I believe that at its current share price, Restoration Hardware (RSTO) presents a very compelling risk/reward profile. Restoration Hardware is a specialty retailer of high-quality hardware, bathware, furniture, lighting, textiles, accessories and related merchandise, often portraying classic and authentic American style. The company has strong and solidly growing top line, but is plagued by back-end operations (supply chain and order management systems) that are inefficient and terribly uneconomical. Since 2006, management has committed itself to completely overhaul these systems. They have repeatedly stated that these initiatives should yield 4%-5% operating margins by 2009 with further improvement (in the range of 100 BPS per year) thereafter. Although this road to improvement has thus far not been smooth, that is precisely what has opened up the opportunity now. If management is able to demonstrate that their initiatives are bearing fruit, I believe this stock could double over the next 12 months and triple in the next 24, with greater upside possible. Moreover, although I do not discount the chance that the stock will become even cheaper in the near term (due to both macro-related issues stemming from the housing downturn, as well as company specific ones stemming from continued hiccups in the operation initiatives implementation), I believe at its current valuation, a margin of safety exists that should protect an investor from permanent capital loss.

 

I will break this write-up into 3 parts: 1) an overview of the company with a history of their front-end (product and brand) renovation. I believe understanding the success of that initiative is important to having confidence in their current back-end initiatives; 2) A description of the state of back-end operations and the progress in revamping them, both already achieved and planned; 3) an analysis of RSTO versus its peer groups in terms of both operating and valuation metrics (with specific interest towards Williams-Sonoma; 4) sketch the conditions under which RSTO achieves the price target I mentioned; 5) discuss briefly the margin of safety present at the current levels.

 

 

Restoration Hardware is a specialty retailer of high-quality hardware, bathware, furniture, lighting, textiles, accessories and related merchandise, often portraying classic and authentic American style. The company has positioned its merchandise between the popular home lifestyle brands such as Pottery Barn and Crate & Barrel and the interior design trade. Restoration Hardware currently operates 102 stores and 8 outlets in 30 states, and in 2006 debuted a new brand called Brocade Home, focused on the broader value end of the trade. Although management estimates it could ultimately get to 150-200 stores, store growth will not be a vehicle for growth in the short term. Rather, the company will focus on growing its direct-to-customer (DTC) business through catalog and internet sales. These are lower cost channels and their growth has been, and management expects it to continue to be, robust. Given that the DTC business is significantly less capital intensive than building stores, focusing on developing this side of the business is wise as the company concentrates on its core task of reshaping back-end operations.

 

 

In order to perhaps better appreciate the prospects of a turnaround on the back-end, it is worth considering how far the company has come with regards to its front-end. Since 2001, when current CEO Gary Friedman took over, the company has been completely redefined its product and its brand. Formerly a hawker of ‘discovery items’ (random gift oriented pieces – like Sharper Image but with a different spin), the company is now a highly regarded destination for premium home furnishing goods with particular emphasis on areas such as bathware, hardware, lighting and textiles. Previously unable to establish any brand identity as a result of its widely diversified and non-exclusive product mix, the company now possesses strong identity with a loyal following. This radical changeover has resulted not only in the creation of a distinct brand identity, but has contributed materially towards margin improvement as well. The following illustration shows how those two benefits developed in confluence with one another: For example, in 2002, only about 15% of its merchandise was directly sourced from offshore vendors and very little of what it was selling was exclusive to the company. In addition to prohibiting the promotion of a defined brand identity, that hodge-podge sourcing of inventory also severely limited the company’s ability to be price competitive and thus depressed margins. As a result of Mr. Friedman’s initiatives, the vast majority of Restoration Hardware’s product is exclusive today, and about 75% is sourced directly from offshore vendors. Aside from the aforementioned brand development, the quantifiable consequence is the substantial improvements in the company’s gross margin, which has expanded from 29.6% in 2002 to 35% for LTM. That is almost 550 basis points of gross margin improvement that has already been accomplished under Mr. Friedman’s leadership– and it is almost entirely before the company really starts to tackle its disastrous supply chain. In short, the front end of the business is secure and vibrant, with growth opportunities abound (I will discuss those later). Therefore, management has wisely decided to focus on prudently selecting certain growth opportunities while investing the majority of their efforts towards reshaping the back-end infrastructure.

 

As RSTO grew over the years (even prior to its front-end recasting – that has only exacerbated problems), the company proved unable to scale its systems and manage its supply chains. Incapable of finding alternative solutions, the corporate entity largely deferred responsibility to the store level. As a result, by 2001, the company was using 63 different companies for direct-to-home deliveries. Aside from problems of service, the operation was terribly uneconomical. The company could not take advantage of either volume discounts or operating leverage through scaling under such a system. Under present management, the company has reduced the severity of that problem, reducing home delivery suppliers to around 20. In the near term the company aims to limit this number to around 10, and eventually get down to one or two.

 

Other problems are still widespread today. The company still uses six different types of products and many orders still entail three or four handoffs. Additionally, until recently, some 40% of the company’s special orders are still manually faxed to its vendors rather than residing within an electronic network (I do not know if progress has been made on this problem). The consequences of those inadequacies are twofold. Firstly, they hurt customer service. Secondly, it is economically draining. The multiple ordering systems all require separate overhead to maintain and costs are further driven by the handoffs from one department to another. Successful companies use their supply chains and management systems as a competitive advantage both for customer service and cost cutting. The potential for RSTO to capitalize on that model has been demonstrated on a small scale: when RSTO began to implement improvements to its supply chain, absolute dollar spending at its distribution centers was down year over year despite significant revenue gains. That implies that infrastructure is so poor at RSTO that improvements are do not result merely from leverage against the same cost base – rather, there are absolute dollar reductions occurring within parts of the supply chain even as revenue continues to ramp up.

 

In total, systems are still largely uncoordinated and there exists tremendous room for improvement, with material margin improvements to come as a result of successful implementation.

 

The full rollout of a supply chain and order management system will take a few years – beyond the H2 2008 and 2009 time frame when management sees its largest current initiatives producing meaningful effects. Management has made it extremely clear – through its words, actions/investments, and its hiring decisions – that remedying the back-end infrastructure is their primary goal.

 

The following are statements from management regarding the primacy of fixing back-end operations as the vehicle towards success.

 

- Q4 ’06 Conference Call: CEO – “Our investment in these supply chain and infrastructure improvements will begin to create leverage in the second half of 2007 and into 2008.”

o   “Clearly, 2007 is a big investment year for Restoration Hardware and we are confident that it will prove to be a very good year that positions us for dramatic growth going forward.”

- Q1 ’07 Conference Call: CEO – “Our success will largely be driven by the transformation of our supply chain and systems infrastructure.”

o   CFO – “Importantly, we believe that a large portion of future margin expansion will be driven by supply chain and headquarters leverage...”

- Q2 ’07 Conference Call: CEO – “The planned transformation of our supply chain is on track.”

o   “We have planned for 2007 to be an investment year with more substantial growth coming in 2008 and beyond.”

o   “The Restoration Hardware brand has undergone a dramatic transformation in the past several years and our supply chain initiatives represent the final phase of building a company that has significant growth and operating margin expansion potential.”

- Importantly, the company has stated that it will not open any new retail stores in 2007 or 2008 to allow management to focus on repairing back-end operations as well as to further develop the DTC business.

 

Over the last few quarters, management has spent time discussing already achieved, ongoing, and future initiatives that are part of the process of overhauling back-end operations. Initiatives (completed and planned) include:

 

- End of CY 2006 the company implemented an in-store ordering systems that reduced in-store ordering time from 20 minutes to 5 minutes. Previously, there was no automated way for an in-store salesperson to confirm that an item was available for rapid delivery or whether it was on backorder. Additionally, the new system allows the salesperson to bypass the company’s call center.

- Completed retrofitting of furniture distribution centers in Q1 ’07.

o   In Q1-Q2 installed narrow-aisle racking, which will improve space utilization, product handling, and productivity.

- In Q2 Consolidated small package direct-to-customer operations from three distribution centers into one.

- Opening a new distribution center next in summer 2008 that will streamline distribution and inventory management and allow RSTO to phase out its third-party distributors. The facility will provide a fixed cost structure upon which they can leverage.

- Installing new warehouse management systems in furniture distribution centers to improve order integrity, tracking, and productivity.

o   In August, this system was successfully installed in one of the company’s distribution centers.

o   Should be fully installed by early 2008.

- Reengineering home-delivered furniture network with the goal of improving customer service and reducing returns and damages.

o   Roll out in H2 ’07.

- Investing in sourcing and production management in order to reduce costs of good in core merchandise categories.

o   H2 ’07 and early ’08.

- Developing an integrated multi-channel order management system.

o   This is the broadest and most important initiative the company is undertaking. It is a longer term initiative that aims for completion in Spring of 2008

o   Management expects it to vastly improve order integrity across channels and delivery methods.

o   It should provide visibility into key data regarding customer buying habits.     

- Additionally, other organizational changes have been made that will contribute to cost cutting (without inhibiting either growth initiatives or supply chain initiatives).

o   Renegotiated catalogue production costs and expect significant savings in H2 2007.

o   Reorganization of corporate headquarters and eliminations of positions that will generate $3.5 million in savings in second half of this year and approximately $9 million annually.

 

Structurally and conceptually, RSTO is trying to replicate Williams-Sonoma (more on this later). The significance of that vis-à-vis margin improvement is that WSM provides a model of strong and sustainable margins built around a robust top line that is supported through superb supply chain and order management systems. The relevance of all this to the prospects of a back-end turnaround at RSTO lies in the fact that RSTO’s two key executives were both very successful WSM alums who were intimately involved with WSM’s own turnaround (front and back-end) and overseeing its back-end operations.

 

Gary Friedman – CEO: took over RSTO in March 2001. Previously, he had been with WSM for 13 years in various executive positions (including President of the Williams-Sonoma and Pottery Barn brands from 1993 to 1995, Chief Merchandising Officer and President of Retail Stores (1995 to 2000) and President and COO of the overall company (May 2000 to March 2001). At Williams-Sonoma, Mr. Friedman is credited with being instrumental in the repositioning of the Williams-Sonoma brand and doubling the average store volume from $1.2 million to $2.5 million per store. He was also a primary architect in driving the Pottery Barn brand from an unprofitable $60 million store group to a highly profitable $1+ billion business while he was at the helm. Thus, he has proven success in brand repositioning, re-merchandising, fully remodeling stores (twice) and revamping back-end operations.

 

Ken Dunaj – COO: with RSTO since May 2006. Formerly, Mr. Dunaj was a SVP of Global Logistics for Williams-Sonoma, where he was in charge of retail and DTC distribution operations, transportation and the furniture home delivery network. At Restoration Hardware, Mr. Dunaj has essentially been charged with the oversight and implementation of the company’s new back-end systems and infrastructure. Having helped to build a top notch supply chain for Williams-Sonoma (the leading multi-brand, multi-channel retailer in the home furnishing space), it only seems logical that Mr. Dunaj should be able to repeat his efforts, while avoiding many of the nasty pitfalls that can occur when making massive changes to a company’s back-end infrastructure by drawing from his past experiences at a similar company in the same industry.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

First, here are historical margins for RSTO and its peer group.

 

It is clear from the data that maintaining respectable margins in the home furnishing space is very manageable. Mid to high single digit EBIT margins, and low double digit EBITDA margins are very reasonable. Obviously, certain companies that once sported such numbers (PIR, FBN, and STLY) have suffered recently from a variety of company specific issues that have brought them down. Those company specific issues have manifested not only in declining margins, but in declining top lines as well. As the table below demonstrates, RSTO has exhibited the most sustained robust top line growth of its peer group recently, and is expected to continue that momentum going forwards [2007 and 2008 estimates for all numbers are based on street consensus estimates].

 

 

 

 

 

 

To put the margin analysis and revenue growth analysis in context, it’s worthwhile to take a look at the valuation multiples afforded the various companies in RSTO’s peer group, as well as RSTO itself. This should start to give us a rough idea at what multiples RSTO could trade at. Obviously, the companies vary significantly in regard to the strengths of their businesses and future prospects – I’m not going to delve into detail about each company, as I think the cursory view provided by the margin analysis and revenue growth analysis puts the multiples in sufficient context for our consideration of RSTO. That said, I do not believe that Pier 1, Cost Plus, Stanley Furniture, or Furniture Brands possess businesses with nearly as strong of profiles going forward as does RSTO. However, RSTO is being valued below those guys and being treated as a bad/declining business with poor management. I maintain that RSTO is a thriving business (on the top line level) with strong management that is trying to reorient the back-end of a company that outgrew and transformed itself without taking care of its vital back-end operations. Therefore, given evidence that the back-end recovery is indeed on track (or simply recognition that one is in the works and that valuation for RSTO, on a relative basis at least, is severely depressed), the market should significantly upwardly re-value RSTO.  

 

 

 

As I mentioned previously, structurally and conceptually, RSTO is trying to replicate the Williams-Sonoma model of multiple strong brand names in the home furnishing and home décor markets. That involves establishing a core product line that enables it to become a key destination in select home furnishing categories, and then expanding their addressable market with line extensions and also adding new brand concepts to the product portfolio over time. Additionally, the company is also emphasizing its catalog and web-business business as a low-cost sales and marketing tool to capture a consumer experience.

 

I’ll digress a moment to comment briefly on the development of RSTO’s DTC business growth and its importance to their future prospects. Management is very bullish on the future of this segment, and considers it key to the fulfillment of both their operating initiatives and overall growth. The CFO stated in a conference call: “…as we pursue our operating and growth strategies, our business is increasingly driven by direct-to-customer transactions, and we continue to see sales migrate from retail to our direct segment. This transformation is the result of our multichannel merchandising and marketing strategies as well as the multichannel infrastructure we are building.” Once RSTO is able to get things together on the back end, the DTC business will prove even more important, as it is a sales platform that is far more scalable than the retail based one. The data below demonstrates that this segment of RSTO’s business has been growing strongly, both in absolute terms as well as relative to the company’s total revenues.

 

 

Additionally, within the direct segment, the company’s website has been taking a greater share of the overall web and catalog business, accounting for 67% in the last quarter over 58% in the year before. Moreover, the new website launched in Q2 ’07 should further propel growth in this segment. [Note that in Q2 ’07, due to a change in segment attribution procedures, $10 in revenue attributed to the direct segment would have been previously attributed to the retail segment.]

 

Back to the comparison to WSM. As said, on the conceptual and structural level, RSTO aims to be a clone of Williams-Sonoma. I believe that for the thesis, the most meaningful consequence of that is that from a margin potential standpoint, there should be no material difference between the original and the copy. Therefore, with its back-end repaired, there is no reason why RSTO should not be able to achieve the margins that Williams-Sonoma has maintained.

 

As the table below demonstrates, RSTO has achieved operating margins nearly in line with WSM before accounting for “unallocated expenses” (i.e. overhead back-end sorts of expenses) in both its retail and DTC segments. Indeed, the two companies’ FY 2006 and LTM numbers are essentially identical (the data table was too large to paste in other years – . This is encouraging because it affirms that the RSTO’s business model is strongly in tact, extremely closely aligned structurally with WSM’s, and that as scale grows (particularly on the DTC segments), margins can improve even further. Simultaneously, the data also confirms (which we knew) that there is something severely amiss with RSTO’s backend operations.

 

 

Although, as mentioned, RSTO has halted store growth as it focuses on establishing the back-end infrastructure, the company has not stalled other types of growth initiatives and brand development. In regards to the growth initiatives that RSTO is taking that are inspired by the WSM model, recent and planned initiatives include:

 

-       Launched a holiday gift catalogue that de-emphasizes hardware/home-furnishing items, and focuses on more holiday gift appropriate products.

-       Launched a Bed and Bath catalogue

-       Launched Brocade Home, a distinct line from Restoration Hardware aimed primarily at female buyers

o   This is RSTO’s first entirely new brand. It was launched by Lisa Versacio, Head of Business Development:

§  Importantly, like Mr. Freidman and Mr. Dunaj, Ms. Versacio is also a WSM alum. While there, she developed and launched the very successful West Elm brand (Williams-Sonoma’s answer for the value segment of the home furnishing market).

-       Launched a trade division directed towards interior designers

-       Planning to Restoration Hardware Baby and Child in spring 2008

 

I don’t think RSTO deserves the revenue multiple afforded either WSM or ETH because even with the margin recovery management is projecting for 2008/9, the company will still lag well behind both WSM and ETH. However, that consideration should be balanced with the fact that RSTO claims a significantly more robust growth profile as well as potential for significantly more margin improvement than either WSM or ETH. So it’s tough to call what should be appropriate, but I’ve sketched out the numbers that would result in a double according to 2008 consensus projections and a three bagger according to downside management projections for 2009 based on haircut management projections: management has internal goals of $1 billion in revenues for 2009 and 4%-5% operating margin, implying roughly 6.6%-7.6% EBITDA margin; I’ve assumed that in 2009 revenue grows 10% from revenue projections for 2008, and I’ve assumed 4% EBIT margin for 2009, translated into a 6.6% EBITDA margin. These numbers might prove optimistic, but I think there is as good of chance that they will prove conservative.

 

 

I believe that it is to the thesis’ benefit that a RSTO is modeling itself after WSM. If RSTO starts to demonstrate it is indeed on the path to margin recovery, the market can use WSM’s valuation as a basis upon which to value RSTO. Moreover, perhaps the market will use RSTO’s more robust growth profile to justify either parity valuation or maybe even a more generous multiple valuation.

 

Importantly, I believe that at the current levels (and upwards towards $4) a strong margin of safety exists. Primarily, I think RSTO could prove attractive for enterprising financial buyers looking for an in-tact business with operational difficulties. Even in the current credit environment, such deals will occur [illustrated most recently this past week by Sun Capital Partners bid for Kellwood – Sun Capital happens to have bought outright both Rowe Furniture and International bedding this year, and currently holds positions in Pier 1, Design Within Reach, and Furniture Brands International. I suspect they see value in this beaten down sector – although they did take positions before things got much worse – and I believe other turnaround and operationally oriented PE players may see the same in RSTO.] Additionally, it is comforting that insiders have meaningful positions in the company’s stock, in particular CEO Friedman who holds almost $9 million worth. His last transaction of the stock was in June of 2006 when he bought 30,000 shares in the $6.54-$6.80 range. Certain directors have recently been acquiring shares as well, all the way from $7.33 to its present $3 range.

 

The situation in which our margin of safety does not exist is where RSTO’s core business – i.e. top line sales – falters severely, impacted not only by the macro effected housing slump, but by company specific matters as well. Nothing currently indicates that scenario – in particular the latter – should unfold. That said, I do not know how bad housing conditions will get and how long they will last. RSTO, like all home furnishing companies, is obviously affected by a slowdown. However, I think that RSTO should at least feel the hurt less than others. My reasoning is that RSTO has a relative advantage over its peer group insofar as its target market is both older (33-55 and up) and wealthier (their product line is decidedly more high end than any of its comps – with the possible exception being Design Within Reach). I believe such a demographic will be materially less affected in their purchasing decisions that the younger and less affluent market targeted by other companies within RSTO’s peer group. So although macro influenced factors could obviously hurt RSTO, I don’t think the impact will be as severe as for others, and may very well be quite light. Also, I think that the vast majority of hurt that the macro-downturn will bring (assuming we do not slide into a true and severe recession), is largely baked into RSTO’s current valuation, as well as much of the sector. See Paul118 write-up on Ross Stores for some brief comments on how so much of retail is being devalued because of housing/sub-prime and general economic concerns.