Image Shown: Shares of RH have exploded higher since the news broke that Berkshire Hathaway Inc had taken a stake in the firm’s equity back in 2019, though shares of RH have shifted lower in recent months.
Executive Summary: RH is an innovative home furnishing company that pairs its products with interior/exterior design services to offer a comprehensive package. The company primarily targets affluent households in the US, Canada, and the U.K. RH has tremendous pricing power and its margins have increased significantly in recent fiscal years, even during the COVID-19 pandemic, and its net revenues are trending higher as well. The firm is expanding into the high-end hospitality industry and has several projects that are set to come online in 2022 and beyond. RH is a stellar free cash flow generator with a manageable net debt load. Though the company has been executing nicely of late, as witnessed by its stellar financial performance and recent guidance increases, shares of RH have sold off in recent months. In our view, the recent selloff is a function of broad based market weakness, but it also may be due to investors growing more concerned about the impact higher interest rates and a deteriorating wealth effect may have on housing and home furnishing demand and on its push into the hospitality space, respectively. We continue to view RH’s long-term capital appreciation upside potential favorably, however.
By Callum Turcan
RH (RH), formerly known as Restoration Hardware, sells luxury home furnishings including furniture, lighting, textiles, bathware, décor, outdoor and garden products along with products that are geared towards families with children. It also offers interior/exterior design services, which helps drive sales of its products, and the company has a membership program which includes discounts for its products and some complementary services.
One quick housekeeping item. RH’s fiscal year ends in late-January or early-February.
Back in 2019, Berkshire Hathaway Inc (BRK.A) (BRK.B) acquired a position in RH’s equity which we covered in this article here. Since then, shares of RH have more than doubled. RH’s omnichannel selling capabilities enabled the company to meet robust home improvement demand during the coronavirus (‘COVID-19’) pandemic. The company’s financials were on a nice upward trend before the pandemic hit and have continued to improve through the pandemic.
Households hunkered down indoors during the worst of the public health crisis, and money that would have been spent on services was instead directed towards physical goods. Home improvement activities proved to be incredibly popular during the initial phases of the pandemic, especially in the US and Canada. RH was well-positioned to capitalize on this dynamic and its luxury home furnishing offerings sold quite well. In recent fiscal quarters, RH’s financials have continued to trend in the right direction.
However, as a luxury player tied to the cyclical housing (home furnishing) market that is tied to interest rate movements and a beneficiary of the massive wealth effect from strong investment returns the past few years, RH will have its work cut out for it to keep the momentum going. Before covering RH’s stellar financials, we will first provide an overview of its operations and major growth ambitions.
Operations Overview
RH’s distribution channels are well-integrated and include its galleries, online portals, and catalogs (which the firm refers to as source books). The company operates under the RH brand (sells about every home furnishing product imaginable) and Waterworks brand (focuses on kitchen and bath home furnishing products), which are considered upscale. RH primarily targets affluent households in the U.S., Canada, and the UK, and its “goal is to establish RH as the undisputed design and quality leader of the luxury home furnishings sector (Form 10-K).”
Image Shown: As of October 30, 2021, the number of Galleries, Outlets and Showrooms that RH operates. Image Source: RH.
What we find interesting is that RH has been slowly optimizing its physical retail footprint in recent fiscal years. In February 2019, RH operated 86 retail galleries across its RH (includes stores in the US and Canada) and Waterworks (includes stores in the US and the UK) brands along with 39 outlet stores in the US and Canada. By October 2021, RH operated 80 galleries (66 RH Galleries and 14 Waterworks showrooms) and 38 RH Outlet stores. Note that the company’s galleries strive to convey its luxury brand aesthetic to consumers and tend to differ materially than traditional home furnishing operators.
Though its physical footprint hasn’t shrunk too much, we appreciate that RH is willing to shut down uneconomical locations that may not fit well with its brand image and to focus more on lucrative endeavors by elevating the perception of its products through more “architecturally inspiring galleries.” Results show that its “gallery transformation” has been successful in attracting more affluent spenders, and management believes that a gallery in every major market in North America would translate into a revenue opportunity in the $5-$6 billion range. Net revenues, by comparison, were $2.85 billion for the year ending January 30, 2021.
Major Growth Ambitions
In January 2021, RH made a $0.1 billion equity method investment “in connection with real estate development initiatives in Aspen, Colorado. The investment includes properties that will be developed into retail locations, hospitality concepts, residential developments, and workforce housing projects” according to the press release.
Furthermore, the press release noted that “Aspen has been selected to develop the first RH ecosystem inclusive of an RH Bespoke Gallery, RH Guesthouse, RH Bath House & Spa, RH Restaurants, and our first RH Residences.” RH has indicated in the past that it wants to be viewed as a lifestyle brand, as compared to just a home furnishings company, and it appears that its efforts in Aspen are effectively a pilot project to enable those ambitions.
We are keeping an eye on these efforts. RH aims to complete some of these real estate endeavors, including the RH Gallery and RH Guesthouse (includes its first RH Bath House & Spa concept), in 2022 (appears to be calendar year 2022). Additionally, RH is working towards bringing its RH Guesthouse concept online in New York City in fiscal 2022 as it seeks to capitalize on the approximately $200 billion hotel market in North America (that figure is cited by RH).
RH is also getting ready to open up RH England, The Gallery at the Historic Aynhoe Park, in fiscal 2022 which will see the RH brand enter the U.K. (as noted previously, its Waterworks brand is already active in the UK). Pushing the RH brand into a new geographical market with a sizable population of affluent households should enhance RH’s longer term growth trajectory. The company is also getting ready to launch its new product cycle, RH Contemporary, in the Spring of 2022. Supporting all of these efforts is the pending launch of its new digital portal in fiscal 2022, ‘The World of RH,’ which will integrate all of its products and services onto one platform.
The company has a lot on its plate right now and possesses the financial capacity to expand into new markets while rolling out new products and services. RH’s push into the hospitality space, which includes restaurants and wine bars, is intriguing, though outside of its core business model built around providing interior/exterior home design services and selling home furnishing products.
We caution that when companies push into new strategic verticals that are outside of their core competencies, the endeavor introduces new risks to their business. For instance, developments that don’t get brought online on time can lead to cost overruns, and cost structures can become bloated while managing several different businesses at once. These risks should be evaluated closely, however, and weighed in risk/reward fashion against the company’s global brand opportunity estimated at $20-$25 billion in the long run. By comparison, RH’s market capitalization stands at ~$8.4 billion at the time of this writing.
RH has nonetheless proven itself time and again. Its stellar operational performance of late combined with its solid understanding of affluent households indicates that its push into the high-end hospitality space may pan out favorably. RH is also laying the groundwork for future growth by continuing to prioritize investments in its digital operations. Launching the firm’s The World of RH platform will help streamline its distribution channels and should better enable RH to capitalize on future marketing and cross-selling opportunities.
Financials Trending in the Right Direction the Past Few Years
In fiscal 2019 (period ended February 2020), before the pandemic hit North America, the company’s GAAP net revenues grew 6% year-over-year to reach $2.6 billion, and its GAAP gross margins expanded by over 200 basis points to hit ~41.4%. Strong revenue growth and gross margin expansion along with modest operating expense growth led to its GAAP operating income rising by 39% year-over-year to hit $0.4 billion in fiscal 2019. RH’s GAAP operating margin stood at ~13.7% in fiscal 2019, up ~325 basis points on a year-over-year basis. Put another way, RH’s business was booming before the pandemic hit.
Pivoting to fiscal 2020 (period ended January 2021), RH’s GAAP net revenues climbed higher by 8% year-over-year to reach $2.8 billion as the firm was able to lean on its digital sales channels to continue meeting demand during the pandemic. The company’s GAAP gross margins increased by over 515 basis points year-over-year to hit ~46.5% in fiscal 2020, highlighting RH’s impressive pricing power. RH’s GAAP operating income rose by 29% year-over-year to reach $0.5 billion in fiscal 2020, as the uplift from meaningful sales growth and gross margin expansion contended with a sizable increase in its operating expenses, which was due in large part to the need to manage complexities arising from the pandemic.
RH’s GAAP operating margin stood at ~16.4% in fiscal 2020, up ~270 basis points on a year-over-year basis, and came in at ~24.8% during the first nine months of 2021 (up from ~13.9% in the same period a year ago), as shown in the image below. Please note that RH’s operating expenses may steadily grow as it pushes into the hospitality industry (running restaurants and wine bars won’t be easy), but the operating leverage inherent in its business model speaks to resiliency, offering the company some wiggle room to experiment and take prudent risks to attain profitable growth.
Image Shown: RH’s revenue growth has been impressive through the first nine months of 2021. Image Source: RH.
More pointedly, when it comes to margin potential, however, the competitive nature of the home furnishings sector may have the greatest impact long term, but RH’s high-end niche is very nice, translating into pricing/earnings power moreso than others. Though we also believe the high-end home furnishings market to be more resilient than lower-end offerings, as it is other luxury retailing environments, operating leverage still cuts both ways. RH also remains more exposed to the wealth effect, and recent damage to the equity markets coupled with potentially slowing housing activity from rising interest rates could prove to be stiff headwinds for RH in the near term (even as it expands nicely).
During the first three quarters of fiscal 2021 (period ended October 2021), RH’s GAAP net revenues grew by 40% year-over-year while its GAAP gross margin stood at ~49.0% during this period (up sharply from fiscal 2020 levels). The company’s GAAP operating income more than doubled on a year-over-year basis during the first three quarters of fiscal 2021. As noted before and worth emphasizing again, its GAAP operating margin stood at ~24.8% during the first three quarters of fiscal 2021, up sharply from levels seen in fiscal 2019 and fiscal 2020 (that represented a ~845 basis point increase versus fiscal 2020 levels). We are incredibly impressed with RH’s margin performance of late and its net revenues are growing at a nice pace as well.
Free Cash Flow Generation and Outlook Impressive
RH is quickly becoming a cash flow generating powerhouse. In fiscal 2020, RH generated almost $0.4 billion in free cash flow, which was up substantially from levels seen in fiscal 2019 (~$0.25 billion) and fiscal 2018 (~$0.15 billion). During the first three quarters of fiscal 2021, RH also generated almost $0.4 billion in free cash flow. In fiscal 2020 and during the first three quarters of fiscal 2021, RH did not repurchase a meaningful amount of its common stock and the company does not pay out a common dividend at this time. RH’s capital expenditures are on the rise due to its aforementioned growth ambitions, though its net operating cash flows are growing at a robust pace.
At the end of the third quarter of fiscal 2021, RH had $2.2 billion in cash and cash equivalents on hand versus $0.1 billion in short-term debt and $2.8 billion in long-term debt (inclusive of finance lease liabilities). RH also has other sizable non-cancellable liabilities to be aware of, such as its operating lease liabilities. While the firm had a net debt load of $0.7 billion at the end of the fiscal third quarter, RH has ample liquidity on hand to meet its near-term funding needs and is a stellar free cash flow generator. We view its net debt load as manageable.
When RH reported its fiscal third quarter earnings in December 2021, the company beat both consensus top- and bottom-line estimates and raised its full-year outlook for fiscal 2021. The company is now targeting annual revenue growth of 32%-33% (versus 31%-33% previously) and non-GAAP adjusted operating margins of 25.3%-25.5% (versus 24.9%-25.3% previously). Furthermore, RH raised its ROIC guidance for fiscal 2021 to 70% from 60% previously, which would represent incredibly impressive performance if realized.
Please note that RH also raised its outlook during both its fiscal first and second quarter earnings updates. Inflationary headwinds and supply chain hurdles are posing significant problems for RH, though the company appears to be handling the situation well. We think the company’s outlook for fiscal 2022, a year that it has dubbed “The Year of the New,” when released, will be paramount for investors on the fence that may be concerned about a weakening wealth effect and the impact of higher interest rates on housing/home furnishing demand, more generally.
Concluding Thoughts
There is a lot to like about RH.
Shares of the company have more than doubled since we first wrote about Berkshire Hathaway taking a position in the company in our November 2019 article. However, shares of RH are now on a downward trend more recently. Given RH’s stellar financial performance of late, it is possible investors may be souring on its push into the hospitality space and exposure to weakening trends (e.g. higher interest rates and a deteriorating wealth effect). That said, from a fundamental and financial standpoint, RH is still looking solid and the recent selloff in its shares appears to be overdone.
RH has put up nice revenue growth in recent fiscal years as demand for its offerings remains robust, and its margins have exploded higher (so far through reported 2021 numbers). The firm’s impressive pricing power is more than offsetting inflationary headwinds. Targeting affluent households is partially why RH has ample pricing power, though there is more to the story. Combining its interior/exterior home design services with its products enables RH to offer its affluent customers a comprehensive package that apparently has been well-received.
All things considered, we view RH’s longer term capital appreciation upside favorably while we monitor its push into the high-end hospitality space. Frankly, it’s hard not to like its long-term revenue opportunity and impressive operating leverage and free cash flow generating capacity. We see technical and valuation support in the $325-$375 per share range, and investors may take greater interest once the selling subsides. Shares are down ~27% year-to-date, trading at ~$390 at the time of this writing.
We note, however, an elevated short interest in shares of ~14%, as we categorize RH as an idea for more speculative investors and only at the right price. Unlike other ideas that are more insulated from the broader economy, if higher interest rates were to meaningfully choke off housing activity and a deteriorating wealth effect hurt RH’s high-end home-furnishing demand, in particular, our fair value range would need to be adjusted lower.
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Callum Turcan does not own shares in any of the securities mentioned above. Berkshire Hathaway Inc Class B shares (BRK.B), Chipotle Mexican Grill Inc (CMG), Dollar General Corporation (DG), Domino’s Pizza Inc (DPZ) and The Walt Disney Company (DIS) are all included in Valuentum’s simulated Best Ideas Newsletter portfolio. Dick’s Sporting Goods Inc (DKS) and Home Depot Inc (HD) are both included in Valuentum’s simulated Dividend Growth Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.