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Williams-Sonoma Inc: Reversion to the Mean

October 17, 2011 | About:
Williams-Sonoma Inc (WSM) is a specialty retailer that operates four brands (Williams-Sonoma, Pottery Barn, Pottery Barn Kids and West Elm) across nearly 600 retail locations in the U.S. and Canada. In addition to its retail locations, the company generates significant sales through its “Direct to Customer” segment which includes its catalog and Internet businesses (approximately 40% of sales arise from this segment). A review of the company’s tear sheet showed a history of strong returns, low debt, a high cash balance and strong free cash flows, all of which prompted me to take a closer look.

Let’s start with the company’s historical performance.

WSM-Historical-Returns-1024x654.pngWilliams-Sonoma Inc. - Historical Returns, 1996 - 2Q 2012

Here we see the cyclical nature of the company’s business, with a dramatic decline in both the 2000-2001 and 2008-2009 recessions. This is to be expected given the nature of the company’s business (selling high end discretionary products) and the sizable fixed costs associated with its retail leases (which cannot quickly be scaled back with sales, thus leading to declines in performance when sales fall in a recession). Noting the cyclical nature of its business, it is important to focus on long-run performance over a complete business cycle.

Next we’ll look at the company’s revenues and margins.

WSM-Revenues-1024x625.pngWilliams-Sonoma, Inc - Revenues and Margins, 1996 - 2Q 2012

The company showed remarkable revenue growth (even through the 2000-2001 recession above) until a decline related to the recent recession. The company’s margins and revenues have been inching back toward pre-recessionary levels. Viewing aggregate revenues like this can mask important issues that exist at the store level, so it is important when analyzing brick and mortar retailers (even those where a large part of sales are conducted online, as in the case of WSM) to look into changes in same store sales.

WSM-Same-Store-Sales-1024x660.pngWilliams-Sonoma Inc. - Same Store Sales, 1996 - 2011

Normally, I would include actual sales per store, rather than simply change in same store sales. The reason I have neglected to do so here is that WSM has changed its portfolio of brands quite significantly over the period presented. I think a better metric for comparing the company’s portfolio over time is to look at retail sales (total sales less direct to consumer sales) divided by the total selling square feet (the portion of the company’s total leased space that is devoted to selling).

WSM-Sales-PSF-1024x641.pngWilliams-Sonoma Inc. - Sales Per Selling Square Foot, 1996 - 2011

Here we see that while the company’s sales per selling square foot have rebounded from 2009 – 2010 lows, they are still well below the company’s long-run average. This is an important factor that should be taken into consideration when creating a financial model.

Let’s move beyond the company’s revenues and earnings and look to free cash flows.

WSM-Cash-Flows-1024x614.pngWilliams-Sonoma, Inc - Cash Flows, 1996 - 2Q 2012

The most important thing we see here is that the company’s free cash flows skyrocketed in fiscal 2010 and 2011. A large part of this was related to a dramatic decline in the company’s capital expenditures (note the difference between the red and green bars historically, and then compare the difference between these bars in 2010 and 2011). Over the same period, the company’s store count declined from 627 stores (total across four brands) at the end of fiscal 2009 to 592 stores at the end of fiscal 2011. This is the first time in the last sixteen years that the company reduced store count, and it related to the closure of the company’s Williams-Sonoma Home brand, and under-performing Pottery Barn and Pottery Barn Kids locations. I believe this shows us that the bulk of the company’s capital expenditures are related to growth rather than for maintenance, which provides the company with greater financial flexibility in difficult times. Growth can be postponed, allowing for capital to be deployed to more urgent areas; maintenance often cannot be.

Beyond reducing capital expenditures, the company’s cash flows from operations also increased dramatically. Part of this is in relation to a reduction in working capital which was both the reduction in total store count (thus freeing up the inventory in those locations permanently) and, as the following chart shows, reducing the level of inventory relative to sales to more normal levels.

WSM-Cash-Conversion-Cycle-1024x652.pngWilliams-Sonoma Inc. - Cash Conversion Cycle, 1996 - 2Q 2012

Here we see that the company’s total cash conversion cycle peaked in 2009, along with a peak in Days’ Inventory. If this figure had not come down in the meantime, this trend would have a real cause for concern. The company’s current Days’ Inventory is pretty close to its long-run average, so there may be limited potential in further reductions (though an increasing shift to online sales is a big opportunity).

Next we’ll look at the company’s capital structure.

WSM-Capital-Structure-1024x635.pngWilliams-Sonoma Inc. - Capital Structure, 1996 - 2Q 2012

As you can see, the company has largely been sitting on its hands with the free cash flow it has generated recently. The company currently has around $430 million net cash on its books, which is around 14% of its current market cap. Moreover, the company had historically used its cash in a shareholder friendly way, repurchasing $844 million in shares since fiscal 2003 and returning $276 million in dividends since it began issuing dividends in fiscal 2007. The sum, $1.12 billion, is about 36% of the company’s current market cap.

So where does all of this leave us? It appears to me that I am looking at WSM about a year (or two) too late. The company’s worst performance in recent memory was two years ago, and it is already well on its way toward returning to its historical performance levels. Gone alone with the poor performance is the extreme negativity and pessimism closely associated with brief stumbles, and so the company is much more fairly valued today.

In valuing WSM, I looked at a range of possibilities for future growth in its online sales and store count (along with a move closer to long-term average sales per store). I then made various assumptions about the time it would take to return to the company’s long-run average margins, and I then worked through to reach a valuation range for the company’s equity. My conclusion is the company is only slightly undervalued at these levels, unless you are willing to rely heavily on future growth.

What do you think of WSM?

Author Disclosure: No position

About the author:

Frank Voisin
Frank is an entrepreneur who owned four restaurants by the time he was twenty. He sold his businesses and returned to school, completing a concurrent Law / MBA degree. At the same time, he successfully completed all three levels of the CFA exams. He now invests full time with a focus on value investing. Frank Voisin writes about value investing topics at http://www.frankvoisin.com.

Visit Frank Voisin's Website


Rating: 2.8/5 (12 votes)

Comments

Matt Blecker
Matt Blecker - 2 years ago
Nice analysis Frank.

I purchased WSM during the most recent correction at approximately $30 per share. The firm is expanding margins because of its successful and growing direct-to-consumer business, which is also increasing traffic to its stores. The customer focused nature of the company also helps, as they are not only pitching a product, but also a lifestyle. This can be seen in its West Elm concept, and also its offerings at WS stores, such as cooking classes.

On a valuation basis, if adjusted for net cash, I paid less than a market multiple (roughly 12-13x earnings) for a business growing earnings strongly. If the firm continues to operate as a going concern, earnings will be helped by margin expansion due to direct-to-consumer, as well as share buybacks, as mentioned in your summary.

But examining the firm as a buyout candidate also made it look attractive. WSM's consistent earnings and strong balance sheet, with approximately $3.50 per share in net cash, certainly make a buyout possible. At $30 per share, WSM was selling at approximately 5x EV/EBITDA. Retail buyout candidates in the past, such as J Crew and Gymboree, were priced between 8-9x EV/EBITDA.

I feel the firm is worth approximately $45 per share on an EV/EBITDA basis, and $40 per share based on discounted earnings/cash flow. You are correct that it is much less attractive now near $36 per share than it was at $30.

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