Williams-Sonoma, Inc.
Q2 2013 Earnings Call Transcript

Published: 29 Aug 2013

[Operator:]

Welcome to the Williams-Sonoma Inc. Second Quarter Fiscal Year 2013 Earnings Conference Call. [Operator Instructions] This conference is being recorded. I would now like to turn the call over to Gabrielle Rabinovitch, Director of Investor Relations, to discuss non-GAAP measures and forward-looking statements. Please go ahead.

[Gabrielle Rabinovitch:]

Thank you, Gwen. Good afternoon. This call should be considered in conjunction with the press releases that we issued earlier today. Our earnings press release and this call contain non-GAAP financial measures that exclude the impact of unusual business events. A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures and our explanation why these non-GAAP financial measures are useful are discussed in our earnings release. 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 initiative, trends, guidance, growth plans and prospects of the company in 2013 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 10-Q, 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 will now turn the conference call over to Laura Alber, our President and Chief Executive Officer, to discuss our second quarter 2013 results and our outlook for the remainder of fiscal year 2013.

[Laura J. Alber:]

Thank you, Gabrielle. Good morning or good afternoon, I should say, and thank you all for joining us. With me today are Julie Whalen, our Chief Financial Officer; and Pat Connolly, our Chief Marketing Officer. I want to start by addressing the early release of our Q2 2013 earnings information today. Our press release, as many of you know, was scheduled to be issued this afternoon at 1

[Julie P. Whalen:]

Thank you, Laura, and good afternoon. We are once again pleased with our results and the outperformance we saw on both the top and bottom line compared to our expectations for the quarter. For the second quarter, net revenues increased 12.3% to a second quarter record of $982 million, with comparable brand revenues increasing 8.4%. Net revenues in our direct-to-customer channel grew 15.3%, driven by e-commerce, which had growth in excess of 20% and represents more than 90% of our total direct-to-customer revenues. Direct-to-customer net revenues generated 49% of total company net revenues in the second quarter this year compared to 47% last year. The growth in the direct-to-customer channel was primarily driven by Pottery Barn, West Elm, PBteen and Pottery Barn Kids. Net revenues in our retail channel grew 9.7%, driven predominantly by Pottery Barn, West Elm and our international franchise operations. This growth was partially offset by a decrease in the Williams-Sonoma brand. Gross margin during the second quarter was 37.6% versus 38.3% last year. This 70 basis point decrease resulted from lower selling margins, primarily in the retail channel, partially offset by occupancy leverage. Occupancy leveraged 20 basis points with occupancy cost at $138 million in Q2 2013 versus $124 million in Q2 2012. While our gross margin decreased versus last year, SG&A improved to 29.6% in Q2 2013 versus 30.2% in Q2 2012, primarily driven by the leverage of employment and advertising costs resulting in a second quarter operating margin of 8.0%, which was equal to last year. As we have said before, different from other retailers, our operating model was close to 50% of revenue coming from the direct-to-customer channel allows us to flex between margin and advertising cost to drive revenue growth while maintaining an overall operating margin. The operating margin was driven by 100 basis point improvement in the direct-to-customer segment to 24% and a 10 basis point improvement in the corporate unallocated segment to 7.2% offset by 150 basis point decrease in the retail segment to 6.9%. The improvement in the direct-to-customer segment was primarily driven by greater advertising leverage. The improvement in the corporate unallocated segment was driven by overall expense leverage and ongoing expense discipline. The decrease in the retail channel operating margin was primarily due to lower selling margins and the upfront investment costs associated with our global expansion, partially offset by the leverage of employment-related costs. Second quarter 2013 diluted earnings per share grew 14% to $0.49 from $0.43 last year. This is the sixth consecutive quarter where we have delivered better-than-expected earnings. We are pleased to be delivering this level of record profitability while continuing to invest in our long-term growth. Merchandise inventories grew 13.4% on a comparable basis, which was relatively in line with our revenue growth, as well as our stated goals to improve in-stock inventory positions, to drive sales and to support our growth initiatives. From a balance sheet perspective, merchandise inventories increased 19.6% to $737 million versus $616 million at the end of Q2 2012. As part of our expanded Asian sourcing initiatives, which include directly procuring our inventory for our global operations through our Asian entity, we are taking ownership of our in-transit inventory earlier in the supply chain. Excluding the impact of this additional in-transit inventory, merchandise inventories increased 13.4%. Cash at the end of the quarter was $205 million versus $337 million last year. Over the past year, while generating $389 million in operating cash flow, we returned $289 million to shareholders through share repurchases and dividends including $120 million in cash to our shareholders this quarter alone through $90 million in share repurchases and $30 million in dividends. As a reminder, consistent with prior years, our cash balance will decrease throughout the year and reach its lowest levels in the third quarter as we use our significant free cash flow to fund our investment and working capital in advance of the holiday selling season. I would now like to discuss our third quarter and fiscal year 2013 guidance. We are on track for 2013 to be another year of record revenues and earnings while at the same time investing in our future growth. For the third quarter of 2013, we expect to grow net revenues to a range of $1,020,000,000 to $1,040,000,000 with comparable brand revenue growth in the range of 4% to 6%. Diluted earnings per share are expected to be in the range of $0.51 to $0.54, and we expect our operating margin to be slightly below last year's rate. For the full year, as a result of this outperformance in the second quarter, we are raising our guidance for revenue by $40 million, and we are raising our guidance for diluted earnings per share by $0.02. As a result, we now expect to grow net revenues to a range of $4,260,000,000 to $4,340,000,000 with comparable brand revenue growth in the range of 4% to 6%. And we now expect fiscal 2013 non-GAAP diluted earnings per share in the range of $2.69 to $2.79, representing growth of 11% at the high end of the range after adjusting for the 53rd week in 2012. This guidance for the back half of the year contemplates several factors that I would like to discuss in more detail. First, as a reminder, the fourth quarter of 2012 included an incremental 53rd week worth approximately $70 million in revenue and $0.07 of earnings per share. On a comparable basis, due to the 53rd week in 2012, there's a 1-week calendar shift this year between the third and fourth quarter. This shift results in a high-volume holiday selling week moving from Q4 to Q3. Second, the holiday shopping season during the fourth quarter will be a week shorter due to the date on which Thanksgiving falls. Third, our fiscal year guidance contemplates the closure of significantly more Williams-Sonoma stores in the fourth quarter than in the fourth quarter last year. We plan to close approximately 15 stores this year versus 8 last year. These closures represent stores that are underperforming and predominantly at the end of their lease life. Fourth, we expect the upfront costs to accelerate the build-out of our global infrastructure in Australia and the United Kingdom will be higher than originally anticipated and will therefore, put pressure on our earnings in the back half of the year. Fifth, as you saw in the second quarter, we expect occupancy expenses, which include depreciation, to increase approximately 10% for the rest of the year as a result of our 2012 capital investments and our investments in our accelerated global expansion. Finally, our capital allocation strategy remains unchanged. We plan to make capital investments in our business as we continue to invest in our long-term initiatives, and we also plan to continue to return capital to shareholders through share repurchases and dividends. In summary, we are pleased with both our top and bottom line performance in the second quarter and with the progress we have made year-to-date against our strategic growth initiatives. We are confident that the strength of our brands combined with our continued execution against our long-term strategic initiatives and our balanced capital allocation plan has us well positioned to deliver on both our near- and longer-term financial goals. I would now like to open the call for questions. Thank you.

[Operator:]

[Operator Instructions] We'll take our first question from Daniel Hofkin with William Blair & Company.

[Daniel Hofkin:]

Just I had a question going back to Williams-Sonoma, specifically, the brand. Do you feel like -- was the outdoor isolated to weather or was it the content of the product in your opinion? And I guess just interested in what you think the timeline is for sort of getting the brand to where you want it to be from a merchandising and service standpoint, and then I just had a quick housekeeping follow-up.

[Laura J. Alber:]

Sure. We saw strength, as I said, in the areas that we're most differentiated and so it's the combination of both newness, and newness is very different from what the competition offers, and those areas were in home, agrarian and cookware. Outdoor, which was a key marketing message, spans several categories, both the tools but also the rubs and sauces and combination of factors that made it softer than we would have liked. And the reality is that we needed new flow of outdoor, too because we told the same story throughout the entire summer season, and the outdoor business is really a cooking trend that's around year-round, and so we need to have more flows of it next year and possibly also less as -- less of it as a marketing statement. There were other great trends that we saw, the ice cream trends, for example, and some of the sweet foods and sweet stories were strong. And as I said, as we move into Q3, we really are optimistic about our product lineup. We have, right now, as you know, if you've been into our store, we have our Wine Country story, which spans both food and -- but also how you entertain, and it's really back to our heritage and chucks fines [ph] , and we're seeing some nice response on that so far. As we go into the ever important holiday season, you'll see us launch Halloween here in stores. We have some of it online now, and we have, I think, a much stronger and broader assortment in Halloween and then also in Thanksgiving and Christmas. The entertaining at home theme is one that we are very focused on, and you're going to see us introduce a lot of exciting things in the home bar. We know that custom cocktails are something that everyone really enjoys, and we think we can help our customer throw those great parties through the holiday season. In the back half, strong holiday execution is key. At the same time, we've talked to you about testing new ideas. And our approach is to test and roll ideas versus making precipitous, far-reaching changes because the customer has told us through a number of focus groups how much they love the brand. So we're being very careful and thoughtful about changes we make, and we're going to keep you posted along the way as we see different things work or not work well. And in summary, I'd say that Williams-Sonoma story is really a story of innovation and execution, and we are making good progress against the initiatives that we outlined.

[Operator:]

And we'll go next to Kate McShane with Citi.

[Kate McShane:]

Julie, in drilling down on the guidance in some of your second half commentary that we just heard, can you help us reconcile the guidance of keeping operating margins at 10% to 10.3% yet having to spend more on your international expansion? You didn't change the comparable brand revenue outlook, but do you expect something different from gross margins in the back half?

[Julie P. Whalen:]

Yes, thanks, Kate. So a couple of things. First, it's important to remember that we plan to drive continued long-term profitable growth by investing in our business both domestically and globally. It's essential to acknowledge that we are maintaining significant earnings growth while investing in the future to fulfill our vision to double the size of our revenues, and these investments will position us for the next phase of growth. They will strengthen our position as the leader in multi-channel lifestyle brand building in the home furnishing space, and it is the power of our multi-channel operating model that allows us to do this. As far as the factors that I spoke to regarding the guidance, I think the one thing you have to remember is that we did roll through the $40 million on revenue on the top end. And so, obviously, not all of that beat, we believe, is going to be going down to the bottom because of the 4 factors that we outlined in the conference call script. Specifically, we did mention that we do have more upfront costs than originally anticipated for the acceleration of our build-out of our global infrastructure, and that's going to continue to put pressure on our earnings in the back half. Also, you mentioned gross margin, we do see that we're going to have approximately 10% higher gross margin for the rest of the year, which, remember that with the occupancy -- 10% higher occupancy, sorry, with occupancy includes depreciation. So within that number, we are absorbing, if you will, our 2012 capital investments and again, our investments in our accelerated global expansion. From a gross margin perspective, in particular, obviously, we don't guide specifically gross margin, but with a continued promotional environment and an increase in these occupancy costs, we do believe there'll continue to be pressure on the gross margins. But as we have said before, different from other retailers, our operating model with close to 50% of revenue coming from the direct-to-customer channel allows us to flex between margin and advertising cost to drive revenue growth while maintaining our overall operating margin. And our operating margin, remember, at the high end, is equal to our record operating levels that we've had in the past, and our operating income will be the highest it's ever been. Pat, maybe you want to explain further on how we're able to do this with our operating model with the ad cost?

[Patrick J. Connolly:]

Sure. Kate, I think it's so critical that we understand how we're able to flex this between the ad cost and product promotions. And the reason we're able to do that is really because of our increased marketing effectiveness, which is a key component of the profitability. And just this year, we've applied a new layer of sophisticated statistical modeling and the new automated process that's yielding further improvements in our catalog targeting, really identifying those people who are most likely to buy and curtailing the mailings to unproductive segments. In our new brands like Mark and Graham and West Elm, Rejuvenation and Williams-Sonoma Home catalog relaunch, we've developed a novel modeling strategy to identify more receptive -- the most receptive populations from our massive house file, and that's enabled to take these brands to the next level of growth. But I think as much as we have done and are doing, we see significant future opportunity here in the near future. Early this fall, we'll launch a new personalization platform that, among other things, will allow us to identify and target almost 5x the number of site visitors and deliver personalized content based on what we know about them. This is a big deal. And about half of our site visitors, and this is true for almost all e-commerce sites, are anonymous. We've never seen them before. We are actively using data science techniques to characterize and understand the intent of these visitors, so that we can deliver relevant content even to people who have never been to our site before, and we're making investments in analytics and technologies that are allowing us to identify customers across devices and across brands. This is very important. So we know -- we're going to be able to know what someone did on their iPads, so when they go to their computer, we can deliver them also a very relevant experience. We're very excited about this and believe that these investments are making -- are really -- are going to allow us to increase our lead in this area.

[Operator:]

And we'll go next to Budd Bugatch with Raymond James.

[TJ McConville:]

It's actually TJ McConville, filling in for Budd. My question, maybe to Julie, goes just to the third quarter guidance. If we take a look at just the comp brand sales guidance for the quarter, even contemplating the tougher prior year comp in the third quarter last year, still seems like you're looking for some sort of deceleration or moderation. So question is what are you seeing right now that would cause you to do that, and what are the potential upside or downside risks to that outlook?

[Julie P. Whalen:]

Okay. I'll take that. So it's important to remember that we are maintaining significant earnings growth while investing for the future to fulfill our vision to double the size of our revenues. Our Q3 guidance actually implies a 10% increase in both the top and bottom line while investing in those future growth opportunities. And remember, per our prepared remarks, our Q3 guidance reflects both the higher-than-originally-anticipated global upfront costs and increased occupancy costs, primarily from depreciation and our ongoing investments. But with that said, we expect our home furnishings brands perform at a high level and that we'll once again deliver record top and bottom line results. Remember we've put out guidance that we believe we will be able to make, there are still questions, question marks around the economy today. We haven't really planned for either an economic downturn nor a housing recovery. And as far as how that Q3 is looking to date, we don't give mid-month, mid-quarter guidance. It's still very early in the quarter. We're only a few weeks in. And unfortunately, what's going to make it an even harder read all year is that because of the 53rd week, the weeks don't actually line up. But with that said, we are confident in our guidance, and we are confident in our strategies. And you just have to keep in mind that the retail environment seems to indicate there's still a lot of uncertainty out there, that the promotional environment has not gone away and that the retail environment in general continues to be choppy, especially with the recent earnings releases in this global unrest, and we just don't want to get ahead of ourselves.

[Operator:]

And we'll go next to Matthew Fassler with Goldman Sachs.

[Matthew J. Fassler:]

Just kind of a very quick two-parter, really a single question, I think, on Williams-Sonoma. You talked about the outdoor products, seasonal product and its impact on the quarter. How significant was that as it relates to any sales and margin issues you had at Williams-Sonoma? And then, just following through that, obviously, the Williams-Sonoma business hit its stride seasonally in the fourth quarter. So should we assume that the thought process is that whatever that you saw kind of broadly speaking in those pieces of the businesses that you haven't overhauled might persist in Sonoma through Q4?

[Laura J. Alber:]

Sure, the outdoor business, we don't quantify that specifically. It contributed. It wasn't the whole thing though, but what's important is that it was the marketing message, right? So even though if you took the numbers, and I were to give them to you, you might say, well that's not that big or that wasn't that negative, the point is that it's the key thing in marketing isn't as strong as you planned, you don't drive as much traffic, right? So that was the learning there. And the truth is in other brands that are performing well, we vary the message more frequently than we did. So we learned from that. And as we look at the balance of the year, we're making sure that we have fresh statements all the time throughout the back half and that we're building on what's working and reducing what's not. As you know, it's very competitive, so I -- to go through specific product launches would probably not make good sense for us to do right now, but we are optimistic about our fourth quarter for Williams-Sonoma and the product that we are going to be offering and the plans for execution that I discussed particularly at retail.

[Operator:]

And we'll go next to John Marrin with Jefferies.

[John Marrin:]

So, Laura, just staying with this question about being deliberately more competitive on price. This might be a fire point, but was that something you saw across both channels, both retail and direct, I mean, given the direct margins being so good in the quarter? I'm just curious if there was some pressure there relative within the Williams-Sonoma brand itself.

[Laura J. Alber:]

I think here's the most important thing

[Julie P. Whalen:]

And to answer your question regarding gross margins in particular, John, it was product margins, but it was predominantly in the retail channel, so it's less of a DTC conversation, it was actually not just Williams-Sonoma, it was across Pottery Barn as well. So further to Laura's point that we're being competitive on promotions and driving market share growth. We are offering our customers value and driving operating income.

[Operator:]

And we'll go next to David Gober with Morgan Stanley.

[David Gober:]

As you spend a lot of time focusing on the enormous opportunity for international, I'm just wondering if you could give us some of the early takeaways from Australia. I know it's super, super early days, but I just wanted to -- I was wondering if you could maybe kind of contextualize the launch relative to what you've seen in the U.S. for some of those -- for the like-for-like concepts or if there's any details that you can give us in terms of how that's gone and building the confidence that, that strategy is going to continue to work long term.

[Laura J. Alber:]

Sure. We believe global is our greatest opportunity for growth, and we said we're looking for additional locations. Next, we're going to really -- we're fill out Australia, fill out the United Kingdom. We're also looking for relevant franchise partners. And as I've said, we're pleased with our relationship with Alshaya. We're equally excited to be working with Store Specialists in the Philippines. And while that's a smaller deal, we think it's a great way to get our foot into Asia. The most exciting thing, I think, to your question specifically is that we are seeing a large percent of our sales online, much larger than we expected. It's incredibly powerful for us and plays directly into our strength as a leader in multi-channel retailing. We've also learned that our brands in Australia are revered and loved, and we also learned the importance of a multi-channel launch, the importance of the experiential retail, the attraction of our cooking school, the power of in-home design services and connecting with our customers and that our customer-centered approach is going to resonate in other countries.

[Operator:]

And we'll go next to Laura Champine with Cannacord.

[Laura A. Champine:]

Laura, I heard your comments about Williams-Sonoma's continued turnaround being about product, but what are some of the signposts, whether financial or otherwise, that we can look to over the next 6 to 12 months to see if your strategy there is working?

[Laura J. Alber:]

As we said today, we're going to be very direct with you about what parts of the strategy work and don't work just like I told you about outdoor. Our focus right now is on retail and retail profitability and getting the right team in every -- and the right people in every single job, and we've made a lot of progress on that front, and those -- that's the first part of any strategy execution, of course. And we'll just -- on every call, we'll keep updating you along the lines of product, along the lines of different direct-to-consumer and retail operational strategies that work and just be very direct with you.

[Operator:]

And we'll go next to Peter Benedict with Baird.

[Matthew J. Larson:]

It's Matthew Larson on for Peter. I just wanted to bring the conversation back to the international business. Just given the robust sales growth there in the first quarter, can you quantify what impact that had on the top line in the second quarter? And then, just generally speaking, what impact this business has on gross and operating margins of the business right now?

[Julie P. Whalen:]

Sure. So you will actually see this come out in the Q, but the revenue for international this quarter is going to come in about $50 million versus last year at about $31 million or $32 million. So again, like Q1, we've seen about a 55-plus percent increase in revenue, which is really exciting for us. We, obviously, are not breaking out in detail how that translates down to bottom line. Obviously, we've mentioned to you today that we are incurring little bit higher than anticipated costs, but I think what's important to remember there is that we're -- when we go into a country, unlike other retailers, we're not just going in with a retail store, we're actually building out an entire fulfillment center. So we're actually going into Australia with full e-commerce capability and delivery. So we've got distribution centers and all the excitement that comes with that, including even if you -- if we enter the U.K. without e-commerce initially, you still have to build out the distribution center capability to do deliveries of sofas different than jeans, for example. So there's a lot of costs that are incurred upfront with that, but I think the most exciting opportunity is the fact that we have got over 55% growth on the top line.

[Operator:]

And we'll go next to Greg Melich with ISI Group.

[Gregory S. Melich:]

I just want to follow up on the top line. The gap between net revenues and comp brands revenue really expanded almost 400 bps this quarter. Was that the calendar shift driving that or is there something else? And I want to follow up on sales again and guidance.

[Julie P. Whalen:]

There's a couple of things. Yes, calendar shift is a piece of it because, obviously, comparable puts it back to the comparable week in the prior year, but we also have West Elm that doesn't have stores from last year in the comp base. We've got other businesses that are new and you've got also global.

[Operator:]

And we'll go next to Christopher Horvers with JPMorgan.

[Mark A. Becks:]

It's actually Mark Becks, on for Chris. Just had a question on Williams-Sonoma. Can you give us an update on where you're at with product innovation and exclusive products? I know you've been reluctant to give penetration rates in the past, but maybe you could give kind of some year-over-year growth rates. And then also just in terms of the context of your overall comp brand guidance, what your expectations are for the Williams-Sonoma brand in the back half?

[Laura J. Alber:]

I'll tell you that the product innovation each quarter is increasing in quantity over last year as we said it would, but in terms of percentage, it's just so highly competitive, and in terms of specific product launches that we haven't brought in yet, given how competitive it is, I'm sorry, I can't give you that now. I will just say that as you look at Wine Country, as a good example, you'll see that there's both product innovation on the durables, but also we're using lifestyle storytelling more in the Williams-Sonoma brand than we had before. It's something that we've learned how to do very well in our Pottery Barn brands and our West Elm brand, but really wrapping the seasonal layer around a theme that resonates with our customer. And so that, in addition to the product innovation, continues to strengthen through the back half of the year.

[Operator:]

And we'll take our final question from Neely Tamminga with Piper Jaffray.

[Neely J.N. Tamminga:]

Laura, can we talk a little bit about West Elm? I would love to hear from your perspective. Clearly, this brand has been -- continue to exceed expectations. And it sounds like the social media footprint is obviously exceeding that at square footage footprint at this point in time. Just wondering how you feel about the ultimate size of this business especially as direct sounds like it's a significant portion of their overall sales maybe relative to some of your other brands. And just one little follow-up question for Pat. Would love to hear from you guys, as you drive towards customization, are you already at the point of being able to do dynamic pricing through targeted promos on the unique user level or you're still batching that out?

[Laura J. Alber:]

Thank you. West Elm is such an exciting growth story. And across the country, we are seeing strong response to the brand's high design, its authenticity and the craft that it brings to the customers. We also have seen success in expansion, particularly in our furniture collections, you should see this fall the expanded sofa collection, and there's opportunities like that in other categories throughout West Elm. Another strength is our decorator palette, which is helping our customers refresh rooms each season with pillows, throws, decorative accessories and flooring. As for the ultimate size, we said $1 billion. Could it be bigger? Given the size of Pottery Barn, you would say yes. I think the question remains how many stores can you have in each market and what is the right amount, and that's -- we're going to continue to open these stores and measure carefully the impact on where we have multi-store markets and let that show us the way. But nice growth in both direct and in retail and in comp. There's still room for margin expansion in that brand, and we continue to push, as I've said, on expansion and category, dimensional size and in authentic design. Pat, do you want to answer?

[Patrick J. Connolly:]

Sure. And Neely, thanks. We're very excited about the customization. I think the whole area of being able to identify so many of our customers when they come to the site. And remember, we're going to be able to identify customer from 1 of 500 million to 700 million visitors and serve a personalized content to them on the web page in 1/31,000 of a second second. So technically, that's a pretty big achievement. Not many -- we don't know of any other retailer who -- conventional retailer who's been able to do that. We don't change the price in the moment based on the customer who happen to come to the site. I mean we do promotions, and we do look at prices across the web on a regular basis and adjust ours to be competitive, but we're not looking at them in the moment and saying, okay, for one customer, it's going to be a different price than another, if that's what you meant by dynamic pricing.

[Operator:]

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

[Laura J. Alber:]

Well, thank you all for joining us this afternoon. We really do appreciate your time and your continued support, and we will speak to you again next quarter.

[Operator:]

Thank you, everyone. That does conclude our conference call for today. We thank you for your participation. You may now disconnect.