WSM | Blind

03/17/16 10:03AM EDT

This quarter told us one thing...we're highly unlikely to ever own this name as a long term investment while this management team is at the helm. They simply don't have the chops, the vision, and perhaps even the authority to do what it takes to turn this company from Good to Great in what is going to be the most dynamic retail climate in a generation. 

The numbers were downright ugly on nearly every metric we care about. The headline number came within the guided range but that was purely a function of WSM cutting 5% of its workforce to offset the worst comp performance we’ve seen in this economic cycle. What’s even more troubling than the choppiness on the top line we’ve seen reported over the past 6 months is management’s inability to articulate the root causes of the slowdown across all banners or identify clear and definable investments that need to be made in order to reignite the top line.

What we got from WSM this quarter was a patchwork investment plan centered around infrastructure additions, SKU reduction, store portfolio rationalization/improvement, and employment cuts. That screams defense to us. It’d be a different story if the company were going to take the additional cash flow saved after streamlining the back-end and reinvested that back into the value equation to stop sales from sliding. That’s not the case. The punchline is that a company in any industry rarely can cut costs and manufacture growth at the same time. Making minor strategic changes after a negative event – and not knowing why – is a recipe for disaster in this business.

From here WSM can either a) cut costs and harvest cash flow as management assesses the problem, or b) confidently make serious investments to tackle offensively the changing way people shop. We’d be incrementally more interested in the name if it were the latter.

Key callouts from the quarter…

1) Investments – WSM’s investments are centered around 5 strategic initiatives: 1) product leadership – lowering SKU count, 2) revolutionizing inventory management – new DC, planning software, consolidating assortment, wages, 3) Marketing – focus on design and value proposition, 4) Real estate optimization – culling stores, resetting assortment, etc., and 5) Head count reduction – corporate reorganization. All defensive moves.

2) Re-positioning Pottery Barn – It’s pretty clear that management is moving Pottery Barn down the price equation with a renewed emphasis on entry level price points to better attract customers on the lower end of the value equation. As the company’s biggest brand at 42% of sales (All 3 concepts = 60%) – this strategic shift (or investment) doesn’t strike us as the brand building event we’d want to invest in. Because it a) materially weakens the brand pretty much forever, and b) lends itself to a more price conscious consumer, i.e. more promotional sensitivity.

3) Why weak? – People can criticize RH CEO Gary Friedman for his explanation of the RH revenue shortfall in the 4th quarter, but we’d argue that the definable issues (execution, oil/energy markets, and softness in the high end consumer) demonstrate a much better grasp of the headwinds facing the company than demonstrated by WSM management on today’s call. In the 60mins of management commentary and Q&A, we only learned that mall traffic was weak, gifting was soft, and furniture wasn’t so bad.

4) Near term sales guidance – The company is six weeks into the first quarter of the year and hasn’t missed a 1Q comp number in the past 5 years. In fact the company has set a precedent of low ball comp guidance in 1Q only to beat handily. Our sense is that the street will shake out on the lower end of the new guidance range despite the acceleration it implies sequentially. We think it’s important to consider RH’s promotional cadence during weeks two through six of 1Q which was zero. That could help explain some of the pickup we’ve seen QTD.

5) Long Term Revenue Goals – We know this is a long way off but CEO Alber threw out a 10 year target to double revenue growth. The quick math on that equates to a CAGR of 7.2%. Over the past 10 years we’ve seen half that at 3.5%. That’s a big time goal for a management team who doesn’t appear to have a handle on the next three quarters let alone the next ten years.

6) West Elm to $2bn – Language changed on the long term outlook for the brand from $1bn to $2bn on this quarter’s earnings call. That makes sense given that the brand is $200mm from the prior goal, but…a) e-comm traffic trends softened materially in 4Q which translated to the 2nd weakest comp from the brand in the past 6 years. That trend has continued into the first quarter. b) store growth is moving away from top MSA’s towards markets like Grand Rapids, MI and Rochester, NY and fill in locations. And, c) store growth is slowing to 11 net new stores from 18 this past year which isn’t an overly bullish statement on long term opportunity.

7) International – There was a lot of real estate dedicated to the international growth opportunity for the company. A concept we were not sold on in the first place. Fact is, the combination of WSM brands has ~5% share of the US market, with the opportunity to grab additional share in a highly fragmented home furnishings space. We’d argue the incremental investment would be better spent doubling down on the US business in order to position the brand for another leg of sustainable growth. Instead, the focus has been shifted from the core to taking its footprint from 9 countries to 35.

8) Teen underperformance – The biggest laggard in the portfolio in the 4th quarter was Pottery Barn Teen at -12.7% a 1000bps swing sequentially on a 2yr basis. No surprise to us given that RH launched its Teen collection with a 300 page source book in the 3rd quarter and really started shipping orders in earnest during 4Q. Managements solution to the slowdown – firing the brand head and doubling down exclusive product. That doesn’t sound like a winning strategy to us.

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