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

There’s not a single day that goes by in which I don’t see bustling activity all around me.

There’s this constant to and fro.

Commerce. Consumption. Growth. The movement of goods and services.

Look around you. You’ll see the same.

There’s only one thought that crosses my mind when I stop to look at this.

Money. 

Don’t miss out.

Whether or not you invest and profit off of global consumption, that consumption is going to happen.

It will happen with or without you.

That train is taking off – whether or not you’re on it.

Well, I say it’s much better to hitch a ride on that train and grow your wealth, passive income, and financial independence.

Indeed, I bought my ticket aboard this train way back in early 2010.

And it’s taken me places I’d never thought I’d go.

In fact, I recount much of that incredible journey in my Early Retirement Blueprint, which documents my ride from below broke at age 27 to financial freedom at 33.

A major element of that journey, of course, includes investing.

I’ve yet to find a better way to ride this train than to buy high-quality dividend growth stocks at appealing valuations.

Dividend growth investing essentially involves buying equity in great companies that are regularly and reliably growing their profit.

Shareholders collectively own publicly-traded enterprises. It follows logic that they should collect their fair share of the growing profit – in the form of growing cash dividend payments.

Building a diversified portfolio full of world-class businesses that are paying you growing dividends is a fantastic way to set yourself up with the growing wealth and passive income you need to become financially independent.

Then you can sit back and enjoy the ride while your money makes you more money. 

You can find more than 800 US-listed dividend growth stocks on the Dividend Champions, Contenders, and Challengers list.

That list includes invaluable information on stocks that have raised their dividends each year for at least the last five consecutive years.

Jason Fieber's Dividend Growth PortfolioMy real-life and real-money dividend growth stock portfolio, which I call the FIRE Fund, generates the five-figure and growing passive dividend income I need to pay my bills and live autonomously.

Of course, I don’t buy stocks randomly. Neither should you.

Instead, the logical approach is to buy the highest-quality firms when their valuations are most appealing.

An undervalued dividend growth stock should offer 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’s fairly valued or overvalued.

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

The higher yield means more investment income on the same invested dollar.

That leads to greater long-term total return potential, because total return is made up of investment income and capital gain.

Meanwhile, capital gain is also given a possible boost via the “upside” that exists between the price you pay and intrinsic value.

If the market closes that gap over time, that’s capital gain that comes on top of whatever would ordinarily manifest as a company increases profit and becomes worth more.

This reduces risk, too.

You want to build a margin of safety.

This protects you from ending up with an investment that’s worth less than you paid.

That can happen if any number of unforeseen events come to pass.

Think mismanagement, new regulation, product recalls, etc. Almost anything.

Fellow contributor Dave Van Knapp put together an excellent piece on valuation.

It discusses the importance of valuation even more. It also provides a template that you can apply to almost any dividend growth stock.

Part of an overarching series of “lessons” on dividend growth investing, do make sure to read through Lesson 11: Valuation.

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)

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. The company controls the Pottery Barn, West Elm, and the eponymous Williams-Sonoma brands.

They operate in two segments: E-commerce (52.5% of FY 2017 sales) and Retail (47.5%).

Their ability to manufacture and sell 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.

The company has historically relied on their stores to tell a visual story about their products and acquire customers.

But retail these days is increasingly becoming about e-commerce.

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

More than half of their sales occur online, which is a substantial advantage over most other retailers.

They’ve generated 25%+ compound annual growth in e-commerce sales sales since FY 2000.

Whereas many other retailers are struggling to adapt to changes and grow, Williams-Sonoma isn’t.

This bodes well for the dividend. That’s music to my ears.

The company has increased its dividend for 13 consecutive years.

The 10-year dividend growth rate is 13.2%, which is obviously fantastic in an environment with low inflation.

With a payout ratio of 55.1%, the dividend appears very secure and in a good position to continue growing.

Along with that security and growth, the stock offers an appealing yield of 3.27%.

That’s well above the broader market. It’s also more than 80 basis points higher than the stock’s own five-year average yield.

This dividend is one of the larger, more secure, and faster-growing dividends in all of retail. And it’s backed by a venerable brand with high-quality products.

Of course, we invest in where a company is going. Not where it’s been.

So we’ll try to estimate the company’s future growth trajectory. This will help with valuing the business as a whole.

That growth model will rely both on what the company has done over the long term and a professional forecast for future profit growth.

Combining the known past and expected future in this manner should allow us to reasonably extrapolate out some numbers.

The company increased its revenue from $3.361 billion in FY 2008 to $5.292 billion in FY 2017. That’s a compound annual growth rate of 5.17%.

Not only is this an impressive top-line growth rate, it’s been very secular growth. Just a steady march upward.

Earnings per share advanced from $0.28 to $3.57 over this period, which is a CAGR of 32.69%.

Obviously outstanding. But this isn’t totally indicative of the true growth rate here.

First, FY 2008 included unprecedented economic difficulties. This was during the worst of the financial crisis. Earning 28 cents per share is more of a one-off event than anything else.

Second, I added back in $0.55 in EPS for FY 2017 due to the one-time tax charge the company took.

More recent bottom-line growth has been in the high-single-digit range, which is a more accurate reflection of earnings power.

Buybacks did help the cause, though. The outstanding share count is down by almost 20% over the last decade.

For further perspective, CFRA is forecasting that Willliams-Sonoma will compound its EPS at an annual rate of 9% over the next three years.

Continued growth in e-commerce sales, market share gains, and more buybacks support that thesis.

Speaking of e-commerce sales growth, the company’s Q3 2018 earnings report showed the E-commerce segment accounting for 55% of total sales. There’s notable acceleration here.

I think this growth forecast is fair.

And it would allow for like dividend growth. The payout ratio is reasonable. And the company is committed to regular dividend raises.

A 3%+ starting yield along with 7-10% annual dividend growth offers a lot to like from both income and total return standpoints.

The business’s quality is apparent.

It becomes even more apparent when you move over to the balance sheet.

The company has historically carried no long-term debt.

They’ve recently added a little long-term debt to the balance sheet under a line of credit, but it’s negligible.

Profitability, meanwhile, is robust. Especially for a retailer.

They’ve averaged annual net margin of 6.01% over the last five years. Return on equity averaged 23.68% over this period.

Both numbers are great. They were negatively impacted by one-time tax charges in FY 2017, however, or else they’d be even better.

The company leverages brand strength and high-margin direct-to-consumer sales to make up one of the more compelling stories in all of retail.

Risks should be considered, though.

There are essentially no switching costs here.

In addition, sales can be cyclical. They’re especially exposed to housing sales.

The company took a big hit during the financial crisis, but they remained profitable and continued to pay their dividend.

Competition is also brutal. And it’s only growing.

But if you’re looking for exposure to retail, this is one of the highest-quality and best-run retailers out there.

They’ve adapted swiftly and adeptly to changing trends. Recent growth rates have been impressive. And the dividend is one of the best in the game.

The stock dropped more than 11% after Q3 earnings. Comps were strong, but they apparently didn’t meet expectations.

Short-term volatility is usually a long-term opportunity, though.

Indeed, there appears to be a great long-term opportunity here…

The stock now trades for a P/E ratio of 14.34 right now. This adds back in the $0.55 aforementioned tax charge to TTM EPS.

That’s almost criminally low for a high-quality company. It’s well below the broader market’s P/E ratio. That P/E ratio also compares very favorably to the stock’s own five-year average P/E ratio of 19.6.

Every other basic valuation metric I can see is also below its recent respective historical average.

The P/CF ratio, for example, is sitting at below 8, which is substantially lower than the three-year average of over 11.

And the yield, as noted earlier, is more than 80 basis points higher than the stock’s five-year average yield.

This stock seems very cheap. But how cheap? What would a reasonable estimate of fair value look like? 

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’s a rather conservative forward-looking DGR, in my view. The demonstrated long-term DGR is well above that. The payout ratio is moderate. And the forecast for future EPS growth is also much higher than this.

However, I’m factoring in competitive pressure and cyclical risk. I always prefer to err on the side of caution.

The DDM analysis gives me a fair value of $61.35.

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.

Even a cautious valuation turns up a number much higher than the current price.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at. This adds balance, depth, and perspective to our conclusion.

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 $70.00.

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 4-star “BUY”, with a 12-month target price of $58.00.

I came out somewhere in the middle here. Averaging these three numbers gives us a final valuation of $63.12. That would imply the stock is potentially 20% undervalued here.

Bottom line: Williams-Sonoma, Inc. (WSM) is a high-quality retailer that controls some of the most venerable brands in home furnishings. They’ve adeptly adapted to changing trends. E-commerce now accounts for well over half of all their sales. With a 3%+ yield, strong underlying growth, a phenomenal balance sheet, and the potential that share are 20% undervalued, this is one of the best long-term plays in retail I know of.

-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 59. 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 borderline with a low risk of being cut. Learn more about Dividend Safety Scores here.

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