Williams-Sonoma Eschews Cookie-Cutter Strategy

Despite the proliferation of e-commerce competitors,

Economic Stability Supports Williams-Sonoma's Profit Growth Outlook Going forward, spending at Williams-Sonoma should still have momentum from economic growth since the Great Recession--home improvement product sales in particular have benefited strongly from the upswing in economic stability. Over the past five years, both disposable personal income and personal consumption expenditures have risen at an average pace of 4% year over year, bolstering sales growth at businesses like Williams-Sonoma.

The stability in demand has led to furniture and home furnishing sales that have risen every month since March 2010, with the exception of January 2014, when it was bitterly cold across much of the northern U.S. Over the same time, Williams-Sonoma's stock benefited from the uptick in category spending, rising from $22 to nearly $55 today.

With shares trading at a 28% discount to our $76 fair value estimate, we view Williams-Sonoma shares as attractive. Moreover, operating margin could continue to rise faster than expected as the company's spending on e-commerce and supply chain initiatives begin to bear fruit.

Defensible Position in the Home Furnishing Space We have raised Williams-Sonoma's moat rating to narrow from none. The company has exhibited an ability to merchandise and market successfully while growing the business through economic cycles and evolving consumer demands. While discretionary spending can be fickle, we believe Williams-Sonoma has built a defensible position in the home furnishings industry despite capturing only mid-single-digit market share.

We contend that Williams-Sonoma's brand intangible asset has historically been the supporting factor in the firm's top- and bottom-line growth, as its ability to drive repeat business relies on customer loyalty and smart marketing and merchandising. Williams-Sonoma is in a unique position to continue to outperform its competitors and capture share. Williams-Sonoma has a nearly 20-year lead on most retailers, collecting insights on end users for more than 25 years. This deep knowledge leads the business to operate more efficiently and turn inventory about half a turn or faster than its peers. Williams-Sonoma can begin to figure out what the consumer's next likely purchase might be and produce information to facilitate that next sale.

We believe the company has used its data to strategically enter new brands based on consumer demand as the enterprise has evolved, acquiring Pottery Barn in 1986 and then launching PBkids, West Elm, and PBteen in 1999, 2002, and 2003, respectively. These brand extensions help keep the Williams-Sonoma portfolio relevant throughout consumer life cycles by catering to different needs at disparate life cycle positions (and multichannel customers have been noted to shop more frequently and spend three to five times more than other customers). We view the West Elm extension as critical in growing the life cycle relevance of the Williams-Sonoma brands, as it helps jump-start the collection of data analytics even earlier in the consumer life cycle, now catering to the initial furniture and home furnishings purchases of millennials. Once the first purchase is notched at a brand like West Elm, Williams-Sonoma can use its prowess to tailor its marketing, using data that indicates the next likely purchase to suggest the right product, which might have the best likelihood of driving repeat business. As millennials age and make more money, upgrade their living arrangements or purchase a new home, the company can more widely market higher-ticket and age-appropriate Pottery Barn and Williams-Sonoma products. With an extensive portfolio of brands under the corporate umbrella, we see PBkids as the natural brand extension--as Pottery Barn and Williams-Sonoma consumers have children, the brand loyalty already exists to market to parents. PBteen closes the gap, looping in the age group between children and becoming a potential West Elm enthusiast. Once the children age through the PBkids and PBteen brands, they will have had experience with Williams-Sonoma's offerings at some level, igniting brand awareness with future customers before they even have an interest in furniture or home furnishings.

Evolution of Multiple Factors Leads to Rising Profitability Not only is market share a place for improvement, there are also longer-term opportunities that Williams-Sonoma can capitalize on to expand its operating margin. There are four key drivers of the improvement in profits and ROICs over the long term. First, the growth of the international franchise business is likely to be margin accretive to the enterprise, as it has been historically. With only around 620 corporate-owned stores across all of the Williams-Sonoma portfolio of brands, franchise performance can become relevant very quickly and contribute meaningfully to the performance of the entire enterprise as the channel expands, and the company has already voiced its growth trajectory for the business over the next few years.

Second, the rise of e-commerce as a percentage of total sales should change the operating margin profile naturally, since e-commerce has delivered significantly better operating margins than the brick-and-mortar business. Third, the new real estate strategy, which is taking Williams-Sonoma's stores out of slowing-traffic malls, could yield incremental cost efficiencies if the rents are more competitive and the product display is expanded, potentially raising the four-wall contribution of these locations. Abandoning the lower-performing stores as they close through attrition should also add incremental margin benefit here.

Finally, differentiated new-brand extensions, focusing on bathroom, outdoor, or other previously underpenetrated areas, can offer both upside in pricing and leverage in distribution costs as the enterprise is able to use its rising scale more opportunistically.

E-Commerce Bolsters Visibility of Brand, Expands Product Availability in Franchise Markets E-commerce will be a driving force in ensuring that some of these new franchise locations merchandise properly. With little capital risk in launching an e-commerce platform in new countries or geographies (and mostly just moderate costs to support distribution), we wouldn't be surprised if the majority of Williams-Sonoma's revenue in new markets was online. In our opinion, product adoption and demand in each local market could be easier to gather and assess with little capital deployed thanks to e-commerce. Williams-Sonoma, or its franchise partner, depending on the market, could use a limited number of brick-and-mortar locations as a type of marketing tool to build brand awareness initially in nascent markets to ease into new locations internationally; we imagine the company could even facilitate a grassroots growth initiative through store events, like technique classes that are offered at Williams-Sonoma locations domestically.

From the primary launch through the initial months of operating in a new geographic location, Williams-Sonoma could capture important information about local consumer trends and then refer to the historical transactions it has captured domestically to better predict which products would be optimal to add into each specific regional lineup as the company's footprint builds. While we don’t expect the progression of transactions to be identical globally, we can anticipate that many purchases will follow a pattern. This type of insight should permit inventory turns to remain elevated, even with respect to local competitors. With Williams-Sonoma entering brick-and-mortar and e-commerce in tandem, we forecast rising e-commerce sales as a percentage of the total, since the "endless aisle" will encourage higher initial channel use because of the wider product selection.

As the company continues to build out brick-and-mortar and e-commerce channels globally, we project that direct-to-consumer sales will reach around 60% of total sales over the next decade. We think this is relevant because the operating profiles of e-commerce and brick and mortar are very different--over the past five years, retail operating margins averaged 11%, while direct-to-customer operating margins averaged 23%, leading to enterprise-level operating margins of more than 10% (there were roughly $300 million of unallocated expenses at the operating line in each of the past three years). If e-commerce can rise from just below 51% of total revenue to 60% of total revenue with 1,100 basis points (or more) of margin outperformance, it should contribute roughly 100 basis points of enterprise operating margin improvement over the next decade.

Extension of Adjacent Categories and Brands Taps Into Customer Interests Additionally, we expect development of new markets to not only occur through e-commerce accessibility, but also by extending new categories and brands. Diversification across related category white-spaces (areas that have not previously tapped into) has historically helped Williams-Sonoma tap into new demographic demands, and we believe the company will persistently move into adjacent categories to stimulate incremental interest from both current and new customers. As Williams-Sonoma builds know-how to successfully launch new brands into its portfolio each time it works through an expansion, forward brand extensions may have a higher probability of being successful--the steps to vet viability and pursuit have been established in these prior test cycles, which have ended in successful launches.