Overall, not an impressive quarter for WSM. EPS was about in-line, but the company got there in a low-quality way. We have a hard time laying out a bull case on this one – as it has virtually no square footage growth in any concept except West Elm, and even that leaves us with consolidated growth of less than 3%. WSM has proven grossly incapable of improving its operating margin over the last three years, with annual margin sitting right in line with where it was at pre-recession peaks. So why own it? Cash flow margin is reasonably healthy, but the current stock repo rate is driving about 300bp in earnings growth. Nice, but nothing to write home about. In the end, we have a hard time building up to a double digit EPS growth rate in our model, and it comes with declining returns. Tough to find a reason to own this name at 23.5x earnings.
What We Liked
1) Top line – though every concept decelerated sequentially on a 2yr basis except for PB Kids (flat) the company beat lowered expectations by 200bps or $19mm. 25-50% of this was due to the guided port strike revenue issues ($5-$10mm) which didn’t materialize during the quarter (sandbag?). That’s good news for RH who a) isn’t reliant like WSM on seasonal merchandise and b) product flow should start to normalize.
2) West Elm continued to hum along with a 15.7% comp in the quarter. To be fair that was a 90bps deceleration sequentially in the underlying trend, but it’s been a fairly good barometer for RH over the past few quarters and the current consensus numbers assume that West Elm outperforms RH in the numbers the company will report in 2 weeks. West Elm has only outcomped RH twice since 2012 in 1Q14 and 2Q14 when the company changed up its source book strategy. We expect to see a bifurcation in growth trends as RH top line growth accelerates in back half of the year as it rolls out Modern and Teen.
3) Unit growth accelerated to 32.9% at the West Elm concept (3.2% for the company) – the highest growth rate for West Elm since 1Q09 and the company will add another 9 units before the year is over. The runway for growth appears to be running out with new doors in Grand Rapids, MI, Rochester, NY, and Charleston, SC not what we could consider ‘A’ MSAs.
What We Didn’t Like
1) Last quarter was the first time in the past 17 that WSM had printed down EBIT growth YY. At that point in time the company attributed all of that loss and then some to the port delay issues. 2Q15 marks the 2nd quarter in a row where EBIT was down and Earnings growth was made up entirely by tax rate (which wasn’t assumed in the company’s guidance). The port strike negatively affected EBIT by 50bps and pressured earnings by ~$0.04 and increased labor hours added another ~30bps of pressure.
2) Op margins were down for the 2nd straight quarter and are guided to a range of 10.2%-10.5% for the year. We give the company credit for being able to offset 8 straight quarters of gross margin declines headed into this fiscal year and still hit a peak EBIT margin of 10.5%. That trend has continued into FY15 and now the company is going back into investment mode (i.e. less SG&A leverage) as it continues to rejigger its e-comm capabilities and clean up its supply chain. Some of the port related costs roll off after we clear 3Q. But, WSM operates at a 10.5% EBIT margin under the BEST conditions, i.e. mid to high singled digit comp growth. What happens when the top line slips to the LSD?
3) The company guided the mid-point of the 3Q range 6% below street expectations implying an earnings growth rate of flat to +7% on 4-6% comps and 6.5% revenue growth. Not heroic by any stretch, but the company needs to prove that it can offset added cost pressures on both the GM and SG&A lines from lingering port issues and investments. For the full year we need to assume that margins get back to flat or +50bps to hit the 10.2% -10.5% range for the year after a 70bps contraction in 1H. We have a hard time getting comfortable with that.