What Is The Market Really Pricing For Williams-Sonoma? (NYSE:WSM)

I am a conservative investor; I have learned that after more than 18 years involved in managing financial assets and that might be a relevant datapoint for readers going through this article. I am giving Williams-Sonoma, Inc. (NYSE:WSM) something that could be interpreted as a bullish hold as the cold hard numbers seem to indicate there is a sufficient margin of safety, but the macro picture indicates that there might be better entry points in the future.

Approximately one year ago, WSM jumped at me on a valuation screener of retail stocks. Wow, that’s cheap was my first reaction, I wonder what they sell (I do not live in the US for those thinking that I might be living under a rock).

The answer was basically products for the Home and Furniture, so I did not give it a second thought, this is surely a covid story, their sales will come back to normal in a couple of quarters, and decided to use my due diligence efforts in another name.

Now, one year later, with many retailers in different categories showing lower sales figures consistently I bumped into WSM again, but to my surprise, they continued to show positive sales numbers until recently.

Having said that, that big jump in revenues in 2020-21 and the word furniture in the mix instinctively made me avoid the company, but this time I decided to dig a little deeper and the following analysis is what came of that digging with some of my own internal dialogue as I kept pushing despite high levels of skepticism given today’s macro picture.

WSM is a Home Furnishing Retailer that operates under 4 main brands Pottery Barn, West Elm, Williams Sonoma, and Pottery Barn Kids & Teens and two smaller ones Rejuvenation and Mark & Graham. But you can find all of that and more by reading two pages of the Business Overview section from their last 10-K or by going through their last company presentation. So, I would go straight into the numbers as my objective is to try to add some value to my articles and not just copy information that you can easily find on your own.

The Elephant in the Room

Let’s start our journey by looking at two basic valuation metrics on a TTM basis.

What is obvious at least to me is that the market does not believe that the figures posted by the company in the last 2 years are sustainable at all. And it’s not even pricing the consensus of an 18% reduction in earnings (according to Fastgraphs) as on a forward basis the company is trading at 8.5 times when it has historically traded closer to 15 times forward earnings.

So, let’s try to assess what the market is really pricing for WSM, and based on historical data, let’s figure out if that seems fair.

Revenues

Let’s start with some historical perspective of the financial evolution of the company.

After the bottom post-GFC (3Q09) up to 4Q19, the company managed to grow Revenues at a healthy 6.7% annual rate. But during the pandemic, the growth rate almost doubled to a 12.1% annual rate. So, here is the first barrier to any skeptical investor. Is that entire jump in growth a covid bump that should melt away?

Maybe, but you should consider one driver of revenue that only formally started in 2019 and that is the B2B business that for 2022 accounted for almost $1 billion in sales. If you assume that $750 million of the revenue growth after 4Q19 came from this new line of business, the annual growth rate for the rest of the organic lines of business comes down to 8.9% that while still high seems much more reasonable given the inflationary backdrop of the last 18 months.

After that, you are faced with a huge 9 points jump in EBITDA margin, so said skeptical investor faces a second barrier. Is that entire jump in margins a covid bump that should melt away?

Maybe, but is there ANYTHING that might at least partially explain that jump apart from the covid/helicopter money effects of the last 24 months?

The $750 million coming from the new B2B business might have helped as they can significantly leverage their operations with this new revenue.

Ok, but 9 points is too much, anything else?

The other thing that might give you some hope regarding the sustainability of that margin is the fact that during the 10 years from 2008 to 2018, the share of e-commerce revenues increased from 41.6% to 54.3% or at a rate of 1.27 percentage points per year. But for the last 4 years, it increased at an annual rate of almost 3 percentage points as today stands at 66%.

Mmm… ok that should also help at least to a degree, I assume that sales with no need for leased retail space should be more profitable, but 9 points is still too much. Is there anything else?

Well, yes. You might remember that the jump in margins starts at the end of 2019 and the end of 2019 marks the peak of total leased square footage from there on the company has reduced it by more than 10% to levels not seen since 2015 when the company had revenues of less than 60% of TTM figures. And that is certainly material leverage to margins.

Finally, the company seems to be very focused on maintaining cost discipline as in their latest report, while things are still looking good, they recognized non-recurring charges of $26.2 million in relation to the closure of a manufacturing facility, a reduction in headcount and the exit from the small non-core aperture SaaS business, all of which should translate into $40 million annualized pre-tax savings.

What is the market really pricing?

Having been able to go through those stages of skepticism I tried to understand what is been priced by the market as the company trades at the bottom of historical ratios. For that, I used a FCF to the firm exercise to get to a scenario that aligns with underlying company valuations.

For a company with no financial debt, the equity cost of capital should be used as the WACC.

And with the 10y treasury standing at 3.7% with a beta of 1.28 according to MarketWatch and an equity risk premium of 5.18% according to the long-term geometric average provided by Professor Damodaran, we get to a WACC of 10.175%

Using that rate, the following are the underlying assumptions that would give you a fair value assessment for the company today.

Revenues: A reduction of 10.5% from the 3Q22 peak to 1Q24 and from there on revenue growth of 2.25% in perpetuity for a company that pre-pandemic showed a solid annual growth rate of 6.7%. Under this perpetual growth assumption, the perpetuity by year 10 is discounted with a rate of 7.925% (10.175% WACC – 2.25% growth) giving an implied exit multiple of 12.62 times FCF that seems conservative vs historical valuation multiples for the company.

EBITDA Margins: A contraction of 9.2 percentage points from peak TTM of 20.4% in 2Q22 to a bottom of 11.2% by 1Q24 and from there on a recovery up to 13.9% by 1Q28. That reduction in margins from peak to bottom is comparable to what the company experienced during the GFC.

Just to add clarity, the long-term EBITDA margin of 13.9% is consistent with an 11.4% EBIT Margin, way below the bottom of 15% that management believes is achievable.

Depreciation and Capex as % of revenues of 2.5% and 3.2% respectively, both in line with recent readings.

Income tax rate of 24%.

The next couple of charts gives a graphic perspective of the future evolution of the company under those assumptions (the red dots mark the last actual TTM figures).

And the following table shows the figures that give you a NPV roughly in line with the current market cap.

So, in the end, for any long-term investor, the question is whether you think that the company will be able to perform better than those assumptions or not. My own perspective is that the company should be able to perform better considering that WSM has been able to weather pretty well a housing market experiencing a sharp contraction for more than a year that today seems to be showing some signs of stability by looking at indicators like one family homes sold and months of supply.

Looking forward, my perspective is that it’s more likely than not that the US economy will experience a recession in the next 6 to 12 months and that surely will put pressure on the company, but the implied financials that are being priced are consistent with a significant downturn in activity.

At the same time, if that recession finally hits causing an increase in unemployment, rates should be able to come down in a material way providing a reasonable level of relief to the housing market, reigniting to a degree, an important driver for WSM.

One final point before my conclusion is a quick look at the inventory picture as for retailers any excesses here usually translate into significant margin contraction in the short term. The picture here looks healthy at least so far, and even with the 10.5% implied reduction in sales, the ratio rises to just 18% assuming stable inventories looking forward.

There is always the risk of a miscalculation looking forward as inventories typically increase until the 3rd quarter as the company prepares for the most important 4th quarter, but so far there is not much to worry which is certainly not the case for many other retailers.

Conclusion

I am giving the company a somewhat bullish Hold; the cold numbers say that I should invest and if you are truly an investor with a long-term horizon, my perspective is that you should do well.

But at the same time, I am still on the fence regarding the industry given the current macro backdrop and considering that valuations alone, while extremely important in the long term, tend to be poor short-term catalysts of performance. Waiting for at least a minor increase in unemployment might give an even better entry point for a more tactical investor.

Anyhow this is just a subjective opinion, and the company is definitely on my radar to open a position. But I think this is less important for readers than the exercise that I presented here I hope gives investors a reasonable perspective regarding what the market is currently pricing so each one of you can make your own assessment against those figures.

Thanks for reading, good luck with your investments, and of course I am more than open to constructive criticism that might help me improve my own understanding of the company.