It’s been a while since I (McGough) have been this perplexed by a quarter and guidance by a retailer. This is either the most underappreciated management team in retail, or one that got lucky, is completely Macro unaware, and is about to get blown up. It’s probably a combination of the two. Either way, I think the stock should be shorted on this beat. Numbers are likely to come down next year materially.
On the quarter, the company put up $3.87 vs the Street at $3.52. It put up an impressive 11.3% comp and leveraged that to 36% EPS growth. Its as if all the Macro headwinds out there simply do not apply to this company. Guidance is bullish, sticking to the long-term guide, with results above that rate over a TREND duration.
One theme that has emerged from this earnings season is that many management teams are guiding in hindsight – they’re playing the dangerous ‘extend the trend’ game with guidance instead of implementing a strong and repeatable Macro forecasting process to plan their business – and set expectations. That’s why the following quote from management bothers me so much. It’s a long one – answer to the third question in the Q&A, but definitely worth a read…
“We're not seeing it [the slowdown], although I could conclude that we're more insulated because our customer is in a better situation from an income perspective. I think the bigger thing about the macro is that although there's been some slowing of the housing market, most of our customers have seen significant house appreciation, okay? And our customers love their homes. -- and it's one of the largest assets. And they are engaged with improving that asset.” “Therefore, the current period metrics on home sales and interest rates don't necessarily rely with the home improvement journey. And as a result, we continue to believe there's significant runway ahead for home pursing sales. And while I'm talking too much, I might as well just add, although there's a lot of smart people out there predicting a recession, we're also seeing consumer sentiment improve as inflation cools. So there's a lot of reasons, I think believe we're gaining share and that we're in the right business.”
Am I the only one who finds that series of statements downright frightening? At a minimum they’re diametrically opposed to Hedgeye’s forecast for four straight Quad 4s. These are the people planning this business over a TREND and TAIL duration. The company is likely to end this year with earnings of about $16 per share. Unless our macro forecast is flat out wrong, we think that WSM is likely to have a down 2023, with a material hit to both top line and margins, and this could/should start as early 4Q of this year.
On $16 per share, the stock hardly looks expensive at 10x earnings. But it could trade at 8x earnings in a heartbeat of the real number next year comes in between $12-$14 – a number NO ONE believes will happen. That’s a stock closer to $100 – big downside from its current $162. We think WSM is a Best Idea short – we’d pair it against RH, where we think numbers are headed higher next year as it scales Contemporary (first new product line in years) and turns on the spigot in its new European business, which should offset declines in its core assortment in this Macro climate. On what I think are REAL numbers, WSM today is trading at a 20% premium to RH, which I think makes zero sense given RH’s superior brand, long-term growth upside, margin profile, and ROIC characteristics.
NOTES FROM THE CALL AND Q&A
Q2
- Revenue $2.14bn-
- Comps 11.3%
- Double digit growth in ecomm (penetration 65.4% YY)
- EPS $3.87 -- 36% growth
- B2B
- Driving 32% increase in demand
- Diversifying product pipeline across industry verticals
- Gain mkt share through renovations and new builds
- Grew momentum internationally -- Mexico
- West Elm -- 6.1% comp
- Pottery Barn - 5.2% comp
- Improved inventory receipts
- Biggest back to school
- Enabled to ship back to school to any store in the fleet
- Holiday will be profitable
- William Sonoma -- 0.5% comp
- CMO now the President of the brand
- Improved in stock position
- Higher conversion
- Advertising and performing leverage
- Merch margin -- expansion YY
- No longer sitewide promotions
- GM decline due to higher freight
- Occupancy 9% of net rev -- up from last year due to new distribution centers
- SG&A 26.4%
- Operational efficiency
- Operating income growth of 12%
- Operating margin of 17%
- $125mm cash
- No debt outstanding
- Nearly doubled cash investment
- $113mm in div
- $766mm in share repo
- Inventories $1.142bb - up 42% YY
- On-hand -- 28% YY
- Backorder levels decreased
Guidance
- FY
- Revenue growth mid-to-high single digit
- Operating margin in-line with 2021 -- 17.7%
- Will see supply chain disruptions
- Higher distribution center costs
- Added costs to ship out of market (continue into Q1 of next year)
- Further William Sonoma brand improvement in 2H
- YDT trends outpacing inventory
- Improvement in inventory receipts and lower backorder levels
- Investments in growth
- In-stock recovery in 2H
- Q3
- International expansion in India
- Seeing accelerating demand comps
Business
- Increasing revenues to $10bb by FY 2024
- See large space for growth in the industry
- Differentiators
- Inhouse design
- Compelling price points
- Digital first, but not only strategy
- Drive B2b growth to $1bb
- Sustainability -- progress and fulfillment of ESG goals
- Reducing emissions
- Responsibly sourced materials
- Global expansion is large opportunity
QUESTIONS
1. Demand in the quarter? Color on early Q3 trends? What can you contribute trends to and how to play offence as things get tougher? Promos in bigger picture, what to expect going forward?
ANSWER: demand comps are strong and improving going into Q3. accelerated comps, but lower than double-digit demand comps.
Outperforming: because of key differentiators. In-house design allows us to have proprietary design and sustainable and have collections no one else has; culture of innovation. Pottery Barn has collab with Hailey Bieber. Pottery Barn Kids has collabs with children's products/themes/characters.
Committed to elimination of site-wide promos, but will still use markdowns to manage inventories and will take markdowns in seasonal inventories.
2: Inventory receipts for 2H, will inventory flow be better in 2H? March margins, promos are flat YY so what is allowing you to expand the merch margins?
ANSWER: it will improve moving into back half. Shifting more to furniture and a lot of inventory coming in to fulfill back log and current demand and new product offering. Elevated back-order levels into 1H 2023.
Back-order freight rates are decreasing. Cancellations are decreasing.
Taken some price increases, but plateauing there. But freight is decreasing so that should flow through with vendors lowering prices and we can pass that on to customers.
3: Lower-end household income feeling some pressure, how do the different income brackets behave? Custom orders vs in-stock, has there been movement to more customer orders?
ANSWER: no real inconsistencies across locations. Gen Z and Millennials are fastest growing segment. Not differentiation among income levels, more based on how much they spend, people who spend over $1,000 continue to spend and those who spend under $200 have slowed spending.
Customers are more insulated from issues because of income level.
Spending more time in our homes
Furniture and home improvement lags home sales, significant runway ahead
"smart people predicting a recession, consumer sentiment increases as demand pools and gaining share"
Custom orders -- upholstery is mostly custom orders so nothing is really changing there. Wood pieces are in-stock orders
4: 2H outlook, if operating margins in line with 2021, that implies some modest decline in 2H operating margins, what is driving that decline? Is it additional supply chain pressure?
ANSWER: reiterating guidance that the environment is uncertain so we're being cautious there. Some pressure on the operating margin line from the ongoing supply chain costs. And continued distribution center costs. Ocean freight costs higher and dray and demurrage costs higher. Then incrementally the costs to get the products to the customers.
Q4 will be bigger impact than Q3.
5: In prior calls, said emerging brands and comps there, any color to give on emerging brands in Q2? Near term, capital allocation?
ANSWER: mark and graham -- double digit comp. pushing the post-pandemic trends.
Rejuvenation -- double digit comp. DTC and B2B are performing the same. More stores opening.
Continue with share buybacks and dividends.
6: Backlog release gains steam, any color on where backlog is compared to last year and where it is higher in certain areas? Increase in occupancy dollars, distribution centers are an addition to that, what’s the future?
ANSWER: backlog is mainly in furniture, so mainly West Elm and Pottery Barn. It is coming down and will come down through the rest of the year and into 1H 2023.
Distribution centers will be adding going forward, but will be closing some stores, which will be lapped next year.
7: Supply chain, challenges still persist, any color on diversification standpoint, reducing China by half? Marketing strategy, leaning into brand ambassadors and influencers, thoughts on how to lean into Gen Z and these digital channels?
ANSWER: have significantly reduced China exposure. Trying to find a few solid vendors to make child furniture rather than a lot of them. Continuation out of China. Will be a continued issue for a while because factories are hesitant to open because of recessionary issues. Issues with flow on high quality vendors.
Video is engaging, so it is actually appealing to all people
Design collabs offer new aesthetic and introduce customers to things
8: Merch standpoint for holiday season and how you're thinking about the consumer and product mix?
ANSWER: built on last year, after last year's sellout. Leverage ideas that barely made it to the floor last year. Holiday season should be an easier celebration this year, so want to provide all that to the customers.
9: Tone of the consumer, sentiment and demand comps? B2B, growth is outpacing house growth, is that pace narrowing or widening? Concentrated in any one brand?
ANSWER: started Q2 with moderating demand comps, but they are coming back and accelerating into Q3. not seeing what other people are out there saying.
A lot of innovation in B2B. West Elm and Pottery Barn are really strong in B2B and William Sonoma has a lot of growth there
10: Detail on margin in B2B business vs rest of business? Will continue on plan to close 25% of stores?
ANSWER: B2B is accretive to business as a whole.
Had success in repositioning stores in their market and they are really successful. Opportunity to improve retail fleet.
11: B2B -- how expense structure works there? Products coming from the brands, is R&D coming from the brands too? Relaunch of holds-everything?
ANSWER: B2B expenses -- dedicated sales team, and working with brand presidents to appeal to clients and getting products contract grade approved.
Holds-Everything -- always had it but bringing it back under William Sonoma banner and creating premium product. Gaining steam.
12: Freight costs -- compare Q1 vs Q2 and how you expect that to change?
ANSWER: bigger change is in ocean freight, big volumes of inventory coming in and big containers that have to be stored and these costs are capitalized in inventory, and don’t realize them until you sell inventory, which is why you feel it in back half
