Undervalued Dividend Growth Stock of the Week: Williams-Sonoma, Inc. (WSM)

Before I started aggressively saving and investing in early 2010, I had thought the idea of retiring early was a total pipe dream.

Even the idea of a traditional retirement in your early 60s seemed harder and harder to attain.

At least, that’s the ongoing rhetoric that the media and politicians spin.

And I bought into that. I really did.

But then I started educating myself.

And my eyes were opened.

I read book after book on money management and investing. Article after article on how to save money.

I started devouring annual reports.

And I started to budget.

Guess what?

The idea of retiring decades before most people is most definitely not a pipe dream.

In fact, it’s actually the only logical life path for many Americans. After all, earning about $40k per year puts one in the top 1% or so of the world in terms of annual income.

Knowing that, it seems almost crazy that one would have to work their entire life if they don’t really want to.

Indeed, I lived way below my means and invested my excess capital in high-quality dividend growth stocks for six years straight – and I’m now in a position where my real-life portfolio generates enough dividend income to cover most of my core personal expenses.

I’m essentially retired in my early 30s.

But I didn’t do anything that most people can’t also do. I’m not keeping any secrets here.

I actually discussed my “blueprint” for early retirement exclusively with you Daily Trade Alert readers – and it’s a life path that almost anyone can take.

It’s a path that simply requires saving plenty of money.

And then you take that money and invest it in great businesses that reward shareholders with growing cash dividend payments.

You’ll find almost 800 examples via David Fish’s Dividend Champions, Contenders, and Challengers list, which is an incredible resource that contains information on all US-listed stocks with at least five consecutive years of dividend increases.

These growing dividends can then fund one’s lifestyle, once the dividend income is sizable enough.

And if your lifestyle is light enough (as it should be if you really want to save and get here), it doesn’t take that much.

The thing is, Mr. Fish’s list has almost 800 stocks on it.

Some stocks are higher quality than others. And some are better buys at certain times.

However, it’s not difficult to whittle things down appropriately.

The first thing one wants to do is focus on businesses within one’s circle of competence.

From there, it’s a matter of quantitatively and qualitatively analyzing a business to make sure it’s a high-quality business that has the right competitive advantages for the long haul.

Finally, one should make sure they have a good idea of what the business is worth so that they don’t pay too much for the stock.

This last point is pretty important.

That’s because the price of a stock only tells you what you’re going to pay.

Price just tells you how much something costs.

Value, though, tells you what something is worth.

Value gives context to price.

And when it comes to stocks, the valuation dictates a number of key points.

Specifically, an undervalued dividend growth stock will generally offer a higher yield, greater long-term total return prospects, and less risk.

This is relative to what would otherwise be offered if the same stock were fairly valued or overvalued.

Price and yield are inversely correlated; all else equal, a lower price will equal a higher yield.

This higher yield positively impacts total return by virtue of yield being one of two components of total return.

Meanwhile, capital gain, the other component, is also positively impacted due to the upside that exists between the lower price paid and the higher value of the stock.

While price is a strong force over the short term, value matters over the long run.

Price and value may wildly diverge over shorter periods of time, they tend to converge over the long haul.

Undervaluation also allows for a margin of safety.

That margin of safety is present when you pay far less for an asset than it’s likely worth.

If you pay $50 for something that’s deemed to be worth $75, you have $25 worth of cushion in case something goes wrong.

And in business, a lot of things can go wrong.

A company might not perform as expected. Maybe competition strengthens. Maybe there’s some kind of management problem. Many things can happen. You just never know.

The last thing you want to do is pay full price or more, which gives you no cushion for these possible events.

That’s why I always try to buy a high-quality dividend growth stock when it’s undervalued.

Said another way, I want to buy a slice of a great business when the price of that slice is less than what it’s worth.

Easier said than done; however, fellow contributor Dave Van Knapp put together a great resource that’s designed to streamline the valuation process for just about any dividend growth stock out there.

Once you have a good idea of what a stock is worth, you have power on your side. You’re not going in blind. And you can feel relatively comfortable if things don’t go just right.

With all of this in mind, I want to show you readers a high-quality dividend growth stock that appears to be undervalued right now…

Williams-Sonoma, Inc. (WSM) is a nationwide multi-channel retailer of high-quality home products and furnishings.

This retailer is known for its high-quality furnishings and accessories, operating through well-regarded brands in Pottery Barn, West Elm, and the eponymous Williams-Sonoma.

Their product offerings range from traditional furniture (couches, beds, chairs, etc.) to cookware and small appliances.

When a person is looking for quality products in the home goods space, these brands come to mind pretty quickly.

The quality and design of its products has lent itself to establishing brand names that consumers can count on, and that is a competitive advantage for the company.

That said, most of the retailing space in general is getting absolutely hammered right now as shoppers continue to move their purchases away from physical stores and toward e-commerce, which changes the dynamic considerably.

However, Williams-Sonoma has responded well to the changing landscape: just over half of their revenue comes from their E-commerce segment.

So about half the company’s sales are coming from the online channel already – and that number continues to grow.

As such, they’re positioned about as well as any legacy retailer I know of.

In addition, its dividend is positioned very well – and growing nicely.

The company has increased its dividend for 11 consecutive years.

While not the longest dividend growth streak around, Williams-Sonoma makes up for some of that with a pretty impressive dividend growth rate of 17.1% over the last 10 years.

If that growth isn’t impressive enough on a standalone basis, consider that the stock offers a very appealing yield of 2.95% right now.

CaptureThat yield is attractive in a number of ways.

First, it’s quite high in a low-rate environment.

Second, it’s well in excess of the broader market.

Third, it’s almost 80 basis points higher than the stock’s own five-year average.

Remember how I mentioned earlier that undervaluation generally presents a higher yield, which itself tends to boost long-term total return?

Well, there you go.

And with a modest payout ratio of just 44.2%, there’s still plenty of room for more dividend increases from the company.

All in all, the dividend metrics are outstanding.

You’ve got a rather high yield that’s supported by a moderate payout ratio. And you’ve got pretty significant dividend growth to boot. Just not much to dislike here.

But let’s now check into the company’s growth and fundamentals.

Knowing the growth rate of the company will help us to determine what kind of dividend growth to expect moving forward, which itself will help us ascertain a good estimate of the stock’s value.

So we’ll first look at top-line and bottom-line growth over the last decade (a pretty good proxy for the long term), before comparing that to a near-term forecast for earnings per share growth.

The company grew its revenue from $3.728 billion to $4.976 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 3.26%.

Not outstanding, but the bottom line grew at a much more brisk pace.

Earnings per share for Williams-Sonoma expanded from $1.79 to $3.37 over this same 10-year period, which is a CAGR of 7.28%.

The reason for the spread between revenue and EPS is what the company did with its shares: Williams-Sonoma reduced its outstanding share count by more than 20% over the last decade via substantial share repurchases.

Looking forward, S&P Capital IQ expects that Williams-Sonoma will compound its EPS at an annual rate of 10% over the next three years. S&P Capital IQ believes new store openings, E-commerce growth, share repurchases, and growth in comparable brand revenue will combine to propel overall company-wide growth.

That would obviously be a noticeable acceleration from what’s occurred over the last 10 years. In this current retail environment, that could be difficult to realize. However, even continued bottom-line growth of 7%+ would be enough to provide for solid long-term total return and dividend growth, especially considering the yield of 3%+.

Meanwhile, other fundamental aspects of the company are really high quality.

The balance sheet is a great example.

Williams-Sonoma has no long-term debt.

With the current shifts in retail, Williams-Sonoma has a very, very flexible balance sheet, which is why I noted above that they’re positioned as well as any legacy retailer I can think of.

Profitability is also quite strong.

Over the last five years, the company has averaged net margin of 6.38% and return on equity of 22.22%.

When you look at other retailers in the high-end home furnishings space, these numbers compare favorably. Moreover, that solid ROE has been achieved without any leverage.

If this isn’t a high-quality retailer, I’m not sure what one would look like.

The fundamentals are great, they’re responding to changing trends, and they have brands with competitive advantages.

And as a dividend growth stock, it checks pretty much all the boxes.

You’ve got more than a decade of dividend growth, a very attractive yield, and a sustainable payout.

With all of this staring at us in the face, you might expect that the stock would be expensive.

However, it actually appears cheap right now…

The stock is trading hands for a P/E ratio of 14.96. That’s well below the broader market. It’s also a significant discount to the stock’s own five-year average P/E ratio of 20.2. Investors are also paying much less for the company’s sales and book value than they typically have, on average, over the last five years. The P/CF ratio is also relatively low. And I already discussed how the current yield compares to its own recent historical average.

Wow. So the stock does look very cheap right now. But how cheap might it be? What’s a good estimate of its intrinsic value?

I valued shares using a dividend discount model analysis. I factored in a 10% discount rate. And I assumed a long-term dividend growth rate of 7%. That’s a reasonable, if conservative, assumption, in my view, when you look at the long-term EPS growth rate, the 10-year dividend growth rate, the moderate payout ratio (which could be further expanded), and the forecast for EPS growth over the next few years. The DDM analysis gives me a fair value of $52.79.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

My analysis was arguably conservative, but I’d rather be safe than sorry in this retail environment.

But even with that stance, the stock still looks cheap. Maybe I’m way off, though.

That’s why I like to check in with professional analysts and compare my viewpoint.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates WSM as a 5-star stock, with a fair value estimate of $73.00.

S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates WSM as a 3-star “HOLD”, with a fair value calculation of $52.60.

Morningstar came in high here; otherwise, you see a pretty solid consensus. But I like to average these three numbers out, which blends together multiple methodologies and viewpoints. That averaged valuation is $59.46, which would indicate the stock is quite possibly 19% undervalued.

WSM_chartBottom line: Williams-Sonoma, Inc. (WSM) is a high-quality retailer with well-regarded brand names across the home furnishing space. Solid growth, no long-term debt, a substantial online presence, and a very appealing yield should be enough to get any dividend growth investor interested. But the potential for 19% upside on top of all that should really pique your interest.

— Jason Fieber

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