Williams-Sonoma (WSM) is a retailer of many kinds of home products, such as furniture, bedding, lighting, rugs, and other products. It operates in two segments: E-Commerce and Retail. It sells its products through the brands Williams-Sonoma, Pottery Barn, Pottery Barn Kids, West Elm, PBteen, and more.
We are bullish on the stock, as we believe it is a high-quality company that is undervalued.
Williams-Sonoma’s Economic Spread
Great companies often have great management teams who can effectively allocate capital to profitable projects. Many professional fund managers tout the importance of meeting with a company CEO to gauge if that person is right for the job.
However, we can get a good picture of management’s effectiveness by simply looking at the numbers. A metric we like to look at is the economic spread, which is defined as follows:
Economic Spread = Return on Invested Capital – Weighted Average Cost of Capital
The idea is straightforward; if the return on invested capital is greater than the cost of that same capital, then the company is creating value for its shareholders through well-thought-out projects. Otherwise, the company is destroying value and would be better off simply investing money into risk-free bonds.
For Williams-Sonoma, the economic spread is a follows:
Economic Spread = 34.6% – 8%
Economic Spread = 26.6%
As a result, the company is creating value for its shareholders, implying that management is efficiently allocating capital.
Competitive Advantage and Margins
There are a couple of ways to quantify a company’s competitive advantage using only its income statement. The first method involves calculating the earnings power value (EPV).
Earnings power value is measured as adjusted EBIT after tax, divided by the weighted average cost of capital, and reproduction value (the cost it would take to replicate the business) can be measured using total asset value. If the earnings power value is higher than the reproduction value, then a company is considered to have a competitive advantage.
The calculation is as follows:
EPV = EPV adjusted earnings / WACC
$10.675 billion = $854 million / 0.08
Since Williams-Sonoma has a total asset value of $4.63 billion, we can say that it does have a competitive advantage. In other words, assuming no growth for Williams-Sonoma, it would require $4.63 billion of assets to generate $10.675 billion in value over time.
The second method to determine a competitive advantage is by looking at a company’s gross margin because it represents the premium that consumers are willing to pay over the cost of a product or service. An expanding gross margin indicates that a sustainable competitive advantage is present.
If a company has no edge, new entrants would gradually take away market share, leading to a decreasing gross margin over time.
When it comes to Williams-Sonoma, its gross margin has expanded in the past several years, increasing from 36.5% five years ago to 44% last year. As a result, its gross margin trend indicates that a competitive advantage is present in this regard as well.
WSM may even maintain or see higher margins in the long term because of the potential growth of its B2B business. Here’s what CEO Laura Alber stated in the most recent earnings call:
“Our B2B business has tremendous potential to contribute to our results. Our growth targets continue to climb as we unlock new opportunities. And not only is our B2B business model accretive to our gross margin, but even more accretive to op margin as a result of its fixed operating costs. We continue to exceed our own expectations for this business, and longer-term, we believe this is one of our biggest opportunities.”
Nonetheless, management’s guidance for the next year calls for its operating margin to be roughly in line with Fiscal 2021, which would be impressive to see in this inflationary environment where operating costs are rising.
In the last 12 months, Williams-Sonoma has recorded ~$1.15 billion in free cash flow, making it profitable by our definition. This means that the company doesn’t have to rely on equity raises to continue funding its growth.
More importantly, its free cash flow has been trending up in recent years, as it was just $341.1 million in the fiscal year ended January 2016. To us, this means that the company’s free cash flows are reasonably predictable.
Dividends, Buybacks, and Valuation
Williams-Sonoma is known for its dividend growth and buybacks. Currently, its dividend yield is 2.3%, which is not bad considering that it has room for quick growth. The dividend increased 10% last month, which is respectable.
Both its five and 10-year dividend CAGR come in at a bit above 13%. To put that into perspective, 10 years ago, its dividend was $0.88 per share; now, it is $3.12. Its payout ratio of 17% suggests that the dividend is well covered and can grow without any issues.
The company also doesn’t have any interest-bearing debt and has a cash pile of $850.3 million. With a market cap of about $9.7 billion, its cash position is about 8.8% of its market cap.
WSM can use its cash combined with its high free cash flow to buy back a large portion of its shares. In fact, that is exactly what it plans to do. Last month, WSM authorized $1.5 billion in buybacks. If the company ends up buying back all those shares at an average price near its current price of ~$135, then this would equate to around 15.5% of its market cap.
Throw in the dividend, and you have high return potential. Lastly, earnings are expected to grow over the next few years, and with an estimated forward EPS of $15.28, this implies a forward P/E multiple of ~8.8, which we believe is cheap.
To measure Williams-Sonoma’s risk, we can check whether financial leverage is an issue. We do this by comparing its debt-to-free cash flow. Currently, this number stands at 1.1 (if you include lease liabilities as debt). In addition, when looking at historical trends, its debt-to-free cash flow ratio has been trending down.
Overall, we don’t believe that debt is currently a material risk for the company because it has paid off all its interest-bearing debt in the past few years and has historically been responsible when it comes to debt.
However, there are other risks associated with Williams-Sonoma. According to Tipranks’ Risk Analysis, the company has disclosed 43 risks in its most recent earnings report. The highest amount of risk came from the Finance & Corporate category.
Wall Street’s Take
Turning to Wall Street, WSM has a Hold consensus rating. This is based on six Buys, five Holds, and four Sell ratings assigned in the past three months. The average Williams-Sonoma price forecast of $178 implies 31.7% upside potential.
Analyst price targets range from a low of $132 per share to a high of $225 per share.
Williams-Sonoma has been selling off lately due to recession and inflation fears. Perhaps the market doesn’t believe that it can sustain its earnings and margins in an inflationary or recessionary environment.
Although this selling may continue in the short term, we believe the long-term picture is better, as WSM has a solid history of growth, profitability, and good returns due to its competitive advantages. At the current low valuation, we are bullish on WSM stock.
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