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The Catalog King

Williams-Sonoma (NYSE: WSM  ) is a premier brand and a market leader in the home-decor industry. It has an assortment of retail brands, including Pottery Barn and West Elm, which offer everything from kitchen appliances to home furnishings. One of the ways it has established its presence in the highly competitive specialty retail market is through its vast distribution of catalogs. Lots of catalogs.

Last year, Williams-Sonoma mailed more than 385 million catalogs, which is more than every man, woman, and child in America. If you ask people what their favorite decorating magazine is, many are likely to say the Pottery Barn catalog, which has established that retail brand as the industry standard.

Williams-Sonoma's catalog distribution sets it apart from the competition, but how has this strategy translated into sales? As mentioned earlier, the specialty retail industry is highly competitive, and many stores, including Bed Bath & Beyond (Nasdaq: BBBY  ) , Cost Plus (Nasdaq: CPWM  ) , Crate & Barrel, Pier 1 (NYSE: PIR  ) , Restoration Hardware (Nasdaq: RSTO  ) , and Sur La Table have imitated Williams-Sonoma's brands and eroded its market share. People say that imitation is the highest form of flattery, but after looking at Williams-Sonoma's last quarter earnings, I'm sure that some may not agree.

On top of the increased competition, Williams-Sonoma is also facing unfavorable economic conditions as the overall housing market continues to cool off and people are putting less money into their homes. During times of market recession, customers are more likely to "tighten their belts" and opt for the lower-cost alternatives on products they absolutely need. Such a scenario does not favor Williams-Sonoma, since its products are marketed as high-priced, quality merchandise.

Competition and cool markets certainly make life difficult, but Williams-Sonoma's catalogs play an integral role in driving sales through all three distribution channels: retail, Internet, and catalog. Direct-to-customer operations, which include catalog and Internet sales, account for 40% of Williams-Sonoma's total revenue, with the other 60% coming from the retail stores. In fact, during its recent earnings release, Williams-Sonoma estimated that 55% of its Internet sales were driven by customers who recently received a catalog.

Maybe the strength of its catalog business in driving sales and brand awareness is the reason management has reacted to these unfavorable conditions by reaffirming its commitment to shareholders and vowing to focus on long-term capital appreciation. In the 2005 annual report, management committed to returning approximately 70% of the 2006 free cash flow to shareholders in the form of dividends and stock buybacks. One might interpret this announcement as evidence of management's confidence in the sustainability of its earnings and that the best place to put company money is in its own undervalued stock.

A further commitment to shareholders is evident in that company insiders hold 13% of the outstanding stock. That stake aligns management's objectives with those of its shareholders. On top of this, CEO Howard Lester recently bought $10 million worth of company stock, which is roughly 2.5 times his total annual compensation (salary plus options). To paraphrase the great mutual fund manager Peter Lynch, there are plenty of reasons why insiders may sell company stock, but there is only one reason why they buy it -- they think it's going up.

On top of the potential signaling, management has done an excellent job maintaining a solid balance sheet. The company has very little debt, has cash on hand to pay dividends or fund expansion, and has increased its return on equity by 5% over the past five years to 19% today. Management has also been successful in reducing shipping costs even while fuel prices have continued to rise; doing so has resulted in some of the highest margins in company history.

Unfortunately, historically high margins can be a double-edged sword for investors. Once cost-cutting measures have been exhausted, earnings growth will have to come entirely from an increase in revenues. Reducing the cost of materials also runs the risk of losing customers by damaging their perception of product quality versus price, which ultimately hurts the bottom line.

Williams-Sonoma faces various challenges, including increased competition and unfavorable macroeconomic conditions, but its commitment to being the catalog king, its shareholders, and a strong balance sheet may enable them to weather the storm. In a cyclical industry such as retail, sometimes the best investments are made when market leaders with long-term sustainability fall on hard times in the short term.

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Bed Bath & Beyond is a both a Stock Advisor and an Inside Value recommendation.

Fool contributor Elliott Orsillo lives in Pasadena with his wife and his basset hound, Lola. His mom is addicted to Pottery Barn and its catalogs. At the time of this writing, he holds no positions in any of the companies mentioned above. The Motley Fool has a disclosure policy.

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