The Market Has More Than Caught Up With Williams-Sonoma

By Stephen D. Simpson, CFA | August 23, 2012 AAA

It would seem that a lot of investors had a vested interest in seeing Williams-Sonoma (NYSE:WSM) make solid progress on its growth recovery. While performance is indeed looking better at this multi-brand housewares retailer, today's valuation seems to assume not only ongoing improvement, but also little economic risk in the near-term.

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Second Quarter Results Spike the Stock
Williams-Sonoma reported over 7% revenue growth for the second quarter, with retail revenue up 3% and direct-to-consumer (DTC) revenue up almost 13%. Comps rose 3.9%, with Pottery Barn and West Elm delivering solid growth once again, but the flagship Williams-Sonoma is still in the red. Comparable brand revenue, though, was up more than 7%.

Margins and profits were also better this time around. Gross margin improved about 40 basis points, with operating income improving by nearly 10%. Although retail margins compressed about 30 basis points on higher labor costs, DTC margins rose almost the same amount and are nearly three times those of in-store retailing.

SEE: Analyzing Retail Stocks

Investors Seem Untroubled by Ongoing Challenges
Playing devil's advocate for a bit, there were at least a few yellow flags for the quarter. For starters, though the West Elm comp was strong, growth is slowing and this represented the slowest/weakest comp in two years. Likewise, while an 11% increase in inventory levels ought to help in-stock levels, it does tie up more capital.

Last and by no means least, the company is still working to dial in the right mix of promotion and brand-building. Williams-Sonoma comps seemed to suffer from a decision not to repeat a year-ago cookware sale. On the flip side, the company announced that it will be the first to launch Starbucks' (Nasdaq:SBUX) new Verismo coffee machine and will carry an exclusive premium model. While these exclusive deals usually come at a cost in terms of margins (the supplier gets a break in exchange for the exclusivity), they can definitely drive traffic if managed right.

SEE: The 4 R's Of Investing In Retail

DTC a Real Opportunity
On a more positive note, investors need only look at Pier 1 (NYSE:PIR) and Cost Plus (prior to its acquisition by Bed Bath & Beyond (Nasdaq:BBBY)) to see the sort of appreciation that a turnaround can produce in houseware retailing. While Williams-Sonoma never flirted with the bottom like these other changes did at their lowest points, the point stands that a healthier flagship brand could be worth a lot.

Building the DTC business could be a significant part of that recovery. Growth was rebounded here nicely, and the margins are definitely strong. Now the question is whether Williams-Sonoma can incentivize shoppers to stick with them online instead of clicking over to Amazon (Nasdaq:AMZN) or one of the many online-only houseware/cookware suppliers.

SEE: Four Online Shopping Alternatives To Amazon

The Bottom Line
While I didn't see Williams-Sonoma as a screaming bargain back in May, I thought there were still good reasons for current owners to hang onto the shares. I suppose many of the same arguments apply today - the Williams-Sonoma brand is still valuable, there is substantial DTC growth potential and I think West Elm could easily become a leader in its category.

The valuation case is a little harder to make now, though, given the Street's renewed enthusiasm and apparent will to believe in the turnaround. Even with a robust improvement in free cash flow, I have trouble seeing how this stock is worth much more than $40 today. So long as the financial momentum stays positive, valuation won't matter much, but new investors may want to wait in the hopes of a pullback and a little margin of safety.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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