Description

RH (RH) | Stock Price: $248

Summary

• Investors are vastly underestimating earnings power trajectory amid a generationally awful macro backdrop for furniture consumption
• While existing home sales are at levels last seen at the depths of GFC, RH business is at the cusp of meaningful inflection point due to overlooked company-specific catalysts
• Combined effect of new products at value-disruptive prices and cascade of new galleries will reaccelerate growth and drive operating leverage on top of a reduced share count
• RH has opportunistically repurchased 30% of its shares at attractive values in advance of business inflection, a move that should create enormous value over time
• With a return to strong revenue growth in 2024 and beyond, the presence of operating and financial leverage creates a coiled-spring dynamic to earnings
• We could see $20 of EPS in 2024, with a path $40 to $50 of EPS by 2026, implying the equity could be trading as low as 5x-6x on our medium-term estimates
• For a competitively advantaged, high ROIC (+50%) business pursuing a massive global TAM, this valuation is exceedingly attractive
• Limited downside given undemanding valuation on trough earnings before benefit of non-cyclical growth catalysts that will, at a minimum, offset potential worsening of macro

Thesis:

RH is a vertically integrated, high-end home furnishings brand.

We think investors are vastly underestimating the odds of a material inflection in earnings power over the next 1-2 years amid macro uncertainty, creating an opportunity to own a high-quality business with a long runway for reinvestment (+50% ROIC) at a single-digit earnings multiple.

The current macro backdrop for furniture consumption is, by historical standards, awful. Now on the other side of pandemic-induced demand, existing home sales are down nearly 30% from their 20-year average – levels last seen in the depths of the GFC. Amid these severe macro headwinds as well as temporal, execution issues that are being addressed, RH will generate $3.1bn of revenue (15% YoY decline) at a 20% EBITDA margin (600bps YoY decline) in 2023.

Precisely when housing turnover could normalize is unknown. However, the odds are high that transaction activity will improve from here as interest rates and/or home values adjust to find a new clearing price for people seeking to move. Simple regression to the historical mean would necessitate a 40% increase in housing turnover, an outcome that would create tremendous demand for furniture. However, this outcome is completely outside the company’s control and is not in our base case.

Independent of the macro, we believe RH is on the cusp of a meaningful business inflection due to two company-specific forces that are being overlooked by the market:

1. Product transformation: RH is undergoing the largest product cycle in its history, launching 70 new collections in 2H 2023. This represents a 70%-80% refresh to the existing assortment and follows a four-year period of limited new product. In addition to macro headwinds, RH has suffered from allowing its merchandise to grow stale and become increasingly overpriced as it raised prices too “arrogantly” amid a backdrop of strong demand and high inflation. RH is curing these issues. New collections will not only inject a sense of newness but will be marketed at value-disruptive price points, reflecting a shift in corporate strategy that focuses more heavily on sharing economies of scale vs maximally optimizing pricing to elevate brand perception. For example, the best-selling Cloud sofa has been repriced to 2017 levels – reversing 6 years of annual price increases – as RH passes along savings from its newly restructured supply agreements. We believe investors do not appreciate RH’s ability to increasingly leverage its buying power with high-end artisan suppliers – now with excess capacity post-Covid – to achieve cost outcomes that its competitors cannot replicate while still maintaining strong product margins. We expect the combination of newness, improved product design and quality, and an enhanced consumer value proposition to stimulate demand off a cyclically depressed base.
2. Platform expansion: RH has a robust development pipeline with over 20 design galleries (both domestic and international) expected to open over the next 2-3 years. To put this platform expansion into proper context, RH has cumulatively opened 27 design galleries since its real estate transformation began in 2011. While timing delays are unfortunately far too common for this business given project complexity, there is high visibility into +10 galleries opening in the next 18 months. With estimated omnichannel revenue of $50mm-$75mm per gallery, execution against the backlog will provide a meaningful, non-cyclical supplement to same-store growth. Included in the near-term gallery pipeline are some major markets: Palo Alto, Newport Beach, Houston, Aspen, Mayfair, Paris, Milan, Madrid, Brussels, Munich, among many others.

The combined effect of new products at value-disruptive prices and a cascade of new galleries should materially reaccelerate revenue growth as we lap GFC-like headwinds in 2024. On a same-store basis, we expect the business to generate double-digit comps next year. This potential outcome seems very reasonable given RH is growing off a base of revenue per sq. ft. down nearly 20% YoY. While it’s difficult to quantify the potential impact from the upcoming product cycle, an examination of prior product cycles lends some insight. RH launched its Modern collection in 2015. According to expert interviews, Modern was run rating at $400mm in revenue six months post launch – 2x the internal company estimate. The Modern sourcebook represented 300 pages of newness. In comparison, RH is now launching 1,500 pages of mostly new products (70%-80%) across multiple product lines and source books. Moreover, RH operated only 10-12 design galleries when Modern was launched vs nearly 30 galleries today. The combination of a fourfold increase in newness at better values and a near tripling in number of design galleries to showcase said newness portends well for same-store sales growth going forward.

In discussing the magnitude of the product transformation, Gary Friedman, RH CEO, said on the 2Q call, “We've never had this much new product hit a market like this, at the design quality, the quality of the make, and at what we believe the value equation is. And any time we've done anything like this, we've moved the business meaningfully. And so, this is the biggest thing we've done. I think it will be the biggest -- the most meaningful thing that we've ever done strategically. It will reset the company for the next five years … We're set up better than we've ever been set up in the history of the business and I think we'll have the biggest inflection point we've ever had next year.”

Gary Friedman’s language may sound promotional, but his statements should carry weight when considering the company’s exceptional capital allocation track record and its recent decision to repurchase 30% of outstanding shares in advance of this business inflection through a levered recap. Gary has literally bet over $2bn on the probability of his business turning in a meaningful way over the near-term. While Gary is by no means infallible, as the company’s largest shareholder (25% stake) and a 23-year insider, his judgement in evaluating the distribution of outcomes of the business is light years better than any outside investor.  It should be noted that the last time RH opportunistically repurchased the stock was in 2017, when the company retried 50% of the shares for $1bn. This move was considered highly controversial at the time but ended up being a highly accretive transaction for continuing shareholders: RH stock would go onto appreciate fivefold inclusive of the most recent drawdown.

With a return to strong revenue growth, the mix of operating and financial leverage creates a coiled-spring dynamic to earnings. We think investors do not fully appreciate the degree of incremental margins in the business given numerous crosscurrents impacting the P&L. Gross margins (48%) have declined by 300-400bps in 2023, but we expect this trend to reverse as elevated clearance activity on discontinued product runs off and is replaced with high merchandise margin (+60%), new product revenue at higher volumes, leveraging rent expense (6%-7% of revenue) that is embedded in COGs. With minimal marketing expense (<3% of revenue), we estimate variable profit margins could be over 50%. Further, with SG&A having cumulatively grown by 40% – more than 5x the rate of revenue growth – since 2020 to support global growth ambitions, we expect this pattern of deleveraging to reverse in 2024 and beyond.

Illustratively, if we assume 15% revenue growth in 2024 off a cyclically depressed base, this would equate to nearly $500mm of revenue and roughly $250mm of pre-tax earnings when assuming a 50% incremental margin. This would yield roughly $10 of incremental EPS, which is over 80% higher than 2023 consensus EPS estimates. While it’s difficult to precisely model the magnitude and timing of revenue growth, it seems highly likely that earnings are on a steep, upward trajectory over a 1-2 year time horizon. Relatedly, we expect net leverage (3.0x) and valuation multiple (20x EPS) – both computed on trough numbers – to dramatically compress. Fast forward 12 months, we believe this stock will have looked extremely inexpensive at current levels.  

If we take the consensus estimates as a proxy for market expectations, investors do not expect RH to eclipse its 2022 EPS of $20 until 2027. We think there is a decent chance that RH could exceed this watermark next year. Notably, we see a path to $40 to $50 of EPS by 2026, implying the equity could be trading as low as 5x-6x on our estimates. For what we view as a competitively advantaged, high return on capital business pursuing a massive, global TAM, this valuation is exceedingly attractive.

In addition to materially higher earnings, we could foresee the market conferring a higher multiple if RH’s international efforts demonstrate success and consistent returns on capital. Doing so would validate the company’s global ambitions and thus extend the reinvestment runway for decades. Yet, at an undemanding 20x multiple, which is consistent with the current trading multiple, the upside asymmetry is incredible over a 3-year investment horizon: $800 to $1,000 per share.

Investors are rightfully concerned about financial and operating leverage risks amid an uncertain operating environment. However, we think fundamental downside is limited given 1) near-term impact from non-cyclical growth drivers such as new products and new galleries that support high incremental margin revenue. Even if these efforts are not as successful as we project, their contributions reduce the likelihood of revenue declining from what we believe are trough levels; 2) RH is soon going to be lapping generational macro headwinds experienced in 2022/23. While mortgage rates could continue to climb, the rate of change is likely to be marginal vs what the industry has already endured (i.e., 400bps increase in 30-year mortgages rates YTD); 3) a broader recession could occur, but this would cause rates to decline, likely stimulating housing turnover after years of depressed activity and offsetting the negative wealth effect to some degree; 4) if the anticipated revenue growth does not materialize, management would likely scale back costs given SG&A has been sized up to support a much larger business (headcount up 20% since 2020); 5) interest expense coverage is at nearly 3x on cyclically depressed EBIT, there are no debt maturities until 2028, and the company is generating several hundred million of FCF despite meaningful revenue decline and operating deleverage.

Jordan Fox

jf@scpinvestment.com

Disclaimer:

This post is for informational purposes only and should not be construed as investment advice. It is not a recommendation of, or an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Our research for this post is based on current public information that we consider reliable, but we do not represent that the research or the report is accurate or complete, and it should not be relied on as such. Information regarding a company or security may be obsolete by the time it is published on Value Investors Club and investors must therefore independently verify updated information regarding a company or investment. Our views and opinions expressed in this report are current as of the date of this report and are subject to change. Investing is inherently risky and comes with the potential for principal loss. Past performance is not indicative of future results.

We have a position in this security at the time of posting and may trade in and out of this position without informing the Value Investors Club community.

Catalyst

Earnings upside over the next 12-24 months