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.

And Then There Were Five: IAC/InterActiveCorp's Spin-off

After feeling the heat from disgruntled investors, Barry Diller has now succeeded at splitting IAC into five publicly traded companies. The parent IAC, until the spin, was an amalgamation of internet sites, cable networks, travel services, and mortgage lending. These groups had little in common (not a lot of 'synergies').

The split finalized today after nearly a year of paying high adviser (lawyers and bankers) fees.
The hope is that the svelter IAC will put the $1.3B in cash it extracted out of its other business to work.

However, Moody's slashed its corporate rating to junk due to "the significant reduction in IAC's scale and business diversity with the spin-off of approximately 78% of its revenue and approximately 73% of segment EBITDA." No matter. With a huge pile of cash and less side businesses to worry about, IAC just might fare well. Investors seem to think so: shares traded up over 8% today.

But what of the other four?

TicketMaster (TKTM) received very little detail in past IAC SEC filings. Independence will be great for a seemingly neglected company. Hopefully, the new company will fight Live Nation, a former customer (14% of revenue).

Tree.com (Lendingtree.com) is still an attractive site for consumers to shop for mortgage loans. Lack of company financials makes it too early to say.

HSN (Home Shopping Network): there are few things in today's economic environment that worry me more than strapped customers' willingness to sit and watch a channel (or surf the website) to buy blenders and gold-plated wrist watches.

ILG (Interval Leisure Group): this is a timeshare company. At just over 2x sales and with recurring revenue from gullible consumers, ILG's valuation looks decent.


The greatest joy is the absence of historical line-by-line economics, especially for the four subsidiaries. Bank analysts love to extrapolate these items into the future to justify their "target prices." Lack of such detail, coupled with forced selling (some institutions will have to sell shares of the smaller companies), and the relatively new entrepreneurial zeal of the new bosses, should create some potential buying opportunities. You won't see that on the Home Shopping Network.


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Disclosure: None
Image: http://aplasticcentral.com/images/then%20there%20were%205.jpg

An earnings followup

Orbitz

The bookings question: overall, bookings rose to $3B, or 4%. This was a tale of two stories: international jumped 41% to $476M; domestic remained basically flat at -1% growth, or $2.6B. The air side of the bookings did less well, down 13% due to a decline in U.S. volume.

This segment of the travel business is tough: margins are negative, returns on equity capital are decreasing and I'm not sure what edge they have over the competition.

Would I like to run the business over the next five years? No. What would I do as a competitor to erode Orbiz' business, I'm not sure. I'd take a pass on this company though fundamentally it doesn't look like a bubble stock.



Cowen

The company is trading at close to cash because of the deterioration of its model. The future of the super-small boutique firm is looking not so hot as panicked companies and investors seek the comfort of larger and more established banks (though their blunders as of late have been huge). At an industry high employee compensation-to-revenue ratio of 60% +, any reduction of business (investment banking is down 32%), cash on hand will get eaten up as the Cowen continues to operate as a going concern. If I were management, I'd look for a bigger player to buy me.



Papa John's

Wheat and cheese prices are rising fast (100%+ and 26% year-over-year). 35-40% of Papa's cost is cheese. The pizza world is too competitive to pass those price increases on to customers. This will pressure margins. Look for the cheapest (Little Caesar's) and the highest-end niche players (The Pie Pizza where I live) to do less poorly. I love pizza. I'm not to keen on pizza economics.


Perini

It's growing somewhere, oddly enough in Cali. and Vegas. That's saying something in today's environment. Revenue is up 21% and its backlog book of construction business is at $6.8B. With an enterprise value of $400M and $5B in sales, coupled with a pristine balance sheet and $460M in cash in the bank, it may be time to say hello to construction.



Beazer

It's adjusted balance sheet is still a mystery. If you're looking at placing a bet with a home builder, try DR Horton or NVR. Both are in better financial shape and run businesses I'd rather operate. They're also the builders I'd be least enthusiastic about competing against.


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Disclosure: None

Earnings Time

Corporate executives are great salesmen. Many have climbed the ladder through actually sales talent, or by selling themselves. One of their preferred pitches once they reach the top is the case for their stock: it's always undervalued by the market.

Quarterly earnings releases are important market signals since a company has to earn real money (either now or in the future) to be worth something. But earnings reports can also be rife with overly optimistic management speak and fuzzy accounting assumptions. Management will border on dishonesty to prove their case. That's why, with no significant research budget, Faro relies on basic economics, common sense, and financials as the foundation for investment decisions.

So when analyzing the earnings releases, look for companies with potential economic signals (Are people eating out less? Do moviegoers habits change in a bad economy? Are people paying their credit card bills?) True, these are lagging economic indicators, but econ is not known for its predictive value. Since learning is cumulative, even if management is full of it, you'll be able to take away useful bits of info. And, you'll be able to hang this on your problem solving matrix framework (PSMF). I just made that up.

As we're in the middle of "earnings season," each day of this week there's a call which is probably worth paying attention to.

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Monday

Orbitz (online travel). How bad are leisure and business travel bookings?

Tuesday

Cowen (boutique investment bank). Why is this company trading at close to cash? 116M net cash vs. 122M market cap.

Wednesday

Papa John's (pizzas). How are commodity costs affecting margins?

Thursday

Perini (general contracting and construction management). What's changed in the last 12 months?

Friday

Beazer (home builder). What would its adjusted balance sheet really look like?

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Enjoy.