WSM

Williams-Sonoma (NYSE: WSM)

Analyst Report

Anjana RadhakrishnanStudent Managed Fund

MBA 2004

Date: 6 December 2003 Sector: Consumer Discretionary Industry: Retail

Williams-Sonoma Inc.(New York Stock Exchange)

3250 Van Ness AvenueSan Francisco

California -94109

http://www.williams-sonoma.com

NYSE: WSMP/E 26.9

Employees 6,000Common Stock 116.76

millionMarket Cap $ 4.1 billion

Business Summary

Williams-Sonoma, Inc. is a specialty retailer of products for the home. The retail segment of its business sells its products through its four retail store concepts: Williams-Sonoma, Pottery Barn, Pottery Barn Kids and Hold Everything. The direct-to-customer segment of its business sells similar products through its eight direct-mail catalogs: Williams-Sonoma, Pottery Barn, PBteen, Pottery Barn Kids, Pottery Barn Bed + Bath, Hold Everything, West Elm and Chambers, and four e-commerce Websites: wsweddings.com, williams-sonoma.com, potterybarn.com and potterybarnkids.com. Its principal concepts in both retail and direct-to-customer are Williams-Sonoma, which sells cookware essentials; Pottery Barn, which sells contemporary tableware and home furnishings, and Pottery Barn Kids, which sells stylish children's furnishings.

Share PerformancePrice ($): 34.25 52 Week High: 37.29 Currency: USDVolume (millions): 0.5 52 Week Low: 19.90

Financial SummaryFor the 39 weeks ended 11/2/03, net sales rose 17% to $1.75 billion. Net income rose 23% to $55.1 million. Revenues reflect higher retail sales from 62 new stores opened. Net income reflects favorable leveraging of fixed occupancy expenses..

Value lineBeta 1.40

Timeliness 2Safety 3

Technical 3Financial Strength

B++

Industry Ranking

18 of 98

Analyst RatingZack’s Moderate

BuyMoneycentral Moderate

BuyWSJ Moderate

BuyMerril Lynch Buy

Prudential NeutralDeutsche

BankHold

Bear Stern Peer Perform

RECOMMENDATION:

BUY# of shares: 400Share Price: $ 34.25Stop Loss: $ 27.40

Company Overview

Williams-Sonoma. (referred to as ‘WSM’ henceforth) was founded in 1956 by Charles E

Williams who opened the first store in Sonoma, California. WSM is a specialty retailer of home

products. WSM has three different channels of sale for their products. First, they sell their

products through four retail store concepts – Williams Sonoma, Pottery Barn, Pottery Barn kids

and Hold Everything. The second channel is the direct –to –customer segment which includes

seven direct mail catalogues - Williams Sonoma, Pottery Barn, Pottery Barn kids and Hold

Everything, Bed + Bath , West Elm and Chambers. The third channel is the e-commerce

websites – wsweddings.com, Williams-sonoma.com, potterybarn.com and potterybarnkids.com

Williams-Sonoma branch of WSM deals with the cookware essentials, pottery barn sells

contemporary tableware and pottery barn kids’ deals primarily with the concept of stylish

children’s furniture. The direct-to-customer channel in the business was started in 1972 and

today it accounts for 39.3% of their revenues. WSM acquired Pottery Barn in 1986.

WSM went public in the year 1982.As of February 2003, WSM had 478 retail stores

across 48 states. The company intends to increase the leased footage area by 9 – 11% by the end

of fiscal year 2003.

RETAIL STORES

Williams Sonoma Pottery Barn Pottery Barn Kids Hold Everything

DIRECT - TO -CUSTOMER

Williams Sonoma Pottery Barn Pottery Barn Kids Hold Everything Bed + Bath West Elm Chambers

E-COMMERCE

Wsweddings.com Potterybarnkids.com Williamssonoma.com Potterybarn.com

WSM purchases most of its supplies/products from foreign and domestic manufacturers

and importers. The largest supplier accounted for 4% of their supplies in 2002. Approximately

58% of their merchandise was foreign sourced in 2002.

Competition and Competitors

The specialty retail business is highly competitive. WSM’s retail stores, mail order

catalogs and websites compete with other department stores, discount stores and specialty stores.

The business is also subject to fluctuating seasonal demands. Historically, a large portion of their

income is generated during the period between October and December. But this is a general

pattern seen in retail industry. The key competitors for WSM are as follows:

Ashley Furniture

Bed Bath and Beyond

Bombay Company

Euromarket Designs

Decorize

Hanover Direct

Pier 1 Imports

IKEA

For the purpose of analysis, the performance of WSM was compared with Hanover Direct

(HNV) and Pier 1 Imports (PIR).

PAST PERFOMANCE

The year 2002 has been a historic year for WSM. In 2002, WSM achieved a pre-tax operating

margin of 8.6%, the highest in the history of the company. The company achieved $ 2.3 billion

in net revenue and increased their diluted earning per share by 60%.

Growth TrendsRevenues and Net Income

Revenue Grow th (5 year)

-10-5

05

1015

2025

WSM HNV PIR Industry S & P 500

Revenue Gorwth (%)

Revenues and Net Income

0

500

1000

1500

2000

2500

1998 1999 2000 2001 2002

c

Net Profit Margin

Net Profit Margin (%)

-6

-4

-2

0

2

4

6

8

WSM HNV PIR Industry S & P 500

Net Profit Margin (%)

0%

1%

2%

3%

4%

5%

6%

1998 1999 2000 2001 2002

The declining trend in the Net Profit Margin from 1998 to 2000 could be attributed to the

expenses WSM had to incur (and investment) to build new facilities, improve infrastructure and

The revenues and net income of WSM has

been on an upward trend from 1998 to 2002.

The revenues for WSM consist of retail sales,

direct-to-customer sales and shipping fees. The

increase in sales in 2001 and 2002 were

primarily from 63 new stores (2002) and 31

new stores (2001) of Williams Sonoma,

Pottery Barn and Pottery Barn kids. The 5-year

average sales growth of the company has been

higher than the industry average and its

competitors.

to reorganize management structure to create more synergy between sales channels. The net

profit margin has been on a rebound phase since 2000. This measure for the company is higher

than the industry average and S & P 500.

Earnings per Share (EPS)

EPS (5-year average)

-20

-10

0

10

20

30

WSM HNV PIR Industry S & P 500

EPS

0

0.2

0.4

0.6

0.8

1

1.2

1998 1999 2000 2001 2002

spending declined in 2001; the company could not make up for the huge investments it had made

for the holiday season. The lesson learnt from this mistake is reflected in its cautious outlook for

2003.

Free Cash Flow

The EPS of WSM is much higher than

the competitors and the industry

average. The decline in EPS in the year

2000 could be attributed to the extra

expenses incurred (as mentioned above)

and the rough economic /market

conditions in that particular year. Prior

to 2002, the company had achieved

exemplary rates of growth and therefore

the management projected its future

performance on the basis of the high

growth rates. When the consumer

Free Cash Flow

-100

-50

0

50

100

150

200

1998 1999 2000 2001 2002

Barn “ brand increased by 50% in the year 2001. The Pottery Barn online wedding and gift

registry was launched the same year.

Dividends

Williams-Sonoma have not paid any dividneds to its shareholders.

Financial Health

Debt/Equity ratio

Debt/Equity Ratio

00.20.40.60.8

11.21.4

WSM HNV PIR Industry S & P 500

Interest Coverage

WSM’s debt to equity ratio is much lower than

that of its competitors and industry average.

According to Harry Domash of

www.winninginvesting.com, a debt-equity

ratio of less than 0.4 is a sign of “bullet proof”

stock. The debt-equity ratio of WSM is 0.02.

Free cah flow is the measure of cash that is

available from WSM’s business operations

after the payment of interest and tax, for

distribution of dividends or for reinvestment

in business. The proceeds of disposals and

acquisitions are excluded from this

calculation. The sales for the brand “Pottery

The interest coverage ratio of WSM is 21.8x. This ratio reiterates the low debt burden on the

company.

Management Performance

Return on Equity (ROE)

ROE

0

5

10

15

20

25

WSM HNV PIR Industry S & P 500

.

Return on Assets (ROA)

ROE = Income/shareholder equity

ALV’s ROE is much greater than the industry

average and equal to its competitor Pier 1 Imports.

From company’s stand point, the ROE has been

increasing from year 2000. ROE has increased from

13.3% in 2000 to 19.3% in 2002 reflecting that the

management has been very effectively investing the

resources provided by the shareholders.

Return on Invested Capital (ROIC)

According to www.global.factiva.com, the return on invested capital for the

past year for WSM is 18.7%. The five year average ROIC for the company is

15.5%. The high ROIC shows that the company has made good use of its

debt and capital.

Economic Value Added

In the year ending 2002, the invested capital for WSM was $662,049,000

(http://global.factiva.com). The weighted average cost of capital (WACC) from

www.bloomberg.com is 10.43%.

Economic Value Added = (ROIC – WACC) x Invested Capital

= (18.7 -10.43) x $662,049,000 = $54,751,452.3

Market Multiples

P/E Ratio

WSM PIR HNV Industry S & P 500

P/E ratio 30.3 18.2 21.3 34.3 31.1

ROA = Net Income / Total Assets

WSM’s ROA is higher than the industry

average indicating that the company has used

its assets very efficiently. This is often a good

sign of management.

ROA

-20

-15

-10

-5

0

5

10

15

WSM HNV PIR Industry S & P 500

ROA (%)

The P/E ratio for WSM is lower than that of the industry average. This suggests that stock of

WSM might be undervalued and its attainable price target is high. The view is also reflected in

the “Moderate Buy” and “Overweight” recommendations of various analysts.

PEG

The PEG ratio for WSM is 1.3, which is lower than the industry average of

1.8 indicating that the stock is undervalued. This could be an indicator that

the investors expect the EPS growth to be much higher than the street

consensus number.

Stock Valuation

Capital Structure

99.53% of WSM’s capital is from shareholders and the remaining 0.47% is funded through short

term and long term debt. WSM has no preferred stock. This means that the company is not as

risky since they do not owe any money.

Equity Capital Structure Debt Capital Structure

Market Capitalization =

$4124.95 MShort-term debt = $ 7.74 M

Preferred equity = 0 Long-term debt = $11.91 M

Common Weight = 99.53% Short Debt Weight = 0.19%

Preferred Weight = 0% Long Debt Weight = 0.29%

Cost of Capital

The Weighted Average Cost of Capital for ALV is calculated under the following assumptions

(based on Bloomberg):

Rf = risk-free rate = 5 year treasury bond rate = 4.23%

Rm - Rf = historical long term equity risk premium = 6.23%

Beta = volatility of the company = 1.22

Long-term growth rate = 19.41% Country Premium = 5.12%

Note rate = 1.87% Bond rate = 4.32%

Debt adjustment factor = 1.38 Tax rate = 38.50%

DebtCommon

Equity

Preferred

EquityWACC

Weight (%) 0.47 99.53 0

Cost (%) 2.80 10.47 0

Wtd. Avg. 0.0001316 0.10420791 0 10.43%

Intrinsic Value Calculation

An intrinsic value/share is a hypothetical value of the company based on the sum of its future

earnings. This value can be compared to a stock’s current price to determine if it is overvalued or

undervalued. The Intrinsic Value for WSM is calculated under the following assumptions:

R = initial earnings = $ 134,900,000.00

n = length of the first stage = 10yrs

E1 = first stage earnings growth rate = 18.7% (www.moneycentral.com)

E2 = second stage earnings growth rate = 6.0% (www.quicken.com)

D1 = first stage discount rate = 15%

D2 = second stage discount rate = 15%

www.quicken.com

05

1015202530354045

Intrinsic Value Current Stock Price

The above calculations show that stock of WSM is undervalued. One must note that for a

company like WSM with new products, new stores and new markets, the growth may be above

the predicted norms on one hand and may also be lower than expected due to sudden market

changes.

Risk Analysis

Insider Trading

From www.wsj.com:

# shares outstanding 117 M

% owned by insiders 5 %

# sold in the past 6

months

130,720 = 0.3% of insider

shares

Discounted Value $1.61B

Continuing Value $3.27 B

Long-term Debt $11.91 M

# shares outstanding 117 M

Intrinsic Stock

Price$41.67

Current Stock

Price$ 34.20

# purchased by insider 0

As seen from the above table, around 0.3% of insider shares were traded (sold) over the last six

month period.

The Board of Directors

Name Occupation Independent

Charles E Williams Founder No

W Howard LesterDirector

Director – Harold Department Stores Yes

Edward E MuellerDirector

President and CEO of AmeritechYes

Adrian BellamyDirector

Chairman – Body Shop InternationalYes

Patrick J ConnolyDirector

Vice-President – Mail Order (WSM)No

Jeanne JacksonDirector

President and CEO of WalmartYes

Micheal R LynchDirector

Director – Goldman SachsYes

James A McMahan

Director

Chairman – McMahan Furniture Stores Yes

Heather M Reisman

Director

Chairman and CEO of Indigo Books and Music Yes

Richard T Robertson Director

Director – Warner Bros Domestic Television

Distribution

Yes

8 out of 10 directors on the board are independent.

Valuation Models

CAPM model

Risk-free rate (Rf) = 4.25% (based on 10-year T-bond rate on 11/17/2003)

Market Return (Rm) = 7.25% (Expected return on S & P 500 for the five year horizon)

Beta = 1.40 (www.valueline.com)

Formula CAPM:

CAPM = Rf + (Rm - Rf ) = 0.0425 +1.40 (0.075 – 0.0425) = 0.099375 = 8.8%

The expected return on WSM based on its risk and the prevalent market and risk free rate is

8.8%.

AVERAGE ANNUAL GROWTH RATE

ROE (5 year average) 16.4%

Retention ratio 100%

Annual growth rate = retention ratio x return on equity:100% x 18.7% = 16.4%

Growth Rate in Earnings

Earning per share (1998) $ 0.48

Earning per share (2002) $ 1.07

PV = 0.48; FV = 1.07; N =5; PMT = 0

Therefore g = 17.4%

The average of both the growth rate is assumed to be the growth rate for further analysis. The

average growth rate is 16.89%.

No Growth Model

Vo = Current EPS / K

= 1.07 /0.088 = $ 12.16

The current market price is $ 34.20, therefore ($ 34.20 - $ 12.16) = $ 22.04 is the value of the

growth. This means that 64% of the value of the company comes form growth and hence it is a

“buy”.

P/E Model

Average P/E for past five years (1998 – 2002)

= (29.8 +34.5+ 29.2 +25.2 + 24.6) / 5 = $ 28.66

The expected EPS in 2003 = $ 1.28

Based on this data, the expected price in the year 2004 = Avg. P/E x Exp. EPS

= $ 28.66 x $ 1.28 = $ 36.7

Based on this model the value of growth opportunities in terms of stock price appreciation is

limited.

Valuepro.net Stock Valuation

This proprietary valuation model is based on observed historical data and growth rate estimates.

According to that analysis the value of the stock is $39.2, which indicates that the stock is

undervalued. The growth rate assumed in this model is 20 %.

Intrinsic Value Growth Rate$ 39.2 20%

Economic Value Added

$54,751,452.3 / 0.1043 = $ 524,942,016.3 + 4,100,000,000 = 4,624,942,016 – 11,910,000

= $ 4,613,032,016

$ 4,613,032,016 / 116,760,000 = $ 39.51

These valuation models indicate that at current price, WSM is undervalued.

Risk Factors

WSM must successfully anticipate changing consumer preferences and buying trends,

and manage our inventory commensurate with customer demand.

WSM’s success depends upon their ability to anticipate and respond to changing merchandise

trends and customer demands in a timely manner. Consumer preferences cannot be predicted

with certainty and may change between sales seasons. If they misjudge either the market for their

merchandise or our customers’ purchasing habits, their sales may decline significantly and they

may be required to mark down certain products to sell the resulting excess inventory or sell such

inventory through their outlet stores at prices which are significantly lower than their retail

prices, each of which would harm their business and operating results.

In addition, they must manage their inventory effectively and commensurate with customer

demand. Much of their inventory is sourced from vendors located outside the United States.

Thus, they usually must order merchandise, and enter into contracts for the purchase and

manufacture of such merchandise, well in advance of the applicable selling season and

frequently before trends are known. The extended lead times for many of their purchases may

make it difficult for them to respond rapidly to new or changing trends. In addition, the seasonal

nature of the specialty home products business requires them to carry a significant amount of

inventory prior to peak selling season. As a result, they are vulnerable to demand and pricing

shifts and to misjudgments in the selection and timing of merchandise purchases. If they do not

accurately predict their customers’ preferences and acceptance levels of their products, their

inventory levels will not be appropriate and their business and operating results may be

negatively impacted.

WSM’s business depends, in part, on factors affecting consumer spending that are out of

their control.

Their business depends on consumer demand for their products and, consequently, is sensitive to

a number of factors that influence consumer spending, including general economic conditions,

disposable consumer income, recession and fears of recession, war and fears of war, inclement

weather, consumer debt, interest rates, sales tax rates and rate increases, consumer confidence in

future economic conditions and political conditions, and consumer perceptions of personal well-

being and security generally. Adverse changes in factors affecting discretionary consumer

spending could reduce consumer demand for their products, thus reducing their sales and

harming their business and operating results.

The growth of WSM’s sales and profits depends, in large part, on their ability to

successfully open new stores.

In each of the past three fiscal years, their retail stores have generated approximately 60% of

their net revenues. They plan a net increase of approximately 34 new retail stores in fiscal 2003

as part of their growth strategy. There is no assurance that this strategy will be successful. Their

ability to open additional stores successfully will depend upon a number of factors, including:

o identification and availability of suitable store locations;

o success in negotiating leases on acceptable terms

o ability to secure required governmental permits and approvals

o hiring and training of skilled store operating personnel, especially management

o timely development of new stores, including the availability of construction

materials and labor and the absence of significant construction and other delays in

store openings

Many of these factors are beyond their control. For example, for the purpose of identifying

suitable store locations, they rely, in part, on demographics surveys regarding location of

consumers in their target market segments. While they believe that the surveys and other relevant

information are helpful indicators of suitable store locations, we recognize that the information

sources cannot predict future consumer preferences and buying trends with complete accuracy.

In addition, time frames for lease negotiations and store development vary from location to

location and can be subject to unforeseen delays. Construction and other delays in store openings

could have a negative impact on their business and operating results. There can be no assurance

that they will be able to open new stores or that, if opened, those stores will be operated

profitably.

WSM faces intense competition from companies with brands or products similar to ours.

The specialty retail and direct-to-customer business is highly competitive. Their specialty retail

stores, mail order catalogs and Internet websites compete with other retail stores, other mail

order catalogs and other e-commerce websites that market lines of merchandise similar to theirs.

They compete with national, regional and local businesses utilizing a similar retail store strategy,

as well as traditional furniture stores, department stores and specialty stores. The substantial

sales growth in the direct-to-customer industry within the last decade has encouraged the entry of

many new competitors and an increase in competition from established companies.

The competitive challenges facing us include, without limitation:

o anticipating and quickly responding to changing consumer demands better

than their competitors

o effectively marketing and competitively pricing their products to

consumers in several diverse market segments

o developing innovative, high-quality products in colors and styles that

appeal to consumers of varying age groups and tastes, and in ways that

favorably distinguish us from their competitors.

In light of the many competitive challenges facing them, there can be no assurance that they will

be able to compete successfully. Increased competition could adversely affect their sales,

operating results and business.

We depend on key domestic and foreign vendors for timely and effective sourcing of their

merchandise, and we are subject to various risks and uncertainties that might affect their

vendors’ ability to produce quality merchandise.

Their performance depends on their ability to purchase their merchandise in sufficient quantities

at competitive prices. They purchase their merchandise from numerous foreign and domestic

manufacturers and importers. They have no contractual assurances of continued supply, pricing

or access to new products, and any vendor could discontinue selling to us at any time. There can

be no assurance that they will be able to acquire desired merchandise in sufficient quantities on

terms acceptable to them in the future. Any inability to acquire suitable merchandise or the loss

of one or more key vendors could have a negative effect on their business and operating results

because we would be missing products that they felt were important to their assortment, unless

and until alternative supply arrangements are secured. They may not be able to develop

relationships with new vendors, and products from alternative sources, if any, may be of a lesser

quality and/or more expensive than those we currently purchase.

In addition, they are subject to certain risks, including availability of raw materials, labor

disputes, union organizing activity, inclement weather, natural disasters, and general economic

and political conditions, that might limit their vendors’ ability to provide us with quality

merchandise on a timely basis. For these or other reasons, one or more of their vendors might not

adhere to their quality control standards, and we might not identify the deficiency before

merchandise ships to their stores or customers. Their vendors’ failure to manufacture or import

quality merchandise in a timely and effective manner could damage their reputation and brands,

and could lead to an increase in customer litigation against us and attendant increase in their

routine litigation costs.

WSM’s dependence on foreign vendors subjects us to a variety of risks and uncertainties.

They source their products from manufacturers in over 34 countries. Specifically, in fiscal 2002,

approximately 58% of their merchandise purchases were foreign sourced, primarily from Asia

and Europe.

Their dependence on foreign vendors means, in part, that we may be affected by declines in the

relative value of the U.S. dollar to other foreign currencies. Although substantially all of their

foreign purchases of merchandise are negotiated and paid for in U.S. dollars, declines in foreign

currencies and currency exchange rates might negatively affect the profitability and business

prospects of one or more of their foreign vendors. This, in turn, might cause such foreign

vendors to demand higher prices for merchandise, hold up merchandise shipments to us, or

discontinue selling to us, any of which could ultimately reduce their sales or increase their costs.

They are also subject to other risks and uncertainties associated with changing economic and

political conditions in foreign countries. These risks and uncertainties include import duties and

quotas, work stoppages, economic uncertainties (including inflation), foreign government

regulations, wars and fears of war, political unrest and trade restrictions. They cannot predict

whether any of the countries in which their products are currently manufactured or may be

manufactured in the future will be subject to trade restrictions imposed by the U.S. or foreign

governments or the likelihood, type or effect of any such restrictions. Any event causing a

disruption or delay of imports from foreign vendors, including the imposition of additional

import restrictions, restrictions on the transfer of funds and/or increased tariffs or quotas, or both,

against home-centered items could increase the cost or reduce the supply of merchandise

available to us and adversely affect their business, financial condition and operating results.

Furthermore, some or all of their foreign vendors’ operations may be adversely affected by

political and financial instability resulting in the disruption of trade from exporting countries,

restrictions on the transfer of funds and/or other trade disruptions.

WSM must timely and effectively deliver merchandise to their stores and customers.

They cannot control all of the various factors that might affect their fulfillment rates in direct-to-

customer sales and/or timely and effective merchandise delivery to their stores. They rely upon

third party carriers for their merchandise shipments, including shipments to their customers and

to and from all of their stores. Accordingly, they are subject to the risks, including labor disputes

(e.g., west coast port strike of 2002), union organizing activity, inclement weather, natural

disasters, and possible acts of terrorism associated with such carriers’ ability to provide delivery

services to meet their shipping needs. Failure to deliver merchandise in a timely and effective

manner could damage their reputation and brands. In addition, they are seeing fuel costs increase

substantially and airline companies struggle to operate profitably, which could lead to increased

fulfillment expenses and negatively affect their business and operating results by increasing costs

and negatively affecting the efficiency of their shipments.

Their failure to successfully manage their order-taking and fulfillment operations might

have a negative impact on their business.

The operation of their direct-to-customer business depends on their ability to maintain the

efficient and uninterrupted operation of their order-taking and fulfillment operations and our e-

commerce websites. Disruptions or slowdowns in these areas could result from disruptions in

telephone service or power outages, inadequate system capacity, human error, natural disasters

or adverse weather conditions. These problems could result in a reduction in sales as well as

increased selling, general and administrative expenses.

WSM may experience fluctuations in their comparable store sales.

WSM’s success depends, in part, upon their ability to increase sales at theexisting stores. Various

factors affect comparable store sales, including the number of stores they open, close and expand

in any period, the general retail sales environment, changes in sales mix between distribution

channels, their ability to efficiently source and distribute products, changes in their merchandise

mix, competition, current economic conditions, the timing of release of new merchandise and

promotional events, the success of marketing programs, and cannibalization of existing store

sales by new stores. Among other things, weather conditions can affect comparable store sales,

because inclement weather can require us to close certain stores temporarily and thus reduce

store traffic. Even if stores are not closed, many customers may decide to avoid going to stores in

bad weather. These factors may cause our comparable store sales results to differ materially from

prior periods and from earnings guidance we have provided.

Our failure to successfully manage the costs and performance of our catalog mailings

might have a negative impact on our business.

Postal rate increases and paper and printing costs affect the cost of their catalog mailings. They

rely on discounts from the basic postal rate structure, such as discounts for bulk mailings and

sorting by zip code and carrier routes. The ur cost of paper has fluctuated significantly during the

past three fiscal years, and their paper costs may increase in the future.

WSM must successfully manage our Internet business.

The success of their e-commerce business depends, in part, on factors over which they have

limited control. In addition to changing consumer preferences and buying trends relating to

Internet usage, they are vulnerable to certain additional risks and uncertainties associated with

the Internet, including changes in required technology interfaces, website downtime and other

technical failures, changes in applicable federal and state regulation, security breaches, and

consumer privacy concerns. Their failure to successfully respond to these risks and uncertainties

might adversely affect the sales through their e-commerce business, as well as damage their

reputation and brands.

WSM must successfully manage the complexities associated with a multi-channel and

multi-brand business.

During the past few years, with the launch and expansion of their e-commerce business, new

brands and brand expansions, their overall business has become substantially more complex. The

changes in their business have forced us to develop new expertise and face new challenges, risks

and uncertainties. For example, they face the risk that their e-commerce business might

cannibalize a significant portion of their retail and catalog businesses. While they recognize that

their e-commerce sales cannot be entirely incremental to sales through their retail and catalog

channels, they seek to attract as many new customers as possible to their websites. They

continually analyze the business results of their three channels and the relationships among the

channels, in an effort to find opportunities to build incremental sales. However, they cannot

ensure that, as their e-commerce business grows, it will not cannibalize a portion of their retail

and catalog businesses.

They have recently introduced a new brand, West Elm, and may introduce additional new brands

and brand extensions in the future. Their introduction of new brands and brand extensions poses

another set of risks. If they devote time and resourrces to new brands and brand extensions, and

those businesses are not as successful as they planned, then they risk damaging their overall

business results. Alternatively, if their new brands and brand extensions prove to be very

successful, they risk hurting their existing brands through the migration of customers to the new

businesses. There can be no assurance that they can and will introduce new brands and brand

extensions that improve their overall business and operating results.

WSM’s inability to obtain commercial insurance at acceptable prices might have a

negative impact on our business.

During fiscal 2002, there was a substantial increase in the costs of insurance, partly in response

to the terrorist attacks of September 11, 2001, and financial irregularities and other fraud at

publicly-traded companies. They believe that extensive commercial insurance coverage is

prudent for risk management and anticipate that their insurance costs will increase substantially.

In addition, for certain types or levels of risk (e.g., risks associated with earthquakes or terrorist

attacks), they might determine that they cannot obtain commercial insurance at acceptable prices.

Therefore, they might choose to forego or limit their purchase of relevant commercial insurance,

choosing instead to self-insure one or more types or levels of risks. If they suffer a substantial

loss that is not covered by commercial insurance, the loss and attendant expenses could have a

material adverse effect on their business and operating results.

WSM’s inability or failure to protect our intellectual property would have a negative

impact on our business.

Our trademarks, service marks, copyrights, patents, trade dress rights, trade secrets, domain

names and other intellectual property are valuable assets that are critical to our success. The

unauthorized reproduction or other misappropriation of our intellectual property could diminish

the value of our brands or goodwill and cause a decline in our sales. There can be no assurance

that we will be able to adequately protect our intellectual property or that the costs of defending

our intellectual property will not adversely affect our operating results.