Williams-Sonoma, Inc.
Q3 2013 Earnings Call Transcript

Published: 21 Nov 2013

[Operator:]

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

[Gabrielle Rabinovitch:]

Thank you, Ann. Good afternoon. This call should be considered in conjunction with the press release that we issued earlier today. Our 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 of why these non-GAAP financial measures are useful are discussed in our 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 initiatives, 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 third quarter 2013 results and our outlook for the remainder of fiscal 2013.

[Laura J. Alber:]

Thank you, Gabrielle. Good afternoon, and thank you all for joining us. With me today are Julie Whalen, our Chief Financial Officer; and Pat Connolly, our Chief Marketing Officer. Our strong third quarter and our performance year-to-date illustrates the power of our business model and the relevancy of our brands. We delivered an 11% increase in revenue and EPS growth in excess of 18%. Importantly, we delivered this revenue growth and accompanying operating margin expansion while simultaneously investing in our multifaceted growth initiatives. We believe we are well positioned headed into the holiday season, and will continue to execute our key strategies to deliver an exceptional experience for our customers. We are focused on generating top line results in conjunction with operational and capital discipline to deliver long-term shareholder value. In the beginning of the year, we outlined to you our key strategic initiatives for delivering sustainable, profitable growth and increasing shareholder value. They are

[Julie P. Whalen:]

Thanks, Laura, and good afternoon, everyone. Our third quarter results exceeded our expectations and demonstrated the advantages of our multichannel, multibrand platform, as well as our ability to continue to drive market share gains and profitability while simultaneously investing in the business. For the third quarter, net revenues increased 11.3% to $1,052,000,000, with comparable brand revenues increasing 8.2%. Net revenues in our direct-to-customer channel grew 14.5% to 49% of total company net revenues versus 47% last year. Net revenues in our retail channel grew 8.5%. Pottery Barn and West Elm were the most significant contributors to revenue growth. Total company operating margin for the third quarter was 8.8%, a 40 basis point improvement over last year, and includes continued investments in our global expansion. The direct-to-customer channel operating margin increased 40 basis points to 22.9%, driven by advertising leverage, which was partially offset by lower selling margins. The retail channel operating margin increased 30 basis points to 9.1%, primarily driven by the leverage of employment costs and was partially offset by lower selling margins. Corporate unallocated expenses increased 10 basis points to 7% of net revenues, partially due to the incremental cost to support our growth initiatives. Gross margin during the third quarter was 38.6% versus 39% last year. The 40-basis-point decrease in gross margin resulted from lower selling margins from competitive pricing strategies across all of our brands, partially offset by occupancy leverage. Occupancy leveraged 30 basis points, with occupancy costs at $142 million in the third quarter of 2013. SG&A improved 80 basis points to 29.8% in the third quarter of 2013 versus 30.6% in the third quarter last year. This improvement in SG&A was primarily driven by the leverage of advertising and employment costs. As we have said before, the high penetration of our direct business allows us to flex between margin and advertising cost to deliver revenue and operating profit growth while generating operating margin expansion. This revenue growth and operating margin expansion drove an 18% increase in third quarter 2013 diluted earnings per share to $0.58 from $0.49 last year. These results demonstrate our continued focus on generating meaningful shareholder returns while investing in our future growth. Merchandise inventories grew 18.5% on a comparable basis. The biggest drivers of the inventory increase are in those brands fueling our growth

[Operator:]

[Operator Instructions] We'll take our first question from Budd Bugatch from Raymond James.

[Budd Bugatch:]

I'm wondering, and I hope you can hear me -- I wonder -- just 2 questions if I can, and I'll phrase them together. One, you gave us international revenues this year. I wonder if you could give us what the comparison was against that for last year. And maybe a little bit more color on the SG&A leverage between segments or -- you said advertising, and I think occupancy -- not occupancy, advertising and leverage in payroll. Can you give us kind of a feeling on how that was between the segments?

[Julie P. Whalen:]

The international, we don't have the growth over the prior year because there wasn't really a substantial amount of growth. If you go 2 years back, we really didn't have as much international operations. All we would have had was the franchise. You can look back in the Q or I can get that for you offline. But as far as the SG&A, it really was significantly driven by advertising and employment leverage. Obviously, the more sales we have -- when we have higher sales than we expected, that leverages all of the costs.

[Operator:]

We'll go next to Daniel Hofkin with William Blair & Company.

[Daniel Hofkin:]

Just -- I guess maybe a follow-up on the Williams-Sonoma evolution. I would like to know kind of where -- you talked about some of the increased exclusivity, where that is right now versus where you think it might be in a couple of years? And then the other question relates to operating margins. You had a nice kind of balance between the 2 segments this quarter in terms of improvement. In the fourth quarter, it looks like the top end of your guidance assumes flattish margin, maybe some decline in margin at the lower end. Just curious what the dynamic is. Is it just the holiday-related competitive environment? Or is there something sequentially that would cause the margin to potentially be down a little bit year-over-year in the fourth quarter?

[Laura J. Alber:]

Sure. Thanks, Daniel. It's Laura. I hate to use a sports analogy, but I guess I would say we're in the third inning, that we're just getting started. Janet has been in her role for 6 months. And while we started evolving our product strategy prior to Janet, the durables product development life cycle takes a while. We also want to make sure that before we change any strategy, we want to make sure that we know it's going to work. And as a result, we've been very thoughtful about testing changes in the Williams-Sonoma brand. As I've told you before, our primary focus is on product exclusives and innovation, retail execution and exciting visual presentation. And we believe there's still more growth to be had in every category, and we're looking for bigger and more broad-based growth. We know the brand is widely loved and revered, but we want to make it more accessible to more people. In the future, you're going to see us bring in a wider range of products, the best quality for what they are but aren't necessarily the most expensive. We also know that we can work more closely with our key vendor partners to develop more exclusives that will further differentiate us from the competition. And we're also seeing emerging trends that we'll be building on in new categories like the Williams-Sonoma Home business, and we are still in the very early stages of developing that.

[Julie P. Whalen:]

And, Dan, regarding the operating margin, a few things going on there. Definitely, this is the first time, I think all year, that we've had operating margin expansion in the retail channel. So that's really exciting. And obviously, the higher the revenues we have, it leverages all the way through and drops to the bottom line. So we had the margin expansion this quarter. For next quarter, we've guided to be in line with last year. And one thing to remember there is that we do lose some leverage from the transition to a 13-week -- transition away from a 14-week to a 13-week, and so some of that does impact the bottom line. But with that said on the year, we basically raised the year on the bottom. It used to be at 10.0% to 10.3%. It's now 10.1% to 10.3%. And at 10.3%, as you guys know, it's equal to the highest rate we've had and will generate the highest level of operating income we've ever had. So -- all while investing in our strategies for the future. So we feel very confident about that.

[Operator:]

We'll go next to David Magee from SunTrust Robinson Humphrey.

[David G. Magee:]

We're hearing from some retailers about their promotions earlier in the season. Just generally speaking, it seemed to be more severe than expected. And I'm just curious what you think about sort of the environment here relative to what you may have thought a few months ago.

[Laura J. Alber:]

Yes, we continue to recognize the promotional environment. We've been talking about it for over a year, that we embrace it and don't think it's going to change. We know our customers would rather buy from us than our competition, and so we are focused not just on price but also on all the other things that makes you buy something from a retailer. And we believe we have the competitive advantage in many of those areas. But on price, specifically, we have a very exciting line up of great value for the holiday season, and we're going to vary it from last year so that we can keep everybody on their toes and drive excitement for the customer. So you're going to see us have planned promotions, as we have all year. And it's hard to get a read on the macro and consumer sentiment, given the multitude of conflicting data points. I don't know what's going to happen with the macro, but I do believe that people are enthusiastic about decorating, cooking and entertaining. And thankfully, that is the business that we are in.

[David G. Magee:]

Great. On the Williams-Sonoma brand specifically, could you tell us sort of what the proprietary product percentage is this year versus last year?

[Laura J. Alber:]

It's higher.

[David G. Magee:]

So it's meaningfully higher year-to-year?

[Laura J. Alber:]

It's higher. And what I think is most important versus SKU counting is the quality of the exclusives.

[David G. Magee:]

And last question, the distribution changes that you're making now, is that going to be meaningful to next year's EBIT number? Is there a chance to really leverage that nicely into next year?

[Laura J. Alber:]

You have to remember that the most important thing about our supply chain enhancements is that we're able to give our customer better service. And in many cases, we have passed along the savings to our customers.

[Operator:]

We'll go next to Peter Benedict from Robert Baird.

[Peter S. Benedict:]

Just curious, your business has been pretty consistent across the year here, but just the cadence across -- during the quarter, was there any choppiness that you saw? Just trying to understand that. And as it relates to Pottery Barn, the complexion of the business, I mean, is there anything in that -- in the mix there that you are seeing that starts to show you evidence that the remodeling boom is starting? I mean, I know the business has been strong, we can see that, but just trying to pull back the covers a little bit on a category standpoint. Are you seeing anything that's been changing over the course of this year that can speak to that?

[Julie P. Whalen:]

Yes. From a cadence perspective, we don't comment on that as it's playing out throughout the quarter. But I'll let Laura talk about Pottery Barn.

[Laura J. Alber:]

Sure. It's clear to us that the customer is very focused on their home and that, while we can't see a correlation one-for-one with housing starts or anything specifically in the macro, we do believe that people feel better about spending money on their home because the value of their homes are no longer dropping. And so at the same time, it's difficult to decorate and we're seeing market share gains, we believe, because we not only offer a wide array of well-priced products that are high quality, but also we help the customer put it together in the home. And I think it's probably early innings of a housing recovery, but we believe that because we are making it easier and offering great assortment to our customers, that we're gaining share and we will continue to do so. And so you'll see us increase newness. And also, we're also seeing uptick because we're offering more dimensional size options for our customers in terms of furniture. I mean, so many times, when you go to buy a new sofa, not only are you looking for style and the right price, but you're also looking for something that fits in your family room. And so we're very cognizant of where those holes are in our assortment and where we're adding new SKUs to gain more customers in the future.

[Operator:]

We'll take our next question from Greg Melich from ISI Group.

[Gregory S. Melich:]

Want to talk about the retail margins international, how they link. If I understand it right, your international revenue falls into the retail segment. And if that's right, how much of the sales growth is really coming from international? Or what was the trend in retail? And then second is how do we think about the retail margins in terms of -- we had a nice improvement this quarter but clearly, the calendar shift helped some there. How much of the margin improvement there would be driven by that week shift, international?

[Julie P. Whalen:]

Okay. So from a retail perspective, really, last time, we specifically called out that one of the biggest drivers was international. This time, it was primarily just across the Pottery Barn and West Elm brands, not specific to international. So that wasn't one of the biggest drivers. With that said, the growth there was 31%. And year-to-date, it is 48%. International is almost 100% in the retail channel. So when I talk about it, it's because of the effective drag on earnings, by the fact that we have costs ahead of revenues. So from a margin -- from a Q3 margin perspective, obviously, if we didn't have those, for example, with the U.K. store, and we're incurring costs ahead of it actually opening later in Q4, our margins in the retail operating margin would be higher. As far as guidance, we don't provide guidance by channel, but we know that the retail channel does drive sales, of course, to our direct channel. So depending on where the customer is shopping at any particular time, you'll see fluctuation in our retail operating margin. And so obviously, you're going to see this change. We're very pleased with the results that we have this quarter and the fact that we did see that operating margin expansion. But that will fluctuate.

[Gregory S. Melich:]

Got it. And on inventory, I just want to make sure I got that right. The in-transit, when you're thinking about [ph] -- you're up 18%. How much did the week shift? Is that included in that adjustment? Or would there be another adjustment, given that the quarter ended a week later?

[Julie P. Whalen:]

No. There would be another adjustment. The adjustment from the balance sheet to the comparable basis is simply taking out that additional inventory that wasn't in the base last year associated with our Asian sourcing initiatives. And that would take you to the 18.5%. And then when we speak about all of these other things that are driving the inventory increase in my prepared remarks, that's in particular to the 18.5%. So there would be an additional adjustment if you backed that out.

[Gregory S. Melich:]

So how much is it if it wasn't calendar shift?

[Julie P. Whalen:]

We're not -- it's hard to tell. We're not quantifying it. It's really hard to actually come up with the exact amount that's representative of that.

[Operator:]

We'll go next to Brian Nagel from Oppenheimer.

[Brian W. Nagel:]

So my question is on gross margins, maybe somewhat of -- I guess maybe a little of a follow-up to the prior question. But the gross margins in the quarter were still down, but the trend was improving, particularly if you look kind of on a multiyear basis. Now we spent a lot of time over the last several quarters talking about the Williams-Sonoma strategy of using select price promotions as an advertising vehicle, and then essentially trading SG&A dollars after[ph] cost of sales. Is there something that -- was there some shift or something to drive sort of, say, the improving trend in gross margins this quarter that maybe we should expect to continue to happen as we look over the next several quarters?

[Julie P. Whalen:]

I wouldn't read too much into that. I think at the end of the day, we said in our prepared markets, the main driver was lower selling margins, which was partially offset by occupancy leverage. We have said even last quarter that occupancy costs in Q4 could be higher, which obviously impacts your gross margin. But I think the positive here is a few things. First of all, when you take the puts and takes form the gross margin, it's actually across all brands and all channels, which reflects our competitive pricing strategy across-the-board, it's not particular to one brand, and the fact, to your point, that we can offset it with the SG&A improvements and still have operating margin expansion is phenomenal. So yes, we say it again and again, but our focus is on operating margin.

[Brian W. Nagel:]

Okay. And then a follow-up, if I could. You gave us a lot of color on some of the merchandising initiatives. I look at my model and it was pretty clear that the Williams-Sonoma brand comps improved here in Q3, again on a kind of a multiyear basis. Was there something that was shifted there for the pause in the Williams-Sonoma brand? Or is that maybe just a culmination of some of the efforts you've been putting forth lately?

[Laura J. Alber:]

As I said in the prepared remarks, we saw a great response to our Wine Country theme, our autumnal theme. And that was stronger than our summer themes of outdoor entertaining.

[Operator:]

We'll take our next question from Mike Baker with Deutsche Bank.

[Michael Baker:]

So I want to focus on the margins as well. Just on the merchandise margins, which looks like it's down about 70 basis points, so it's similar to last quarter. Is there an impact there? Is that just lower pricing? Or is there an impact from more free shipping, which I think you include in that selling margin. That's the first question. Then the second question is related, but more longer term. How do we think about -- you said you're focused on operating margins. How do we think about the long-term operating margins? Remind us what's in your 3-year plan? I think [indiscernible] is about 10.3% roughly over the last 3 years. Will that start to expand, or do we just expect more top line growth, or flat margins [indiscernible] earnings growth going forward?

[Julie P. Whalen:]

Okay. So as far as the gross margin, it is -- definitely, lower selling margins is what we indicated, which, to your point, does include free shipping. At the end of the day, we were intentionally competitive across all of our brands, all channels. And clearly, it worked. As I said earlier, we can afford to do that because our strategies allow us to do that and still have operating margin expansion. So it's just a choice we make between whether we do a free ship, a pricing promotion that hits gross margin, and we pull off from doing e-marketing, which the benefit hits SG&A, to still generate the top line sales and the bottom line growth in the operating margin. So that's going to continue. I don't see that changing at all. We think that's very healthy. And clearly, it's working for our brand. As far as operating margin expansion, for the year, on the high end, we're at 10.3%, and we have said that over our 3-year outlook, that we do plan on operating margin expansion. It goes from low double digits to mid-teens in our 3-year outlook.

[Michael Baker:]

And so the margin expansion then starts to accelerate at some point in the next couple of years?

[Julie P. Whalen:]

Yes.

[Operator:]

We'll go next to Neely Tamminga with Piper Jaffray.

[Neely J.N. Tamminga:]

Laura, I'd love to talk a little bit more about the theme that I heard over and over again. I haven't counted exactly how many times you said personalization, but clearly, that is a theme for you guys this holiday. And I was just wondering if we could get a little bit into what personalization actually means for you. Is it higher-margin goods? From a financial perspective, is it margin accretive? It would seem to me that it would be lower returns and maybe an additional average price point that would be a little bit higher, but what sort of penetration are you looking at for Q4 for the holiday season? How do you look at that last year versus this year for personalization?

[Laura J. Alber:]

Thanks, Neely. I see personalization as really a key differentiator and a great gift more than anything. I mean, you can give someone a beautiful glass paperweight from Mark and Graham for $35, and it may be the most thoughtful gift they receive during the holiday season. And I think that's rare these days. We spent a lot of time talking about what kind of gifts we like to receive and to give, and have developed our category that way. It's great that it happens to be high-margin and oftentimes lower queued [ph], and the -- of course, we stand behind any damages we have. We allow our customers to return if there's damage. But you're right, they don't return if there's no damaged so it is very profitable business. We have made investments to make sure that we can ship as much as we possibly can ship this year because we expect, based on last year's results, to see very, very strong growth in this category. It's not an easy thing to execute, and so we are very fortunate we've been working on this for many years and making investments every year in how we do this, how we bring all this together across multiple categories and multiple techniques. It's not just embroidery, it's so many new techniques this year. And we do it all ourselves.

[Neely J.N. Tamminga:]

Do you have a sense of how much of the penetration of your holiday products will be offered with personalization this year?

[Laura J. Alber:]

Of course, I do, and it's been so competitive. And I'd prefer not to quantify any of the growth numbers or the SKU count increase.

[Operator:]

And we have time for one last question, which will come from Marni Shapiro with The Retail Tracker analyst.

[Marni Shapiro:]

So my question circles around -- centers around food. You guys have historically had an outstanding assortment of food at Williams-Sonoma through the year, but particularly in the holiday season. And it looks great this year. And I see -- as the market has continued to do well and expand, I've seen a few food items. So I guess it begs the question, is there an opportunity to expand a little bit more into the food there? And, Laura, you've talked over and over about whether it's getting closer to the table, farm to table, or the focus around cooking and entertaining at home, and I was curious if you guys have looked into some of these subscription things. I'm sure you've seen them, most of them are coming out of your own backyard, where people receive a box to sample things. And is that something that, either through West Elm Market or Williams-Sonoma, that would be interesting to you guys?

[Laura J. Alber:]

Yes, thank you. It sure is. So many of the food products that we carry are from local and artisanal food people, and we have a lot more continuity programs this year that, if you go online, you'll see make excellent gifts. We look for very high quality in our foods, as you know. And I'm very excited personally this year about the expansion of -- particularly our peppermint bark. We have a lot more this year because it's our 15th year anniversary in peppermint bark. And when you go into the store, there's so much irresistible product in that category.

[Marni Shapiro:]

I saw that, by the way. I thought it looked fantastic this year.

[Laura J. Alber:]

Thank you. We also spent a lot of time on making packaging changes to our Thanksgiving product that I think is much more appealing. So while it's the same great quality that it's always been, updated the graphic layer and that's being met with good response. So, so far, so good. We're just early here in the fourth quarter, but we're seeing a nice response to the food offering that we have. It's a small business for market, but you're right in that we can even be more localized and smaller there because the scale is so much smaller. So we just are very selective about the great products that we carry and offer differentiated products to the customers who come into our stores.

[Marni Shapiro:]

And would it be okay if I took this all kind of one step further? You said at Williams-Sonoma the Wine Country was a very strong theme for you. Is it out of the question to think that Williams-Sonoma could be pairing with local vineyards to do some kind of wine, I don't know, club or offering or something along those lines? Or is that just something you're not going to get involved with?

[Laura J. Alber:]

We do have a wine club already online.

[Marni Shapiro:]

Oh, I missed that.

[Laura J. Alber:]

Yes. We do have it. And so you can look at that, and we carry -- and we select all of the line ourselves and taste it here and carry wine from small growers and then some larger ones, too.

[Operator:]

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

[Laura J. Alber:]

Well, I just want to thank all of you for joining us this afternoon. We appreciate your time and your continued support. And we'll speak with you again in the new year. In the meantime, I hope you have a wonderful holiday season.

[Operator:]

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