It’s difficult to make such a bold statement at a time when many retailers are struggling to survive while others are outright closing their doors. Williams-Sonoma, Inc. (WSM) is a bright light in a pretty dim retail environment, but even WSM stock is having difficulties.
Retail ain’t easy.
That said, if you believe omnichannel retail is the best way to thrive in an industry so bitterly competitive, thanks in part to the absolute domination of retail by Amazon.com, Inc. (AMZN), one must consider Williams-Sonoma a leading candidate for the presumptive title of “The Best Stock in Retail.”
Whether you live in the U.S., UK, Asia or elsewhere, it’s impossible to avoid the discussion of omnichannel retail. It’s hypercritical if media is to be believed and unfortunately, there aren’t many retailers able to walk the tightrope that is omnichannel retail.
Williams-Sonoma just happens to be one of the outliers.
But before I get into why I think WSM is the best stock in retail, let’s catch up on the not-so-good stuff happening at the company.
Williams-Sonoma’s Current Woes
First, and most importantly, WSM stock is down 35% in the last year and basically flat for the last three. Clearly, investors don’t like what they’re hearing from the company. In the last four out of five calendar years, Williams-Sonoma has underperformed relative to its specialty retail peers generating a rate of return almost 500 basis points lower on an annualized basis.
Investors have moved on from WSM stock and the million-dollar question is whether they’ll ever come back. At the moment, it’s a momentum stock that’s headed in the wrong direction.
The weakness in Williams-Sonoma’s stock began in earnest last August when it reported mixed second-quarter results. Analysts were particularly troubled by its inability to increase margins, especially those in its e-commerce business, which accounts for a big chunk of its revenue, and the rout was on. WSM stock saw monthly declines in five of the next six months.
While Williams-Sonoma’s operating margins have contracted about 120 basis points over the last year, it’s hardly what I would classify as a disaster; yet its stock has been severely punished by investors — unjustly in my opinion — despite the fact it’s generating plenty of free cash flow ($341 million in fiscal 2015) from its operations.
What’s Saving WSM?
That’s some of the bad stuff. Now let’s look at what’s good about Williams-Sonoma as we prepare to head into the second half of fiscal 2016.
Williams-Sonoma saw Q2 2016 e-commerce revenues increase 8.2% year-over-year to $576 million or 52.5% of overall revenue of $1.1 billion. That percentage is an 80 basis point improvement from Q1 2015 and a 250 basis point improvement from Q4 2015. The increases might be slightly lower than in previous years — Q1 2013 saw e-commerce revenues increase by 11.9% year-over-year — but they are healthy just the same.
As mentioned previously, some analysts have expressed concern over its e-commerce operating margins shrinking. Let’s put that in perspective.
In Q1 2016, William-Sonoma’s non-GAAP e-commerce operating margin was 22.8%, 120 basis points lower than Q1 2015. Taken in the context of a business that’s exclusively online, it might be a reason to worry. However, its physical stores, which still generate 47.5% of its overall revenue, had an operating margin of 5.8% in the quarter, 20 basis points higher year-over-year.
These so-called shrinking margins delivered an extra $98 million in operating profits in the quarter that wouldn’t have existed if not for its e-commerce business. The margins are just fine.
Although Williams-Sonoma’s same-store sales growth in the first quarter were 10 basis points lower than Q1 2015 at 4.5%, the performance of West Elm should more than placate Williams-Sonoma investors. It saw same-store sales grow 19% in the quarter, 370 basis points better than in the first quarter last year.
While the company only breaks out the revenues by brand in the 10-K, it’s clear that West Elm is surpassing Williams-Sonoma as the growth vehicle for the company. Over the last 12 months through Q1 2016, West Elm opened 15 stores, 71% of Williams-Sonoma’s net store openings.
In fiscal 2015, West Elm had annual revenues of $821 million, up 55% in just two years. Meanwhile, the Williams-Sonoma brand had annual revenues of $993 million in fiscal 2015, up just 2% from fiscal 2013.
If it keeps up this pace, it could be a billion-dollar brand by the end of this fiscal year.
Williams-Sonoma’s current price-to-earnings ratio of 15.6 is lower than it has been since 2008. Its earnings yield (the inverse of P/E) is 6.4%. By comparison, TJX Companies Inc (TJX), one of retail’s most successful stocks over the last decade, has an earnings yield of 4.5%. In essence, WSM gives investors a much bigger bang for its earnings’ buck. The same story applies for all the other usual suspects when it comes to valuation metrics such as price-to-book ratio, price-to-sales ratio, etc.
WSM stock hasn’t been this low since May 2013. Currently yielding 2.8%, WSM will pay you to wait for its stock to move higher.
Bottom Line for WSM Stock
My biggest concern with Williams-Sonoma is Pottery Barn. It accounts for 42% of the company’s overall revenue and yet the brand’s same-store sales barely budged in the first quarter up 0.2%, 220 basis points lower than a year earlier. At $2.1 billion in annual revenue, it appears to have hit a wall.
It’s not so much I think Pottery Barn is done, but rather that WSM needs a replacement sometime in the next decade that can be the No. 1 brand for the company. West Elm certainly could be.
Williams-Sonoma, on the other hand, is also fairly mature, so either West Elm keeps hitting those 19% quarterly comps or it goes out and buys itself a brand that is still growing and lends itself to e-commerce. My guess is it will buy a brand before too long to avoid putting too much pressure on West Elm. What that brand is, I couldn’t tell you.
Will WSM stock keep dropping? Probably. But, market timing is for fools. Williams-Sonoma, in my opinion, is one of the best stocks in retail, if not the best, specifically, because it is the poster child for omnichannel retail.
Again, if you believe omnichannel retail is the way, you must own WSM — warts and all.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.