn, 89 Pottery Barn Kids, 8 Hold Everything, 12 West Elm, 3 Williams-Sonoma Home, and 16 Outlet stores. The Williams-Sonoma stores sell kitchen essentials and accessories. The products are high quality and priced as such, making William-Sonoma kitchen products a must have for most upper-middle class American housewives. They offer in store demos and cooking classes to help sell products and educate customers. The customer service is top notch according to the customers I interviewed. Pottery Barn sells furniture and home accessories with a classic, muted, country style. They are considered the industry standard in home décor. The product quality is somewhere between the low cost retailers (e.g. Target) and the individual mom & pop furniture stores, although the products are priced closer to the high end market. WSM is developing a new store brand called West Elm which is similar to Pottery Barn, but carries products with a more edgy, modern, urban style. Around 60% of WSM's revenues are derived from its retail stores. The other 40% of revenues is derived from direct-to-customer operations including catalog and internet sales. WSM mailed over 385 million catalogs last year, which is enough for every person in America to have one. These catalogs have become the industry standard for home décor and drive all three sales channels: retail stores, internet, and catalog. “When you ask people what their favorite decorating magazine is, they say the Pottery Barn catalog,” according to BB&T Capital Markets retail analyst Laura Richardson. In fiscal 2005 net revenues increased by 12.8%, which was broken down as:• 12.3% increase in retail store sales (7.4% due to new store openings & 4.9% due to an increase in comparable same store sales) o Core brands (Williams-Sonoma, Pottery Barn, & Pottery Barn Kids) net revenues increased 10.9%. o Emerging brands (Hold Everything, PBteen, West Elm, & Williams-Sonoma Home) net revenues increased 35.6%. Excluding Hold Everything, which incurred additional expenses for shutting down stores and absorbing the brand into other WSM brand stores, net revenues in the emerging brands increased 48.8%.• 13.6% increase in direct-to-customer sales (internet sales increased 36.5% and passed catalog orders for the first time in company history. Many of these new sales were probably at the expense of catalog orders, which would have a zero net effect on revenues).The U.S. home décor market is around a $40 billion industry. In 2005 William-Sonoma's revenues were $3.5 billion accounting for a little less than 10% of the total market share indicating that WSM has room to grow. WSM maintains its revenue and ultimately earnings growth by launching new brands, opening new stores across its portfolio of retail brands, and increasing same store sales by bringing in more customers and/or raising the price of the merchandise. Specialty retail and direct-to-customer business is highly competitive making it difficult to differentiate a brand/store from the competition. Pottery Barn is considered the industry standard for home décor, but this has led to many low cost imitators entering the industry. Crate & Barrel, Restoration Hardware, and Sir La Table are WSM's main competitors at similar pricing points. Lower priced competitors include Target, Pier One, and Wal-Mart (who competes in every industry…or so it seems). MANAGEMENTOver the past year, management has worked hard to reduce costs through refining the furniture delivery system and implementing a new daily store replenishment program. The new furniture delivery system was able to reduce shipping costs versus last year even though fuel prices increased. The daily store replenishment program was implemented just this last year to cut down on inventory costs. All the cost cutting measures have led to the highest operating margin in company history last year.Management is committed to increasing shareholder value and plans to return around 70% of the 2006 free cash flow to shareholders in the form of dividends and stock buy-backs. This commitment is further exemplified by the fact that 13% of the outstanding stock is held by company insiders, which aligns management's objectives with its shareholders. On top of this, the CEO recently bought $10 million worth of company stock., which is roughly 2.5 times his total annual compensation (salary + options). In one of his books, Peter Lynch said that there are plenty of reasons why executives might sell company stocks such as large item purchases (home, boat, car), portfolio diversification, or retirement, but there is only one reason why insiders buy stock and that is because they expect the price to go up.FINANCIALSWSM has a stellar balance sheet with excellent financials. They have very little debt, ample amounts of cash to fund expansion, and stable levels of return on invested capital and equity.• Debt = $30M (Debt/Equity = 3%). Room for additional financing to fund expansion if cash flows go through a “down cycle”, which is typical for the cyclical retail sector.• Cash & Short-term Investments = $187M (makes up 10% of Total Assets).• Return on Invested Capital has fluctuated between 12.5% - 13.3% over the past 5 years. • Return on Equity has increased from 14.1% to 19.1% over the past 5 years.VALUATIONLast month, WSM beat analyst's Q2 earnings estimates, but lowered its Q3 forecast. The stock sold off, which is when CEO W. Howard Lester made his purchase. I think this is an indication that Wall Street's pessimism is overblown. Today the stock sits around $32, off about 50% from its 52-week high. Using a discounted cash flow model (DCF) and fairly conservative estimates taken from the 2005 Annual Report, I estimate the Intrinsic Value of each share to be around $38, which equates to a 15% margin of safety. It has been my experience that a DCF can be made to say whatever you want it to say, so please take that estimate with a grain of salt. I usually look for a 25% or greater margin of safety for my investments, but then again, it is better to pay a fair price for a great company than a great price for a fair company (Warren Buffett paraphrase).RISKS• Revenue growth from same store sales accounted for less than 50% of total revenue growth which has been slowing over the past 3 years (16.7%, 13.9%, 12.8%).• Merchandise is produced and imported from overseas; therefore orders are placed up to 12 months in advance of the applicable selling season before the trends are known. This also adds supply chain and international risks.• Products are already highly priced so revenue growth will have to come from increased customer traffic or store expansion. I liken this to the same problem The Cheesecake Factory faces since they run their restaurant at 100% capacity.• Operating Margins are at all time highs, so it will be difficult to grow earnings with additional cost cutting measures. Reducing the cost of materials also runs the risk of customer's perception of quality/value. Smart Money tested Pottery Barn, Crate & Barrel, and Restoration Hardware's furniture and decided that the quality was not worth the money.• Inventory Turnover (the number of times inventory has been sold during the year) has decreased from 5.2 in 2002 to 4.3 in 2005. This is not necessarily a bad thing since revenues are increasing and WSM's merchandise mix may be different today than it was 5 years ago (for example, they could be selling more furniture which turns-over fewer times than dishes and glasses), but it could be a red flag that merchandise sales are slowing.CONCLUSIONWSM has a very strong brand presence, which defines trends in home décor. They have consistently been able to grow sales and have been disciplined in their expansion plans by not taking on excessive amounts of debt. The management has aligned itself with its shareholders by holding significant amounts of company stock and returning the majority of free cash flow to its shareholders. The promising new West Elm brand could turn into a major source of revenue growth going forward. The biggest risk facing WSM is the customer's price/quality perception. If this ratio gets too high, customers will leave and revenues will fall. As long as WSM can continue delivering quality products at “reasonable” prices, I see plenty of years of growth to come. Sources: Williams-Sonoma Inc. 2005 Annual Report Smart Money, October 2006 IssueCustomer Interviews
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