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  • Brett Schafer

Not So Deep Dive: RH Stock

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  3. Apple Podcasts

Show Notes

(Ryan) What they do: “RH is a curator of design, taste, and style in the luxury lifestyle market”. Basically, it’s a high-end retailer of home furnishings, but it has some unique characteristics. So they primarily sell through these really grand locations which they call galleries. These pretty much function as show rooms and they’re pretty stunning looking. They are these extravagant buildings in major metropolitan areas that are just ultra-luxurious. They have 81 retail locations in total, and they sell things like furniture, lighting, home decor, outdoor & garden items, and a few more categories. And the items are really expensive obviously, so like the cheapest couches tend to start at ~$4,000 and a sectional can cost upwards of $10k.

RH sources its products by working closely with 3rd party vendors and manufacturers. About 3 quarters of their purchases came from 29 vendors, with the largest accounting for 11%. And they manage their own distribution and delivery. They have home delivery services for their customers as well. So that’s the basics of the business, pretty easy to understand. But they’re trying to do a lot more now as well. They want to become this all-in-one luxury experience by expanding into hospitality services, but we’ll touch on that more in future growth opportunities.

(Ryan) History: RH, or Restoration Hardware as it was known initially, was founded by Stephen Gordon in Eureka, CA in 1979, with a somewhat similar concept to what it is today (only it was just hardware, and didn’t have quite the luxury appeal). Gordon had experience working in merchandising and his goal was to sell high-quality but affordable hardware. That business expanded gradually, and eventually, IPO’d about 20 years later in 1998. Fast forward 3 years and Restoration Hardware hired Gary Friedman as the new CEO. Friedman from what I can tell has worked in retail all his life starting as a stock boy at GAP. At one point he was passed over for the CEO role at Williams-Sonoma so he joined RH.

For the next several years, Restoration Hardware continued their expansion but met turbulence during the GFC. So in 2008 they were actually taken private, and started going more “up-market” at this point. By 2012 they rebranded as RH and re-IPO’d that year. However, this new strategy was met with skepticism from the investment community (keep in mind, it’s about the same time that Amazon was gonna kill everything), so RH kind of became a battleground stock. There’s even sort of this famous quote from Gary Friedman from 2017 where he says “52% of our shares were short, for God’s sake, okay? Honestly. And the shorts, and those of you in the room, listen, I don’t care, everybody can gamble the way they want to gamble, honestly. Again, I care about our long-term investors.” Around that time they also started a levered buyback program, so since that point the stock has gone from $20 to about $340 today.

(Brett) Industry/Landscape/Competition:

  • Two markets:

  • Current: upscale fuiture market

  • Future: hospitality, restaurants, and travel

  • Management believes there is $20 - $25 billion in demand worldwide for their niche. Total home furnishing market is $170 billion

  • The long-term market gets a bit into TAMsanity at a $7 trillion - $10 trillion TAM estimate from management (really just ignore that)

  • Competitors: Pottery Barn, Ethan Allen, the Citizenry, Herman Miller, Wayfair. There are a ton of competitors out there.

(Brad) Management and Ownership:

  • Gray Friedman

  • CEO and credited with “Founder of the RH brand as we know it” since 2014

  • Former Co CEO there and a BOD from 2001 on

  • Former President and COO of Williams-Sonoma and C merch O

  • President of Pottery Barn

  • Awesome resume

  • About the lowest glassdoor score I’ve ever seen with 46% approval and over 1,000 reviews

  • President is Eri Chaya

  • Climbed way up the ladder for 15 years

  • Former Banana Republic Creative Director

  • CFO Jack Preston

  • Former Director in consumer and retail IB at Bank of America

  • Ladder climber as well

  • long tenures (great SBC?)

  • Ownership:

  • Gary has 28% – total compensation of $178 million thanks to a massive options package in 2021 but salary $1.25 million – cashed out from a 2017 stock price performance package.

  • Blackrock has 8.4%

  • Berkshire has 8.2%

  • T Rowe Price 6.0%

  • Goldman Sachs 4.6%

  • All execs and officers have 33.4% anthough no other executive has a material stake

(Brett) Valuation:

  • Market cap of $8.3 billion, ticker RH

  • EV is right around the same as market cap if you exclude leases

  • P/S of 2.2

  • P/OI of 9

  • P/FCF of 17 (in a heavy investment period and inventory headwind)

  • All the tugs and pulls of dilution/convertible notes are too much for this show but they have 7.7 million options outstanding vs. 24.5 million current shares outstanding (they just diluted through closing the convertible notes)

(Ryan) Earnings:

  • 2021 revenues of $3.8B, up 32% YoY

  • On that revenue, RH had a 25.2% adjusted op. Margin (that’s up YoY, and up from 14.3% versus 2019)

  • They also had $477M in FCF for the year, which is about a 13% free cash flow margin. That also includes a $191M increase in inventory which certainly hurt their cash flow.

  • But this quarter was a tough one for them with the supply chain. So they’ve built up this big backlog.

  • In fact, Friedman’s commentary around this kind of went viral. When asked about new product launches on the CC he said “What do you think? Of course, it’s impacting launches…I mean the supply chain; I think many of us thought it would have been we have been caught up by now. I mean, we'll be lucky to be caught up by the end of the year. And because it's just hitting everybody from all angles, all the raw materials all the transportation issues, not just the transportation getting it to us. Our vendors having to get all of their components from all over the world shipped to them. So you just have this compounding supply chain kind of puzzle happening.”

(Brad) Balance sheet and liquidity:

  • $2.2 billion in cash and equivalents on hand

  • $1.9 billion term loan with another $294 million in convertible notes

  • Looks like 2%ish dilution YoY

  • Operating cash flow positive

Anecdotal Evidence:

  • (Ryan) Never been, but the one in Seattle looks crazy nice. The building looks way out of place though. Looks like a European Villa in the middle of a college shopping center.

  • (Brett) Seems fine, don’t have a grasp on it I’ve never been.

  • (Brad)

Future growth opportunities:

  • (Ryan) Moving to hospitality. As I mentioned earlier, RH is trying to make their customer experience more holistic. This includes live fire restaurants, caviar bars, wine bars, and even guest houses. So far they’ve integrated RH hospitality at 13 of their locations, and they plan to expand it into more as well as making it a staple of all new galleries. This should not only increase spend through food and drinks, but RH believes that the addition of hospitality will drive incremental sales of home furnishings too. I like the thesis here, – drunk people spend more.

  • (Brett) European expansion. This is happening in 2022 and next few years in England, France, Germany, and Spain with galleries opening up. Friedman thinks there is less competition in luxury furniture than in the United States. However it is still a big risk since luxury product culture seems very different in Europe compared to North America. Will RH be embraced?

  • (Brad) Auto OEM partnerships to build them a nice interior? Peloton purchase to expand into upscale gym equipment to round out the in home portfolio?

Highlights and lowlights:

  • (Ryan) Highlights: I like Gary Friedman, and he’s obviously run the company really well. The luxury market should do better in a recession. And I think they can be successful with these new initiatives. Lowlights: They are in a really tough spot right now with the supply chain. 69% of their products come from Asia. I saw a chart this morning, that showed there are almost 800 ships waiting to load or discharge in Shanghai. An it’s at an all-time high by a long shot. In the short-term I’m not sure what cash flow is going to look like.

  • (Brett) Highlights: Definitely an upscale brand with pricing power (maybe luxury), strong unit economics with great real estate strategy that has generating good ROICs, lots of optionality with these new initiatives. Lowlights: There are two things I don’t like. One, they are probably still tied to the business cycle and are more consumer discretionary. Two, the growth initiatives are on the border of ambitious and reckless.

  • (Brad) Freight and inventory pressures are beginning to fade just looking across public data. Pair that with less budget conscious and more affluent consumers they serve and margins could get a boost off of the current pain they’re dealing with. I think we could be seeing a bottoming of margins. Lowlight is that the glassdoor rating stood out to me. I’ve never seen a score anywhere near that bad and that sample size was large. Also that earnings call messaging from Gary was a bit dramatic.

Bull Case:

  • (Ryan) At a single-digit operating income multiple, there’s a good chance this has at least 20% returns over the long haul. Especially if they’re able to be successful juicing more revenue out of their existing galleries. Not to mention luxury is a far more resilient market.

  • (Brett) Given the decently cheap valuation on trailing numbers, you need to believe North American business is fairly immune to economic cycle and European expansion is a success. Driving top-line at 10%+ a year and bottom-line slightly quicker. No need to do any fancy modeling here just a few big questions to ask.

  • (Brad) The company can overcome daunting supply chain issues and continue finding affordable demand as it expands into B2B segments.

Bear Case:

  • (Ryan) The short-term headwinds prohibit RH from expanding or launching new initiatives. If they aren’t able to grow the top line by at least high single digits over the coming years, even if they get back to being highly profitable the returns won’t be fantastic. I do think there’s a solid floor here though.

  • (Brett) The new projects burn a ton of money and cyclicality is more of an issue than we think.

  • (Brad) Macro forces margins down and new growth channels don’t work

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Disclosure: The author and podcast guests are not your financial advisors. Ryan Henderson and Brett Schafer are general partners and portfolio managers at Arch Capital. Clients of Arch Capital may hold securities discussed on this show.

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