We See Value in Williams-Sonoma

Williams-Sonoma relies on its e-commerce business (51% of total revenue) to build the brand cost-effectively and help leverage costs via low overhead expenses, driving operating margin improvement; e-commerce EBIT margins are 24% versus 11% in retail. The firm should enjoy opportunities to build the brand globally while improving the cost structure thanks to an improving supply chain and distribution network through initiatives like insourcing of foreign buying offices 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 company took its first step into direct global retailing in Australia during 2013 and franchising into Mexico in 2015.

With West Coast port confusion out of the way, merchandise should match demand more closely, leading to improving sell-through; however, over the near term, we expect the consumer shift to durables could weigh on the softlines side of the business. Longer term, our main concern is that the business is tied to conditions in the housing market; a downturn could lead to profit swings. For example, 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 13% the past five years.

Innovative Products, but Little Pricing Power Despite its healthy returns on invested capital (an average of 13% over the past five years), we believe Williams-Sonoma has no economic moat. In our opinion, nonexistent switching costs could weigh on pricing power persistently, even though we believe the innovative product offerings the company delivers from its suppliers are particularly well tailored to its customers, thanks to a wealth of information and thoroughly examined behavioral patterns that it has harnessed from its e-commerce business. The company has captured around 100 data points on each transaction since the early 1990s, providing more than 20 years of robust information with which to run targeted direct marketing algorithms (and even further back from the catalog, which began circulation in 1972). As the years tick by, a wider net of information has become even more powerful, with every transaction making the already robust set of data points more accurately predictive of consumer demands. With about half of company sales coming from e-commerce sources (mostly online, but also catalog), we do think searching online for similar products at more competitive prices poses a threat. Nonetheless, Restoration Hardware RH is the only competitor that has nearly half of its sales from the direct channel; we believe Pier 1 PIR and Ethan Allen ETH procure a significantly lower proportion of their sales directly.

We view numerous categories that Williams-Sonoma peddles as commodified with ample domestic brick-and-mortar and online rivals, including department stores and home-improvement companies, which frequently entice consumers with coupons and discounts. This underlies our no-moat rating. We believe the firm's brands and quality carry weight with consumers, but view the core consumer as easily swayed by economic conditions, particularly in the housing market (comps fell 17% in 2008). We expect returns on invested capital to reach more than 18% over the next five years, well ahead of our 9% cost of capital assumption, but we remain concerned that performance across the brick-and-mortar retail segment could weigh on true earnings potential, owing to increased price competition with online players like Amazon AMZN, warehouse clubs, mass merchants, and other specialty retailers.

We believe Williams-Sonoma's ability to execute target marketing concisely will cause customers to return consistently and continue to build brand loyalty. Integrating the consumer base through social media sites like Pinterest and Instagram also allows the business to reach customers through additional touch points. Although the brick-and-mortar business has more than 600 locations, we think Williams-Sonoma could also leverage operating costs longer term across its e-commerce channel (as well as its expanding global brick and mortar footprint, which we think the company could probably grow at a low-double-digit location rate), especially as it improves its distribution network and supply chain. Recent initiatives here include bringing sourcing in-house and expanding its upholstery/furniture business domestically (which already represents 50% of the upholstery business), which could lower costs materially longer term.

In our opinion, it is Williams-Sonoma's carefully edited assortments of products across its brand portfolio that will continue to attract consumers to its business. Additionally, product selection and offerings at Williams-Sonoma remain favorable and compare well with online players and other mass merchants from a pricing perspective. Our main concern is that weaker home furnishings, department store, and specialty retail rivals could be forced into irrational pricing decisions to survive, which may change the economics across the entire home furnishings retail category and dilute company profitability, at least for a short period.

Demand Depends in Part on Housing Market While we believe Williams-Sonoma's brands remain aspirational, we still see risk from competition with online players like Amazon and other mass merchants, which have passed on their scale and other cost advantages with 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 has recently announced its entry into the teen space, making it more crowded), 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.

Smart Capital Allocation Over the past five fiscal years, Williams-Sonoma has produced cumulative free cash flow of more than $1.1 billion. Its cash requirements are primarily for inventory, property, plant, and equipment, advertising and marketing, share repurchases, and dividends, which we believe will mostly be funded by cash generated from operations. 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. In general, we consider management to be excellent operators, balancing growth and profitability while prudently allocating capital, driving a five-year average return on invested capital of 13%. The company has also consistently returned excess cash to shareholders via dividends and share repurchases, spending around $1.4 billion cumulatively for both over the past five years.