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Morningstar | Healthy Brand Comps Offer Confidence for Modest EPS Bump at Williams-Sonoma; Shares Undervalued

Narrow-moat Williams-Sonoma continues to defend its position in the home furnishing industry, delivering brand comps of 3.5% in its first quarter as product offerings continue to resonate with customers. While the Williams-Sonoma brand broke its 14-quarter streak of flat to positive comps growth (with a 1.6% decline), West Elm (25% of sales) continues to be a stand out contributor, posting 11.8% comps on top of 9% in the year-ago period. With solid performance underway, Williams-Sonoma has held the line on its sales outlook for $5.67 billion-$5.84 billion (in line with our $5.8 billion forecast), but has raised its full-year earnings per share outlook by a nickel, to $4.55-$4.75 (versus our $4.68 projection). In this vein, we don’t plan any material change to our $70 fair value, and view shares as undervalued even after a low-double-digit pop post report, trading at a 17% discount.

Tremendous top-line support exists for the firm ahead, as it just enters the B2B business (which it believes could represent a $2 billion opportunity), expands into the marketplace and apartment categories, and still has room for West Elm growth (with just 115 stores and $3 billion in sales potential, versus $1.3 billion in 2018 sales), when assessing against Williams-Sonoma’s $5.7 billion 2018 total sales base. However, we think the speed of growth remains constrained by online competitors that are willing to spend aggressively on customer acquisition, without regard to long-term profitability. However, we don’t think these types of tactics are sustainable over time, and that ultimately operators with both brand equity and an eye turned to profitably growing its business will win over the long term. These factors underlie our 3% average sales and 9% average operating margin outlook over the next five years, despite ample new avenues for sales hikes.

Overall performance was solid for the quarter on the top line, with the majority of the brands under the Williams-Sonoma umbrella delivering growth. Pottery Barn brand comps ticked up 1.5%, PB kids/teen rose 1.2%, West Elm again toed the line with double-digit growth, while Williams-Sonoma contracted just 1.6%. For reference, Williams-Sonoma represented just 16% of total sales in the quarter, so failed to act as a material drag on growth despite its underperformance. The gross margin was 20 basis points worse than we forecast, and contracted about 10 basis points year over year, to 35.9%, hindered by higher shipping costs due to a greater mix of furniture sales, despite both product margin and occupancy cost improvement. However this was more than offset by an adjusted selling general and administrative ratio that declined 80 basis points year over year and was 80 basis points better than we expected at 28.9%, helped by cost savings initiatives across the organization (advertising, employment, general expenses, amongst others). All in, this led to a corporate operating margin of 7%, a more than 70 basis point improvement. In our opinion, Williams-Sonoma's competitive advantages have allowed shares to climb more than 25% over the past 24 months (May 30, 2017-May 30, 2019, including the price gains post report), representing significantly better performance than a litany of other retailers with mall exposure (including Macy’s, Nordstrom, and Tapestry amongst others) over the same time frame, and outpacing the S&P Retail Index, which has been basically flat over the same time horizon.

Williams-Sonoma continues to be one of the better run retailers on our coverage list, in our opinion. The firm has smartly been pivoting to mitigate China tariffs, moving part of its upholstered furniture business domestically and to overseas locations outside of China (versus no-moat peer RH which is set to have around 30% of its business sourced from China in 2019, down from more than 45% in 2017), a change that should help divert volatility in the gross margin ahead. Furthermore, we think leadership continues to tactically adjust the store base, noting last quarter that with one-third of the store base up for renewal over the next three years it may be able to extract better economics from landlords, benefiting occupancy costs and supporting stable operating margin performance even if industrywide discounting ticks up. These efforts leave Williams-Sonoma in an enviable operating position, allowing for steady cash flow to support continued share repurchases and a rising dividend.