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Morningstar | Operating Margin Compression Spooks Williams-Sonoma Shares, but our Long-Term Thesis Intact

Greater than anticipated third-quarter operating margin compression (falling 90 basis points to 7.6% versus our 8% estimate) in narrow-moat Williams-Sonoma’s third quarter has sent shares tumbling more than 10%; however, the firm’s financial report was largely in line with our expectations. With sales rising 4.4%, well ahead of the low-single-digit clip the industry captured over the same time, results imply that the firm continues to gain market share. While store sales lagged our 3% outlook, rising just 0.2%, e-commerce revenue (55% of sales) outperformed our forecast, rising 8.2% versus our 6% estimate, indicating digital initiatives are taking hold. Furthermore, with the key fourth quarter (45% of 2018’s profit estimate) set to come in on target with our prior outlook, we don’t anticipate any material change to our $70 fair value and view shares as attractive, trading at more than a 20% discount. Our final quarter anticipates sales of $1.8 billion and EPS of $1.94, at the midpoint of the firm’s guidance for $1.73 billion-$1.83 billion in sales and $1.89-$1.99 in EPS, generating an 8.5% operating margin in 2018, at the low-end of guidance.

Cyclically, with rising interest rates (mortgage rates up 80 basis points over the last year) impacting affordability and existing home sales volumes slowing (declining in 8 of the last 9 months), we expect demand for home furnishings to moderate. We see this trend already arising, with furniture and home furnishing sales rising 2.4% over the third quarter versus a 4.2% clip over the fiscal year-to-date period. We have already included this slowdown into our forecast, calling for sales growth that averages 3% over our explicit forecast, a modest downtick from the nearly 7% increase we expect in 2018. Given the firm’s ability to spend tactically to defend its market position, we still have the operating margin rising over the next decade to around 10% from 8.8% in 2017 and the firm capitalizes on its brand intangible asset.

In our opinion, there were a number of reassuring metrics indicating that the brand intangible asset remains intact. First, with the exception of PBkids/teen (0% comp growth), brand comps were all positive, and this marked the 13th consecutive quarter of positive brand comps at Williams-Sonoma and another banner quarter for West Elm (with comps up 8.3%, decelerating modestly sequentially from 9.5% last quarter). Second, both retail and e-commerce operating margin expanded year over year, by 30 and 60 basis points, respectively, to 7.6% and 21%, leaving operating deleverage stemming largely from unallocated expenses (higher incentive comp which was not earned last year). Further supporting operating margin, gross margin rose primarily on the change in accounting standards, up 60 basis points to 36.5%, but higher selling margins and occupancy leverage were noted as favorable in the period. Additionally, inventory rose just 1.8%, significantly lower than the 4.4% top line growth, potentially positioning inventory optimally heading into the holiday season, offering Williams-Sonoma a better opportunity to avoid discounting ahead.