Description

Shorting furniture retailers has arguably become a consensus view on the back of widely known tough comps from early 2021 (+26% and +40% SSS Comps for WSM in calendar Q1/Q2 ‘21) and fear of pull forward of demand. Thematic macro analysis that stops there, however, paints an incomplete picture of what has transpired at many individual companies like WSM that have been deemed COVID beneficiaries that are now at all-time low valuations. WSM put up +11% SSS Comps again this latest quarter, defying all expectations when bears seemed to have been bracing for a negative print. 

WSM is a furniture and home décor retailer that owns several well-known brands: William Sonoma, Pottery Barn, Rejuvenation, Mark & Graham, and most importantly, west elm. While perhaps thought of as a dying mall-based brick & mortar retailer, WSM derives the vast majority (66%+) of its revenue from e-Commerce and has been a remarkably steady performer, remaining free cash flow positive every year since at least 2007 and achieving positive same store sales comps since 2010, including +17% in 2020, +22% in 2021 with guidance for a further mid-to-high single digit growth again this year. Within the overall positive sales trends, west elm’s consistent growth has been even more impressive, with a 16% average annual same-store sales growth rate since 2012. To little fanfare, by our calculation, WSM has become the single highest quality retailer in public markets with a 58% return on invested capital (ROIC) in 2021 and a 39% ROIC on average over the past 3 years.

With WSM the 5th most shorted retail stock on the consensus that furniture demand was pulled forward, it’s important to point out that furniture spending as a percentage of total personal expenditures is still far below the long-term average and remains lower than any single quarter from 1990-2006. The depressed furniture market post-GFC due to weak new home sales was the historical anomaly as opposed to the upward reversion that kicked off in 2020. In 2020 the average annual expenditure on furniture per affluent household (top 20% by income) was still below 2015 levels. Furthermore, WSM’s growth has outpaced the furniture market overall by an > 8% CAGR since 2012. So even with a moderate industry slowdown, they are likely to continue taking market share at a fast clip as they did in 2020, growing 15% while the home furnishing industry overall declined 23%.

With the stock trading near an all-time low valuation currently, at 6.5x EV/2023 EBIT (vs. 12x historical average), it is at a nearly 50% discount to a basket of slower growth, lower margin, lower e-commerce penetrated, lower ROIC retailers and is clearly pricing in some severe margin compression and revenue declines.

By our calculation, WSM’s current stock price is pricing in no revenue growth despite guidance for mid to high single digit growth and for operating margins to get cut in half, from 17.6% to less than 9%. However, our variant view is that there are several reasons to believe that majority of WSM’s margin gains post COVID lockdown will be more sustainable than the consensus thinks.

Recent Results

Pottery Barn, the largeset brand within WSM, was particularly impressive with +21.5% comps lapping 29.6% (51.1% two-year). West Elm was also impressive managing to grow 6.1% on top of 51.1% last year (57.2% two-year).

Gross margin in quarter were down slightly by 60 bps y/y to 43.5% but stayed around record highs and were 44% for the LTM. The company attributed the slight decline to "higher freight costs from our strong furniture demand, higher back order fulfillment and global supply chain disruptions, driving freight rates higher for all".

Despite all the fears of margin collapse, operating margins in Q2 were actually up 40 bps y/y to 17.1% and reached a new LTM high of 18%. This is above the company's 2024 target of 17.6%.

SG&A averaged 28.2% of revenue from 2012 - 2020 and reached as high as 29.4%. Since Q2 2020, SG&A has stayed below 27% and is trending lower, now down to 26% for the LTM.

B2B

While we like the core WSM business and collection of brands by themselves, the company has an entirely new initiative that began in mid-2019 that almost no one talks about despite its valuation potentially eclipsing the entire current enterprise value on its own within a couple of years.

In this relatively fledgling business-to-business (B2B) segment, WSM acts as full-service interior designer and furniture outfitter for large commercial clients and hospitality chains such as Marriott, Salesforce, Disney, and several professional sports team arenas. This business faces little competition from players who can operate at the same scale WSM does or who can provide the “one-stop-shop” experience of sourcing from a single vendor. Across WSM’s 8 brands customers can select everything from couches to outdoor furniture to bedsheets to light fixtures. The business is currently growing at over 60% y/y doing $900 million in LTM revenue last year at an estimated 25% - 30% operating margin. Even assuming a revenue growth slowdown to 30% per year, at 30% operating margins we think WSM’s B2B business can generate over $500M of EBIT by 2024. Using a valuation multiple comparable to a basket of the top tier public retailers (as measured by margins and ROIC) we estimate just this one segment alone could be worth ~70% of the current enterprise value, or $6 billion, within the next 2 years.

While the growth rate has slowed substantially for the B2B down to a measly 32% y/y (lapping 122% last year), the business is now doing $900 million in LTM revenue.

The beauty of the B2B business is that it's a natural extension of what WSM does best with its in-house design team and sourcing. It simply opens the door to a previously untapped $80 billion, highly-fragmented market opportunity, which WSM has quickly captured >1% of. The business fully launched in 2019 with management initially setting out the target of $1 billion in revenue by 2024. The growth has exceeded all expectations and should easily exceed $1 billion by then as its currently at $900M LTM. As the CEO said on the Q4 earnings call, “B2B just continues to go. I think I've revised my estimates every time I've gotten on this call. I decided not to give estimates anymore because I keep undershooting it. And that's embarrassing as well."

Despite the rapid success, the B2B business is still relatively nascent in our view. For example, the company just began designing restaurant and hotel-specific furniture in mid-2021. Prior to this, the company was simply making contract-grade versions of its existing furniture line. Now the company leverages its industry-leading, sustainable manufacturing operations to cater to specific types of commercial customers with WSM, the CEO noting in May 2021, "our win rates on large projects continue to improve."

In addition to the high growth driving overall company comps, B2B sales also come at a higher gross and operating margin relative to the core business. While margins aren’t specifically disclosed, the CEO says the margins are "incredibly accretive" since each B2B salesperson does “a ton of volume” working on large commercial accounts. There is also a high amount of repeat and replacement purchases which come at a low incremental cost to WSM. For example, of the $280 million in B2B sales in the first half of 2021, 70% of it came from repeat customers. The company has suggested that this is because once they land a commercial customer, they then have visibility to a pipeline of continued business:

"We're seeing the Marriott pipeline continue... we're seeing good internal indicators that the pipeline is only going to get stronger." – WSM President & CEO, November 2020

"We continue to see repeat business from some of our key customers like Salesforce, and we have a growing number of new projects currently underway." – WSM President & CEO, May 2021

"Our B2B sales are accelerating week after week as our project pipeline continues to expand" – WSM President & CEO, May 2021

• More comments from the Q2 2022 call
  • "well on track to becoming a $1 billion business this year"
  • "In hospitality, we continue to gain market share through renovations and new builds"
  • "in our commercial office pipeline, we are encouraged to see the momentum continue as companies return to the office and workspaces are reimagined."
  • "We remain optimistic and excited about the potential of this business as there is no one else providing the full suite of services and offerings that we do.
  • "In terms of penetration, Rejuvenation by nature, a small business, but a large percent B2B, has always been... West Elm and Pottery Barn are really very strong in B2B and Williams-Sonoma has a lot of opportunity."
• Names some new clients: Marriott headquarters hotel, Waldorf Astoria, Marriott Vacations, Hilton Boston, New Orleans, Charlotte Ceria Scottsdale, IHG Kimpton, InterContinental San Antonio, Hotel Indigo, Hyatt Regency, Huntington Beach

Hotel PIPs (Property Improvement Plans) were deferred during Covid lockdowns, but most hotel franchisors have mandatory property refresh plans whereby the hotel franchisee has to spend a certain dollar amount replacing soft surfaces (e.g. hallway carpet), furniture, linens, etc. every few years depending on the category. Our own recent channel checks with the top hotel Furniture & fixture procurement firms reveal that RFPs for hotel remodels are up hundreds of percent y/y and the "number of projects slated for 2023 looks insane." 

The growth and margin profiles of B2B have required relatively little incremental minimal investment and will continue to bolster WSM's already industry-leading ROIC. 

Maintaining Margins

In addition to B2B, other new initiatives include International Franchising and Marketplace. These are also both higher margin than WSM’s core retail furniture sales with faster growth and as they become a larger percentage of the sales mix, they should help to maintain WSM’s mid-teens margins.

Marketplace is where WSM sells third-party vendors’ merchandise without holding inventory or taking ownership of it. They simply use their website to list the vendors’ products and take a fee. Global Franchise is a similarly high margin opportunity and is showing early success, particularly within India.

In addition to these new initiatives, over the last few years, WSM has been shutting less profitable stores (with the exception of unit growth in west elm) and has renegotiated leases on 90% of the remaining stores which has helped lower their occupancy cost by over 500 bps, and stopped full store discounting/sales. 

While investors are currently in a state of what we believe could only be characterized as negative hysteria on durable purchases, if one looks beyond the lapping of tough 20-40% comps, we see the longer-term outlook as positive for WSM to continue profitably take market share in a growing industry. One of the best leading indicators for demand for WSM’s furniture is the sale of homes that cost >$750,000, which are still running at + >50% y/y on a LTM basis. WSM’s gem asset, west elm, does particularly well with Millennials and Gen-Z who are just now aging into their prime homebuying years and will need to furnish entire homes as millions migrate out of smaller multifamily units into multi-bedroom houses. 

The trades at a low 5.7x EV/EBITDA (20-year Median is 7.8x) with zero debt, and $800M+ of a $1.5B buyback authorization remaining (can buyback another 9% of shares outstanding at current prices). The company has consistently returned capital to shareholders and when they complete the current buyback, they will have repurchased 1/3 of the shares outstanding since 2015 and we expect the large buybacks to continue indefinitely as they've remained FCF positive every year since 2007. 

Valuation

The stock has 80% upside in our base case price target of $242, derived from giving the fast growing/higher margin B2B EBIT a 12x multiple ($500M of EBIT from B2B in 2024), the core business 6.5x multiple (versus 10-year median 10.3x), and assuming the fully utilize the existing buyback taking the share count down to ~54.3 million. 

As another sanity check, at 7.8x EBITDA, which would just put it in line with its 20-year median EBITDA mutliple and a 30% discount to its long-term average multiple when ROIC and margins were much lower, the stock has 53% upside from here. 

Catalyst

-Continued execution

-Short covering on continued operating strength

-Continued B2B growth

-Continuation of large buybacks

-Ongoing FCF generation