Williams-Sonoma Is Set to Gain Share

Williams-Sonoma relies on its e-commerce business (52% of total revenue) to build its brands cost-effectively and leverage costs (low overhead), driving operating margin improvement; e-commerce EBIT margins are 23% versus 10% in retail. The firm should enjoy opportunities to build its brands globally while improving its cost structure, thanks to an improving supply chain and distribution network as a result of direct sourcing and furniture delivery operations.

Additionally, the firm’s expanding global footprint could help improve sourcing and distribution costs longer term, improving operating margins. Global expansion allows access to a wider profile of consumer preferences, lending to better local merchandising and marketing, which could facilitate higher unit sales as supply increasingly matches demand; the firm took its first step into direct global retailing in Australia during 2013.

Becoming a faster and more dynamic merchant via supply chain and inventory optimization could boost operating margins, which we forecast rising to about 12% over the next decade from an estimated 9.5% in 2017. In the longer term, our main concern is that performance is tied to housing market conditions; a downturn could affect profits (EBIT margins were 1% in 2008). That said, disciplined capital allocation and controlled costs allowed Williams-Sonoma to deliver an average return on invested capital of 14% over the past five years.

Customer Data Collection Sets Williams-Sonoma Apart While discretionary spending can be fickle, we believe Williams-Sonoma has built a defensible position in the home furnishing industry, despite capturing only mid-single-digit market share. In our opinion, the company has carved out a narrow economic moat when considering the solid returns on invested capital that the business has delivered over the past decade--at around 12%, this is higher than our 9% cost of capital, even with the inclusion of the recession years that yielded low-single-digit ROICs for the business. We forecast that ROICs will remain in the midteens as the economic profits that are generated more widely surpass the company's WACC. We contend that Williams-Sonoma's brand intangible asset has historically been the supporting factor in top- and bottom-line growth, as the firm's ability to drive repeat business is widely reliant on customer loyalty and smart marketing and merchandising.

Relative to its peer group, Williams-Sonoma is in a strong position to continue outperforming its competitors and capturing share; a key tenet of our thesis is the company’s continued access to some of the best analytics in retail. Williams-Sonoma has a nearly 20-year lead on most retailers, collecting insights on end users for more than 25 years at a granular level (more than 100 data points on each transaction). This deep knowledge, in our opinion, is ultimately what leads the business to operate more efficiently and turn inventory nearly a full turn faster than its peers. The robust capture of customer purchasing patterns allows the firm to market tactically, since vast amounts of transactions can become predictive in nature; Williams-Sonoma can begin to figure out what the consumer’s next likely purchase might be and produce information to facilitate that next sale more quickly.

We believe the company has used its data to decide to strategically enter new brands based on consumer demand as the enterprise has evolved, acquiring Pottery Barn in 1986 and then launching PB Kids, 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. We view the West Elm extension as critical to improving 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, catering to the initial furniture and home furnishing purchases of the millennial cohort. Once the first purchase is notched at a brand like West Elm, Williams-Sonoma can use its marketing prowess to logically tailor its marketing, using data indicating the next likely purchase to suggest the product that is most likely to drive repeat business. As millennials ascend age and income demographic segments, upgrading their living arrangements or purchasing a new home, the company can move to market higher-ticket and age-appropriate Pottery Barn and Williams-Sonoma products to the right consumer. We see PB Kids as the next natural brand extension as the Pottery Barn and Williams-Sonoma consumers have children. PBteen closes the gap, looping in the age group between children and producing potential West Elm enthusiasts. Once children age through the PB Kids and PBteen brands, they will have experience with Williams-Sonoma’s offerings at some level, igniting brand awareness before they even have interest in furniture or home furnishings.

While the idea of data collection seems simple (and almost all retailers are capturing data on purchases to some degree), we believe it is more complex for Williams-Sonoma, as the company can use it to market more dynamically. For every additional point of data collected, the company’s marketing algorithm should get smarter, more accurately predicting future purchasing patterns and boosting the efficiency of the overall marketing platform. This in turn should continue to bolster operating margins at Williams-Sonoma, which already surpass those of peers on a regular basis (and are noticeably more stable over time), as less capital is need to stimulate the next incremental sale. It also ensures the brand is positioned properly to its consumers, supporting the brand intangible asset and narrow economic moat.

Market Share Gains Are Still Possible Although the business has operated for more than 50 years and has developed a more tailored approach to marketing and advertising to the individual consumer over the past 25 years, we still see market share gains as achievable for Williams-Sonoma from current levels. The $109 billion furniture and home furnishing industry (according to the U.S. Census Bureau) remains very fragmented, and with Williams-Sonoma capturing only 5% share (up from 4% just four years ago and 3% three years prior to that), it seems that ample opportunity for growth exists. We think there are a few ways the company can take share. First, incremental share grab can come by category extensions; PB Kids and PBteen are two of the most populated youth stores on a national level with any scale (PB Kids has fewer than 90 stores and PBteen has around 20 locations, both supported by robust e-commerce offerings). While the children and adolescent furniture space is niche and an abundance of local boutique competitors remain in regional markets, we think Williams-Sonoma's national scale allows for better supply chain and consumer trend responsiveness. These will ultimately lead to more consumers choosing one of the portfolio's brands over time as its broad marketing bandwidth offers better share of mind. Additionally, we believe this will lead to a shift away from boutique retailers and other national retailers that are currently struggling. While companies like Pier 1 PIR and Restoration Hardware RH try to right their ships, Williams-Sonoma can capitalize on the disconnection in the marketplace between peers and potential consumers.

Furthermore, we believe Williams-Sonoma can capture additional global market share through the expansion of its corporate-owned boxes and its franchise relationships. As the firm has little international brick-and-mortar exposure at this point, we assume that any new location growth overseas will be taken on methodically. This will ensure that the brand is represented properly in the local marketplace and that local demand is addressed carefully to craft wider knowledge about the brand over time, helping to strengthen the brand intangible asset globally.

Producing healthy double-digit ROICs is bound to attract competition in the category, and the concern that investors voice the most regularly is with respect to peers that solely operate online, like Wayfair W, which can offer similar products, including known name-brand lines, and free shipping to boot. However, we believe the lead time Williams-Sonoma has on reading its customers’ behavior will be hard to copy. A young company like Wayfair doesn’t have a long history of transactions that it can read into to efficiently market to its end users. This ultimately means that a younger firm’s marketing will remain costlier in the years ahead until the nascent business can close the gap, which could take a decade or more as trends change (both Williams-Sonoma and Restoration Hardware spend 5%-7% of sales on advertising, while Wayfair allocated around 13% on average over the past three years). In our opinion, this will surface in operating margins that remain higher at Williams-Sonoma than at some of its newer peers, helping to keep its double-digit ROICs and narrow moat intact.

Competition Remains a Risk While we believe Williams-Sonoma's brands remain aspirational, we still see risk facing the company from competition with online players like Amazon AMZN and other mass merchants that have passed their scale and other cost advantages into lower prices for consumers, particularly in commodified categories. Additionally, Williams-Sonoma's fundamental demand is tied somewhat to the performance of the domestic home-improvement market and consumer confidence, which tend to fluctuate over an economic cycle, driving significant volatility in comparable-store sales. We think international expansion will help insulate the company from these fluctuations in the revenue base, as global consumer confidence levels don't necessarily move in tandem (though geographic risk will take some time to diversify). A slowdown in the cadence of improvement in the real estate market, which could be indicated by increased home inventories for sale or slower growth in new- or used-home prices, could alter the wealth effect on consumers and cause them to spend less on replacing goods in their homes.

Although new competitors could feasibly set up shop in Williams-Sonoma’s territory (and Restoration Hardware now operates in categories like teen and baby), we think a completely new player in the industry would be hard-pressed to replicate the brand equity and consumer loyalty that the firm has built over the past 50-plus years. Internationally, the company risks marketing improperly to audiences in Australia or franchise markets (Middle East, Mexico, Philippines), which could have significantly different consumption preferences than Americans do, and entering markets where consumers already have brand loyalty to incumbent operators.

Williams-Sonoma is in fine financial health, and it carries no long-term bank or public debt. Free cash flow has averaged about 6% of revenue during the past five years, which we think is decent for a company that produces somewhat volatile results that are closely tied to the performance of the housing market.

Management had access to a $500 million share-repurchase authorization starting in March 2016, with $400 million availability remaining at year-end. This should allow the firm to buy back an average of 2% of its shares over the next two years, which should help it get back to its long-term double-digit earnings per share growth target. Williams-Sonoma is positioned to earn around $300 million or more in free cash flow every year for at least the next five years. It also pays out a $0.39 quarterly dividend, which we believe will grow as the company accumulates more cash.