Williams-Sonoma, Inc.
Q2 2016 Earnings Call Transcript

Published: 25 Aug 2016

[Operator:]

Welcome to the Williams­Sonoma Inc. Second Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. We will conduct a question­and­answer session after the presentation. This call is being recorded. And I would now like to turn the call over to Beth Potillo­Miller, Senior Vice President, Finance and Corporate Treasurer to discuss non­GAAP financial measures and forward-looking statements. Please go ahead.

[Beth Potillo Miller:]

Thank you, Matt. Good afternoon. This call should be considered in conjunction with the press release that we issued earlier today. Our discussion will contain non­GAAP guidance, including non­GAAP EPS and operating margin, which excludes the impact of unusual business events. A reconciliation of the non­GAAP financial measures to the most directly comparable GAAP financial measures and our explanation of why the non­GAAP financial measures may be useful are discussed in our press release. During the first quarter of 2016, we incurred a one­time reorganization charge related to the reduction of headcount primarily in our corporate functions of approximately $13 million, or $0.09 per diluted share. This charge was recorded as SG&A expense within the unallocated segment. The remainder of the discussion today will reference full-year guidance related to EPS and operating margins on a nonGAAP basis excluding this unusual item. This call also contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which address the financial condition, results of operations, business initiatives, trends, guidance, growth plans and prospects of the company in 2016 and beyond, and are subject to risks and uncertainties that could cause actual results to differ materially from such forward-looking statements. Please refer to the company's current press releases and SEC filings, including the most recent 10­K and 10­Q for more information on these risks and uncertainties. The company undertakes no obligation to update or revise any forward-looking statements to reflect events or circumstances that may arise after the date of this call. I would now like to turn the conference call over to Laura Alber, our President and Chief Executive Officer, to discuss our second quarter 2016 results.

[Laura Alber:]

Thank you, Beth. Good afternoon and thank you all for joining us. On the call with me today is Julie Whalen, our Chief Financial Officer; and John Strain, our Chief Digital and Technology Officer. John joined in 2006 as Senior Vice President and Chief Information Officer and was promoted to his current position in 2014. Welcome to the call, John. Not on the call today is Pat Connolly, who most of you know after 37 years at Williams-Sonoma retired last month. I want to reiterate my deepest thanks to Pat on behalf of our management team and all of our associates for his many contributions to the company. Our executive team isn’t like that of most companies of our size with an average of more than 10 years at the company and several of us with much more. So we've all worked together very closely for a very long time and couldn't be happier to see our colleague, Pat, begin his well-deserved retirement. Now I'll discuss the second quarter. In the second quarter, we delivered revenue growth of 2.8% and earnings per share of $0.58. These second quarter results once again reflect our competitive advantages

[Julie Whalen:]

Thank you, Laura, and good afternoon, everyone. Before I walk you through the second quarter financial results in more detail, I would like to begin with a few second quarter financial and operational highlights. We are particularly pleased with the progress we have made on our long-term initiatives and the impact of these initiatives on our financial statements. First, our focus and disciplined execution against our long-term growth initiatives are driving quarter-after-quarter top and bottom line growth. West Elm, which we believe will be our largest brand over time, delivered their 26th consecutive quarter of double-digit profitable growth with comparable brand revenue growth of 15.8% on top of 15.7% last year. Our newer businesses, Rejuvenation and Mark and Graham combined, had another quarter of double-digit growth of approximately 32%. In our global business, we also saw improved profitability and another quarter of double-digit revenue growth of approximately 20%, taking our global revenues to $80 million for the second quarter. Second, we have made progress on our operational initiatives. Our direct sourcing advantage continues to drive material cost reductions, allowing us to provide value to our customers and still maintain merchandise margins that are only slightly down to last year. Our focus on our supply chain initiatives has generated reduced shipping and fulfillment-related costs, resulting in improved selling margins, and our inventory initiatives have already allowed us to reduce our inventory levels and to reduce costs from our distribution network. Finally, we are a company with a culture of strong financial discipline. We continue to leverage our SG&A with strong cost control, particularly across employment and general expenses. We maintain a strong balance sheet, which in turn has allowed us to continue to invest in our business for future growth and to provide returns to our shareholders in the form of dividends and share repurchases. Now I would like to discuss in more detail our second quarter results. For the second quarter, net revenues increased 2.8% to $1.159 billion, with comparable brand revenues increasing 0.6% on top of 6.3% last year. The strength in West Elm and our newer businesses was partially offset primarily by the 4.8% decline we saw in the Pottery Barn brand. The strong growth in our global business and our newer non-comp West Elm stores drove total revenue growth to exceed our comparable brand revenue growth by 220 basis points. Net revenues in our e-commerce channel grew 5.2% to $600 million, or 51.7% of total company net revenues, a 110 basis point increase over last year. This e-commerce growth was driven by the continued strength in West Elm as well as in Williams-Sonoma, whose strategy to aggressively pursue strong e-commerce growth is clearly working. Our retail channel net revenues increased 0.4% to $559 million in the second quarter. Strong growth in West Elm as well as growth in our global business was partially offset by the general weakness we saw across our U.S. retail store base, primarily from an overall decline in nationwide mall traffic. Gross margin for the second quarter was 35.4% versus 36.1% last year. The 70 basis points of gross margin deleverage was largely driven by occupancy deleverage of 40 basis points. Occupancy costs were $165 million in the second quarter of 2016 as compared to $156 million in the second quarter of 2015. The remaining 30 basis points of deleverage was primarily due to higher franchise and wholesale revenues, which are dilutive to gross margin but accretive to the operating margin. Excluding the impact of the higher franchise and wholesale revenues, our selling margins were essentially flat. This is a testament to all of the positive financial contributions our efforts in our supply chain and inventory initiatives are providing. SG&A for the second quarter was 28.2% of net revenues in 2016 versus 28.7% in 2015. The 50 basis point improvement primarily resulted from employment leverage and lower overall general expenses from strong financial discipline. The improvement in our employment costs was primarily a result of the corporate reorganization that we implemented during the first quarter. Operating margin for the second quarter was 7.2% versus 7.4% in the second quarter of 2015. By channel, the operating margin in the e-commerce channel was 22.1% versus 21.5% in 2015. The 60 basis point improvement in operating margin was driven by higher gross margins, primarily due to improved year-over-year shipping and fulfillment-related costs as a result of our focus on all of our supply chain and inventory initiatives. This was partially offset by an increase in SG&A, driven by higher advertising costs from incremental e-marketing investments as a result of our increased focus on new customer acquisition. The operating margin in the retail channel was 5.9% versus 7.3% in 2015. This decline in operating margin primarily resulted from lower gross margins from lower selling margins and occupancy deleverage from lower overall retail revenue growth. The selling margins were particularly impacted by our decision to more aggressively liquidate less productive SKUs and aged inventory to our retail outlets as part of our supply chain and inventory initiatives. Selling margins were also impacted by higher franchise revenues. The gross margin decline was partially offset by SG&A leverage, primarily from lower employment costs from strong financial discipline as well as cost leverage throughout SG&A from higher franchise revenues. Corporate unallocated expenses as a percentage of net revenues were 7.1% in the second quarter, flat to 2015. As a result, second quarter 2016 diluted earnings per share was $0.58 versus $0.58 last year, which included an approximate $0.03 benefit from a reduced tax rate. On the balance sheet, we ended the quarter with a cash balance of $111 million after investing an additional $50 million in our business during the quarter and returning $69 million to stockholders through share repurchases and dividends. Merchandise inventories at $963 million decreased 6.6% compared to Q2 2015. This is the first year-over-year decrease we have had since the recessionary time period and reflects our commitment to drive inventory levels below sales growth. Our inventory initiatives are driving substantially reduced inventory levels as well as improved efficiencies in our supply chain. I would now like to discuss our third quarter and fiscal year 2016 guidance. Our guidance reflects our best estimate at this time as to the possible outcomes for the back half of the year. As we have said, we are seeing a softening retail environment. As a result, we have revised our guidance for the remainder of the year to reflect this change in trend. For the third quarter of 2016, we expect to grow net revenues to a range of $1.235 billion to $1.285 billion with comparable brand revenue growth in the range of zero to 4%. We expect our third quarter operating margin to be relatively in line with last year, and we expect diluted earnings per share to be in the range of $0.75 to $0.80. For the full year, we are reducing our revenue growth by 100 basis points and our earnings per share by $0.10 on the high end of the range. As a result, we now expect to grow net revenues 2% to 5% to a range of $5.075 billion to $5.225 billion with comparable brand revenue growth in the range of 1% to 4%. We now expect operating margin to be 9.4% to 9.8%, and our diluted earnings per share are expected to be in the range of $3.35 to $3.55. All other financial guidance within the press release remains unchanged from the previous guidance. From a capital allocation perspective, there are no changes to our plan. Given our strong balance sheet and operating cash flow, we intend to continue to make the necessary investments across our business of approximately $200 million to $220 million in capital expenditures to strengthen our competitive advantages and to support our long-term growth initiatives. And we also intend to continue to return capital to our shareholders in the form of share repurchases and dividends. In summary, we are pleased that we were able to deliver upon our second quarter financial commitments despite a challenging retail environment. We believe that our competitive advantages are driving our success

[Operator:]

Thank you. [Operator Instructions] And we'll move to our first question. This will be from Daniel Hofkin with William Blair & Company.

[Daniel Hofkin:]

Good afternoon. Just wondering, you cited obviously the softer retail environment. Wondering what gives you confidence that that's the main factor versus – and I'm am thinking particularly about Pottery Barn here – versus internal merchandising or execution or, let's say, competitive factors. And then just a related question. How should we think about your outlook for the rest of this year in the context of your three-year plan issued earlier this year?

[Laura Alber:]

Thanks, Daniel. It's mixed out there. We know mall traffic's down. Certain categories are more challenged than others. On the flipside, housing metrics appear to be strong, and we also are seeing growth in some of our smaller businesses. Our approach has always been the same. We're going to focus on the things that we can control, and we would prefer to be self-critical. The things we can control are our product, our value prop, and our service. We're executing on our growth strategies and against our operating initiatives to drive improvements across the company, and we believe that these priorities, along with the combination of our portfolio of strong brands and our multi-channel model, will leave us well positioned amongst the competition regardless of what's going on in the external world.

[Julie Whalen:]

And, Dan, this is Julie. Regarding the outlook, three-year outlook, our three-year outlook still remains unchanged with mid- to high-single digit revenue growth to low-double digit to mid-teens EPS growth. Obviously, in the short term for 2016, our earnings growth is guided to obviously be below that outlook, and that is both due to the revised guidance on the year resulting from the softening retail environment, but it was also due to the investments we spoke to you about last time that we're making in our supply chain and inventory. But we are confident longer term, first, by the fact that West Elm is definitely clearly on their path to $2 billion with another quarter of double-digit growth; the scaling of our global businesses that I spoke to; the improvement in our newer businesses and their continued growth; and all of these supply chain and inventory initiatives that we said we were doing, we're working on for a while and clearly now they're showing that we are executing upon them and getting the benefits from them. When all of those come together, plus all the strategic initiatives that Laura mentioned on the Pottery Barn brand, we are absolutely confident in our ability to grow in the longer term.

[Daniel Hofkin:]

Thank you.

[Operator:]

This time we'll take a question from Peter Benedict with Robert Baird.

[Peter Benedict:]

Hey, guys. Julie, in your remarks, you mentioned the gap between revenue growth and CBR in 2Q, 220 basis points, and that's the way it's been for the last several quarters. What would affect that going forward? Why wouldn't that gap continue as we look out to the back half of this year? Thank you.

[Julie Whalen:]

I mean it could. In our full-year guidance, we do show that. We do have the revenue growth a 100 basis points above the comp growth. Obviously, it just depends on the mix of revenues in any given quarter, but we've certainly reflected that in our full year. We’ve got no belief, to answer your question, that West Elm is slowing down anytime soon nor our global operations. So with those two being the big drivers of the non-comp growth, we still think that's going to continue.

[Peter Benedict:]

Great, thank you.

[Operator:]

At this time, we'll move to Matt Fassler with Goldman Sachs.

[Matt Fassler:]

Thanks a lot and good afternoon. I want to ask one question about the guidance. You spoke about the retail environment eroding presumably over the course of the quarter, and since you last spoke to us in May the midpoint of your comp brand guidance for the third quarter is actually a bit better than the number that you put up for Q3. So is that a function of the environment stabilizing? Is it a function of other steps that you're taking? Particularly I'd ask on the promotional front to try to shore up that revenue because even though there's some deterioration, I guess, it doesn't seem like you're modeling a much softer outcome for Q3 than you saw in Q2.

[Julie Whalen:]

Yes. Our guidance obviously, as I said, reflects our best estimate at this time as the possible range of outcomes for the back half and for Q3. Obviously, the higher end of our range does assume improvement, and depending on the ongoing success of our growth initiatives and all the areas that we're focused on that Laura went through in detail for the Pottery Barn brand, those should drive improvements. Obviously, we've got a range. We still have the softening retail environment. We don't know if that's two weeks or two months or what have you, so that is why we have a range of zero to 4%. But on the upper end of that range, we do expect improvement.

[Matt Fassler:]

And then just, by the way of very quick follow-up, would you say, if you think about underlying demand that you can detect within the e-commerce channel versus underlying demand that you can track at retail, particularly as it relates to traffic, would you say that this is more of a footfall issue in brick-and-mortar stores or more of a consumer issue broadly speaking?

[Laura Alber:]

I would say that it's both. In retail, there's reported reduced traffic from all the counter aggregate data you see. And then the customers’ just more careful right now. I'm not an economist, so I'm not going to go through all the reasons that could be. But our focus is on giving them incredible service and great value and innovative product, and we are testing a lot of things in both channels, and we have a lot of things that are working that we're building on. As I said earlier, particularly in Pottery Barn, we are very aggressively ordering what's working and canceling what's not. And it's really good to have new bestsellers that are really, really strong that you can build on, even though you also are seeing some softness in other categories.

[Matt Fassler:]

Got it.

[Laura Alber:]

So to give you a little bit more color. We're working across all of our channels, which do affect each other quite a lot to increase conversion and drive traffic, and over the long haul, really build a much stronger, more loyal customer base. So we have a lot of initiatives. I went through them in probably too much detail in my script that are all focused on customer acquisitions and driving traffic and conversion in both of our channels.

[Matt Fassler:]

Thank you, Laura.

[Laura Alber:]

Welcome.

[Operator:]

We'll move now to David Magee with SunTrust.

[David Magee:]

Hi, good afternoon. Can you give us sort of an early read on what you see with the success of the seasonal merchandise thus far? Just maybe an early read on what you have for seasonal for the fall.

[Laura Alber:]

Sure, great question. It's early, and we love the seasonal holidays. They provide the customer a great reason to buy new things and decorate their homes. And I know, for me, it gives me a lot of pleasure to put up those Halloween decorations every year for the kids, and our customers’ telling us the same thing. Despite what I said about the caution, we're delighted to see strong results to Halloween so far. It’s really early, so I hesitate to even tell you that, but it is true. And we have incredible costumes in kids and some wonderful entertaining stories in both Williams-Sonoma and Pottery Barn, and so far, so good. Following that, of course, we don't know about Christmas yet. We did see a nice back-to-school with kids. I mentioned that earlier. And also in teen despite the softness in other categories, the seasonal merchandise has been selling. And this is important because not only is it important for sales, obviously, in the short term, those are the categories that bring the new customers in. So you want to make sure that you're getting customers in with those things because then they're more likely to buy a sofa from you or a rug in a different life stage or when they move than they would if they'd never experienced the brand.

[David Magee:]

Good. Thank you, Laura.

[Laura Alber:]

Welcome.

[Operator:]

We'll move now to Chris Horvers with JPMorgan.

[Chris Horvers:]

So I want to ask a couple questions on gross margin. Can you quantify how much the inventory clearance impacted enterprise-level gross margins? And do you expect any remnant markdown pressure in the third quarter? And then I have one follow-up.

[Julie Whalen:]

It predominately hit the retail operating margin the most. As we've said that we did most of the clearance through our outlet stores, which hit the retail operating margin. So you can look at the delta on the retail operating margin and come to some conclusions. We haven't disclosed the exact amount, but it was material to that margin. As far as the guidance, could we still have some pressure from some of our inventory initiatives? Sure, but I think the bigger story to take away from what I'm really pleased to be able to say is if you look at our gross margin, if you look at it sequentially, it has improved from Q4 to Q1 to Q2, and we've gone from basically holding our merch margins either flat to slightly down and our selling margins taking out global are flat. And I think it's been a long time since I have said that. So, clearly, everything we are doing from a supply chain perspective is allowing us – trust me, we are still promotional, but we're able to be able to offset that unlike other retailers because of all these initiatives we've been tirelessly working on. It is finally coming to fruition. So I think that's the great story about the gross margin going forward.

[Chris Horvers:]

That's a perfect segue to my follow-up question. So previously you had talked about improved gross margin performance in the back half. Obviously, lower comp, you have occupancy deleverage, but can you update us on your thoughts on selling margins? Will you promote more to drive the business? Can you offset that? And then the impact of shipping and fulfillment costs, obviously, a lot of pressure from out-of-market shipping and returns of damages last year in the back half. Do we get those back now that inventories are cleaning up?

[Julie Whalen:]

So we're seeing all of that even today. We're getting a lot of benefits from the fulfillment-related costs that are improving as we speak. I don't expect that to change. So we should see that. To your point about occupancy, it depends on the top line, right. Occupancies depending on where the revenues come in can deleverage and that would affect total gross margin. It also depends on the mix of revenues from a global perspective. If you got higher franchise, all of that. So it's hard to say exactly where clearly, we don't guide it, where the margin's going to come out. But what I did say is that the op margin we expect for Q3 to be relatively in line with last year, so hopefully, that gives you some indication that we're not feeling that the gross margin's going to be changing.

[Chris Horvers:]

Understood. Thanks very much.

[Operator:]

We'll move now to Greg Melich with Evercore ISI.

[Greg Melich:]

Hi, thanks. I guess, I want to switch gears a little bit. If we think about the overall sales growth, the comp brand comp of 0.6%. And I think, Laura, in your comments, you mentioned more opening price point items being added at Pottery Barn, and I think PBteen. Could you help give us some examples on the second quarter as to whether ticket was actually up or down and if this is meant to help improve conversion and gets to a price point that's more affordable for the consumer? Or what's really driving that decision?

[Laura Alber:]

Customers are savvy. As I said earlier, they know a value when they see one, including if it's a higher price point type of item. So a sofa that's a great value, maybe a lot more money than a candle. The truth of the matter though is that the candle a lot more people can afford. So, as I said earlier, we have to make sure that we are not just driving our furniture business but bringing in really innovative decorating and entertaining ideas into all of our brands. It's a very competitive area, so I hesitate to go through specific examples because, as you know, the competition is listening very carefully to our strategies. So I'm sorry not to give you more detail. I'll just say that there's no tricking those customers. They know a good price when they see them, and we are looking at our pricing, both versus the competition but also where we cannot just stay status quo but where we can really win. And because we have better quality and they know it and we also offer a lot of service, I believe if we continue to give them innovation and that combination, we will outpace our competition.

[Greg Melich:]

Okay. That's helpful. And, Julie, just to follow up the gross margin question from before. I think last year, you mentioned something like 50 or 60 bps of headwind on supply chain and related to the West Coast port and some of that? And how should we think about cycling that in terms of the second quarter and then the back half guidance?

[Julie Whalen:]

I don't recall that I exactly gave the amount. Probably what I did was allude to more the fact that the gross margin was down. It was predominantly associated with the supply chain challenges that were occurring. So we are seeing a lot of that return and come back to us, as we should expect, but I think the bigger story for – it's a shift. We're turning around, but it takes a while. But we've seen all of it start to come back first quarter, second quarter, and it's gaining momentum. But I think the bigger story there that we have to take away is that we are now seeing opportunities to get back to even better than we've been before. And so that's what we're focused on. So we've got improvements from last year, but as we move forward, as we move through the end of the year and subsequent years, we've got improvements even beyond that. So that's the exciting part.

[Greg Melich:]

That’s great. Good luck.

[Julie Whalen:]

Thanks.

[Laura Alber:]

Thanks.

[Operator:]

We'll move along to Michael Lasser with UBS.

[Michael Lasser:]

Good evening. Thanks a lot for taking my question. Could you frame the margin benefit that you're seeing from all the supply chain initiatives that you've been putting in place? Also, how long can that last? And how are you thinking about, from a strategic perspective, letting those margin benefits fall to the bottom line versus reinvest them back in the promotions to drive the business? Thank you.

[Julie Whalen:]

Yes. We haven't disclosed it, and there's different kinds of margin benefits we're getting. So specifically from the merch margin line item, it's a lot of the sourcing benefits that we've been talking about for years. I know I've gotten the question a lot that is this going to end next quarter. Well, no, it keeps going on. So first, we started with just the reductions in actual cost vis-à-vis versus the third party and that's still continuing, but now we're moving into that second phase where we've got our employees out there and they're actually make a difference on the raw material and the negotiation of prices. And so that's one piece of it. The other piece of it is all the supply chain initiatives that we're working that were challenges last year. So you get to improve from that but then also to move ahead from it. So I think the way I would think about it is it's the fact that we are almost – effectively only slightly down in merch margins and flat on selling margins if you take out the global impact, we weren't less promotional. So if you look at other retailers and see how promotional they were, you might be able to get some idea of how much benefit we are getting. And would we ever have let it drop down? I mean, of course, but at this point, we see the opportunity to continue to be aggressive and competitive and move forward.

[Michael Lasser:]

Thank you so much.

[Operator:]

We'll now move to Dan Binder with Jefferies.

[Dan Binder:]

Yes, thank you. Just two items. I was wondering if, first, you can discuss a little bit more color on the cadence of the quarter from a sales perspective. And then secondly, on the promotional environment, I'm just curious with the change in the comp momentum, customers what have they stopped responding to versus maybe what they were responding to before. Thanks.

[Laura Alber:]

On the cadence of the comps, Julie, you want to answer that?

[Julie Whalen:]

Yes. We usually don't comment on the cadence of the comps. But as far as I can comment or Laura can comment, but on the promotional environment and what we thought was different at least from my perspective, from a financial perspective, if you look at many retailers, we are not alone in this situation. If you look at Q1 versus Q2, it was much more broad based. You saw deceleration from Q1 to Q2. It was much more across categories than we've seen before. So I think that's where you start to step back and say, hmm, this is something a little more than we've got the wrong product category in a particular brand.

[Dan Binder:]

Thanks.

[Operator:]

We have time for one more question. This will be from Simeon Gutman with Morgan Stanley.

[Simeon Gutman:]

Thanks. I'll make it two parts just to get it all in. Just a follow-up on gross margin, Julie. You talked about a few minutes ago on a response how you think you can get back to or maybe better than some of, I don't know exactly your words, but to some levels that you were before. In that context, can you talk about do you feel like the gross margins are bottoming cyclically temporary and you should be able to move on from here? And then my follow-up question, to sneak it in, it looks like the first, I guess, through third quarter margins are roughly flattish. And so doesn't the full-year guide imply that margins are going to be down in the fourth quarter? And why is that the case?

[Julie Whalen:]

For your second question, are you talking about operating margins or you’re talking about gross margins?

[Simeon Gutman:]

Operating.

[Julie Whalen:]

Okay. So as far as gross margins, there are so many moving parts in there. That's why it's so hard for us to answer that. Clearly, I am confident in our supply chain and inventory initiatives, both sourcing and comping the supply chain challenges we had last year. So I'm confident in that piece of it and that piece moving forward. Obviously, it depends on the promotional environment. It depends on the mix of revenues that we have how much is global. It depends on the level of revenue to determine where does occupancy play out. And so I can't give you a specific answer to that, but I think the fact that we've seen Q4 to Q1 to Q2, we've seen improvement and we’re seeing the success of our supply chain initiatives roll through, I feel really good about the gross margin. From an op margin perspective, really, that is a revenue play. It really depends on – obviously, we said for Q3 we're going to be relatively in line with last year, so in the Q4 conversation, one of our biggest quarters and where the revenue lands. At the high end of our range, we're flat to last year, and it's a range. So we could be a different level on the revenue, different level on the op margin relative to our guidance, but it does assume that we've got continued improvement in our supply chain.

[Operator:]

And that concludes our question-and-answer session for today. I'll now turn the call back over to Ms. Alber for any additional or closing remarks.

[Laura Alber:]

Well, thank you all for joining us, and we look forward to catching up with you again next quarter.

[Operator:]

Thank you. And again, that does conclude your conference for today. We thank you for your participation. You may now disconnect.