Description

The Company

Williams-Sonoma (WSM) is a specialty retailer of products for the home. The company operates in 2 business segments: retail and direct-to-customer (DTC). The retail segment of its business sells products through 5 retail store brands: Williams-Sonoma, Pottery Barn, Pottery Barn Kids, West Elm and Williams-Sonoma Home. The DTC segment of the company's business sells similar products through its 7 direct-mail catalogues (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Pottery Barn Bed + Bath, PBteen, West Elm and Williams-Sonoma Home), and 6 e-commerce websites (williams-sonoma.com, potterybarn.com, potterybarnkids.com, pbteen.com, westelm.com and wshome.com). During the fiscal year ending January 29, 2006, retail net revenues accounted for 57.4% of its business, and DTC net revenues accounted for 42.6% of the company's business. The company operates 570 retail stores, located in 43 states, Washington, D.C. and Canada. This represents 254 Williams-Sonoma, 188 Pottery Barn, 89 Pottery Barn Kids, 8 Hold Everything, 12 West Elm, 3 Williams-Sonoma Home, and 16 Outlet stores (the Outlet stores carry merchandise from all the brands).

Situation Analysis

About 3 weeks ago, WSM reported a 2^nd consecutive quarterly drop in sales in the company’s Pottery Barn (“PB”) division and cut its full-year financial outlook. Net revenue at PB declined by 1.2%, and sales dropped in all categories except textiles. While revenue at WSM rose 3%, the company reported a 21% decrease in net income and lowered its financial outlook.

Chairman W. Howard Lester’s comments during the Q3 conference call were reminiscent of those made in recent years by the management of Pier 1 Imports (PIR). This has spooked the WSM investor base and the analyst community. Similar to PB, PIR struggled to turn around sales and boost declining margins after key styles became commoditized and mimicked at discount retailers, such as Target (TGT) and Wal-Mart (WMT). Lester reiterated that, while PB’s recent performance has been softer-than-expected, it is still outperforming the majority of all home-furnishing retailers. Unfortunately for shareholders, his comments in regard to WSM’s response and strategy going forward were unspecific and unsatisfactory. Lester merely stated that the company would ramp up marketing, add a PB catalogue and boost customer-service in stores.

As such, the shares are down 30% from 52-week highs set last January. SunTrust Robinson Humphrey, one of 4 brokerage firms to downgrade WSM following the earnings release (and one of at least 3 firms to note similarities to PIR in management’s comments) noted that the company “sounds very frustrated with the persistence of challenges at Pottery Barn and we suspect that any turnaround there will take time…For the first time in our memory, it doesn’t seem like the company has a good answer on how to turn it around.”

I believe that the WSM situation is very different from that faced by PIR, and that the ‘doomsday’ scenario currently priced in the stock is unwarranted. I believe that fears of a perpetual decline, or PIR ‘repeat’, are misguided and are creating a unique buying opportunity. Unlike WSM, PIR did not generate free cash, had little brand recognition, and was a one-trick pony with no offsetting brands. In sum, PIR was a small-cap stock, with little financial flexibility and a relatively high debt burden. On the flip side, WSM is six times the size, well-managed and capitalized, and has top brands and strong defensible margins. WSM has been modestly affected by a sharp macro downturn and is now trading at levels that are as much as 40% below a reasonable private valuation.

Financial Weakness – Two Drivers

Weak sales at PB, and the soft home furnishing market in general, can be attributed to 2 factors: a deceleration in housing, and an increased competitive/promotional environment.

Macro Environment

Given the fact that 49% of home furnishing spend at PB is related to a “housing event” (i.e. moved, expanded/renovated, or bought a 2^nd home), and given that there is certain to be further decline and/or stagnation in the housing market over the next 9-12 months, demand may remain soft into 2007. Barring a further downturn in housing, however, I believe that demand will remain relatively healthy.

Competition

This is the primary cause of investor fear. While the market has attributed weakness to increased competition, I believe that further downside is limited, as WSM is well differentiated from lower-cost alternatives. Discount retailers, such as TGT and WMT, are believed to be gaining share from their higher-end/more specialized competitors, such as WSM, Bed Bath & Beyond (BBBY) and Ethan Allen (ETH). Although TGT’s home furnishing results have been mixed, a recent Morgan Stanley survey suggests that over 70% of PB customers have taken notice that the furnishing offering is improving. Of the PB customers with annual income above $50,000, 96% have shopped TGT within the last 6 months vs. 86% for households with income below $50,000. Moreover, almost 50% of this group indicated that they are shopping TGT more for home furnishing merchandise. While recognizing the validity of these findings, there is no evidence that they have not always been the case. In fact, WSM and TGT stores seem to have a complementary relationship, rather than a substitutional one: WSM stores are opened in proximity to TGT stores more often than TGT stores are opened in proximity to WSM stores. While there is a clear demographic overlap, the evidence (i.e., company financials) does not support that pricing or significant sales have been lost to these competitors.

Positive for West Elm Brand = Negative for Pottery Barn Brand?

Ironically, while increased Web traffic indicates that WSM’s new West Elm (“WE”) brand is coming on strong and gaining traction, this could result in further cannibalization of the company’s PB brand. A recent MS survey concludes that the brand appeals to a higher and older income demographic than was initially targeted – one that is quite similar to the PB demographic. Despite the very different styles of PB and WE, PB customers appear to be 3x as likely to shop WE than an average customer. This suggests that cannibalization rates could accelerate, putting further pressure on PB sales. While MS Research and the Street view this as a categorical negative, I disagree. Although clearly a near-term negative, WE cannibalization of PB will be a long-term net positive as the company will be able to allocate future investment to its highest return brands.

Management

WSM management is best-of-breed and seasoned, with collectively 100 years of brand management experience.

W. Howard Lester (70) was appointed Chairman of the Board of Directors on July 14^th, 2006. He previously served as CEO from 1979 to 2001. Laura J. Alber (37) has been President of PB Brands since 2002, and was appointed President of the entire company on July 7, 2006. Alber previously served as Senior VP of PB Catalogue and PB Kids Retail, and Executive VP of PB. David M. Demattei (49) has been Group President since 2003, before which he was President of North America Retail and Wholesale Divisions of Coach from 1998 to 2003. Sharon L. McCollam (44) was appointed Executive VP, COO and CFO on July 7^th, 2006. Previously, McCollam served as Executive VP and CFO. Patrick J. Connolly (59) has been Executive VP and CMO since 2000. From 1995 to 2000, he was Executive VP and General Manager of Catalogue.

It is important to note that management has dealt with adversity before. About 2 years ago, the WSM brand started posting negative same-store sales. In response, management adjusted its merchandise and instituted much-needed changes to the stores. As a result, the stock has more than doubled from its trough. In fact, Lester stated in November’s earnings announcement that the WSM brand is performing at its best level in 10 or 15 years, and same-store sales rose 4.3% in Q3.

Recent Insider Buying

WSM management bought 7,900 shares of its own stock at a value of $251,378 ($31.82/share) during the week ending December 1^st, 2006. This is a clear sign that management has great confidence in its strategy going forward and recognizes the attractive value of its shares at the current levels.

Cheap Valuation & Potential LBO – A Clear Buying Opportunity

Margins are holding up on higher sales, despite the macro downturn. In fact, they remain near all-time highs. While the macro downturn is certainly having a negative effect (as evidenced by recent underperformance by HD, LOW and peers), the competitive effect has been less impactful. I believe that this is supported by the numbers in the table shown below (downloaded from Bloomberg):

Among its home decor peers, WSM is the cheapest. The market has clearly priced in future degradation beyond a macro downturn. See table below:

WSM would be an attractive target for an LBO: the company has no debt (net cash position of $80mm), generates lots of free cash (FCF yield = 5.4%), invests at high rates of returns (20%+ ROC in recent years), and has a top-flight brand name. It is quite notable that PIR was a fraction of WSM’s size and had none of these traits before its slide into financial oblivion. The recent LBOs of Michael Stores (MIK) (arguably an inferior franchise) for 12x EBITDA, and Linens-N-Things at 9x EBITDA earlier this year, imply share values north of $45 for WSM. These businesses can generally sustain a lot of leverage, and those with established brands are particularly attractive targets. As fears of TGT and WMT domination subside, WSM’s multiple should adjust accordingly.

Given the stock’s historical range, coupled with recent takeout valuations, I believe that WSM is correctly valued between 9x and 11x EBITDA, representing at least 30% upside from current prices. A DCF valuation (~11% discount rate) using currently depressed forecasts supports a valuation north of $43/share.

Conclusions

WSM shares are down 27% YTD and trading at a rock-bottom (vs. almost any retailer) 7x EBITDA multiple. Therefore, I believe that a further downturn in housing and/or moderate increase in competition from TGT and WMT is already priced in. However, even if further cannibalization from discount retailers is not fully accounted for in the current price, the stock’s cheap valuation, high quality balance sheet, brand recognition and healthy margins may potentially appeal to private equity investors. At the very least, this should create a price floor at current levels in the near-term.

Catalyst