A Letter to Williams-Sonoma Management

Corporate excess is nothing new. The below is a letter that will be sent today to executives of Williams-Sonoma regarding the firm's use of a leased jet.

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September 29, 2008

W. Howard Lester
3250 Van Ness Avenue
San Francisco, CA 94109

Dear Mr. Lester:

Williams-Sonoma, Inc. has a storied past of brand equity and profitable growth. From its humble beginning in 1956, to its coveted Oprah endorsements of recent years, the company has pushed forward with winning strategies and has an impressive base of loyal customers. This, coupled with an attractively-valued stock, is what led us recently to become part owners (shareholders) of Williams-Sonoma (WSM).

We know things are tough. As shareholders, we salute the company's efforts to maximize returns on advertising by trimming the length of the catalogs and by tweaking both circulation numbers and catalog recipients. To say the market is challenging is an understatement. Home prices are correcting (falling). According to futures on the S&P/Case-Shiller Home Price Index this is likely to continue through the next several quarters.

Though systematic risk is unavoidable, certain expenses are well within management's control. Our concern is the company's use of a leased corporate jet. The related-party nature of this arrangement also raises eyebrows. As you read this, a jet is parked, or is perhaps soaring through the air, at the cost of over $12,328.78 per day (plus use-related expenses). Williams-Sonoma's likely future dealmaking and travel convenience needs do not warrant such lavish travel perks, independent Board approval aside. What could possibly justify such an expense?

We are cheerful about the long-term prospects of the company, and as shareholders, are compelled by its rock-bottom equity valuation. However, saying no to corporate waste and conspicuous luxuries is an important cost-cutting measure in any macro environment. Cruising in style in an owned or leased jet should not be part of the corporate ethos. It costs four cents per share and no measurable value can be expected from it. That money would be better spent increasing the share repurchase program. Now is the time to reverse this misappropriation of shareholder funds.

We welcome your comments.


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Brink's Home Security

A Breakup

Companies are always in flux: acquiring, divesting, buying back stock, retiring debt, borrowing money, managing investments, dealing with macro concerns (housing, joblessness, markets), and appeasing customers. Divestitures, often times, are part of the "creative destruction" of capitalism, and serve as chances to break up crappy businesses that a company's overpaid for, or to truly separate units that don't share common "synergies."

This can help boost returns. Spinoffs fall into this category. Unloved, unwanted, or companies in the better-off-on-their-own category soon break free and relish their independence as new entities. They're now let loose of the parent company's TPS reports and fading memories of clashes over uses of capital. Parents are relieved and can now truly focus on how to appeal to shareholders' complaints. Ain't the life of a public company grand?

Independence can ironically be the most synergistic. Brink's Home Security (BHS) sells monitored security services in a highly fragmented market to over one million North American customers. Activist investors Steel Partners and MMI Investments have encouraged a divorce of BHS from Brink's, a provider of armored transport and cash services. The company is set to break free from its parent by the end of October via a tax-free spinoff. Shareholders will receive one share of BHS for every share of Brink's (the parent). BHS will emerge with a spotless debt-free balance sheet and will be allowed to use Brink's name for three years. Then, a rebranding campaign will ensue. That sounds like a perfect opportunity to be acquired.

Revenues are largely recurring and costs fairly consistent. Operating margins have stood at an enviable 25-26% over the last couple years. Returns on capital, a sign of business strength, run close to 18%. Business is good. Revenues are up 8% year-over-year. Amidst the bursting of the real estate and credit bubbles, homeowners seem to still worry about strangers breaking in.

The Competition

ADT is probably the biggest name in the game. It is 15x BHS' size in sales but has nearly twice the attrition rate (12.7% vs. 7%) and less than half the operating margin. ADT, a division of Tyco, would love to gobble up a smaller but better run competitor.


The Breakup Fee

From the most recent form 10Q:

"Year-to-date expenses related to our strategic review, proxy matters and the spin totaled about $9 million. We’ll probably spend another $8 million to $11 million on this effort, so total expenses for these matters should be in the range of $17 million to $20 million for the year."


And....

To spend close to 50% of last year's operating income on strategic review, proxy stuff and other legal and accounting bills is a gutsy move. As future details surface, namely executive comp and insider ownership, BHS appears to be a strong, easy to understand, and predictable business. At 15x EBIT I'd consider a deeper look into this soon-to-be-public subsidiary.


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Disclosure: none

Rambling on crunches, herds, lies, and bankers

The most impressionable thing with the current economic correction (most often called credit crunch) is not about the magnitude Lehman's chapter 11 filing, Merrill's sale to BofA, or AIG's balance sheet problems. It is what otherwise extremely intelligent people will do when led by greed and herd-like behavior. Nevermind the liquidity crisis, market dislocation, sharp selloff, or whatever bullshit terms rich managers use to justify their behavior and poor risk management, finance needs more straight talkers. "I made a mistake. I foolishly benchmarked my decisions against my peer group and I lost your money. I'm sorry." Failing to acknowledge the truth is both dangerous and detrimental to learning.

Bad lending and falling home prices

I daringly call it a correction (not a credit crunch) because it is leading to return of old-fashioned lending standards, the four C's: character, collateral, capital, capacity. Banks, for fear of future losses if anything, are returning to this standard (1). Housing prices in the short- to near-term will feel the affect. The Case-Shiller Home Prices futures index seems to agree prices will decline through 2010 (2). This bodes ill for most. Banks especially will suffer as a significant portion of real estate will continue to fall in value. Sometimes getting kicked in the nuts is the only way to learn.

A pain in the ARS

Auction-rate securities (ARS) are not cash equivalents (3) and everyone knows that. The maturity is greater than 90 days and they were never in the same seemingly "risk-free" category as T-bills. Banks sold them because of the commissions they made and failed to support the market when people stopped showing up for the auctions. Investors were left with discounted illiquid securities and firms only capitulated on making the investors' whole when regulators levied fines and warnings of great legal headaches. Their behavior has been nothing short of deplorable.

Securitizations and cheap money led to lackadaisical lending standards as banks tried to outshine other banks in their quest to chase yield. Banking once was about making a reasonable spread on interest paid on deposits vs. interest earned in long-term investments. We should learn a lesson from the less enviable traits of human nature.





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Disclosure: None

Notes:
(1) "Banks to toughen lending standards into 2009"
(2) "Composite 10 city U.S. Futures Market"
(3) According to SFAS-95, cash and cash equivalents are: risk-free assets with original maturities of 90 days or less.
(4) Image

The Rembrandt Question

Williams-Sonoma

It's usually a bad idea to buy the stock of a company only because you like their product. Clearly, however, there must be a service or product behind the business that: 1) is needed or desired, 2) has pricing power (ability to raise prices ahead of inflation, and 3) trades at a reasonable price (more like a bond than a Rembrandt painting). In the end, business models and economics are critical.


In addition to these points, there are a couple questions I often ask myself when I consider owning a piece of a public company (buying a stock). Could I LBO (leverage buyout) the company? Is there any Rembrandt premium? Stocks are valued partly like bonds (discounted expected future cash flow) and partly like Rembrandt paintings (1). If stock picking is presumed to be a worthwhile exercise then this statement is critical. I only wish I had been the first to say it in those words.

A brief overview

Williams-Sonoma is "a specialty retailer of products for the home." That wins the award for the simplest opening line of a business description section of a 10K. The company operates 600 stores, primarily Williams-Sonoma (WSM) and Pottery Barn. WSM sells really nice kitchen-related items while Pottery Barn sells furniture and other housewares. 58% of sales are made in retail stores. 42% are direct-to-customer sales (catalogs and online). WSM has felt the downturn of the housing market. Same-store-sales numbers have dropped over 10% while shares have fallen over 50% from last year's high. But are they worth a look today? Two important questions follow.

Could I LBO Williams-Sonoma?

Assuming a 30% premium, the historical average for buyouts, and 60% debt and 40% equity at a 6.5% pretax cost of debt, would put the interest coverage ratio (EBITDA/interest) at 4.5x. This would likely fall in the BBB debt rating, the last notch of investment grade. Would bankers loan under such a structure? Maybe in today's market. Very likely in tomorrow's. It kind of passes the LBO check.

What is the Rembrandt premium?

A Rembrandt premium is most obvious when the bulk of the discounted future earnings is out 5 years plus. Capitalism works its magic when numbers look super good; returns revert to the mean and creative destruction runs its course in most cases. I've recently had this theory of shorting any company that's on the cover of Fortune or Forbes. Since journalists are generally backward-looking, I think this might make sense.

WSM now sells for 7x cash flow, or a 14% cash flow yield. Given the relative strength of its yuppie customer base, and the current valuation, it is not selling for a Rembrandt premium. I don't lose sleep about owning a portion of Williams-Sonoma. The current credit environment has reinforced my belief in understanding not only a company's potential future earnings, but also its balance sheet. The balance sheet has no net debt and the company sells for 2x current assets.


Though I've never bought $40.00 pumpkin loaf tins from Williams-Sonoma, as a shareholder I'm glad thirtysomething white people do.

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Notes

(1) Charlie Munger
(2) 2007 10K

Disclosure The author has a covered call position in WSM.