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.

----------------------

Notes

(1) Charlie Munger
(2) 2007 10K

Disclosure The author has a covered call position in WSM.