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

Collecting income usually requires a job of some sort.

You show up, clock in, do your work, clock out, go home.

And then you collect a check at the end of the pay period.

But what would be better than getting paid to work? 

Getting paid to not work.

That’s right.

Getting paid just to exist might be a better way to put it.

Just imagine being paid while you sleep.

Instead of counting sheep, you’re counting dollars. And then you wake up already ahead of the game, sitting on positive cash flow before you even start your day.

Talk about having sweet dreams. And talk about having a good morning!

That’s essentially the life of a dividend growth investor.

Dividend growth investing basically involves buying equity in some of the world’s best businesses.

You then let those great businesses go out and make a lot of money.

And that money – that profit – is shared with shareholders via dividends. As the profit grows (which tends to happen when you’re dealing with wonderful businesses), so do the dividend payments.

See, these companies can and will work for you. And they’ll pay you while you sleep.

Dividend growth investing pays you to not work. It pays you just to simply be alive. 

And that’s a pretty amazing thing.

I’d know exactly how this feels, as I’ve been dividend growth investing since mid-2010.

I’ve spent the last almost eight years of my life building my real-life and real-money dividend growth stock portfolio, which now pays me five-figure annual passive dividend income while I sleep.

So I’m having the sweetest dreams I’ve ever had in my life.

Now, it does take a little time to get to that level of passive income.

But it’s not hard to take that first step…

Dividend growth investing almost couldn’t be easier.

In fact, dividend growth stocks for potential long-term investment can be found with very little effort.

David Fish, a valuable member of the investment community, has compiled data on more than 800 US-listed stocks that have paid rising dividends for at least the last five consecutive years, and he shares that data via his vaunted Dividend Champions, Contenders, and Challengers list.

Of course, it’s not as easy as picking a random stock off of that list and buying it.

A business model should be within your circle of competence.

And you should perform a quantitative and qualitative analysis on a business before investing, weighing that analysis against any known and perceived risks.

Perhaps most important of all, you should also go through the appropriate steps to value a business and its stock, as valuation will play a critical role, especially over the short term, in terms of how well your investment performs for you.

Price is what a something costs, but value is what something is worth.

Assuming the two are one and the same is never a good idea, but it’s arguably never more important to separate the two and have a good idea of value than when dealing with stocks.

An undervalued dividend growth stock should offer an investor a higher yield, greater long-term total return potential, and less risk. 

That’s all relative to what the same stock might otherwise present if it were fairly valued or overvalued.

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

That higher yield gives one’s potential long-term total return a boost right off the bat, because investment income (via dividends or distributions) is one component of total return.

The higher yield will result in more income on the same dollar invested.

But potential total return is given another boost via the “upside” that exists between the lower price paid and the higher intrinsic value of a stock.

That’s because that upside could result in more capital gain than would otherwise be available, and capital gain is the other component to total return.

While the market isn’t necessarily very good at correctly pricing stocks over the short term, price and value tend to roughly correlate over the long run.

If/when price catches up to value, that results in capital gain, increasing one’s total return.

The dynamic that exists between price and value when undervaluation is present also serves to reduce risk.

After all, it’s naturally and intuitively to be less risky to pay less than more for the same exact thing.

And you introduce a margin of safety when undervaluation is present, which provides a “buffer” of sorts to protect the investor against unknowable problems or unfavorable changes in a business.

As you can see, a high-quality dividend growth stock that’s undervalued can be a fantastic long-term investment.

Fortunately, it’s not all that difficult to value a dividend growth stock beforehand.

Fellow contributor Dave Van Knapp has actually streamlined this process for you readers and investors, putting together an excellent valuation lesson that’s part of an overarching series of lessons on the entire strategy of dividend growth investing.

This lesson is a fantastic valuation template that can be applied to just about any dividend growth stock out there, putting the investor in control.

With all of this in mind, let’s take a look at 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.

Founded in 1956, Williams-Sonoma now operates as a global business with almost 20,000 employees.

Their brands are some of the most respected and sought after in all of home furnishings, with the company controlling the Pottery Barn, West Elm, and the eponymous Williams-Sonoma brands.

The company’s ability to manufacture and provide premium products that command premium prices is what’s led to their unique spot in the market.

When a customer wants to furnish their home with high-end products, Williams-Sonoma is going to be in that conversation.

And they’ve built on that reputation in order to continue thriving in a retail landscape that has radically changed in recent years.

While the company has in the past relied on their stores to tell a visual story about their products, retail these days is quickly becoming an area dominated by those who are able to master e-commerce.

Well, Williams-Sonoma saw that corner coming years ago.

For fiscal year 2016, their e-commerce sales segment accounted for 51.8% of all revenue, with the other 48.2% of revenue coming from net retail sales.

As we can see, more than half of the company’s revenue is already coming from online sales, which positions this unique and high-quality retailer excellently moving forward.

And that could position the dividend very well, too.

The company has paid an increasing dividend for 12 consecutive years.

The 10-year dividend growth rate stands at 13.2%, which is obviously outstanding.

With US inflation being in the low single digits over that same period, investors have seen a very large increase in their purchasing power (on the stock’s dividends) every single year.

However, I wouldn’t expect dividend growth to continue at that kind of pace going forward. But as we’ll see by going through the fundamentals, dividend growth in the high single digits is a very plausible assumption moving forward.

Meanwhile, the stock yields a very appealing 2.90%.

A yield of 3% with annual dividend growth over 7+ is where you want to be. Assuming a static valuation, the sum of yield and dividend growth will approximate your total return. Well, a 10%+ annualized total return is fantastic.

That yield, by the way, is 50 basis points higher than the stock’s five-year average.

So undervaluation leading to a higher yield can be seen pretty clearly here.

And with a payout ratio of just 44.4%, there’s still plenty of room for continued dividend growth.

But in order to get a reasonable idea about that future dividend growth, as well as the value of the business and its stock, it’s imperative that we look at underlying business growth, as that is what will drive dividend growth and valuation.

While we invest in where a company is going and not where it’s been, one of the best places to look in order to build an expectation for future growth is a company’s past long-term growth rate.

So we’ll look at what Williams-Sonoma has done over the last decade (using that as a proxy for the long term), and then we’ll compare that to a professional near-term forecast for future growth.

Combining the known past and estimated future in this manner should give us a sensible idea of the company’s growth moving forward, telling us a lot about expected dividend growth and valuation.

Williams-Sonoma has increased its revenue from $3.945 billion in fiscal year 2007 to $5.084 billion in fiscal year 2016. That’s a compound annual growth rate of 2.86%.

Just slightly disappointing here, as I like to see something closer to mid-single-digit top-line growth from a fairly large and mature company such as this.

That said, it’s not a terrible number, especially considering all of the ongoing turmoil in retail.

The company’s bottom-line growth fared better over this stretch, however, thanks to massive buybacks that saw the outstanding share count reduced by almost 20%.

Earnings per share advanced from $1.76 to $3.41 over the last ten fiscal years, which is a CAGR of 7.63%.

That’s a very solid result.

But it doesn’t support the lofty 13%+ dividend growth that’s occurred over the last decade, which is why I think dividend growth expectations need to be tempered a bit moving forward.

Still, the most recent quarter saw 8% diluted YOY EPS growth.

And CFRA is calling for Williams-Sonoma to compound its EPS at an annual rate of 9% over the next three years, which would be right in the neighborhood of what the company has done over the long term and short term.

That kind of EPS growth could very easily support similar dividend growth. And that’s further supported by a very modest payout ratio, which could even be expanded a bit.

As such, 7%+ annual dividend growth moving forward is a conservative estimate for the stock, in my view.

Further evidence of exemplary fundamentals is shown when looking at the balance sheet.

Williams-Sonoma has no long-term debt.

It’s a flawless balance sheet.

And this will almost surely work to the benefit of the company and its shareholders as interest rates inevitably continue to rise from here.

While some could argue that some debt is a good thing, especially relative to the historic period of low rates we’ve experienced over many years now, the company is positioned extremely favorably in terms of flexibility moving forward.

Profitability is quite robust, as we have to remember that this is, at its core, a retailer.

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

This is one of the most unique, high-quality, and well-positioned retailers I know of.

They have the brand recognition and pricing power. The balance sheet is without flaw. And the e-commerce infrastructure is already built out, with over half of the company’s sales coming from online transactions.

Retail is typically a tough industry to invest in, due to low margins and stiff competition on price.

But Williams-Sonoma sports great margins. And there’s relatively limited competition in its niche.

With all of this working in the company’s favor, you’d think the stock would priced a premium (like the company’s merchandise).

However, I’d argue the stock is priced at a discount right now…

Shares are available for a P/E ratio of 15.30 here.

That’s not only significantly below the broader market, but it’s also well below the stock’s own five-year average P/E ratio of 19.6.

And the P/CF ratio, at less than 9, is approximately 20% lower than its three-year average.

Plus, the yield, as noted earlier, is 50 basis points higher than its five-year average.

The stock does appear to be cheap based on these initial basic valuation metrics, but what, then, might a reasonable estimate of the stock’s intrinsic value be? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 7%.

That DGR is pretty conservative when we consider the forward-looking forecast for EPS growth, the moderate payout ratio, and the most recent quarter’s diluted YOY EPS growth.

But the most recent dividend increase was a bit small. And the retail landscape continues to shift and change.

Plus, it’s always better to err on the side of caution when looking out over the very long term.

The DDM analysis gives me a fair value of $55.64.

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.

So the stock still looks attractively valued, even after running it through a valuation model that’s arguably quite conservative.

However, my DDM analysis is but one look at the valuation, which is why we’ll compare my valuation to that of what two select professional stock analysis firms have concluded.

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 4-star stock, with a fair value estimate of $65.00.

CFRA 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.

CFRA rates WSM as a 3-star “HOLD”, with a fair value calculation of $54.00.

Morningtar might be a bit sanguine, but I think I was just as cautious on the flip side. Nonetheless, averaging the three numbers out gives us a final valuation of $58.21. The stock thus appears to be potentially 9% undervalued right now.

Bottom line: Williams-Sonoma, Inc. (WSM) is a high-quality retailer that sports some of the biggest, best, and most sought-after brands in all of home furnishings. It’s clearly a wonderful business. The fundamentals are spectacular across the board, the stock yields almost 3%, the e-commerce business segment is incredibly strong, and the stock appears to be 9% undervalued. These are just a few reasons why this is one of my top 10 stocks for 2018.

— Jason Fieber

Note from DTA: How safe is WSM’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 61. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, WSM’s dividend appears safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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