Dividends and redemptions offer high return potential

Williams-Sonoma (WSM) is a retailer of many types of home products, such as furniture, bedding, lighting, rugs and other products. It operates in two segments: E-Commerce and Retail. It sells its products under the brands Williams-Sonoma, Pottery Barn, Pottery Barn Kids, West Elm, PBteen, etc.

We are bullish on the stock as we believe it is an undervalued high quality company.

Economic spread of Williams-Sonoma

Large companies often have excellent management teams that can effectively allocate capital to profitable projects. Many professional fund managers tout the importance of meeting with a company’s CEO to assess whether that person is a good fit for the job.

However, we can get a good picture of management effectiveness just by looking at the numbers. One metric we like to look at is economic spread, which is defined as follows:

Economic distribution = Return on invested capital – Weighted average cost of capital

The idea is simple; if the return on invested capital is higher than the cost of this same capital, then the company creates value for its shareholders through well thought out projects. Otherwise, the company is destroying value and would be better off just investing the money in risk-free bonds.

For Williams-Sonoma, the economic breakdown is as follows:

Economic spread = 34.6% – 8%

Economic spread = 26.6%

As a result, the company creates value for its shareholders, which requires management to allocate capital efficiently.

Competitive advantage and margins

There are several ways to quantify a company’s competitive advantage using only its income statement. The first method is to calculate the Earning Power Value (EPV).

The value of earning power is measured as adjusted EBIT after tax divided by the weighted average cost of capital, and the value of reproduction (the cost it would take to replicate the business) can be measured using the value total assets. If the earning power value is greater than the reproductive value, then a firm is considered to have a competitive advantage.

The calculation is as follows:

EPV = Adjusted Earnings EPV / WACC

$10.675 billion = $854 million / 0.08

Given that Williams-Sonoma has a total asset value of $4.63 billion, we can say that it has a competitive edge. In other words, assuming no growth for Williams-Sonoma, it would take $4.63 billion in assets to generate $10.675 billion in value over time.

The second way to determine a competitive advantage is to look at a company’s gross margin, as it represents the premium consumers are willing to pay over the cost of a product or service. An expanding gross margin indicates that a sustainable competitive advantage is present.

If a company does not have an advantage, new entrants will gradually take market share, which will cause the gross margin to decline over time.

As for Williams-Sonoma, its gross margin has increased in recent years, from 36.5% five years ago to 44% last year. Therefore, the evolution of its gross margin indicates that a competitive advantage is also present in this regard.

WSM may even maintain or see higher long-term margins due to potential growth in its B2B business. Here’s what CEO Laura Alber said on the last conference call:

“Our B2B business has enormous potential to contribute to our bottom line. Our growth targets continue to increase as we unlock new opportunities. And not only is our B2B business model accretive to our gross margin, but even more accretive to operating margin due to its fixed operating costs. We continue to exceed our own expectations for this business and, longer term, we believe this is one of our greatest opportunities.

Nonetheless, management’s forecast for next year calls for its operating margin to be roughly in line with fiscal 2021, which would be impressive to see in this inflationary environment where operating costs are rising. .

High profitability

Over the past 12 months, Williams-Sonoma has recorded approximately $1.15 billion in free cash flow, making it profitable by our definition. This means that the company does not have to rely on capital increases to continue financing its growth.

More importantly, its free cash flow has been on an upward trend in recent years, being just $341.1 million in the fiscal year ending January 2016. For us, that means that the company’s free cash flows are reasonably predictable.

Dividends, redemptions and valuation

Williams-Sonoma is known for its dividend growth and buyouts. Currently, its dividend yield is 2.3%, which isn’t bad considering it has room for rapid growth. The dividend increased by 10% last month, which is respectable.

Its five- and 10-year dividend CAGR is just over 13%. To put that into perspective, 10 years ago its dividend was $0.88 per share; now it’s $3.12. Its payout ratio of 17% suggests that the dividend is well covered and can grow without any problem.

The company also has no interest-bearing debt and has cash of $850.3 million. With a market capitalization of approximately $9.7 billion, its cash represents approximately 8.8% of its market capitalization.

WSM can use its cash combined with its high free cash flow to buy back a large portion of its shares. In fact, that’s exactly what he plans to do. Last month, WSM authorized $1.5 billion in buybacks. If the company ends up repurchasing all of those shares at an average price close to its current price of around $135, that would equate to around 15.5% of its market capitalization.

Add the dividend and you have high return potential. Finally, earnings are expected to increase over the next few years, and with forward EPS forecast at $15.28, this implies a forward P/E multiple of around 8.8, which seems cheap to us.

Risks

To measure the risk of Williams-Sonoma, we can check if leverage is an issue. To do this, we compare its debt to free cash flow. Currently, this number rises to 1.1 (if you include rental debts as debt). Also, looking at historical trends, its debt to free cash flow ratio tends to go down.

Overall, we don’t think debt currently poses a significant risk to the company, as it has paid off all of its interest-bearing debt over the past few years and has always been responsible when it comes to debt.

However, there are other risks associated with Williams-Sonoma. According to Tipranks’ risk analysis, the company disclosed 43 risks in its latest earnings report. The highest level of risk came from the Finance & Corporate category.

The Taking of Wall Street

As far as Wall Street is concerned, WSM has a Consensus Hold rating. This is based on six buy ratings, five hold ratings and four sell ratings given over the last three months. The Williams-Sonoma average price prediction of $178 implies 31.7% upside potential.

Analyst price targets range from a low of $132 per share to a high of $225 per share.

Conclusion

Williams-Sonoma sold recently on fears of recession and inflation. Perhaps the market doesn’t believe it can sustain earnings and margins in an inflationary or recessionary environment.

While this sale may continue in the short term, we believe the long term situation is better as WSM has a strong track record of growth, profitability and good returns due to its competitive advantages. At the current low valuation, we are bullish on WSM stock.

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