Broken Pottery Barn

Shares of Williams-Sonoma (NYSE: WSM  ) dropped nearly 10% yesterday to close at $31.70, the result of a disappointing third-quarter earnings announcement and lowered fourth-quarter guidance. On the related conference call, management unveiled some new strategies to improve future operating performance, especially for the company's struggling Pottery Barn unit. The company's problems, however, seem bigger than the proposed solutions.

Net earnings fell 21% in the third quarter to $29.1 million from $37.1 million a year ago. Diluted earnings per share fell 19% to $0.25, from $0.31 over the same period. The earnings declines occurred in spite of a 3% increase in revenue to $853 million. To some extent, this lower profitability could be explained by special circumstances. In particular, results were hurt by the implementation of new accounting pronouncements and the elimination of Williams-Sonoma's Hold Everything unit.

Unfortunately for the company and its shareholders, profits were lower even when the negative effects of special events were excluded from the financial results. Net earnings fell 9% on a non-GAAP basis, a consequence of both lower gross margins and higher overhead costs. New store openings increased revenue, but overall sales at existing stores were flat on a year-over-year basis.

Williams-Sonoma's biggest challenge seems to be the performance of its Pottery Barn unit, the company's biggest brand. Management points to a soft market for home-related retailers and heavy promotional activity from competitors to explain the 2.5% drop in same-store sales. The company certainly does not lack for competition. The CEO considers Restoration Hardware (Nasdaq: RSTO  ) , Target (NYSE: TGT  ) , and even Wal-Mart (NYSE: WMT  ) to be among the imitators of Pottery Barn's product lines and merchandising strategy.

Williams-Sonoma intends to employ some new tactics to better differentiate itself from the competition this holiday season and beyond. Its catalogs will seek to highlight gift-giving ideas in compelling ways and its stores will feature pre-wrapped gifts. Pottery Barn plans to sponsor a regular segment on CBS' (NYSE: CBS  ) Early Show to inspire decorating and hospitality purchases. Williams-Sonoma also sees great long-term promise in the early success of its newest retailing concepts, such as West Elm and PB Teen.

This fourth quarter will provide an important test of management's ability to refresh the value proposition of Williams-Sonoma's brands. The company, however, is already trying to adjust expectations by lowering revenue guidance by $46 million to a range of $1.23 billion to $1.26 billion and earnings guidance by $0.15 to a range of $1.00-$1.06 per share. Ultimately, Williams-Sonoma may find that its Pottery Barn merchandise is too easily copied by discounters for the company to compete while sustaining high profit margins.

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Fool contributorMichael Leibertwelcomes your feedback. He does not have a position in the stocks of any of the companies mentioned above.

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