Sunday, March 31, 2013

Is Williams-Sonoma Fairly Valued Now?

There are a few precious themes working in the retail market right now and investors would be well advised to stick with them. Housing and autos are doing okay. High end, specialty stores and discount stores are doing fine and, e-commerce continues to grab market share from retail. The interesting thing about Williams-Sonoma $WSM is that it is exposed to more than a few of these positive themes and its rising stock price demonstrates that amply.The question is where is it going to be in future?

Williams Sonoma’s Growth Drivers

I’m going to get into the details of WSM quickly, so for those who are not at least familiar with the company I have a primer article on it linked here. As discussed previously there are a few initiatives that the company is pursuing in order to drive growth

  • International expansion with an immediate focus on Australia and the Middle East
  • Expanding its growth brands like West Elm and Pottery Barn
  • Launching new business and brands in order to offer a differentiate range of product
  • Ongoing expansion of Direct to Consumer (DtC) and its online offering
  • Investment in the supply chain and technological infrastructure in order drive multi-channel sales

As you can see from these growth drivers WSM is a direct beneficiary of a cyclical recovery in the housing market as well the secular theme of the expansion of online sales. Indeed DtC sales now represent 46% of total revenues and its fast growing e-commerce sales should help improve margins in future.

The longer term question relates to increasing competition in the online space. Home furnishing is a competitive market and when markets grow they become attractive for new entrants. Now when that ‘new entrant’ is Amazon $AMZN, there should be cause for concern. Not only is AMZN increasing its own product range of home furnishings but it also bought Quidsi last year. The latter having launched (home goods). Indeed Quidsi is believed to be considering expanding its number of physical stores in order to support its sales expansion. Incidentally this is a strategy that WSM is also following but rather it is supporting its online sales via investing in in-store technology so customer orders can be made online from the stores.

In a salutary reminder of the competitiveness in the industry I would refer to Bed Bath and Beyond $BBBY. It’s been a difficult year for its shareholders. For large parts of the year it managed to report weakening sales trends while seeing margins squeezed by cost prices rising. The ongoing restructuring seems to be taking forever and all this is going on in a sector where everyone else is doing well. It’s hard not to conclude that BBBY is the victim of online competition from the likes of Amazon, WSM and even Pier 1 Imports. Is WSM immune?

The strategic key to WSM’s future is going to lie in differentiating its products (its differentiated products and new launches have tended to outperform) in order not to offer a commoditized products that can be undercut on price from online competitors. Moreover it is aiming to release the potential in its brands via online expansion.

Williams Sonoma’s Potential

In order to see the relative importance of its brands I’ve broken full year net revenue share by brand below.

Naturally Pottery Barn has experienced the benefit of the nascent recovery in the housing market but it has been tougher going at the core Williams-Sonoma brand where comparable brand revenue growth actually decreased 1.1% for the full year. However within that WSM managed to increase the core brands DtC sales and e-commerce revenues in particular.

Time to look at the last two years growth rates.

The decline at the core brand is an obvious concern but the largest brand (Pottery Barn) is doing well. I also think that the international expansion of Pottery Barn Kids is a good idea. The stores in the Middle East are doing well and this is largely a consequence of oil rich disposable income colliding with a youthful demographic. It is no coincidence that the Pbteen franchise store in the region is also doing well. I’m not the sure that Australia shares the same demographic advantages but it certainly offers a relatively strong housing market.

The real story with geographic expansion in 2013 centers on the West Elm stores. WSM rolled out 12 West Elm stores this year as opposed to the initial plan for nine. In addition there are another nine stores planned for this year. As West Elm is a more modern brand it is reasonable to expect WSM’s investments in in-store technology and customer analytics to bear more fruit in this brand.

Where Next For Williams-Sonoma?

WSM is certainly bullish about its future. Management forecasts mid to high single digit growth in revenues accompanied by EPS growth in low to mid teens, for the next three years. This implies significant margin expansion but it’s worth noting that gross margins were flat on the year (although they increased throughout the year) and operating income margins declined 60 basis points to 15%. Moreover the expansion plans will mean increased capital expenditures of $200-220m for the next three years. By way of comparison they were only $130m in 2011. Clearly WSM is in an expansion phase.

As ever there are risks and opportunities with a growth strategy. To buy/hold the stock I think you have to be positive that e-commerce and international expansion will create margin expansion. Meanwhile you should also believe that the management can continue to generate differentiated products in order to avoid potential margin compression. I like the sector and the company but I’m not sure that on a current PE of 20 that it is good value for the risk

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