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Big Quarter, but Uncertainty for Williams-Sonoma

Earnings top estimates, but the company doesn't raise guidance.

Third-quarter earnings soared at


(WSM) - Get Williams-Sonoma, Inc. Report

, but the home and kitchen products retailer gave investors some cause to doubt its future results.

Williams-Sonoma beat Wall Street's estimates by posting a greater-than-50% jump in per-share earnings in its just-completed quarter. But company officials pointedly declined to up earnings estimates for the fourth quarter. Instead, they warned of growing unpredictability in the company's business due in part to increased circulation of its catalogs.

"There's a level of uncertainty in our forecast," acknowledged company CEO Ed Mueller on a conference call with investors and analysts.

Rob Wilson, who covers the company for Tiburon Research Group, praised Williams-Sonoma for having an impressive third quarter, but worried about the company's prospects going forward, particularly next year. The company has used a number of levers to increase its performance this year, including a massive inventory bet and the introduction of a private-label credit card. Not only will the company have to compare itself against those increases next year, but it won't have the same levers at its disposal, Wilson noted.

"There's certainly reason for concern," Wilson said. (Tiburon does not do investment banking and Wilson does not hold Williams-Sonoma shares.)

But investors as a whole didn't appear overly worried with Williams-Sonoma's prospects on Thursday. In recent trading, the company's shares were up 65 cents, or 1.9%, to $35.

Investors may have merely been cheering the company's outstanding third-quarter results.

In its quarter ended Nov. 2, Williams-Sonoma earned $23.88 million, or 20 cents a share. That result improved on last year's third-quarter profit of $15.14 million, or 13 cents a share.

The earnings increase outpaced sales, which jumped 19.9% to $632.82 million.

Analysts surveyed by Thomson First Call were expecting Williams-Sonoma to earn 19 cents a share on sales of $622.16 million. Company officials had projected that the company would earn 18 cents to 19 cents a share on revenue of $615 million to $625 million.

The company's outperformance came as the result of strong sales at its older stores. Same-store sales, which compare results at like outlets open more than a year, increased 5.6% in the quarter. In the same period last year, the company's comparable-store sales were up just 2.8%.

The strong sales came nearly across the board. At its core Williams-Sonoma chain, same-store sales rose 6.9%. At Pottery Barn Kids, which posted a same-store sales decline of 2.7% in the third-quarter last year, comparable-store sales increased 6.3% in the just-completed quarter.

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But the company's bottom line also benefited from impressive cost controls in the quarter. The company's gross margin, for instance, increased about 20 basis points. To calculate gross margin, companies subtract their product, occupancy and shipping costs from their sales.

In the quarter, Williams-Sonoma's gross margin expanded as a result of a decline in occupancy costs as a portion of sales and an increase in shipping margins on products shipped to customers, company CFO Sharon McCollam said on the conference call. Those factors outweighed a rise in lost inventory, or "shrink," that occurred as the company raised its overall inventory levels, she said.

Meanwhile, the company's operating costs declined by 1.2 percentage points from the third quarter last year to 33.2% of sales. Lower employment and administrative costs as a portion of sales helped to bring down operating expenses, McCollam said.

Despite the impressive result, Tiburon Research's Wilson and others found cause to worry about the company.

Williams-Sonoma gave guidance for 2004, and its estimates for the fourth quarter were marked by caution. While the company raised its revenue guidance for the quarter, it left its earnings guidance unchanged. Williams-Sonoma officials now expect the company to earn 80 cents to 85 cents a share on revenue of $980 million to $1.01 billion.

Previously, company officials projected revenue of $945 million to $981 million in the quarter. Wall Street had forecast earnings of 83 cents a share-- the midpoint of the company's current range -- on sales of $973.58 million.

Company officials declined to up earnings guidance because of some fluctuating sales results in recent weeks. Additionally, the company plans to increase its circulation of catalogs in the quarter, they said.

About 30% of the catalogs the company plans to send out in the quarter will be for its new and emerging brands, such as West Elm and Pottery Barn Teen, company officials said. The company now expects to increase its total catalog circulation for the year 17% to 19% over last year, compared to earlier estimates of a 15% to 17% increase.

While this increase in circulation could result in higher sales, it likely will result in significantly higher costs as well.

The circulation increase this year comes on top of a 10% jump in circulation last year, noted Wilson.

"How can they keep doing that and doing it profitably?" he wondered. "Those catalogs are expensive to send out."

Meanwhile, not everything is going well with the company's revenue. Comparable-store sales at the company's discount Hold Everything chain fell 8.3% in the third quarter after posting a 6.6% increase in the year-ago period. Williams-Sonoma has already closed one of its Hold Everything stores this year and plans to close four more by the end of the year, the company said.

Hold Everything "is falling apart," said one buy-side analyst, who asked not to be named. "That could become more of a negative," added the analyst, whose fund has no position in Williams-Sonoma.

To be sure, the Hold Everything chain is only a small portion of Williams-Sonoma's base, comprising just 12 stores currently. Williams-Sonoma operated 516 stores across its brands at the end of the third quarter.

Of perhaps more concern is the company's inventory build over the last year. At the end of last year, company officials warned that Williams-Sonoma had too little inventory on hand and was missing sales as a result. By the end of the third quarter, the company's inventory was up $107.96 million, or 30.1%, to $466.37 million.

That increase in inventory has clearly benefited sales, as evinced by the comparable-store sales gains, Wilson said. But considering the large inventory outlay, a 5.6% increase in same-store sales is only a good result, not an outstanding one, he said. "At end of the day, I don't know if that's a great return on investment."