Value Investors Club / RESTORATION HARDWARE HLDNGS (RH)

Description

Short of Restoration Hardware (RH)

Elimination of a sustained discount pricing strategy leads to opportunity to short retailer with a lot of

question marks surrounding its business.

 There are multiple examples of a change in discounting strategy (JCP, M, TLRD) leading to short-

term to permanent damage. We cannot think of one counterexample of where this strategy has

worked.

 We have data that shows that RH’s sales and gross margins will be down materially in 1Q.

 RH’s aesthetics and furniture are facing a large increase in lower priced copies being rolled out

by competitors.

 RH’s core mid-century modern aesthetic is already long into its trend cycle and unlikely to

remain popular for much longer. The company’s attempts to diversify into other styles might

not be successful.

 RH’s new larger store strategy has little data behind it and has thus far led to uneven results.

 RH’s returns are not exceptional (ROE 13%), and the valuation is still very high.

Quick background:

Many of you are aware of Restoration Hardware’s recent history so I’ll just give a brief overview and

then discuss parts of my thesis that might add value. RH came back to the public markets in 2012 as a

more furniture focused brand under new leadership. The company quickly made drastic changes, the

most critical one being its move to expand from roughly 7,000 sq. ft stores to stores 2-3x that size to

showcase more SKUs. After some initial success with a few stores, this strategy was put on steroids

when the company started moving into department store spaces as much as 10x the size of the legacy

stores, featuring full cafes. RH’s plan is to fully convert to larger stores over the next 7-10 years. The

idea is also to have a more efficient store and cheaper real estate. Additional big changes include that

RH converted from multiple catalog mailings to one giant merged catalog mailing and that RH started to

expand into additional rooms (bathroom and kitchen), demographics (teen), and aesthetics (modern).

There are also further expansion ideas and plans, including hotels, music and international markets.

RH ends promotional emails (transitions to Grey card)

On March 23, RH announced the Grey card, which is a discount card for $100 annually, entitling the

holder to 25% savings on regular items and 10% on sale items. Prior to the Gray card, RH would run

periodical sales of certain departments. Thus the customer was trained to anticipate and wait for a sale.

RH sent out roughly two emails every three days, advertising sales of approximately 33% off and often

as high as 50%. The idea behind the Gray card is that RH will transform into a club store with a more-

smooth sales pattern. Of course on the flip side it loses a key traffic generator with promotional sales.

The story behind discontinuing promotional discounts always makes logical sense. First example, JC

Penney saw the expenses of mailings and store signage as unproductive when everyday low prices could

be used instead. Second example, Tailored Brands (formerly Men’s Wearhouse) was wary of the

detrimental effect discounts were having on its newly acquired Jos. A Bank brand. Of course, in both of

these cases their attempts to end discounting were disastrous. And these two cases are not the only

attempts to cut back discounting, just the most audacious. Many companies, such as Macys (M), have

tried and quickly reverted. We can only think of one successful attempt at upwardly changing pricing

strategies, and that is Lacoste. Although, Lacoste is not a retail store, just a brand that split away from

Izod in the early 2000s.

RH will say that this is a long-term strategy and that the company is different because of the shopping

experience within its new large stores. The problem is this—while the new stores do look beautiful,

there are only a few of them--the vast majority are simply furniture stores. The timing of the plan is

very similar to JCP’s who had barely converted any part of its entire store to mini-stores within its store

and who was years away from instilling a unifying “Town Square” in the store when it eliminated its

discounting model. RH’s plan is likely better implemented once it’s near fully converting its store base.

RH’s plan also leaves little flexibility since it will create outstanding discount memberships which might

be tough to undo if the plan flops.

Data indicates falling margins and sales in 1Q:

First we see that visits to RH’s website have gone from raging growth to fairly deep drops in March and

April. We used compete data for this documentation (see chart above.

Next using data scrapes off the internet, we see that RH has actually increased discounting fairly

substantially since March 23 (the end of sales day). We find that the average discount has gone from

35% on March 23 to 41% on May 17, with the discount percentage rising nearly every day. While we

only have data going back to late January, this is near the highest rate of 44% reached in early February.

These sales are pre-Grey card savings.

Restoration’s core aesthetic is under siege; it might not be able to transition well to other looks:

Furniture looks follow fashion in colors and overall aesthetic trends that last for about 5 years. RH has

what is called as mid-century modern look as its core aesthetic. Mid-century modern has been the

hottest look for roughly the past 3 years. While you may think this gives RH another 2 years under the

sun, we recently spoke with a furniture executive who showed us countless ads in industry publications

for mid-century modern furniture. According to this executive, everyone is trying to copy RH, and these

RH copies will be hitting store shelves over the next few months. There is little proprietary about

furniture design, especially when one manufactures in China as RH does.

Ethan Allen, which also has a signature (traditional) look, had poor sales when it expanded into other

styles. It remains to be seen whether RH, now offering new styles with its modern collection, can

successfully transition to other looks outside of its core mid-century modern.

Larger stores lack data and have produced inconsistent returns:

RH has released practically no data on how the company’s new large stores are doing, only saying that

they are exceeding its plan. However, the plan was always seen as a lowball number. If this is truly a

formula that works, we would expect to see the stores with more capex and bigger to do better.

Obviously, there is some room for randomness and the peculiarity for certain markets, but the relative

trend should be identified and present if this is going to be an executable strategy to roll out to 70

stores. Yet, on the limited info that RH gives out on its previous generation of stores, the new Boston

flagship store had the worst performance among the bundle of new stores. The Boston store did about

48% less sales per sq. ft than the other 4 stores (I got this data speaking to them, just under two years

ago) on average. Boston was about twice the size of the other new stores, yet its total sales were the

median of the group. Boston is very significant because it was the company’s flagship at the time. RH’s

job of resurrecting the historical building was so breathtaking that RH’s website featured a video of it

(the only video for a while). So Boston should have performed better compared to the other stores, yet

it may be the weakest link and on a return basis probably is. This store was arguably the basis for the

hype in the company and stock. Granted, Boston was the first major store so maybe management has

worked out the kinks. But given that all the stores are somewhat unique, how can we assume that the

company will execute on its plan as it rolls into 70 stores? If anything a flagship should be the best and

most creatively focused. Another observation worth noting is that the first large stores have been in

large cities, and we wonder how many more can be sustainably done.

What we find within RH are many conundrums about the company and simply a lack of consistent logic.

Here is a list:

 The furniture is incredibly highly priced and is above or on par with high end Italian furniture

imports, yet the quality is lacking, according to multiple sources, who believe it’s not built to last

very long.

 With the fall in antique furniture prices, you can likely buy authentic antique cheaper than RH

which was designed to mimic that antique.

 Despite low quality and absurdly high prices, RH’s gross margin is just 37% (some accounting

differences vs. other retailers).

 RH claims by not having designers and manufacturing in-house that it is able to curate from

artisans who others cannot get. These same “artisans” then mass produce the stuff in China.

 RH plans on taking advantage of abandoned anchors to roll out its large format stores, yet the

malls that RH would go into do not have Sears and JCP; the Neiman Marcus’s of the world are

still doing quite well and not looking to exit leases.

 For a store with such a great experience we found that RH had unimpressive Yelp ratings,

including a full point below competing Williams Sonoma, nearly half a point below Pottery Barn,

and a rating even below Ethan Allen. We note that we did this analysis over a year ago and RH

ratings were actually going down at the time, but we doubt that RH’s recent delivery problems

have helped its ratings.

 RH is a San Francisco based company supposedly catering more to millennials, yet it has nearly

no social media presence.

 RH services an extremely well-heeled upscale high income clientele, and it does so by repeatedly

bombarding them with emails and store signs for 0% financing.

 RH’s expanded offering enabled by larger stores includes from what we can see is largely the

same item in slightly different colors.

 While not a conundrum, the CEO and his videos make him appear to be hands down the most

pompous businessman on the planet. Just look, it’s not hyperbole.

Valuation & Returns:

For all the hype surrounding RH, its ROE is just 11.5% over the last 12 months. The company’s ROE has

never hit 15% and has been largely negative since and in the years up to coming public again. The

returns simply aren’t there, and this is despite issuing zero coupon converts. While RH no longer trades

for nosebleed multiples, it still trades for over 12x this year’s consensus earnings which are declining and

we obviously believe are unlikely to materialize. RH also produces nearly no free cash flow. Since RH

runs a very capital intensive business, I would value it at book value or roughly $22.00 a share, but

seeing a floor could be tough if the bottom falls out of its business.

Conclusion:

It appears that RH is building a great customer experience at its stores. However, what has really driven

the company’s sales growth has been a combination of strong furniture market (especially at the high

end, very favorable fashion trends) and the roll out of financing. The company’s attempt to end

discounting will likely yield a lot of short-term pain. Though the shares have fallen dramatically in the

past 5 months, there could be much more to go as the discount changes show up in results over the

next few quarters.

Risks:

My analysis is more short-term based. Long-term most of what RH is doing does have a logic to it, and

the new stores (at least the ones I have seen) do look beautiful. At the store in Chicago, I saw so many

people with wine on a Saturday, which I thought it was free but was not--the place does millions in café

sales. The other risk is that the discount elimination is simply priced in already and an earnings miss

does not faze the market. Lastly, RH does have some pent-up sales from shipping delays which should

provide bump in the current quarter.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

The next two quarters are likely going to be the worst times for RH. RH should report earnings in the second week of June,

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			2016	2017
Price:	31.70	EPS	2.66	3.13
Shares Out. (in M):	41	P/E	0	0
Market Cap (in $M):	1,288	P/FCF	0	0
Net Debt (in $M):	40	EBIT	201	237
TEV (in $M):	1,327	TEV/EBIT	0	0
Borrow Cost:	General Collateral