EUR 850.00 For Business Accounts Only

Morningstar | Williams-Sonoma Trades Sales Growth for Profitability, Stabilizing Operating Margin Profile Ahead

Williams-Sonoma closed out the final quarter of 2018 strong, posting a 9% revenue increase (above our 7% forecast), helped by solid performance across most of the brand fleet. West Elm marked 11% brand comps in the quarter, while Williams-Sonoma generated its 14th consecutive quarter of nonnegative brand comp performance, implying the company’s portfolio of brands remains relevant across the home furnishing consumer cohort. More importantly, the firm continues to grab share, with the industry declining 1% on average over the same three months and rising just 2.5% on average over the 12 months included in Williams-Sonoma’s fiscal year, versus Williams-Sonoma’s 7% full-year gain. We believe this share grab indicates the brand intangible asset is intact, which underlies our narrow moat rating.

With the company’s initial 2019 outlook in line with our prior forecast, calling for sales of $5.67 billion-$5.84 billion (versus our $5.81 billion forecast), flat adjusted operating margin (we posited 20 basis points of expansion) and adjusted earnings per share of $4.50-$4.70 ($4.64) we don’t anticipate any material change to our $70 fair value. We view shares as undervalued, trading at a 20% discount and 12.5 times our 2019 EPS estimate. The firm’s inaugural long-term financial targets, which seek mid-to high-single-digit sales growth and operating margin performance that matches sales implies low-double-digit EPS growth when we consider share repurchases (the Board announced an additional $500 million authorization in tandem with financial results). Our prior five-year forecast included 4% sales, 4% operating profit, and 10% EPS increases on average, slightly less sanguine than the company’s outlook, given the competitive pricing and rising landscape home furnishing players are facing.

But we think Williams-Sonoma continues to carve out opportunities to drive profitability ahead of existing expectations. First, the team noted it had already reduced supply chain costs and vendor pricing, while pivoting to source outside of China to mitigate expenses affiliated with a 25% tariff. However, the 25% tariff is already incorporated in the company’s 2019 outlook; if the tariff gets rolled back over the next year, it could provide upside to current guidance. Second, the company continues to prune its store base (with 30 fewer locations expected at the end of 2019), shuttering underperforming locations while keeping premier locations in operation. Given the higher productivity at remaining locations we'd anticipate with such a change, there should be a natural lift to operating margin as the mix of the fleet changes. Lower revenue from fewer stores should theoretically be more than offset by higher profitability of the remaining fleet.

Additionally, around 250 stores are up for lease renewal over the next three years. As store closures in the U.S. have escalated, it has left retailers in a solid negotiating position to request concessions from mall operators. Coresight Research noted more than 8,000 store closures in 2017 and 5,000 closures in 2018, leaving landlords in a less favorable position to hold rental pricing firm, giving the rising vacancies. In turn, companies are extracting better economics from landlords. For example, no-moat peer RH now has some landlords financing 60%-100% of its leasehold improvements on certain locations, freeing up more cash flow to reinvest in its business and to return to its shareholders. We believe the mall operators will be warm to such concessions for brands that drive foot traffic to their brick-and-mortar locations and expect Williams-Sonoma will be a beneficiary of this trend. Any gains on rental concessions should benefit profitability, despite partial benefits in lower rent expense being reinvested into innovation across the company’s brands.

Finally, a number of nascent business lines including Williams-Sonoma Inc business to business (potential of $2 billion in annual revenue stemming from an $80 billion market) and its marketplace, curating products from outside its ecosystem to attract a wider audience and build further awareness of the brand. If some of these efforts lead to faster top line growth than the company anticipates, operating margin leverage should ensue, and potentially raise the metric above the almost 10% we have modeled at the end of our 10-year forecast.