We're adding RH to the long side of the ledger in the Hedgeye Virtual Portfolio. With the stock down 9% on an otherwise great quarter, it's a great time for us to get involved on a high conviction research call. The Street does not like the lack of guidance -- particularly given the bumps and bruises around short term events like Sandy and the West Coast Port Strike. Based on what we see, the company is executing on its its growth strategy. We have that confidence, plus our own research -- and that's all we need. We'll let the Street stress about not being spoon-fed. We'll buy on the down days.
We were asked this morning what we thought a fair value for RH was. Our response sounded something like this.
"I rarely like to ‘pick a multiple out of nowhere’, but the way I look at the earnings power, we’re coming off $0.57 last year headed to $3.00 in 4-years. I’m ahead of the consensus by 40% next year alone. With a 30% earnings CAGR could I justify a 25x earnings multiple? I think so. Apply that to $3.00 in calendar 2015 and I get a $75 stock. I discount that back at a hefty 20% discount rate and I get a $62 stock in 2 years, and $52 1-year out."
Here's our Thoughts on the Print
This story is still full steam ahead, which is notable given that investor interest around the name has been paltry at best since the day after IPO. Comps are crushing it at +29%, the new Design Gallery in Scottsdale opened at or ahead of plan, and the company announced two new catalog businesses to launch this Spring – RH Tableware and RH Objects of Curiosity. It also announced RH Fine Art, which is likely an ASP-lifter. There’s usually not this much new info out of a recent IPO, but we definitely liked what we heard. There's noise around 4Q-to-date trends given the port stroke and lingering impact of Sandy, but that's hardly a sign of real underlying trends.
We’re taking up our Direct Numbers my next year about 4k catalogs without any degradation in revenue per page. This takes up our total Direct revs by about 800-900bp, and total RH sales by about 400bp.
There seemed to be some concern on the call about the Gross Margin. That shouldn’t be the case. The company went up against up a +450bp gross margin in this quarter last year. On a 2-year run rate, the gross margin was up 200bp despite an incremental shift to furniture which is lower GM (COGS includes shipping costs). This not a Gross Margin story on a longer term basis. It is about sheer top-line growth leveraging SG&A (which only grew 12.9% vs 22% sales growth).
We still like this one a lot. The key rationale is that…
1) We think that the company can leverage mid single digit square footage growth into double digit growth, and 20% top line. The company can then leverage fixed costs and grow EBIT by 30%, and EPS approaching 40% while it pays down debt. It is not without its volatility – especially on a quarter to quarter basis, but the growth algorithm works.
2) Scale is critical in this business. That’s not a problem for RH if you measure by number of stores given that it has 73 locations as it can leverage a national distribution platform. Unfortunately, store count is a pretty useless metric when your average store is so small that it can only show 25% of the assortment. Categories like apparel might be ok in showing a prospective customer an item in an iPad 'lookbook' in hopes of placing an order. But when buying a sofa, desk, or bunk beds, people need to touch and feel. The shift to the company’s Design Galleries allow the ENTIRE assortment to be visible in the appropriate places.
3) With the larger (25,000 square foot) Galleries, the company can also get into new categories like we’re seeing it do in the Spring of 2013. These will allow the company to cherry pick the best and most appropriate mix of product in each region and for each store to maximize sales productivity.
4) While it opens Design Galleries, the existing base of stores allows the company to backfill existing markets with the new categories that are being tested in its new concepts.
5) It has only scratched the surface with its design services offering. Ever try to furnish a home with the help of a designer? Plan on spending 2x your budget.
6) In the end, the Home category is one of the most fragmented in retail. Though people are quick to complain that prices are too high, we'd be quick to answer that there's a difference between high price and expensive. RH’s existing prices on like-for-like items are very competitive, and there are no other retailers that are doing what RH is trying to do with the same scale. It has had ‘defacto SKU proliferation’ in the past that held back profitability – which was only the case because it did not have the real estate to show 75% of its product in the way it needs to be presented to consumers.
RH remains one of our top picks for those with a higher risk tolerance.