Description

Summary: William Sonoma’s e-commerce segment is over-earning, has driven all of its growth and is facing new competition.

For those unacquainted, WSM has three main brands (William Sonoma, Pottery Barn and West Elm) that comprise ~$5b in annual sales across 600 stores and online. Pottery Barn has a few different concepts (regular PB, PB kids and PB teen). Collectively, William Sonoma and Pottery Barn account for the vast majority of sales (80%), but West Elm represents the vast majority of the growth (40-50%), which has registered in the HSD range for the past few years. If you look at it by channel, e-commerce represents 51% of the total.

The thesis here is as follows:

1. E-commerce comprises 70% of EBIT and has been the main source of earnings growth.

2. Moreover, the e-commerce business is unusually profitable and high margin.

3. There are reasons to believe this segment could slow. In particular, Wayfair is a serious competitive threat that is just starting to accelerate and gain scale.

4. This thesis has already started to evidence itself in the numbers as WSM’s e-commerce business has begun to display cracks.

5. WSM has been able to maintain high online margins (despite merch margin pressure) through decreased ad spend. This is unlikely to prove sustainable.

6. The brick & mortar retail business is not much help if the online business slows.

I came across this idea as a consumer. My wife and I are fans of West Elm and recently moved so we needed some new furniture. A few years ago when we relocated, we bought everything from West Elm. This time around, we still bought from West Elm but found ourselves ordering much of our furniture and home decor online. The options have gotten much better. This piqued my interest and so I channeled my inner Peter Lynch and took a closer look at WSM. I was surprised with what I found.

Believe it or not, WSM ranks as the 20th largest internet retailer and its e-commerce division boasts “the highest reported profit margin of any ecommerce company in the US.” In fact, their e-commerce business is the main source of earnings. In 2015, e-commerce (which does a 22-24% EBIT margin) accounted for 51% of sales and 70% of EBIT before corp. More interestingly, if you look at EBIT growth over the last 5 years, it has all come from e-commerce. To put some numbers around this: FY10 EBIT was $344m and that grew $145m to $489m for the just ended FY15. Of that $145m in net new EBIT, $249m was from e-commerce, which offset a $25m decline in brick & mortar retail and $80m in greater corporate. Said differently, EPS went from $1.94 in 2010 to $3.36 in 2015 and that has been entirely driven by selling more stuff online. Surprisingly, most investors and sell-siders don’t look at the business by segment (i.e., e-comm vs. retail) and seem to miss this point.  

This would all be well and good if it wasn’t for the fact that there’s new online competition that is willing to earn next to nothing and spend aggressively on advertising. I’m speaking, of course, of Wayfair – an online furniture retailer, which is trying to be the Amazon of furniture. There are others as well and, as a consumer, I can tell you that there’s a decent amount of overlap with WSM. Wayfair is growing like a weed (sales up 70% in 2015) and spending so heavily that it’s destined (and content) to be loss making for the foreseeable future. Wayfair will surpass WSM in 2016 when it should do online furniture and home décor sales north of $3b, up from $1.3b in 2014 (WSM did $2.5b in e-comm revs in FY15). I have no view on Wayfair’s stock but, similar to Amazon, it’s fun to think what businesses it disrupts. I think the answer is WSM, the self-proclaimed “most profitable ecommerce businesses in the U.S.”

Unsurprisingly, such quotes are no longer found in WSM’s investor deck (the above references are pulled from their June 2014 presentation). This may be because the e-commerce business has started to hit a wall. In fact, Q4’15 was the first time e-commerce EBIT has ever been down y/y (remember: this has been the engine of their growth). That’s a very important point. But this isn’t just a last quarter observation. E-comm sales growth has markedly slowed over the past 5 quarters (as can been seen in the chart below) and online EBIT margins have declined in 6 of the past 7 quarters (on avg by ~100bps y/y). I try to keep it simple and just focus on the y/y change in e-comm EBIT and that has come to a grinding halt in 2015 (again, see chart below). Investors had been giving the company a free pass over the past few quarters as mgmt blamed the margin woes on a west coast ports issue that impacted shipping costs. This was supposed to get better in Q3 and Q4 but margin pressure actually accelerated. This suggests something else is going on. If you go back through the prior calls and 10-Qs, the company has called out e-comm pressure from decreased selling margins over the past 10 quarters. This makes sense given competitors like Wayfair are operating at 25% gross margins vs. 38% for WSM. So the idea here is that new competition is impacting their e-commerce results and is already starting to play out – e-commerce sales are down and margin has come under pressure. Moreover, these forces should intensify as Wayfair continues to grow (and spend) aggressively.

Wayfair is not new and this risk has been “out there” for a while. Indeed, my short thesis may sound stale. The problem in the past though was that Wayfair was just too small to matter. For example, Wayfair’s sales were up 52% in 2013 but that was only $300m in incremental dollar sales or ~40% of what WSM was doing at the time. It mattered but didn’t make as much of a dent. Things have changed. As of the end of 2015, Wayfair’s sales are now close to 100% of what WSM is doing (see chart above). Wayfair did sales this past year of $2.2b (up from $600m in 2012) and, as mentioned before, those sales are expected to top $3.4b in 2016. To put this growth into perspective, WSM has added $1b in online sales since 2010 and that was considered remarkable. Wayfair added $930m in incremental sales in FY15 alone, and is expected to add $1.1b in 2016 (and that # will likely prove low). So Wayfair is going to add in new sales this year 50% of what WSM did in total e-comm sales in 2015. That’s a remarkable statistic.  

In total, WSM did e-commerce sales of $2.5b in 2015 vs. $2.2b for Wayfair. In 2016, Wayfair will surely pass WSM as the leader: WSM should do ~$2.7b in e-comm vs. $3.4b for Wayfair. This is very relevant because the entire online home goods market is only $20b, meaning that Wayfair and WSM comprise ~25% of the market. It’s tough to imagine that Wayfair’s gain isn’t WSM’s loss.

Wayfair has a number of brands (Wayfair, Joss & Main, All Modern, Dwell Studio and Birch Lane), and I’m of the opinion that there’s enough overlap with WSM for this to really matter. For those more interested in this topic, I would refer you to a Wedbush note from 1/11/16 that discusses at length some of the overlap with Pottery Barn. I think WSM has a loyal following but, like I found in my own household, expect shopping trends to be impacted at the margin, which can have a big impact on results and profitability.

It shouldn’t be a shocker then that WSM’s online sales growth has slowed. In 6 of the past 7 quarters, y/y growth has been <10% (which had never happened before), and in this last quarter growth was a measly 3%. What is more surprising though is how WSM has stretched to maintain margins and why that’s likely untenable. If you go through the past calls, they call out “advertising leverage” or “efficiencies” in their script when talking about the e-comm segment. They also note lower e-commerce merch margins on several occasions. While I don’t think most sell-side analysts really look at this, the 10-K shows that ad spend has gone from $318m in 2012 (7.9% of revs) to $333m in 2015 (6.7% of revs). So while sales are up 23% over that time, ad spend is up less than 5%. In short, I think they are offsetting online merch margin pressure with decreased ad spend.

The reason this is a problem is because Wayfair has gone from spending $66m in 2012 to almost $300m in 2015. The chart above speaks for itself. Wayfair will likely outspend WSM this year on advertising. As a result, I can’t imagine that WSM will be able to continue moderating ad spend in the face of slowing e-comm sales and heightened competition. Best case is that it’s no longer a tailwind. Worst case is that ad spend becomes a headwind as WSM turns into a re-investment story. Wayfair is a tough competitor because the market is (at least for now) treating it like Amazon, and the company is content to spend all of its incremental sales on SG&A and increased ad spend.

Finally, it’s worth noting that the brick and mortar retail business is unlikely to be much help to the story. Sales growth has been low-to-mid single digits, and margins have declined in 7 of the last 9 quarters. As noted at the start of this report, the brick and mortar retail business has detracted $18m in cumulative EBIT over the past 5 years and is much less profitable vs. online.

The market has partially caught onto this idea but I don’t think investors have fully contemplated how bad it could look. There are a few reasons for this:

1. WSM has historically been a good business with excellent management. It’s easy to give them a pass.

2. As mentioned, the Wayfair risk isn’t new.

3. Retail analysts focus solely on the comp, ignoring the margin pressure in e-comm that’s bright as day.

I think this creates an opportunity and, while the stock is down from its highs, I expect that it will fall further. When you put this all together, I project EBIT to be flat-to-down this year (the 3rd straight year of flat EBIT), which puts the stock at 18x earnings. With no growth and increasing competition, I target $45-$50 (13-14.5x EPS). The stock is currently at $61.

My estimates though do not assume draconian margin erosion in the e-commerce business. And, that’s where this idea could get much more interesting. The e-comm segment did a 22% EBIT margin in 2015, down from 24% in 2014. For all of the reasons already discussed, it’s not hard to imagine that margins could move much lower as WSM has to invest in faster shipping, a better online/mobile experience or lower pricing. At a 20% online margin, EPS would be $3.12. At 18%, EPS would total $2.75. Applying the same 13-14.5x gets me to $36-$45.

Catalyst

Continued slowing sales growth and margin pressure in the e-commerce segment, leading to negative earnings revisions.