Description

RH (previously Restoration Hardware) has been written up on VIC as a short four times and as a long one time. The short theses all cite execution risks and the aggressive capital allocation by RH’s CEO, Gary Friedman. Today, RH operates a business model that’s one of a kind in the industry of furniture retail while Gary’s outsider-like share repurchases have turned out to be highly accretive. Simply put: Gary is a proven winner. 

This is a bet on the jockey stock that’s attractively valued on the existing opportunity in North America with material upside from an expansion into Europe and other new concepts, operated by one of the best living retail executives with a history of brilliant capital allocation (and he’s repurchasing shares aggressively right now: 10% of shares outstanding retired since quarter end).

The near-term future for RH is highly uncertain because of the macro environment and potential missteps with RH’s latest product cycle, but if you have a longer time horizon, I believe it’s likely that RH will be worth a lot more in 5 to 10 years than it is today.

Gary Friedman

Gary taking a bath with his clothes on (very contrarian)

Gary Friedman had a difficult childhood. His father passed away when he was only five years old, and his mother suffered from schizophrenia. The two lived off food stamps and what little money his mother could earn. Gary got his first job as a stock clerk at The Gap in 1977. By 1988, he had risen to regional manager, but quit to join William-Sonoma after receiving an offer from the CEO. Thirteen years later, Gary was passed over for the William-Sonoma CEO role. He decided to quit and join Restoration Hardware as CEO in 2001, taking 11 other WSM executives with him.

Restoration Hardware was founded in 1979 and IPOed in 1998. The company’s stock price had dropped to 50 cents by 2001 and the company was flirting with bankruptcy. After Gary was appointed CEO, he raised $15 million of equity, $4.5 million of which was his personal money. While not definitionally the founder of RH, Gary was responsible for saving the failing retailer and transforming it from a company whose number one selling product was Auto Bingo to the brand it is today.

RH then

RH now

The Business and Opportunity

RH operates 67 RH Galleries (furniture), 14 Waterworks showrooms (bath and kitchen hardware), and 39 Outlets (Damaged/returned products). The company doesn’t do traditional advertising/marketing and has no social media accounts. Instead, it mostly sells product out of one-of-a-kind real estate locations, 14 of which have high end restaurants attached. And while the restaurants drive foot traffic into the galleries and are an impressive business in their own right (~$10 million of revenue on average), RH has other enterprises that exist simply to elevate the brand. These include an extremely high-end hotel in NYC with 9 rooms (the cheapest of which start at $2k/night), a compound with apartments and spa being developed via JV in Aspen, two private planes that can be chartered, and a yacht that can be chartered in the Caribbean or Mediterranean. The model is really one of a kind.

The result is an LTM operating margin of 23.4% compared to WSM at 17.5%, ETD at 17.5%, and ARHS at 15.0%.

Of the 67 RH Galleries, 28 are Design Galleries with footprints of ~34k square feet while 35 galleries are Legacy Galleries averaging ~8k square feet. I believe all of the Legacy Galleries will be converted to Design Galleries, adding roughly ~900,000 additional square feet of selling space. At $2,000 of revenue per square foot (includes e-com), this represents a $1.8B revenue opportunity. Converting 3-4 galleries per year can grow square feet of selling space by ~5%/year. Adding in a 2% comp gets you to ~7% revenue growth off a normalized base.

Determining what’s normalized is difficult right now for obvious reasons, but my estimate for 2023 is a revenue decline of -5% to $3.4B, an EBIT margin of 19%, and $355 million of net income. That puts the stock at ~16x 2023 earnings after accounting for the share repurchases that have occurred since the last reporting period. This is below the street and I think it’s likely RH offers a disappointing 2023 outlook when they report earnings next week.

With 7% top line growth from the gallery conversions, operating margin expansion into the mid-20s, and leverage on interest expense, earnings can grow at a ~15% CAGR for 8-10 years while spitting off FCF from the North American gallery transition opportunity alone.

On top of this, there is the potential to expand internationally- a market opportunity that Friedman estimates to be 3-4x that of North America. RH will soon open its first location in Europe. RH England is kicking the expansion off with a 16th century 73-acre estate that contains 3 restaurants, an architectural library, and a deer park (you don’t know what a deer park is??). The company is guiding margins in Europe to ultimately be higher than they are in North America. As most forays into Europe go, progress has been slower than initially expected. RH England was originally planned to be opened in summer of 2021 at the earliest and Spring of 2022 at the latest. Here we are in spring of 2023 and now they’re planning to open this summer. However, RH is learning and the continent represents a potential market roughly the size of North America.

As a bet on the jockey type situation, I believe there’s further upside from whatever Gary can execute on- whether it’s the Aspen joint venture, lodging, or something we haven’t seen yet like leather goods, jewelry, etc. RH has historically been good at testing new concepts in a capital light way and shutting them down if they’re unsuccessful.

Share repurchases

RH has aggressively repurchased shares in the past. In the first six months of 2017 the company repurchased $1B of shares at an average price of $51.00. This was roughly half the shares outstanding. The repurchases were funded with leverage and a dramatic reduction in working capital from replatforming the company’s supply chain.

In 2018 the company spent $250 million repurchasing another 2 million shares at an average price of $122. In 2019 the company spent a final $250 million repurchasing 2.2 million shares at an average price of $115. In total, the company repurchased ~60% of its shares outstanding in three years. The company has historically issued convertible debt, but now that most of the converts have been retired and the dust has settled, we can see that the company’s diluted shares outstanding declined from 40.9 million outstanding as of 2016 down to 26.1 million in Q3. That’s a -7.5% CAGR in shares outstanding, the majority of which was done via repurchases timed exceptionally well.

The company also didn’t repurchase any shares during 2020 or 2021 when the market was over-estimating the durability of the COVID surge in home goods. Now that the stock price has collapsed some ~65% from its highs, RH is aggressively repurchasing shares. There are disclosures in RH’s recently filed proxy that indicate the company has repurchased 3.7 million shares for ~$1 billion (average price of ~$270) since its June 22nd repurchase authorization. Based on the latest Q, this implies the company has repurchased ~2.6 million shares since quarter end diluted share count- that’s ~10% of diluted shares outstanding!

The RH bears will point to dilution from Gary Friedman’s lush equity compensation packages. Since the company’s IPO in 2012, he has received three awards, each covering 4-year periods. The latest was granted in October 2020 and gives Friedman 700,000 options, exercisable at $385. Performance based restrictions on the grant start to fall off at $500/share, and more shares are released at $650 and $800/share. The way it’s structured essentially gives Friedman 8 years to achieve the target share prices.  The grant was valued at $174 million. Of course I would prefer to have Gary’s services without paying him what he’s worth, but the way this probably plays out is with the company repurchasing shares today at $270, which it then sells to Gary at $385 when (hopefully) my shares are trading for $500+… It doesn’t seem so bad.

Risks

-Key man risk: Friedman is driving this train and he’s 65 years old. If something were to happen to him, well, that wouldn’t be good for the stock. There is an existing playbook for growth in place in North America, upside beyond that and my comfort with the execution comes from Friedman.

-Macro risk: The big question mark right now is obviously what’s going to happen to housing. RH is an ‘event driven’ company. Purchases are driven by housing transactions. Decorating budgets are related to home values. Luxury home prices are still near all time highs while supply is barely off all-time lows, yet the bid-ask seems to be widening out resulting in collapsing volumes. If there is a catalyst we will probably see home prices decline substantially (and transaction volume increase). I think it’s possible that RH’s sales per square foot returns to pre-pandemic levels in 2023 despite the inflation we’ve experienced and an uplift from the RH Contemporary collection. This is a hard stock to hold right now, but everyone knows these issues which is why it’s trading at 1/3 of the price it traded at a year and a half ago. There’s no question that the stock could be trading at a higher multiple of normalized earnings than I think, but no one knows the business better than Friedman and he’s repurchasing the stock very aggressively.

-Execution risk: RH has a lot of irons in the fire. RH England has been delayed and delayed again. This has been related to restrictions on developing the historically important real estate in which the facilities are located. Still, I worry that the environment in Europe is generally not as hospitable (for ex, how well is distribution going to work there?).

Early indications are that RH’s new Contemporary line is not living up to expectations. This was presciently detailed in the VIC write up of ARHS, but the sell side is now starting to publish on this. RH Contemporary is priced 30-35% higher than RH Modern, which may be pricing out some customers. Or perhaps it’s the timing of the launch. Gary likens RH’s journey to a climb up “luxury mountain”. As RH goes higher it leaves behind pieces of the market. It’s possible that the air is too thin up here. But Friedman is a hell of a retailer and if that’s the case, I think he’ll figure it out. RH already has a great model that it can expand domestically and abroad without advancing further up the mountain.

There have been other missteps in the past, such as the Contemporary art gallery. But if they don’t work, RH has been quick to shut them down.

Catalyst

Macro fears subsiding/execution/new concepts