Williams-Sonoma (NYSE: WSM) is a premium retail company that specializes in selling high-end home furniture, kitchen appliances, and cookware. The company was founded in 1956 by Chuck Williams who turned a passion for cooking into a business idea. Today the company boasts a strong portfolio of brands that include Williams-Sonoma, Pottery Barn, Pottery Barn Kids, West Elm, PBteen, Rejuvenation and Mark & Graham. In addition, it also operates through an e-commerce business which also provides access to all of its products and services.
Business overview
To understand WSM’s business let’s look at its main brands – Pottery Barn, West Elm and Williams Sonoma.
Pottery Barn, WSM’s largest brand, continues to deliver strong performance. It delivered comparable brand revenue growth of 19.6% during the quarter, driven by their proprietary furniture business. Strong growth for Pottery Barn is expected to continue due to elevated back-orders for home furnishings due to record number of homes sold in Fiscal year 2021. Growth for Pottery Barn may start to slowdown in the back half of 2023 as home sales have continued to drop for ten months in a row and as a leading indicator this would likely impact sales for home furnishings as well in coming months.
West Elm has also grown at high double digit annually, but growth has slowed in recent quarters. West Elm’s comparable brand revenue growth was 4.2% as compared to last year’s 22.5%. West Elm offers affordable products for home decor, so it is more exposed to general consumer discretionary spending and to consumers who are more sensitive to rising costs due to inflation. Slowdown in spending levels can be clearly seen from US consumer spending trend for fiscal year 2021, and West Elm’s revenue trend is a consequence of that current market trend.
Pottery Barn and West Elm together contribute 70% of total revenue. The rest come from brands like Williams Sonoma, Pottery Barn Kids & Teen and other emerging brands like rejuvenation and Mark & Graham. Revenue from these brands combined is mostly flat and lacks any consistent growth trend.
A key growth agent, B2B is WSM’s goal to diversify into new industry verticals. Most importantly they have been building velocity with projects from long-term partner Starbucks and hospitality partners like Marriott and Hilton; healthcare is other industry which management aims to enter. Other potential growth driver is international expansion. Management highlighted, in their latest Q3 earnings call, India as the biggest opportunity however expansion is still in its nascent stage and is to be seen if it actually grows to expectation. Revenue from international is only $150 million currently.
Why has the stock price dropped? Has anything changed fundamentally?
WSM stock has had a spectacular run in 2021 and reached peak price of $220 in Nov 2021. This was mainly due to strong growth in sales across the retail industry during COVID19 pandemic seen due to the stay-at-home trend, high home sales and sharp increase in consumer spending. WSM, was able to scale their e-commerce operations quickly and able to capitalize on this new trend resulting in stellar revenue growth of 22% annually, as opposed to 6% seen traditionally, accompanied by doubling of operating margin to 18%.
Now as the world has gone back to way of life before the pandemic, growth rates across industries have started to come back to levels seen before the pandemic and WSM is no exception. Furthermore, darkening macro-economic outlook, rising interest rates, inflationary pressures, and continued supply chain challenges have also caused the stock price to drop.
Fundamentally, Williams-Sonoma remains strong as ever. It has no long-term debt, a strong balance sheet due to stable and positive cash flows and a healthy working capital position which is further supported with $750 million line of available credit to scale any near-term operations if needed. Dividend for TTM ended in Oct 2022 was $3.05 with dividend yield of around 2% and dividend per share growth rate of 15% during the past three years. WSM has also been providing shareholder returns by buying back shares since 2011 at an average buyback rate of 3.5%.
Growth Outlook
WSM’s conventional growth rate before pandemic has been 6% – 8%. The pandemic provided a strong growth opportunity due to stay at home trend which saw revenue growth rates reach 15% and 20% in fiscal years 2020 and 2021 respectively.
However, revenue growth rate now has dropped and stabilized at 10% which is also in line with management’s revenue expectation of mid to high single digit growth. I agree with this guidance and believe that Pottery Barn will be the primary growth driver here. Even though the real estate market has started to slow down but the backlog of orders created from homeowners who have already bought homes should sustain demand. I also see B2B as a potential hedge against slowdown in the home furnishings business and other consumer facing products. WSM’s push to create more vertically integrated B2B partners should fuel its ambition to keep revenue growth at mid-to-high single digit growth and long-term revenue target of $10 billion by fiscal year 2024.
Risks
B2B business is seen as a sizable growth driver for WSM but it not big enough to influence the overall revenue growth. Pottery Barn and West Elm account for 70% of total revenue and slowdown in housing market and consumer spending will put pressure on WSM sales numbers. Furthermore, general economic downturn will also mean that a lot of businesses will also start to re-think on their capital investment plans which would put pressure on WSM’s B2B growth aspirations.
Near term, margins also continue to be negatively affected by supply chain disruption, inefficiencies, and cost pressures to WSM’s operations. This includes higher distribution center costs, higher ocean freight, added costs to ship out of market and shipments to service customers.
The macro-economic environment is still quite uncertain, this includes uncertainty around consumer spending, decade high inflation and Federal reserve monetary policy, which is intentionally moderating economic demand. The combination of these negative economic signals makes revenue and margin guidance for WSM very difficult.
However, based on historical performance, I remain confident in management’s ability to operate in this tough environment and their ability to maintain mid to high single-digit revenue growth with operating margins relatively in line with fiscal year ’21.
Valuation
Intrinsic value of WSM is calculated using DCF model with following inputs to calculate future cash flow from operation for the next 5 years followed by terminal value.
- Revenue growth of 10% for next year, followed by 8% and then moderating to 6%.
- Operating margin of 15% for current year and then moderating to 9%
- Tax rate – 22%
- Reinvestment rate of 53% to sustain revenue growth
- Cost of financing (weighted cost of capital, WACC) is 12.76%, calculated using current risk-free rate of 3.8%, market premium – 6% and cost of debt – 0.13%.
Terminal value is calculated based on the following assumptions:
- Perpetual growth rate of 4% assuming industry average.
- Operating margin maintained at – 9%
- Tax rate – 22% assuming same as current tax rate.
- Perpetual WACC – 8.65% calculated using beta of 1, cost of debt of 0.13% (consistent with current levels) and current proportion for debt-to-equity.
- Perpetual reinvestment rate to sustain 4% growth and cover cost of capital – 46%
This gives a value of $94. At current stock price of $128, Williams-Sonoma is over-valued by around 35%. Looking at recent stock performance, I would hold the stock right now and wait for the stock price to fall closer to my intrinsic value to buy.
Final Thoughts
Williams Sonoma is a high-quality stock. It has strong financials supported by stable cash flows, no outstanding debt and with industry leading returns sustained over a period of years which shows clear competitive advantage. It makes high quality premium products with strong pricing power that enables such returns. Stock price for Williams Sonoma has dropped significantly compared to its peak in Nov 2021. The price drop certainly provides an opportunity to enter the stock but I believe the current stock price is still hovering about its fair value, so it should be on your watch-list.
Disclaimer
The opinions expressed in the Blog are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. It is only intended to provide education about the financial industry. The views reflected in the commentary are subject to change at any time without notice.