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Executives

Stephen C. Nelson - Director, Investor Relations

W. Howard Lester - Chairman of the Board, Chief Executive Officer

Sharon L. McCollam - Chief Financial Officer, Chief Operating Officer, Executive Vice President

David DeMattei - Group President - Williams-Sonoma, Williams-Sonoma Home, West Elm

Laura J. Alber - President

Patrick J. Connolly - Executive Vice President, Chief Marketing Officer, Director

Analysts

Lauren Levitan - Cowen and Company

Rexford Henderson - Raymond James

Matt Nemer - Thomas Weisel Partners

Scot Ciccarelli - RBC Capital Markets

Chris Horvers - Bear Stearns

Colin McGranahan - Sanford Bernstein

David Magee - Suntrust Robinson Humphrey

Marni Shapiro - The Retail Tracker

Williams-Sonoma, Inc. (WSM) F4Q07 Earnings Call March 27, 2008 10:00 AM ET

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Williams-Sonoma Inc. fourth quarter and fiscal year 2007 earnings and fiscal year 2008 guidance call. (Operator Instructions) I would now like to turn the call over to Stephen Nelson, Director of Investor Relations at Williams-Sonoma Inc., to discuss non-GAAP measures and forward-looking statements.

Stephen C. Nelson

Good morning. This morning’s conference call should be considered in conjunction with the press releases that we issued earlier today. I would first like to discuss the non-GAAP financial measures that are included in this morning’s earnings press release and today’s conference call.

Our press release contains non-GAAP financial measures that excludes the impact of unusual business events and new accounting pronouncements. For the remainder of today’s call, we will be discussing our fourth quarter and fiscal year 2007 results excluding the impact of these items and will refer to these results as non-GAAP.

These non-GAAP financial measures are provided to facilitate a meaningful year-over-year comparison. A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures and an explanation of why these non-GAAP financial measures are useful and how they are used by management are discussed in Exhibit 1 of the earnings press release.

I would now like to discuss our forward-looking statements. The forward-looking statements included in this morning’s call constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements address the financial condition, results of operations, business initiatives, guidance, growth plans, and prospects of the company in 2008 and beyond, and are subject to risks and uncertainties that could cause actual results to differ materially from such forward-looking statements.

Please refer to the company’s current press releases and SEC filings, including reports on Forms 10-K, 10-Q, and 8-K, for more information on these risks and uncertainties. The company undertakes no obligation to update or revise any forward-looking statements to reflect events or circumstances that may arise after the date of this call.

I will now turn the conference call over to Howard Lester, our Chairman and Chief Executive Officer.

W. Howard Lester

Thanks, Steve. Good morning and thank everyone for joining us today. With me today are Laura Alber, our President; Pat Connolly, our Chief Marketing Officer; Dave DeMattei, our Group President for the Williams-Sonoma, Williams-Sonoma Home, and West Elm brands; and Sharon McCollam, our Chief Operating and Chief Financial Officer.

Let me begin today by providing you with an overview of our 2007 business results and our 2008 outlook. Then I’ll turn the call over to Sharon, Dave, and Laura for further details.

In fiscal 2007, net revenues on a 53 to 53-week basis, increased 3.8%, including a comparable store sales increase of three-tenths percent and a direct-to-customer sales increase of 3%.

Taking into account the generally bleak retail environment in the first half of the year and the recessionary warnings that followed in the back half, we were pleased with these results, especially when compared to the significantly lower growth rates of the home furnishings industry overall in 2007. We believe the strength of our brands and superior multi-channel business model drove these competitive top line increases.

Non-GAAP diluted earnings per share for the fiscal 2007 included an estimated $0.05 benefit from the 53rd week, increased $0.01 to $1.77 a share. We believe these results once again demonstrate our ability to react to a rapidly changing business climate and illustrate our management team’s commitment to optimizing profitability, even in difficult economic times. We also returned nearly $240 million in cash to our shareholders during the year through share repurchases and dividends.

We spent 2007 focusing on the things we could control and we made substantial progress on the strategic initiatives we set forth at the beginning of the year. The first of these initiatives was the revitalization of the Pottery Barn brand, where we began to differentiate our product assortment, reinstate our value proposition, and refine our direct-to-customer contact strategies. We also expanded the reach of the West Elm brand, which ended the year with 27 stores, and improved the operating performance of Williams-Sonoma Home.

There were also several supply chain advancements that we made during the year that we are very proud of. First, we successfully in-sourced our West Coast furniture hub, which currently processes approximately 10% of our national furniture volume. This operational change, which mirrors the changes we made on the East Coast in 2006, will allow us to substantially improve the furniture delivery experience for our customers and reduce furniture return rates.

We also added additional vendors to our furniture delivery network, significantly expanded our monogramming and personalization capabilities and reengineered our returns processing operations in an effort to differentiate our service offering, improve our customer service, and reduce our operating cost.

In information technology, we continued the rollout of our new retail inventory management system to the Pottery Barn, West Elm, and Williams-Sonoma Home brands. This system will allow us to optimize the flow of inventory and improve the in-stock position in our retail stores.

We also implemented new functionality in our direct-to-customer channel that’s allowing us to improve the relevancy of our marketing interaction with our customers and optimize catalog response rates.

In e-commerce, we launched our first next generation website in the Williams-Sonoma brand. Our other brands which we’ll begin to roll out to similar features and functionality in late 2008.

In addition to the supply chain and information technology advancements we made during the year, there were several brand specific highlights that we were very proud of. In the Williams-Sonoma and West Elm brands, we delivered the highest direct-to-customer operating contributions in the brands’ histories. We also made progress in our objective to improve profitability in the Williams-Sonoma home brand, particularly in the direct-to-customer channel. And in PBteen, new product innovation and superior execution drove a 25% increase in year-over-year revenues.

As we look forward to 2008, current trends indicate that we’ll be operating in one of the most challenging economic environments we’ve seen in many years, and we believe there are circumstances under which it could get progressively worse, particularly if we find ourselves in a protracted recession.

In light of these trends, we are aggressively driving the appropriate changes in our business while maintaining a very flexible outlook. While we are committed to driving future growth across all channels, we believe sector declines are likely and that our revenue growth in 2008 could be negative low single digits. Given this belief, we are equally committed to driving down cost and inventory levels to the extent that the actions do not affect service levels to our customers. Our approach in this environment will not be business as usual.

To support future growth and to continue to expand the reach of our brands, we expect to add 29 net new retail stores and expand or remodel an additional 20 stores. We also expect to intensify the marketing behind our fastest growing channel, e-commerce. In our emerging brands, PBT and West Elm and Williams-Sonoma Home, we will continue to focus on building brand awareness and enhancing customer service access to the brands.

We will achieve this by adding 12 new stores in West Elm and one in Williams-Sonoma Home. We will also identify new customers for the brands through retail name capture and third-party list rentals, as well as through natural and paid search. Additionally, we’ll continue the ongoing rollout of our Pottery Barn revitalization initiatives.

In our efforts to drive down costs, we’ll be executing against the following initiatives in 2008: one, strategically optimizing catalog circulation, catalog versioning, and paid search, with the objective of improving overall productivity of our advertising costs; two, implementing new sourcing and logistic initiatives that in early tests are proving to be effective in reducing customer returns, replacements, and damages; three, improving efficiency in our domestic supply chain by expanding our furniture hub in-sourcing initiative; and four, reducing corporate overhead.

While we are confident in our ability to execute against all these cost reduction initiatives, we believe they will be more than offset by lower earnings associated with a projected low single digit decrease in net revenues, along with higher raw material and occupancy expense. Therefore, there is significant pressure on 2008 diluted earnings per share.

In 2008, we are expecting diluted earnings per share in the range of $1.42 to $1.56, a decline of $0.20 to $0.34 per share. This reduction is expected to be driven by the negative earnings impact of a low single digit decrease in net revenue, including the $0.05 per diluted share impact in 2008 from the loss of the extra week in 2007, higher occupancy expense costs, and increased raw material costs. This negative impact will be partially offset, however, by lower SG&A expenses and a reduction in furniture returns, replacements, and damages.

To drive down inventory levels, we are significantly modifying our 2008 receipt plans, maintaining a high level of flexibility in our vendor commitments, and aggressively liquidating slow movers through our outlet stores and e-commerce websites.

We will also be working to reduce our average weeks on hand in key merchandising categories through better forecasting and demand planning. While we believe that these initiatives will be challenging in the short-term due to the high volatility in sales trends, they are key priorities for our inventory teams this year.

Also in 2008, we expect to continue to return excess capital to our shareholders, as reflected by today’s announcement to increase our quarterly cash dividend by 4.3% to $0.12 per share, in addition to the $150 million share repurchase program announced in January of 2008.

While we are disappointed that our 2008 revenue and diluted earnings per share guidance is softer than initially expected, we are excited about the opportunities that retail conditions like this can create. We’ve seen these difficult macro environments before and particularly in the early to mid 90s, and I believe with great confidence that when the consumer begins reinvesting in their home, our brands will lead the way. Our brands remain extraordinary assets and during this time, we will protect what they stand for in the eyes of our customers. Our multi-channel strategy remains one of our greatest competitive advantages and during this time, we’ll invest in our capabilities that emerge at peak performance levels. And our vendors remain the foundation of our future and during this time, we will capitalize on these strategic relationships.

We appreciate your ongoing interest during these challenging economic times and are committed to delivering on the expectations that we’ve set for ourselves over the next several quarters.

Let me now turn the conference over to Shannon for additional details on the ’07 performance and ’08 guidance.

Sharon L. McCollam

Thank you, Howard. Good morning. Before we discuss 2007 results, it’s important to note that both the fourth quarter and fiscal year include an extra week versus 2006. We had projected the benefit of this extra week at approximately $70 million in revenue and $0.05 in diluted earnings per share. Additionally, some financial comparisons may be discussed on a non-GAAP basis as described by Steve earlier in today’s call.

Despite a very challenging home furnishings environment, fourth quarter 2007 results on a comparable basis to 2006 were consistent with expectations and above last year. The highlights are as follows.

Fourth quarter non-GAAP diluted earnings per share increased 8.5% to $1.15 versus $1.06 in the fourth quarter of 2006, including the $0.05 benefit from the extra week.

Net revenues on a 14 to 14-week basis in the fourth quarter increased 3.4% to $1.37 billion. Key drivers of the growth included a 5.3% increase in retail leased square footage and an 18.7% increase in Internet revenues. Comparable store sales decreased 0.1%. In our core brands, net revenues increased 1.5% compared to a 23.2% increase in our emerging brands.

Circulation of catalog and catalog pages increased 9.4% and 16.6% respectively, due to an approximate 12% increase in the extra week of 2007.

Gross margin expressed as a percentage of net revenues decreased 160 basis points to 41.6% in the fourth quarter. This decrease was primarily driven by increased markdowns, increased raw material costs and higher inventory related costs, partially offset by the sales leverage of fixed occupancy expenses due to the extra week in 2007.

SG&A expenses as a percentage of net revenues in the fourth quarter decreased 30 basis points to 27.3%. This decrease was primarily driven by certain asset disposal and asset impairment costs incurred in 2006 that did not recur in 2007. Partially offsetting this [stability], however, were increased employment costs primarily driven by higher incentive compensation.

The effective income tax rate in the fourth quarter decreased 150 basis points to 37.1%. This decrease was primarily driven by certain favorable income tax resolutions in 2007 that did not occur in 2006, partially offset by the current period impact of FIN-48.

Now I will discuss our fiscal 2007 earnings results. Fiscal year 2007 non-GAAP diluted earnings per share increased $0.01 to $1.77. Net revenues on a 53 to 53-week basis in fiscal year 2007 increased 3.8% to $3.94 billion. Key drivers of the growth included a 5.3% increase in retail leased square footage, a comparable store sales increase of 0.3%, and a 15.8% increase in Internet revenue. In our core brands, net revenues increased 1.4% compared to a 32.4% increase in our emerging brands.

Circulation of catalogs and catalog pages increased 3.7% and 7.9% respectively, due to an approximate 5% increase in the extra week of 2007.

Gross margin expressed as a percentage of net revenues on a non-GAAP basis decreased 110 basis points to 38.9% in fiscal year 2007. This decrease was primarily driven by increased markdowns, increased raw material costs, and higher inventory related costs, partially offset by the sales leverage of fixed occupancy expenses due to the extra week of sales in 2007.

SG&A expenses as a percentage of net revenues on a non-GAAP basis in fiscal year 2007 decreased 30 basis points to 31%. This decrease was primarily driven by certain asset disposal and asset impairment costs in 2006 that did not recur in 2007, and lower advertising costs due to a higher percentage of direct-to-customer revenues being generated in the Internet channel, which operates at a lower advertising cost than the catalog. Partially offsetting this favorability however were increased employment costs, primarily driven by higher incentive compensation.

Significant year-over-year working capital balance sheet variances at the end of fiscal year 2007 were as follows: cash and cash equivalents at the end of fiscal year 2007 were $119 million, after returning nearly $240 million to our shareholders over the past 12 months through share repurchases and dividends. Our consolidated statements of cash flows are included in this morning’s press release.

Merchandise inventories increased $83 million, or 13.6% to $694 million. Of this increase, approximately 55% was driven by the growth of the emerging brands, 35% by the product mix and cost increases in the Williams-Sonoma brand, and 10% by increased units on hand in the Pottery Barn and Pottery Barn Kids brands, primarily in core merchandise.

Within all of these percentages is the fixed investment for new and remodeled stores. In 2007, 30% of the $83 million year-over-year increase was attributable to this fixed investment.

Customer deposits increased $14 million to $202 million. This 7.5% increase was driven by a year-over-year increase in unredeemed gift cards and higher customer orders in transit.

Accounts payable decreased $17 million, or 8% to $198 million. This decrease was primarily driven by the timing of payments due to the additional week in 2007.

I’d now like to discuss the details of our fiscal year 2008 guidance. Before I begin, however, I’d like to point out again that 2007 was a 53-week year. Therefore, our 2008 guidance inherently reflects the negative impact of the loss of the extra week.

As Howard said earlier, we believe that in 2008, we will be operating in one of the most difficult macroeconomic environments we have seen in many years. We believe this not only because of the softer trends that we are seeing in our own business today but also because of the trends we are seeing in the home furnishings industry overall.

We are also looking beyond the home for key indicators and believe that the declining trends in consumer confidence over the past several months, even at the higher income levels, are cause for concern.

Based on all of these factors, we have approached our 2008 guidance with an unprecedented level of caution and will operate our business with maximum flexibility, so as to be able to immediately react in the event that the macro environment begins to shift in either direction.

In light of our cautious outlook, net revenues in 2008 on a 52 to 52-week basis are projected to increase 0.2% at the high end of our range or decline by 2% at the low end of the range. To achieve this growth, we are expecting a 7.5% to 8.5% increase in retail leased square footage, positive growth in the Internet, but offset by a projected comparable store sales decrease of 3% to 5.5%, and a reduction in catalog circulation in the range of 10% to 15%.

Gross margin as a percentage of net revenues in fiscal year 2008 is expected to decrease 160 to 180 basis points. This decrease is primarily driven by the fixed costs deleverage associated with a low single digit decrease in net revenues, partially due to the loss of the 53rd week, in addition to higher occupancy and raw material costs.

SG&A expense as a percentage of net revenues in fiscal year 2008 are expected to decrease 50 to 80 basis points. This decrease is primarily due to a reduction in advertising and other general and administrative costs.

Income tax expense as a percentage of pretax earnings in fiscal year 2008 is expected to increase 60 to 90 basis points due to the certain favorable income tax resolutions in fiscal year 2007 that are not anticipated to recur in fiscal year 2008.

Capital spending in fiscal year 2008 is expected to be in the range of $215 million to $235 million, of which approximately 60% is for new stores, 20% for information technology, 10% for store maintenance, and 10% for distribution and other facilities.

Inventory growth for fiscal year 2008 is expected to be in the range of negative 1.3% to positive 5.2%. Our goal in 2008, as Howard said earlier, is to reduce our weeks on hand in core merchandise inventories without affecting service to our customer. We are aggressively working to achieve the low end of this range, but are guiding the potential for ongoing sales volatility.

Consistent with our strategic initiative to enhance shareholder value, we remain committed to optimizing growth and profitability wherever possible in 2008, despite the challenges we face in the current macroeconomic climate.

I will now turn the call over to Dave DeMattei to discuss the Williams-Sonoma, Williams-Sonoma Home, and West Elm brands.

David DeMattei

Thank you, Sharon. Good morning. I would like to begin this morning by discussing the performance of the Williams-Sonoma brand. In fiscal 2007 on a 53 to 53 week basis, net revenues in the Williams-Sonoma brand increased 2.7%, driven by a strong e-commerce growth, a comparable store sales increase of 0.7%, and incremental revenues from new and expanded stores.

In addition, the brand delivered one of the best operating margins in its history due to the ongoing success of new merchandising, catalog versioning, and e-commerce strategies. Given the overall softness in the macro environment, particularly in the back half of the year, we are pleased with these results.

From a merchandising perspective, sales growth was primarily driven by cookware, cook’s tools, tabletop, and electrics. These increases were partially offset, however, by softness in our traffic-driven categories like houseware and books and bakeware.

As we enter 2008, we are facing extremely challenging macro headwinds but we believe that our strong merchandising, innovative marketing, and superior customer service will continue to differentiate our brand as the destination of choice for the consumer. Therefore, we are executing against several key initiatives that we are excited about, offering an expanded premium luxury assortment in key merchandise categories, leveraging the new features and functionality of our next generation e-commerce website that was just launched in January, expanding our e-commerce marketing support, including natural and paid search and targeted electronic direct marketing, strengthening our marketing message to the consumer by highlighting the quality, value, and cultural authenticity of our exclusive product offerings, and maintaining a superior level of customer service while balancing the cost pressures of a softer top line.

We believe that executing against all of these initiatives in 2008 will allow us to continue to expand the reach of the brand and leverage the strength of the brand’s authority as the destination for high quality cooking accessories, gift-giving ideas, and home entertaining essentials.

In 2007, the key strategies for the Williams-Sonoma Home brand were to build brand awareness, enhance operational execution, and improve overall brand profitability. We are pleased to say that we made progress against all of these initiatives, driven by strong merchandising, more efficient retail operation, and the implementation of an optimized catalog circulation plan.

During the year, we opened two new stores, one in St. Louis, Missouri, and one in Plano, Texas, ending the year with nine stores.

From a merchandising perspective, sales were primarily driven by strong growth in furniture and decorative home furnishings and accessories. Expanding our assortment, including non-furniture merchandise, was a top priority this year and the overall consumer response was positive.

As we enter 2008, we will be continuing to focus on the key -- the same key strategies we pursued in 2007 -- building brand awareness, enhancing operational execution, and improving brand profitability. In support of these strategies, we are executing against the following key initiatives that we believe will allow us to take the brand’s performance to the next level: leveraging the marketing power of the Williams-Sonoma kitchen brand; opening one additional store in Scottsdale, Arizona; expanding the marketing support behind the growth of e-commerce, our most profitable channel; continuing to refine the merchandise assortment, including expanding the breadth of our co-branded programs; and reengineering our sourcing network to improve the customer experience and reduce the high cost of returns, replacements, and damages.

We believe all of these initiatives will attract new customers to the brand, enhance the customer experience, and improve our financial results.

In West Elm, we are extremely pleased with our performance in 2007 from both a brand-building and brand execution perspective. Net revenues continued to exceed expectation, driven by incremental sales from new and existing stores in addition to strong growth in e-commerce and operating margins continued to improve. We ended the year with 27 stores, including our first flagship in Washington, D.C.

From a merchandising perspective, our furniture business and new product introductions were key drivers of growth. Expanding our assortment was a top priority for this year and consumer response has been positive.

From a marketing perspective, we rolled out two significant initiatives in 2007. The first was our private label credit card combined with a customer loyalty program. The consumer response exceeded all expectations and continues to drive strong sales in the brand. We carry no credit risk associated with this program.

The second initiative was the rollout of our design with style advertising campaign. This program allowed us for the first time to create a voice for the brand and speak about our brand principles -- affordability, design know-how, and accessibility. The consumer response again was very positive and we plan to carry this program into 2008.

As we enter 2008, we are focused on several additional brand-building initiatives, including aggressively expanding our retail store base by opening 12 new stores versus five in 2007; increasing conversion in the direct-to-customer channel by optimizing the balance between shipping income and customer response rates; rationalizing our merchandise assortment across key categories and improving gross margins through strategic sourcing and aggressive quality assurance programs.

We continue to believe the unique, design-driven merchandise offering in the West Elm brand is a significant competitive advantage and we are excited about its long-term growth.

I would now like to turn the call over to Laura to discuss the Pottery Barn brand.

Laura J. Alber

Thank you, Dave. Good morning. First I’ll start with the Pottery Barn brand. In fiscal 2007 on a 53 to 53 week basis, net revenues in the Pottery Barn brand increased 0.8%, primarily driven by growth in retail leased square footage and e-commerce. Comparable store sales decreased 0.3%. Taking into consideration the significant weakness in the home furnishings sector and the fact that brand growth was in line with the growth of the home furnishings category overall, we believe these results reflect the positive net impact of our 2007 revitalization initiative, offset by a progressively weakening macro environment.

From a merchandising perspective, revenue growth was primarily driven by furniture and home furnishings. These increases were substantially offset by ongoing softness in table top. We do not believe that it is a coincidence that our strongest performing categories, furniture and home furnishings, were also the categories that saw the greatest impact from our revitalization initiative. These initiatives were centered on specific merchandising, marketing, and operational opportunities that were within our control and successfully executed against.

As we enter 2008, we’ll move forward with the next phase of our revitalization strategies. While we recognize that we are going to be operating in one of the most difficult home furnishing environments in many years, we believe that we have an opportunity to attract new customers to the brand through superior merchandising and execution. Therefore, in 2008 we will be focused on the following four key initiatives.

First, we will introduce a greater level of newness to the customer through innovative product development and enhanced visual merchandising. Today, change is resonating with our customers and they are voting yes for newness.

Second, we will continue to reinstate value as a key competitive advantage. In this tougher macro environment, our customer expects new home décor to provide impactful change at a great price.

Third, we will optimize the effectiveness of direct marketing by implementing strategic changes in catalog circulation, catalog versioning, and paid search.

And finally, we will make meaningful improvements to the service levels in our stores. In 2007, we made significant investments in the operations of our stores, including the implementation of a new labor scheduling tool. We believe these investments will significantly enhance our customer store experience while at the same time optimizing store payroll.

While we are confident in our ability to deliver against these initiatives, we believe that the external factors that affected our business in 2007 are likely to have a greater impact in 2008. Therefore, despite our confidence in the strength of the Pottery Barn brand, we believe that our sales growth in 2008 could directionally trend with the home furnishings category overall, which we believe could be negative.

Accordingly, we are committed to optimizing profitability to the extent possible by aggressively managing down our costs and tightening our inventories without negatively impacting customer service.

Now I would like to talk about Pottery Barn Kids. In fiscal 2007, net revenues in the Pottery Barn Kids brand decreased 0.4% on a 53 to 53-week basis. This decrease was primarily driven by negative comparable store sales of 1.5%. While we are disappointed in these results, we believe that Pottery Barn Kids has become increasingly more impacted by the macro environment than our other brands due to its significant dependence on broader, discretionary categories, like core textiles.

During 2007, our strongest performing categories were those in which we had meaningful differentiation or competitive positioning, including decorative accessories, infant apparel, and core furniture. The growth in these categories, however, was more than offset by a substantial shortfall in textiles, which were extremely soft through the home furnishings sector all year.

While we believe that the progressive decline we have seen in the performance of Pottery Barn Kids, particularly in the fourth quarter and continuing today, is macro driven, we believe that there are opportunities we can aggressively pursue to mitigate the impact. Therefore, as we enter 2008, we are focused on the following four key strategies.

First, we will capitalize on our strong positioning in the kid’s bedroom by filling in gaps in the merchandise assortment across categories.

Second, we will revitalize and reinvent our top of bed category to create a meaningful differentiation between us and the competition.

Third, we will continue to strengthen our vendor base in the nursery category. Superior execution is critical in this category and our 2007 back orders were too high. We have an important opportunity in this area to improve our service to our customer.

And finally, like Pottery Barn, we will optimize the effectiveness of our direct marketing by implementing strategic changes in catalog circulation, catalog versioning, and paid search.

While we believe all of these initiatives can be impactful in the coming year, business trends today are extraordinarily challenging and we do not anticipate that changing in the near-term. Therefore, we are aggressively managing the aspects of the business we can control to optimize profitability while at the same time protecting our brand image in the eyes of our customer.

As Howard said earlier, retail environments like this can create significant long-term opportunities for great brands. Pottery Barn Kids is the clear leader in the home furnishings category today for children under 10 years old, and we believe that we have an opportunity to emerge from these times with an even strong competitive presence.

I would now like to talk about Pottery Barn Teen. In fiscal 2007, on a 53 to 53-week basis, net revenues in the PBteen brand increased a better than expected 24.9%. We are extremely pleased with this performance, particularly in light of the macro headwind.

From a merchandising perspective, we saw strong growth across all teen merchandising categories, particularly furniture, textiles, and decorative accessories. As we enter 2008, we are extremely encouraged by the strong consumer response to our new spring merchandise assortment. New and innovative products designed specifically for the teen market continue to attract new customers to the brand as it solidifies its role in the life stage marketing strategy in the Pottery Barn portfolio of brands.

I would now like to open the call for questions and thank you.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll take our first question from Lauren Levitan from Cowen and Company. Go ahead, please.

Lauren Levitan - Cowen and Company

Thank you. Good morning. I’m hoping that all of you could provide us with a little bit more color on how the consumer is behaving. Howard, you made some references to this but maybe you could give us some sense of are you seeing regional variations, are there categories or price points or things that they are responding to better than others? I’m curious if that focus on quality that you’ve been communicating in the catalog and in stores, if that’s resonating.

And then related to those expectations for the consumer, I mean, clearly you’ve said that you aren’t expecting things to get better. If you could give us some sense of how that comp trend that you’ve given us for the year, what the underlying assumptions associated with that are.

And then I have a second question for Howard; it’s almost two years since you returned into the CEO role. I’m wondering if you can give us some update on your plans and thoughts around the overall management structure. Thank you very much.

W. Howard Lester

Well, that’s a lot of questions, Lauren, and we wish we had all the answers for you.

First, to kind of give you a little more color on the consumer, you know, we are seeing regional variances, and distinctly so. It’s pretty negative in some of the places, like Florida, Atlanta particularly are difficult. The West Coast is difficult, particularly in Southern California, places where home prices rose the most and dropped the most dramatically and Las Vegas, places like that, are bad; Scottsdale, Arizona -- and on the other hand, we are seeing some really bright pockets. We don’t know whether that’s going to continue or not -- places like Texas and Oklahoma and through all of that part of the country is quite strong. Chicago, the upper Midwest amazingly enough has been strong from a comp basis, although we suffered in the upper Midwest a couple of years ago, so that kind of accounts for that to some extent.

So we are seeing those. We just don’t know what to make of it. We do know that considered purchases are more difficult. You know, as we told you before, we started to see higher transaction rates this fall and lower average tickets, and so we know that the consumer is just spending less when they spend. And we are seeing that, and of course that makes it difficult for those of us in the home business particularly, because of our price points and the ticket that they have to step up to is more difficult than in Williams-Sonoma, for example, where our business has remained -- has been affected but has remained relatively strong.

This feels a lot to me like 1990 -- maybe more difficult, I think. I think this is probably the worst time that I’ve seen since I’ve been in this business in 30 years prospectively. And we have the election coming along. That’s going to be distractful, I think, so I think it’s going to be a difficult year.

But having said that, if it’s not, we’re in a position to take advantage of it and so we are not going to give anything away. I mean, we are optimistic but we are trying to be realistic about where the consumer is.

Was there another part to that question? The management team and how they are doing -- well, I think they are doing great. I’ve been back doing this not quite two years. I think I started back in the summer, July or so, so it’s been about a year-and-three-quarters. We’ve been very active here. It wasn’t the best time to come back. I wish that the comps -- if we’d been up 20, it would have been a lot more fun but honestly, we’re having fun.

You know, as I said in my talk, this is when you learn to run a business. It’s a lot easier when the wind is at your back and you are kind of riding the horse. When things are tough, that’s when you have to make the hard decision. And so I think this team is really dealing with these things really well. I mean, I’m proud of the team. I think all the people are doing a great job. I think they are maturing as we go and I am looking forward to another couple of years here before you get rid of me but I think this team is going to be able to run this business in the not-distant future without me and I’m really encouraged as to where we.

But right now, we’re not thinking about that. Right now as a group all we’re focused on is doing these things that we talked to you all about this morning and we’ll let the rest of the future play out as time goes by.

Operator

Thank you. We’ll take our next question from Rexford Henderson with Raymond James and Associates. Go ahead, please.

Rexford Henderson - Raymond James

Good morning. I think the question that I want to focus on is on the sourcing of goods, we’re seeing significant inflation and raw material inflation in your source countries, and you’re focused naturally on maintaining the brand image and maintaining your quality level and without pricing yourself out of the market. I’m just wondering how you are balancing those issues and what we can expect and what actions you are taking to address those issues.

Sharon L. McCollam

I think that it’s different answers, to some extent, between Dave and Laura, so I’ll let Dave take his brands and then we’ll let Laura speak to the Pottery Barn brands.

David DeMattei

Okay, so I’ll start with the Williams-Sonoma brand. You know, Williams-Sonoma, a lot of our goods come out of Europe and we have the dollar pressures there, so we work with vendors. We look for alternate sources when possible and we try to balance our mix to attain the margins we need and we take price increases where we have to.

In terms of West Elm out of Asia, West Elm has going for it increased order volumes, so we use those through strong negotiation and as I said in my comments, much more strategic -- exploring new countries, exploring new vendors and building a vendor base to support it. West Elm is currently able to increase its orders because of its large growth rate and we are using that as a great leveraging factor, but it is a balance act, as you say.

Laura J. Alber

Similar response -- you know, we have extremely strong partnerships with our vendors that we’ve built over many, many years and our success and their success are completely interdependent and they understand. We were just over in Asia with all of our -- about 200 vendors talking about this very issue and while raw materials are increasing, we are looking for other ways to take price out without sacrificing quality. And we’ve really become more sophisticated in understanding how to engineer value into our products.

On the return logistics side, we also have an opportunity to improve our efficiency and take costs out, which will help our margins. And then lastly I’ll say the other thing we’re doing to really combat higher raw materials costs is tighter inventory control, higher sell-throughs at regular price.

W. Howard Lester

Just another comment on that; Laura mentioned we were in Asia for a long trip and meeting with all of our vendors -- Dave and Laura and I and some others were over there and I think that our brands and the size of our brands, the magnitude of our relationship with our vendors, it really is serving us well in this time. Many of these factories, we’re 20% to 60% to 70% of their volume and it’s a common problem that we have to share and we do have some price increases here and there but by and large, they know that we are committed to if anything engineering more quality into our products, not less. We’re not going to accept less and they are working with us and in some cases probably taking shorter margins on their side in order to get the right kind of product into consumers’ hands here in America.

So I think our size and the strength of our brands are a really big asset here during these particular times that maybe others don’t have.

Operator

We’ll take our next question from Matt Nemer with Thomas Weisel. Go ahead, please.

Matt Nemer - Thomas Weisel Partners

Good morning, everyone. My first question is I was just wondering if you could comment on the sequential change from Q1 to Q2. And I guess what I’m getting at is what specifically are your macro assumptions as we move through the year? And then my second question is could you comment on your strategy to reduce weeks on hand of inventory? Will we see that in the outlets, online, in the stores, in the catalogs? Kind of what should we look for? Thanks.

Sharon L. McCollam

Laura, would you like to take that?

Laura J. Alber

Sure. We have been aggressively managing our inventory for the past 12 months and are prepared to handle a weakening sales environment. We’ve been looking at our outlet strategies to modify them so that we can move more in-season goods there. But most importantly, really forecasting realistically our trends and working with our vendors to maintain flexibility as the year goes on.

We also have made investments in systems and process improvements that allow us to more accurately flow goods to our stores and predict demand in the future, so I think this is going to be an area where we are able to make changes and continue to reduce inventory throughout the year because we have been preparing for this for the last year.

Sharon L. McCollam

And then Matt, in response to your question about what we are assuming as we progress through the year, I think you can see from the comp guidance that clearly we came into February and March with extremely challenging comp numbers and that we have a lot of newness coming in. We are excited about some things that we are doing internally, the Pottery Barn revitalization initiatives, et cetera, so as we launch our summer assortment, we felt a little -- we do feel better about that and we think there are some positives there.

So as you look at what we’ve given you in the comp guidance, you can pretty much see that throughout the year on a two-year comp basis, that you’ve basically got a flat outlook between now and the end of the year. Our assumptions were very similar on the direct side.

The reason that you see the little differences in the growth rates by quarter is because of the significant leased square footage growth we have this year. You know, what is so exciting about these times, like Howard talked about, is when you have times like this, great retailers can seize opportunity. We’re going to have 7.5% to 8.5% leased square footage growth this year and those stores will open during the year, so that’s given us some top line coming from stores.

And what’s particularly encouraging about that is on those 20 remodels and expansions, those are in our core brands, too. So you’ve got a really nice bump coming this year from the leased square footage growth, but that’s when you’re looking at the top line, we’re not assuming a big deterioration going into the back half and we’re not assuming a big positive.

Laura J. Alber

I want to add one thing to what I was saying about inventory that is also really important, that I didn’t mention, is that we are aggressively looking at our assortments to rationalize our SKUs. And this is really important because it allows us to put the investments in the things that drive the most business and reduce those that just create noise for both the customer, our distribution centers, and our vendors. And we are really excited on the progress we’ve made on that front and the progress to be made throughout this year. And we do not believe that will affect the customer or sales, so that’s another key part of our inventory management strategy.

Operator

We’ll take our next question from Scot Ciccarelli with RBC Capital Markets. Go ahead, please.

Scot Ciccarelli - RBC Capital Markets

I guess this is a question for Sharon; it looks like you guys are looking for about a 5% or $50 million to $60 million reduction in absolute SG&A on a year-over-year basis, and it just feels like a lot, given the expected growth in square footage. Is the primary difference the cut-back in catalog circulation and advertising or are there other things that would really impact that?

Sharon L. McCollam

That would be the largest contributor is coming from the productivity that we believe that we are going to be able to deliver as a result of our new circulation strategy. You know, we’ve talked, Scot, for the last 12 months to 18 months about the systems investments that we’ve made in the direct-to-customer channel and the advancements that Pat has made, and I’m going to turn this over actually to Pat because I think he can speak to this. It’s very exciting for us. We’ve said there would be benefit and this year, we’re going to see it. So Pat, would you like to speak to that?

Patrick J. Connolly

Sure. That’s a great point, Scot. I’m glad you asked it. I think when we talk with all of you, we talk about the ability of our marketing systems to identify the best possible prospects. But in these times, we’ll also be able to identify those people who are very much least likely to buy. We use not only our internal data but we also use external data, including mortgage balances, aggregate credit scores and the like, and changes in those credit scores. And that has really allowed us to eliminate, as Sharon indicated in her guidance, somewhere between 10% and 15% of our circulation with a minimal impact on the resulting sales.

Sharon L. McCollam

And then additionally, Scot, we are seeing general and administrative cost reductions. We are serious about managing down costs in this type of an environment and we are aggressively going after that, so that additionally will be part of that number but the big dollars are coming out of the productivity and advertising costs.

Operator

Thank you. We’ll take our next question from Chris Horvers with Bear Stearns. Go ahead, please.

Chris Horvers - Bear Stearns

Thanks and good morning. Sharon, to follow-up on the inventory question, if you laid out that about 10% of the inventory increase was related to units on hand; I’m just curious if those other two factors maybe aren’t as controllable, why won’t it be very difficult to manage the inventory lower?

Sharon L. McCollam

I’m sorry, I don’t think I know your question. When you look at the increase year over year in the Pottery Barn brands, Pottery Barn and Kids, about 10%, we’re talking about $8 million. And so the question -- I want to be sure that I answer your question, so could you tell me what it is that you are asking me? Chris?

Chris Horvers - Bear Stearns

Hello?

Sharon L. McCollam

Can we bring Chris back, please? Chris, are you there?

Chris Horvers - Bear Stearns

I’m here.

Sharon L. McCollam

Could you just repeat your question? Because I want to make sure I answer what you’re asking me.

Chris Horvers - Bear Stearns

Can you here me now?

Sharon L. McCollam

I can.

Chris Horvers - Bear Stearns

So the question is if that other 90% of the inventory growth that you saw this year is related to emerging brands and product mix and raw material cost pressures, doesn’t that make it very difficult to get the inventory lower if you are just managing the weeks on hand? Like, is that something that’s systematic and fixed there and you can only do so much with the units on hand?

Sharon L. McCollam

I think that we are going to see optimization of inventory actually across all of our brands. This is not a Pottery Barn discussion. Even in the emerging brands, as they get bigger, they end up, you know, as they are small, they end up buying minimums and of course, that’s difficult because it ends up giving you more inventory at any point in time than you would prefer to have at that point in time. So as they grow, they get to optimize that.

In addition, we have seen for the last several years some substantial increases in Williams-Sonoma because of the Stonestown project and the shift in their mix and that’s going to start mitigating going forward and we think there’s some real opportunity there.

So we have -- it’s not going to be -- I expect to see every one of our core brands see reductions in inventory net year and inventory levels to the extent they can, and then we will have less SKUs and that will be helpful. So we feel pretty good about this inventory guidance. We are organizationally focused on achieving these numbers. The risk we have, of course, is the sales volatility. If the sales fall quickly, it’s hard to modify and that’s why we gave ourselves a cushion there. But we are prepared to do what we need to do to get these inventories down.

Operator

Thank you. We’ll take our next question from Colin McGranahan with Bernstein and Company. Go ahead, please.

Colin McGranahan - Sanford Bernstein

Thank you. Good morning. I have actually two questions. The first is maybe you could comment just on the overall competitive landscape and how you think about your promotional approach in this kind of an environment. And maybe in that you can include some commentary on whether there was -- how much the change in the promotional environment sequentially from let’s say last November through the current has impacted the rather severe sequential decline in the comp trend from the fourth quarter to the first quarter. In other words, have you intentionally been less promotional relative to some of the extreme things we’ve seen out there in the marketplace and you are factoring that in. So that’s my first question. If you could just comment on promotional intensity, your approach in this kind of environment, and the trade-offs you are making.

The second question is more on store growth, and understanding there is lead time here, there are attractive opportunities in malls that don’t come available that often, but have you thought about the 8% square footage growth in this kind of an environment? Howard especially, it sounds like you think there’s some possibility we could be in a challenging environment for quite some time. Maybe it would make some sense to be a little bit more conservative on that store growth.

W. Howard Lester

Let me take the first and the last, if I can, and then with Laura and perhaps Dave’s help, we can talk about more specifically about the promotional kinds of things that are going on.

I would say that as a general thing for the last couple of months, or since the first of the year, we have not been promotional and that’s been on purpose. So we have not been ultra-promotional. We’ve tried to maintain our margins and maintain the philosophy of our brands.

I would say that in general from a competitive standpoint, and not knowing that much about what’s going on in all the other companies, of course we are seeing just through public information many of our competitors struggling, having substantial struggles and some are struggling to stay alive and some are going through all sorts of things, particularly those companies that are in the furniture business primarily.

So we are seeing that. We think that’s a good sign. While we’re sorry it’s happening for them, we are seeing that as an opportunity for us to gain share and do the things that we talked about in our talk.

Let me ask Laura and Dave if they want to add a little more specifics to your question and then I’ll come back to the store strategy.

Laura J. Alber

On the promotional environment, we do know that a lot of our competitors are trying to get through inventory and that’s putting pressure on prices across the market. We have made the conscious decision not to run promotions in our core brands to drive sales. We run promotions and markdowns when we have inventory problems and that’s a very different strategy. So we clear goods in-season when they are moving slower than our anticipated sales rates.

But as an example, I’ll give you one in Pottery Barn, we did not run a white sale in January, consciously. It probably cost us some regular priced business -- or I’m sorry, it probably cost us some sales but where we believe we have a great value and the customer buys it at regular price, we are maintaining that philosophy. And to the extent also on shipping, we are -- our goal on shipping is to be competitive and fair and easy to understand and have less gimmicks and promotions around that. And so we are doing some things differently than what the market is doing and we feel really good about them.

So you will see us take the mark-downs when we need to but particularly -- and I speak for the Pottery Barn brands mostly and I’ll let Dave comment on his areas -- that we are not just trying to buy our sales, because we don’t think that’s a sustainable strategy.

W. Howard Lester

I think the same thing is probably true in Sonoma. I mean, we’re holding our prices but it’s basically a full price --

David DeMattei

Yeah, philosophically we’re a full-priced brand. We take markdowns to clear seasonal goods in the first half of the year. It’s a very small percentage of Williams-Sonoma's inventory.

W. Howard Lester

And we haven’t changed anything, so -- back to the store issue, you know, we have had here a -- what I regard as a very strong process of the way that we pick and decide on new retail locations. And we continue to use that process, we rely on it. Now obviously in more difficult times, we’re more conservative on our estimates for the sales forecast that we are giving to those stores. And what happens to us, and it’s kind of unusual this year, really, is that over the last couple of years, that we’ve had more opportunities come to us that are solid store locations that we’ve been waiting for. And they are opportunities that we want to take advantage of.

We are not going to take advantage or open any store that we don’t think is going to give us the kind of returns that we are looking for. And that’s been consistent as long as we’ve been opening stores here, at least for 25 years. I mean, we have this process that we look for a certain sort of contribution level and if we don’t get it, we just don’t do it. And that’s not to say we’ve been perfect every time but we didn’t mean to do it.

So the same thing is true here. You know, as we look at brands like West Elm, those locations are very difficult to come by, otherwise we would have been much more aggressive with West Elm, so when those come along we take them. And it’s just kind of worked out this way.

But if you look at the store count that we are doing, new stores next year, I mean, they are kind of spread. There’s six Sonoma, six Pottery Barns, two Pottery Barn Kids and a couple of more outlets and then, you know, the 12 West Elms that we talked about in our talk and one Home. So they are spread across. We’ve been very discriminating about whether or not we should do them. I can tell you we reviewed them several times but a lot of these were also done a year or two years ago, you know, made the deal and then we’ve been waiting on the space so there’s that factor as well.

Operator

Thank you. We’ll take our next question from David Magee with Suntrust Robinson Humphrey. Go ahead, please.

David Magee - Suntrust Robinson Humphrey

Good morning. Just a couple of questions on West Elm; you mentioned better profitability. I’m curious whether that’s a function primarily of productivity improving or is there maybe a more favorable mix of the business as you get deeper into it. And what do you think the ultimate profitability of that concept might be relative to your core concepts?

David DeMattei

We continue to make productivity improvements in our direct channels. That, as I said in the prepared comments, it was the highest in the brand’s history, so we continue to work on that through both mix and through working with Pat through the optimization of the circulation strategy.

And you know, in our stores, we’re learning a lot about opening our stores. We really -- I think it’s a combination. We see a ramp period in our stores over 18 to two months. Our oldest, more mature stores are the ones that are performing the best for us, so as they mature they get better. Probably that’s a combination of the brand becoming more known in the marketplace, coupled with our marketing into the market.

We are tweaking the size of our stores as we learn more, so we are -- we were -- probably 20,000 square feet is all stores. Now we’re dropping to 15,000 and where we think the markets can utilize a little bit of a smaller store and that again increases profitability of those.

And then the markets that we opened, we are performing best where we are best known from our catalog data. So as we accumulate data, I think we can become much more strategic in the [inaudible] of the business.

Operator

Thank you. We’ll take our last question from Marni Shapiro with The Retail Tracker. Go ahead, please.

Marni Shapiro - The Retail Tracker

Hi, guys and before I forget, I just want to wish you luck in this environment. If you could talk a little bit about -- you talked about this at Pottery Barn, top of -- table top, top of edge, certain areas. If you could talk a little bit about that at West Elm, if you are seeing reaction to table top and the soft goods part of that business.

David DeMattei

I think across the industry, Laura talked about the textile business. It has been a rough one across all of our home furnishings businesses this year. We are seeing -- West Elm has been driven this past year by the furniture business. You know, it continues to be a very strong point for the business. We’ve worked a lot on our innovation there. We’ve really been able to build an upholstery business for the first time there. Our bedroom continues to trend, especially our storage pieces. And we’ve really worked on our decorative accessories part.

The table top business is a very small one for West Elm, one that we are continually working on and trying to get going but again, it continues to be a very small one, unlike Pottery Barn's business.

Operator

Thank you. That is all the time we have for questions today. I will now turn the call over to Howard Lester for closing comments.

W. Howard Lester

Well, we just want to thank everybody for joining us today and we want to thank you for your support and we’ll talk to you next quarter. Thank you. Good morning.

Operator

That concludes today’s teleconference. Thank you for your participation and you may disconnect at any time.

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Source: Williams-Sonoma F4Q07 (Qtr End 2/3/08) Earnings Call Transcript
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