Sales Rise but Earnings Fall at Williams-Sonoma

Advertising costs at its catalogs eat into margins and the company is adding inventory.
By Troy Wolverton ,

Updated from 12:56 p.m. EDT

Williams-Sonoma

(WSM) - Get Report

piled up inventory in the first quarter with the expectationthat sales will improve in later quarters after a sub-par performance.

Inventory at the home products retailer jumped 47.5% over the prior yearquarter to $372.5 million. The inventory gain far exceeded both thecompany's same-store sales and its increase in square footage.

"It's a risky strategy," said Rob Wilson, who covers the company forTiburon Research Group. "If the economy worsens, they have a lot ofinventory risk."

Williams-Sonoma allowed its inventory levels to decline after theSept. 11 terrorist attacks and then saw them drop further afterexperiencing strong sales in the first quarter a year ago, company officialssaid. The build-up is an effort to get inventory back up to levels seen in2001, they said. In the company's namesake stores, where inventory increasedmost dramatically in the first quarter, the build-up resulted in strongsales, they said.

"We're feeling good about the progress we're making in reinstatinginventory," said Sharon McCollam, the company's chief financial officer,during a conference call.

Retailers' inventory levels have been a growing concern in recent weeks,as companies including

Wal-Mart

(WMT) - Get Report

,

Target

(TGT) - Get Report

and

Kohl's

(KSS) - Get Report

have warned thatinventory increases could force them to take substantial markdowns in thesecond quarter. Williams-Sonoma officials did not issue a similar warning,but noted during the call that the company sold fewer goods during the firstquarter at full price, indicating that the company is already facingmarkdown pressure.

In the first quarter, profits slipped at Williams-Sonoma on decliningcomparable-store sales and increasing operating expenses.

The San Francisco-based company posted a profit of $13.4 million, or 11cents a share, in its first quarter, which ended May 4. In its year-agoquarter, Williams-Sonoma earned $15.4 million, or 13 cents a share.

Overall revenue at the retailer increased 12% over the first quarterlast year to $536.84 million. But on a same-store basis, which comparesresults of like retailers open more than one year, sales fell 0.8% after a6.2% increase in the year-ago period.

Earnings and revenue beat analysts' expectations. Analysts surveyed by Thomson First Call were projecting that the companywould earn 8 cents a share on $536.17 million in revenue.

While reporting its fourth-quarter results in March, Williams-Sonoma hadsought to temper analysts' expectations, saying it expected to earn between7 cents and 8 cents a share on comparable-store sales ranging from a 2%decline to 1% growth.

For the second quarter, Williams-Sonoma projects that it will earnbetween 12 cents and 14 cents a share on sales ranging from $557million to $575 million. Meanwhile, the company increased its full-yearestimates. For the full year, the company now expects to earn $1.23 to $1.27per share on revenue ranging from $2.646 billion to $2.718 billion.

Wall Street had been expecting the company to earn a $1.21 a share on$2.68 billion in sales. Williams-Sonoma previously projected it would earnbetween $1.20 to $1.24 a share on sales of $2.638 billion to $2.728 billion.

Although the company's overall comparable-store sales fell in the firstquarter, its performance varied by division. At its eponymous stores,comparable-store sales grew 5.4% over the first quarter last year. Companyofficials attributed that growth in part to higher in-stock levels ofproducts due to the inventory increase.

But same-store sales fell 4.4% at the company's Pottery Barn divisionand 9.7% at its new Pottery Barn Kids stores. Company officials blamed thesteep fall-off in comparable-store sales at Pottery Barn Kids on the fact that it has located most of its newer stores in the same markets as older stores.

"We are confident in our strategy going forward," said Laura Alber,Pottery Barn's president, on the call. The decline in same-store sales atPottery Barn Kids is "consistent with Pottery Barn's growth."

But Wilson called the decline "disturbing," saying that he didn't buythe company's cannibalization explanation. Pottery Barn Kids has held muchof the company's growth potential going forward, he noted.

"When you start to see

sharply negative comparable-store sales, youstart to get concerned," he said.

During the quarter, Williams-Sonoma increased its gross profit margin,which is the difference between what a retailer charges for itsproducts and what it pays for them, by 10 basis points as aportion of sales, to 38.1%. The company's gross margin was helped by adecrease in returns, an increase in merchandise margins and a decrease in"shrink," or lost inventory, McCollam said. The decline in full-price sales,higher occupancy costs and increased freight costs related to the inventorybuild-up prevented the company's gross margins from increasing more, shesaid.

While the company increased its gross margin, it lost some ground with itsoperating expenses. Wiliams-Sonoma's sales, general and administrativeexpenses jumped 16.7% in the quarter to $182.8 million. As a portion ofrevenue, such costs increased 1.3 percentage points to 34.1%.

McCollam blamed the increase in operating expenses on rising catalog andemployment costs. Williams-Sonoma increased its circulation in the quarterof its Pottery Barn, Hold Everything and West Elm Catalogs, she said.Meanwhile, the company faced higher worker's compensation and otheremployment-related costs.

Wilson and other analysts noted that the company's catalog circulationincreased faster than catalog sales, indicating a decline in productivity.Last year, the company touted an investment in some new technology that wassupposed to help it be more effective in choosing whom to send catalogs to,Wilson said.

"I'd like to ask them what happened to that initiative," Wilson said."You reach a point at which more catalogs are not going to return the levelof productivity that you're used to. I think they've reached that point."

But company officials blamed the decline in productivity on new catalogssuch as Pottery Barn Teen and West Elm for which the company is still tryingto establish a customer base.

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