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Williams-Sonoma Hunkers Down in Q1

Do you know the difference between a Hunker and a Barnburner? A Barnburner was a member of the reform wing of the New York state Democratic Party in the 19th century, while a Hunker was a member of the conservative opposition. Since then, hunkering down has come to refer to holding to a course, even when things aren't going well for the person doing the hunkering.

The two words are particularly appropriate in describing Williams-Sonoma (NYSE: WSM  ) . For several years, the company's Pottery Barn brand was knocking the cover off the ball. But since the second quarter of last year, when its comp sales turned negative, the company has been in hunker mode. It continued in that stance for the first quarter of 2007.

Q1 sales and EPS
The stock surged after the announcement of better-than-expected results for the quarter, but it quickly fell off as cooler heads prevailed. The reality is that earnings continue to head south -- just not as rapidly.

Total revenues for the quarter increased 5.2% -- and keep in mind that all of the numbers we'll look at here exclude the effect of exiting the Hold Everything brand in Q1 of 2006. Revenues on the bricks-and-mortar side of the business gained 5.6% -- square footage increased 6.3%, and same-store sales were down 0.8% -- while the direct-to-consumer business grew revenues 4.8%.

Earnings per share excluding unusual items came in at $0.17, down 19% from $0.21 last year but beating the guidance the company had previously announced of $0.11-$0.15.

Behind the numbers
The problem for Williams-Sonoma, in addition to negative comps, is margin weakness. Gross margin fell 170 basis points in Q1 -- partially from soft sales deleveraging occupancy expense, and partially from markdowns and inventory liquidation activities. Sales, general, and administrative expenses were 60 basis points lower than last year -- respectable, but not nearly enough to offset the margin slide.

I'm also concerned about inventory creep. During Q1 of 2006, the last quarter when the Pottery Barn brand posted positive comp sales, inventory was only 5% higher than in the prior year. Since then, inventories have steadily crept up as sales trends have worsened -- up 8% in Q2; up 12% in Q3; up 17% in Q4. They flattened during the first quarter of 2007 -- up 17% -- so at least the situation is not getting worse.

In its release, management noted seeing higher inventory levels among competitors and is concerned about this situation leading to higher industrywide markdowns. It sounds to me as though the company is signaling its own problems. If so, we can expect continued margin weakness in future quarters. The company lowered Q2 EPS guidance by about 10% but held to the full-year estimate because it beat guidance for Q1.

Some Foolish advice
The first quarter has been tough for retailers in general. Gas prices are high, the economy is mushy, and the housing sector is in a full-fledged funk. But Target (NYSE: TGT  ) and Best Buy (NYSE: BBY  ) continue to soar. Closer to home for Williams-Sonoma, Bed Bath & Beyond (Nasdaq: BBBY  ) doesn't report Q1 results until June, but last quarter, the company showed no perceptible weakening in its business. Until Williams-Sonoma can reinvigorate the Pottery Barn brand, I think the hunkering will continue.

For more on home-related retailing, check out:

Best Buy and Bed Bath & Beyond are Motley Fool Stock Advisor selections. Bed Bath & Beyond is also an Inside Value recommendation. Take a free 30-day trial to either market-beating newsletter.

Fool contributor Timothy M. Otte surveys the retail scene from Dallas. He welcomes comments on his articles but doesn't own shares of any companies mentioned in this article.

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