Experiential Retail? Restoration Hardware and the Furniture Kings

Introduction

Of the three buckets of competitive advantages- economies of scale, technological prowess and brand- creating a brand is probably the most difficult. Of course, these buckets aren’t mutually exclusive, and one may give birth to another (i.e. technological prowess giving rise to brand name of Microsoft); generally speaking, however, creating a brand in isolation or in a previously commoditized industry is near impossible. Companies that accomplish this, though, are enormously successful. Coca Cola, despite sharing 99% of its DNA with Pepsi, still has its die-hard fans. Ferrari famously caps production to maintain exclusivity, in the process maintaining 30+% margins on every vehicle sold. If Ferrari is the father of luxury, the grandfather is LVMH, the French multinational family of brands from Louie Vuitton handbags to Bvlgari watches.

Restoration Hardware (now known as RH) is trying to do the same thing to furniture. As of now, the provider of luxury furniture doesn’t exist; the market is currently served by fragmented businesses or as subsidiaries of larger corporations. Unfortunately, Restoration Hardware has a checkered past (which is a large reason they rebranded as RH). The company originally sold niche antique furniture sourced through inheritances/estates. While this market continues to exist, and some may argue it constitutes luxury, it is my no means modern and the market for antiques is very small. Nevertheless, for the first half of its corporate existence, this is precisely where RH operated (and probably why a repulsive name like Restoration Hardware was admissible). In 2001, the company got a new CEO, Gary Friedman, who remains the CEO today notwithstanding a short respite in 2012 as the company IPO’d. Friedman, who considers Apple and LVMH his role model companies, had the vision to transition away from this antiquated market and move into the higher margin and larger luxury market, and this is the vision of the company today. The company expanded its retail “Gallery” footprint, created an elegant website and began a re-branding strategy. From then to now was really an execution of this strategy, and while we don’t have data from the early days (company IPO’d in Q4 2012), we do know that RH brunt the financial crisis while many other luxury furniture retailers filed for bankruptcy. On the other hand, in the years leading up to the IPO, the company was tethering near bankruptcy, most likely a result of its ownership by private equity in 2008.

A luxury brand is naturally experiential. Especially when a product isn’t significantly better performance-wise (think handbags or watches), people are drawn to Tiffany stores or Rolex watches because of the experience of purchasing. We like to be coddled by the waiter after ordering an expensive wine or personally attended to at a Bentley dealership. But this experiential driver of brand recognition is at odds with the retail industry as a whole. The rise of e-commerce, the insistence on convenience over all else and the “gig” economy all but erodes the sense of indulgence one desires of such a brand. The retail industry especially is undergoing this change: malls are closing, retailers with historically large brick and mortar presences are investing in their e-commerce capabilities and interactions with brands are increasingly occurring on computer/phone screens. The human touch that is particularly integral to the sale of high ticket, experiential items (think asking your waiter what expensive wine they recommend) is also eroding as retailers prioritize technological capital over human capital. Moreover, we’ve seen how successful luxury brands can be when they carve out a niche in the industry- just look at the history of Lululemon.

This is what makes RH interesting- it is doing the opposite of other retailers. As companies are closing down stores and reducing their brick & mortar footprint, RH is reinvesting ~50% of operating earnings into building retail locations. While companies are investing in less catalogues and reducing their reliance on mail-list marketing, RH spearheaded a “Source Book” initiative that it mails to customers every year. And while companies are investing in their technological capabilities, RH spends a proportionally larger amount on its human capital. In a sense, RH has blurred the line between retail and hospitality, creating an interesting niche in the process. Thus far, the results of this transformation have been spectacular: RH is growing revenues on the order of 10-12% per annum and already has the highest margins in the industry. Operating earnings have likewise increased more than five-fold since 2014. Despite the rapid success thus far, the company only has 21 “Galleries” (stores) and it estimates the United States market is large enough to support over 60 stores. The stock has also responded in lockstep, but we will get to valuation later. Gary Friedman currently owns 28% of the company, followed by T Rowe Price at ~7% ownership. Berkshire Hathaway also revealed last year that it purchased ~6% of RH’s shares outstanding.

Industry

The furnishings industry can be divided into two main pillars: business and residential. Interestingly, different companies serve each segment (I would expect that it’s relatively easy for companies to serve both, but only one public company has an established retail and business segment), and the industry is extremely fragmented. The business side can further be deconstructed into contract sales and supply-driven sales, and this market is much smaller that the residential side (~$20bn vs. ~$150bn). The contract sale market primarily represents large companies looking to furnish a large retail footprint (think Hilton refurnishing its North American hotels). Revenues from these contracts are recurring and easy visible over a period of 3-5 years. The supply-driven market represents the furnishing needs of small and medium-sized companies. This market is served by players such as HNI Corporation (HNI), Herman Miller (HMI), Haworth (private), Kimball International Inc. (KBAL) and Knoll Inc. (KNL). While all these companies compete in these two submarkets, HNI, HMI and Haworth are more skewed towards the contract market while Kimball and Knoll towards the supply-driven side. Besides manufacturing efficiency, there really is no competitive advantage between these players; they compete on the usual things like quality, design, price and customer service. All these firms have incorporated lean manufacturing initiatives (although HMI was the pioneer in this effort) and they all ebb and flow with the general industry. KBAL is by far the most efficient and profitable but Herman Miller has the best brand recognition and not too far behind in terms of profitability itself.

These companies I’ve described are primarily manufacturers. They vary between having an in-house design team or outsourcing their designs. This is important because it has a direct effect on their brand perception. Designers are, by far, usually independent freelancers or run their own design business, although some work for these larger firms. A company like Kimball will have its own design team while a company like Herman Miller will have a mix of in-house designers and outsourced designs, in which contracted designers are paid a royalty based on the sales of their designs. After the manufacturing process, most of this furniture is sold through independent dealerships (i.e. ~70% of Herman Miller’s sales are through independent dealerships). Because the market is so fragmented (the top 10 firms control ~20% of the market), there really is no brand power of these firms and no dealer allegiance. The customers are usually businesses but oftentimes inventory will flow through another intermediary: design firms who consult for companies/consumers although this is a smaller distribution channel.

The retail market is much more interesting and has more potential for a brand name to gain power. Herman Miller is the only one of the companies I’ve listed that also has a retail presence, although this segment is fairly small (~$400m run rate revenue and virtually no operating income vs. a ~$2bn+ contract sales business at a mid-to-high single digit operating margin). The retail market is also larger (~$150bn in annual sales) and more fragmented. Of this $150bn, about half, or ~$70bn, is spent on furniture with the remainder in lighting, rugs, etc. There are three primary distribution channels: larger retailers (think Bed, Bath and Beyond), a company’s own retail stores (think Tempur-pedic or La-Z-Boy stores) or through e-commerce (think Wayfair). It is difficult to pit these companies against each other, however, because they are not necessarily the same: you won’t go to a Sleep Number store if you’re looking to furnish a new house even if you are technically in the market for a bed. Similarly, the margins on chairs and rugs are completely incomparable to that of beds or other furnishings. Wayfair delivers everything to your home while companies with a retail footprint have a completely different distribution model (Restoration Hardware, for instance). Moreover, the whole industry can be divvied up in another way: a spectrum from low-end to high-end. College students looking to furnish their new university apartment won’t shop at a Restoration Hardware; likewise, multi-millionaires looking to furnish their beach house aren’t as price sensitive and will value convenience and customer service more highly. Finally, the margins depend heavily on how vertically integrated these companies are: retail sales are generally higher margin relative to sales to independent dealerships.

Despite these inherent limitations, we can make some broad strokes regarding the relative performance of this industry. The average furniture retailer will operate at a margin of ~6-10%. Herman Miller and Kimball’s core office furniture businesses operate at between 11-12% margins. On the other hand, HNI is comparatively a badly run business with margins of 4-6% (the company’s consolidated margins are around 8-10%, but this is including the company’s highly profitable (>15% margin) hearth business- HNI is the largest hearth manufacturer in the country). Wayfair is significantly unprofitable but has a bloated cost structure to support growth (11-12% of sales on marketing, for example). One can make the argument at a Wayfair closer to steady state can be generating anywhere from 3-5% on revenue based on its current economics.

Given this backdrop, who are Restoration Hardware’s largest competitors? It is hard to say. Definitely not any of those office suppliers. But Wayfair isn’t necessarily the company’s biggest threat either. E-commerce is quick, efficient and cheap for the customer, but it isn’t luxury. RH isn’t in the business of efficiency either: lead times are 3-9 months vs. Herman Miller’s 10-20 days. I would argue that RH’s biggest competition lies in the fragmented independent businesses run by designers, but this could also be RH’s biggest opportunity: consolidation in this market. One can argue that Herman Miller sells luxury furniture, but it doesn’t have a luxury brand by virtue of it concurrently being an office supplier and a retailer; moreover, its retail operations are $400m vs. RH’s $2.6bn and are barely break-even vs. RH’s 15% operating margin business. RH argues that they’re “building a brand with no peer”. It is a very sales-markety proclamation, but there is some truth in it. Yes, they have peers and they’re also competing with all these companies mentioned in one way or another, but they have no direct competitor that is operating at a similar scale.

The RH Evolution

When RH IPO’d, it had about 70 retail stores across the U.S. and really looked like any other retailer: the company had cut down from over 90 stores a few years earlier, it was over-levered and operating at razor-thin margins. Then Friedman had an idea to completely revolutionize the store layout and re-think the company’s retail strategy. While retail has been the primary selling model for the past century, it does face inherent limitations. Each store has its own varying levels of inventory, requiring a vast distribution network that is difficult to outsource. While previously physical stores were the only places to shop, given the myriad of options available to consumers today, simply getting someone to walk into your store is a difficult endeavor. Finally, each store must be staffed during its operating hours, resulting in incremental working capital requirements that aren’t present in a warehouse distribution or e-commerce model. Nonetheless, physical stores are still the best way to stimulate a customer’s senses and nudge them to buy a product. So, whereas previous stores looked like this (essentially a box):

Restoration Hardware decided to do this:

These new “Galleries” are adorned with lights, gardens, restaurants, bars, etc. They’re really more of a luxury house than a store, often containing multiple floors with different themed rooms (like a Rooms2Go for millionaires it seems). They’re also much larger than previous Galleries: whereas the “Legacy Galleries” were 8,000 square feet, these new Galleries are 30,000-40,000 square feet. They also have grandiose openings with performances and high-profile invitees. RH’s real estate strategy is to replace all its Legacy Galleries into these newer Galleries in key markets; management estimates the U.S. potential is 60-70 Galleries, while the company only has 21 today as of its most recent public filings (although I count 22 on Google Maps). Complementing these Galleries are “Source Books” where are essentially catalogues mailed to current and potential customers showcasing new designs and collections. Both the Source Book and the Galleries have a luxurious feel to them, a marked departure from the company’s history of selling antique furniture (case in point, the company launched its “RH Modern” brand two years ago to combat this exact perception). As a result of these developments, the company’s sales channels are essentially Retail Galleries (45-50%), Source Books (45-50%) and Traditional Methods (phone calling, etc. although this channel generates less than 5% of the company’s revenue). RH began this strategy in 2012. Before the first new Gallery, the company was generating ~$1bn in revenue and earning ~3-4% in operating income, nothing special. However, as RH expanded, each market that was replaced with a new Gallery saw its sales increase 50-100% within a year of opening, and substantially all markets doubled within 3 years of opening. Moreover, sales per square feet increased from $600-700 in a typical Legacy Gallery to $1,100-1,300 in a new Gallery, allowing the company to leverage its fixed cost base. Today, despite increasing revenue by 100% (while only increasing store count from 71 to 86) RH has not added a single head in its corporate office. Margins have increased from 3-4% to 13-15% today. Why? The average RH store today is generating ~$30-35 million in annual revenues vs. $5-8 million back in 2012 when all the stores were Legacy Galleries, allowing RH to leverage substantial fixed costs on the operating level.

The second pillar of this transformation was a rationalization of the company’s supply chain. While these new Galleries are “stores”, nothing really gets “sold” from the store. People buy furniture from RH stores (~$1.3bn in revenues originate from stores), but no inventory ever goes out the door. According to company estimates, less than 1% of the inventory will leave a store in a given year. These Galleries are really just showrooms where potential customers can enjoy leisure and browse the company’s collection. The real sales happen after the customer places an order (half of the time in the store, but often outside the store) that gets fulfilled through the company’s distribution network. Based on the way the distribution system is organized now, if I visit the RH New York store (which is earning about $30m per annum on $113m in revenues) and I like a certain living room collection, I’ll speak to a customer representative within the store and place my desired order. Then, the actual furniture will get shipped from the company’s Maryland distribution facility to my home fully assembled. Most of the distribution network is handled by third-party logistics providers (think FedEx), but in certain markets the company delivers itself (part of the mantra of controlling the brand from concept to customer). Then, if I return the furniture, it is directly shipped to one of 39 RH “Outlet” stores which exist to liquidate returned/obsolete inventory at discounted prices. As a result, there is no distribution center-to-store supply chain network, nor is it needed. RH has two manufacturing facilities- one in Patterson, California and the other in Baltimore, Maryland (~2.7m sqft. in total)- that service the company’s domestic operations.

It wasn’t always like this. Back in 2013, the company had 6 distribution centers with a total square footage of 5.3 million. On top of that, there were 7 home delivery locations (vs. 3 today). There was a vast (some would argue bloated) DC-to-store distribution network and another reverse-logistics network. Stores needed to be restocked every few months and returns were shipped to a warehouse before going to the Outlet store. By increasing store size and emphasizing the “Showroom” model over the “Retail” model, RH was able to show a wider assortment of its products within the store (over 30% of SKU’s today per Gallery vs. less than 10% in a Legacy Gallery) while eliminating a huge logistics cost. RH also eliminated the redundant trip back to the warehouse for returns by shipping directly to the Outlet store. As the company plans to expand internationally, Gary Friedman thinks they can service the U.K. market directly with their Maryland distribution center, although I think that is a stretch and they might need a local center, albeit a small one with only 1/3 of total SKU’s. Obviously, this decreased costs, but more incredibly, RH accomplished this while doubling its revenues; this increased its supply chain productivity by four-fold over a period of five years. Maybe FedEx should take notes.

The last pillar is the revenue model. Instead of having a promotional model to drive sales (i.e. Christmas sales or summer sales), RH tried out a membership model. For a flat fee of $100 per year, RH members could get discounts on furniture, receive interior designing consultancy, etc. According to a badly annotated graph by the company, this has resulted in less volatility in sales, putting less pressure on the newly lean supply chain network and the in-store workforce. I am skeptical about a membership model for a low-volume purchase (how often do people refurnish their houses?), but it seems to be working for RH. According to the company, members drive 65% of retail sales, which comes out to a very significant $800m in revenue. In addition, RH created an integrated sales channel: rather than having separate teams for different sales channels (i.e. the retail team in charge with maximizing ROI for the retail spend and vice versa for the e-commerce and mailing teams), RH has a single sales organization with performance metrics related to the overall ROI of different selling channels. As a result, the Source Books compliment the retail footprint and vice versa. Apparently, when a collection is featured on a Source Book, retail sales can increase by up to 30% in that year. In addition, when a Legacy Gallery is replaced with a new Gallery, we don’t just see retail sales climb from 60-100%, but “direct” sales (Source book, mailings, etc., basically everything except retail) also increase from 20-50% conservatively speaking:

“We opened our first three Full Line Design Galleries in Los Angeles in June 2011, Houston in November 2011 and Scottsdale in November 2012. In the Los Angeles and Houston markets, store demand increased by approximately 90% and 60%, respectively, and direct demand increased by approximately 30% and 45%, respectively, in the first full year of operations of those Full Line Design Galleries. In the Scottsdale market, we experienced an approximate 80% increase in store demand and an approximate 75% increase in direct demand during the months from the store’s opening in November 2012 through the end of fiscal 2012. In April 2013 we opened our fourth Full Line Design Gallery in Boston.”

2013 10-K

Of course, newer stores today won’t have similar increases given that the concept isn’t “new” anymore, but there’s a clear path to double revenues of Legacy stores by replacing them with these newer ones and implementing this new revenue model.

All this gives a rosy picture of the company. Naturally, you wonder, is this really the future of retailing? No one knows, and I won’t pretend I do. I will say looking at picture of these new Galleries make me want to go. But I also know they’re showing the public only their best-performing Galleries. One would have to visit a substantial portion of them (which isn’t impossible; there are only 22 as of now) to make up his/her mind. This question is extremely important, however. RH faces little competition and has a huge tailwind, that is, no other retailer has the will or resources to copy their strategy given that the industry is kryptonite. While other companies are struggling to maintain their 6-9% margins, RH is growing sales and margins and generating tons of cash for growth (~$300-400m and growing, but we will talk about this later). Moreover, what is the potential here? If management estimates are right and if history continues to play out as it has, then the North American market itself has the potential for 50-70 new Galleries. The company has 21 Galleries now which were the sole contributors to the company’s ~$800m in retail revenue growth. If we say each Gallery increased revenue in a given market by 100% (double), then this implies the 21 Galleries are contributing $1.2bn in revenue ($800m growth plus 50%*$800bn lost revenues from legacy Galleries), or $57m per Gallery. That sounds like a lot, but if we take $60m incremental revenues per Gallery, then another 40 Galleries would result in $2.4bn in incremental revenues, double what the company is currently earning. And if it plays out in North America, it is difficult to believe it won’t play out to a similar degree in a place in Europe. This is all I will say on the matter, since I want to allow you to come up with your own conclusion on whether you believe on the viability of this grandiose, luxurious Gallery model.

What does the future look like?

What have we established so far? The two big takeaways are that RH has no real comparable peer, which is both a challenge from an analysis standpoint but also an opportunity, and that the company has successfully executed on its strategy for the past five years. As of now, it looks like a viable business model, but how much more room does it have to run? Well first on the revenue side. Back in 2013, the company said:

“We have identified approximately 50 key metropolitan markets where we can open new Full Line Design Galleries in iconic or high-profile locations that are representative of our luxury brand positioning. We believe, based on our analysis of the market, that we have the opportunity to more than double our current selling square footage in the United States and Canada over the next 5 to 10 years as we transform our real estate platform by opening Full Line Design Galleries in these 50 identified markets.”

2017 10-K

Sounds great, but were they right? Back in 2013, they had ~500,000 selling square footage; today its over 1,000. Seems like they hit their target, but they only have 22 Galleries today. Moreover, the company is still projecting double digit sales growth for the next 10 years. And they’ve identified 60-70 potential targets, an increase from the 50 they talked about 6 years ago. Moreover, the total North American opportunity, according to management today, is $4-5bn, about double current revenues (similar to the outcome we got in the previous section). Based on these numbers, an incremental 38-48 stores should generate an incremental $1.3-2.3bn in revenues, or ~$27-60m revenue contribution per store (you can start to see how rough these numbers are- according to management, a $10-12m store is considered ‘low volume’ and I believe their highest volume store is NY, which generates ~$115m in revenues per year). And this is just the North American opportunity; naturally, the international opportunity is much larger. Europe is probably a $1-2bn opportunity in itself. Management thinks the global opportunity is $20bn, but frankly I don’t think any critical analysis went behind this number.

How to margins look? This is much more difficult to conceptualize. As we’ve discussed, furniture manufacturers that sell through wholesale will average 6-9%, those who also have a retail presence will average 8-12%, however this can differ wildly depending on who you’re talking about (La-Z-Boy has a 7-8% margins, for example). On the other hand, luxury retailers enjoy amazing margins: Tiffany (TIF) at 18%, LVMH at 25+%, etc. But I also think we can all agree that furniture can’t be compared to jewelry or handbags. RH is currently operating at a 14% operating margin (last quarter at 16%), but I believe this margin is understating the true profitability of the business. The new model that we talked about last section results in some accounting irregularities. For example, if a Source Book is sent out towards the end of the fiscal year (which happened last year- the Source Book for the year was sent out in Q4), RH must expense the full cost of producing the book even if the company hasn’t received all the corresponding revenues. Another example relates to the mix of Outlet store revenue (which is much lower margin because the product is heavily discounted) vs. Gallery retail revenue. Last year, Outlet store revenue was much higher as the company liquidated almost $100m in inventory, so high luxury margins were bogged down by low discounted retail margins. I think the business is currently operating at a margin of over 15%. Management thinks that they can get it up to 20%, and while Gary Friedman has put out a line-by-line disclosure on how they plan to get there, there is no way of verifying whether 20% is achievable. Despite all this, even at 15%, RH is the highest margin publicly traded furniture retailer by a long shot (which is probably what makes 20% so dubious to me personally).

Finally, I think management has a habit of under-promising and over-delivering. We’ve seen the stark under-promise they gave in 2013 when they implied 1 million selling square feet would capture the whole U.S. market and 50 Galleries would be the North American saturation point. Moreover, since Q4 2017, the company has beat on pretty much every single earnings guidance. And executives have said it themselves:

“And then frankly as we’ve said before, we give a number – the guidance we give versus what we have internally. Obviously, what we have internally is higher.”

Q3 2019 Earnings Call

“We looked at our five-year plan. 20% is not the not the endpoint, not by any means. So, if you think about the operating margins that many people run at luxury brands, it can be 25% to 30%.”

Q3 2019 Earnings Call

“I think the other thing of this is – ton of the questions is all kind of based on our guidance, right? And I would just remind everyone to think about what was our original guidance in Q1 and what happened? What was our original guidance in Q2, and what happened? There’s – there might be a pattern.” -Q2 2019 Call

Q2 2019 Earnings Call

CEO: “And so, here he is and I can tell, I mean, in his first signing of 30 days, it’s like when we said, well, we said $15 million to $20 million, or $15 million to $30 million?”

CFO: “$15 million to $20 million.”

CEO: “Yes, $15 million to $20 million, which means, it’s always more than we tell you, right?” – Q2 2019 Earnings Call

You should go through the other earnings calls… they all have similar quotes. And yes, the last one is supposed to be a joke, but the pattern still exists. In this year, RH raised its full-year 2019 guidance in Q1, Q2 and just recently in Q3 back in November. So, when the company says that their North American market is $4-5bn and steady-state operating margins are 20%, we should be aware that the expectations of management are probably closer to the $5bn figure on revenue and over low-20s for operating margin.

Valuation

What do I think? I do believe the revenue side. We have 21 examples in which sales have increased dramatically given after the introduction of a new Gallery. Moreover, there are 42 legacy Galleries left and so far, the closure rate has been a little over 1 Legacy Gallery per new Gallery. Gary has spelled out in detail (perhaps too much detail) on earnings calls the major markets that they plan to develop in: California, for example, is currently running at $450m per year in revenues with just one new Gallery in LA and many Legacy Galleries in other cities. Gary expects this to be a $700-800m market after all is said and done with the Legacy Galleries. I’m not so sure about the margin side. Yes, the company has done very well improving margins over the past several years, but we must not forget that the company frontloaded a whole bunch of expenses in 2017, a bad year. Moreover, the company acquired WaterWorks in 2017 and according to management, just let it sit there for 2 years. Integration of this brand (which came with 15 showrooms) will take some time and money. I don’t think a 25% margin is achievable. I also think a 15% margin over the long run is pretty achievable. The true value will be somewhere between the two.

It is also important to recognize the cash side of the equation. Before the new Galleries, RH was turning inventory 3-4x per year. Today that number is closer to 6-7x. In addition, the popularity of Galleries and the increased foot traffic that they generate has allowed RH to negotiate better leases with landlords. Whereas many leases in the past were a function of revenue, leases going forward are a fixed rate per square foot. RH has is also negotiating three types of “capital light” deals going forward:

  1. Capital-Light deals. In the past, if the landlord and RH were jointly developing a property, the landlord would put in anywhere from 35-50% of the capital. Now RH can negotiate deals in which the dealer puts up 65-100% of the capital.
  2. Development Model: RH actually develops the property and enters into a sale-leaseback with the landlord. This allows RH to target specific locations and lower rent expenses.
  3. Joint Venture deals: RH contributes the value of its lease to a development project in exchange for profit interests in the development (usually 20-25%). When the project is sold/refinanced, RH can “cash out” without putting up much capital.

The details of these deals aren’t important. What is important is the following: (1) the fact that RH can secure these deals on a going-forward basis is further proof of the new Gallery model and (2) future Gallery investments will require less upfront investment and generate a higher return on invested capital. The higher return on capex coupled with lower working capital requirements should drive increases in ROE going forward (return on net tangible assets is already 23% currently). There are also a few other potential bright spots driving value: (1) as RH secures a “luxury” position in the industry, it will have a customer base that’s less price-sensitive, allowing it to increase prices, (2) if RH can successfully and profitably roll-out its home delivery service, it will further enhance its “ecosystem”, and of course (3) international expansion which will substantially increase the revenue opportunity if it works. Here are the financials as they stand today:

As of now, RH has been building 3-5 new Gallery locations per annum. Because of the lower cash requirements to build these out going forward, RH expects to ramp this up to 5-7 per annum. Based on our analysis above, each Gallery has revenues by ~$60m. This also lines up nicely with management projections. At $60m revenue per new Gallery, 60-70 Galleries should generate $3.6-4.2bn vs. management projections of $4-5bn. Moreover, each Gallery is ~30,000 square feet vs. ~8,000 for a Legacy Gallery: each additional opening should increase selling square footage by ~22,000. At 5-7 Galleries per annum, we should hit ~1,600-1,800 selling square footage over the next five years (22,000*Number of Galleries opened). At the current sales productivity of ~$1,200, this retail footprint should yield us $1.9-$2.1bn in retail revenues. On average, retail revenues represent 45-50% of total revenues, so this gives us a total revenue figure of $3.8-4.6bn generated by 47-57 Galleries. Management thinks they can get to low-20s operating margin by then, but I’m a little iffy on that number. I think it’s reasonable to assume they continue to operate at a 15% margin. If this is the case, RH should be generating operating income of ~$570-690m within 5 years. If we would like an EBIT yield of 15% within five years, then, using the midpoint of this range, we should be buying this company at $264/share ($630*10/23.8m diluted shares outstanding). Another way of looking at it is the following: at 10x EBIT, EV is ~$5.7-6.9bn. With $500m in net debt (assuming 2020 converts were paid off with 2019 FCF generated from operations for the finance nerds), market cap should be $5.2-6.4bn. Relative to the current market price of ~$4bn, our 5-year IRR becomes 5.4-9.9%.

Now, I for one think the foregoing analysis is too conservative. I penalized the company on both the revenue and operating margin front for no real reason other than conservatism. I also assumed the company will trade at only 10x within five years. If RH reaches this stage that I’ve described in this previous paragraph, however, the future becomes a lot clearer: we’ll know for sure if this is a $5bn opportunity or $20bn opportunity as management touts. Moreover, RH will have solidified itself as a clear leader in this space with an established brand. An industry leader earning 20+% on net tangible assets with operating margins double its nearest competitor will trade much higher than 10x. In the preceding paragraph, I wanted to show what bad execution of a good strategy would look like, and an average return of ~7% (midpoint) doesn’t seem too bad. What would good execution of a good strategy look like? Well, we would hit anywhere from $4-5bn in revenues and margins would increase to 18+% (~200bps planned for 2020 and operating leverage from there). The company would also trade for far greater than 10x, perhaps 15-20x. If we stick to 10x for now and assume an 18% margin on $5bn in revenues (representing a ~13% revenue CAGR), operating income in five years should be $900m, and EV would be $9bn. Doing the same exercise as above gives us a 5-year IRR of 17.6%.

Like with most opportunities, the answer is somewhere in the middle. 7-17% is a big confidence interval, but at least it doesn’t contain 0%. There is one outcome we didn’t consider, however. What if this is a bad strategy? Despite historical performance, we don’t really have too much to go on. RH has been aggressively executing this strategy for about 6 years now and thus far it has been successful. But the company also has a very powerful economic tailwind propelling it forward. And why should we take these 6 years as representative of the future when this company has existed for 40 years. Greg was the CEO since 2001; why did he just think about this strategy recently? Anyone who listens to this company’s earnings calls will know it is run by some very confident managers, but can they handle direct competition? Over the past decade, RH has had an operating margin above 10% only last year, and we are extrapolating margins of 15-20% going forward. I don’t have certain answers to these questions, but certainly time will tell.

Conclusion

Interestingly, while the stock has gone up some 60% over the past year and over 600% from its lows of ~$25 back in 2017, it still seems cheap. The company is on track to produce $350m in FCF this year ($14.70/share) and EPS of $11.50/share (more like $10/share if you include non-cash interest expense). This implies that the stock is trading at 20x after-tax earnings and 14x FCF. If you take management’s word at face value (revenue growth of 8-12% and operating margin of 20% over the long run), then that implies earnings growth of over 15% over the next 3-5 years. On top of that, add the fact that management’s guidance, by their own admission, understates what they can actually achieve. And if the economics of international growth are similar to that of the North American market, which management stipulates they are, then we have a company that can grow at this rate for 10+ years. A company that can grow at 15+% for an extended period of time should be trading at a much higher multiple (25-30x would be cheap for a company that grows earnings at 15% for 10+ years). This implies that, despite the run-up in the stock price, people don’t really believe in what management’s saying. Or rather, the market is cautiously listening. Make of that what you will; personally, I don’t care what the stock price has done.

This write-up has a lot of “if’s”. But I believe that is truthfully all someone can offer given the inherent limitations of the industry. There is nothing to benchmark RH to except itself. For example, while we know luxury retailers enjoy 20-30% operating margins, the extent to which RH can increase prices to achieve this are dependent on how its brand perception changes over time. As Greg mentioned, “We are climbing the luxury hill.” Few other brands have successfully revamped their brand image from a classic niche player to a global luxury brand. Despite this uncertainty, there is also no question on how well RH has performed to date and how successful the brand has become even today, both from a public perception and financial standpoint. So again, RH is a company that has amazing economics and high returns on invested capital. It also has a potential runway to invest capital for many years given the size of the market it is trying to carve out for itself. I have tried to present the information I believe is relevant to making a judgement regarding these “if’s” without passing my own judgement, but as we all know, smart people can come up with different conclusions given the same information. RH could become a great company if it continues doing this well. Caveat emptor.

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