RH: Turning A Frown Upside Down

Takeaway: Sensing the Chinese water torture of S1s could hurt, RH upped guidance a lot closer to what we think it will earn (but still not enough).

RH got some good advice on this one and averted what could have been a multiple-killer.

 

When the company announced yet another follow-on offering on July 5, the story immediately lost some momentum. The underlying fundamentals were still solid, but anyone with a shred of analytical integrity had to step back and wonder if it was going to be like a 'Chinese water torture' of additional stock sales.

 

That was particularly the case with the size of the deal growing to 12mm shares from 10mm after the close tonight, and with officers and Directors participating instead of just Home Holdings (the three firms that took it private -- whose ownership will be down to 15.9% post offering ).

 

But alas, RH came out and issued new long-term growth targets that are nothing short of parabolic. It made the following changes…

    1. revised revenue growth to low 20s vs prior goal of mid-high teens. 
    2. EBITDA growth from twenties to high 20s
    3. EPS growth of mid-high twenties from prior growth of 'about 20%'

 

Note that the revenue growth guidance is a bit closer to our model, but our much more aggressive top-line forecast of 30%+ is the base of our roadmap for RH to achieve triple-digit status (see our research below). We should also note that we think that the company is being conservative with the leverage to the EPS line of a company in this business that is growing its top line in excess of 20%.  In three years' time we get to $3.36 in EPS vs the Street at $2.22. Ultimately, in 5-years we're over $5.

 

RH: Turning A Frown Upside Down - 1

 

HERE'S OUR RECENT NOTE POST 1Q THAT WE THINK BEST HIGHLIGHTS OUR CALL

06/14/13

RH: CAN EBIT GO UP BY 10X?

Takeaway: RH is expensive and it's built to stay that way. It continues to meet or beat our lofty expectations. The consensus is low by 60%.
 

Conclusion: Still one of our favorites. The company overdelivered on a heck of a lot more than the EPS line. It took up sales and EPS guidance well ahead of what the 1Q beat would imply. It accelerated square footage, announced yet another two businesses, two new catalogs for Fall, and made a  major hire in luring away the President of the Williams-Sonoma brand to be CMO for its RH Kitchens and Tableware business (where current share is near zero). RH continues to meet or beat our expectations in almost every area. The biggest question for us here revolves around how much higher the stock can go. After all, the stock is up 82% in six months, and is flat out expensive. But it was also expensive 82% ago. In addition, if our model is right, we're looking at an earnings CAGR of about 50% for each of the next three years. Then it eases to something in the mid/high 20s. So what's a fair multiple for that? 30x? 40x? It's tough to say. But what we can say is that we're 60% ahead of the Consensus in the outer years, and until the Street realizes that there's $5.00+ in EPS over 5-years, then we're comfortable owning it even if it's expensive. 

 

 

RH was one of our favorites headed into the quarter, and it remains so after the quarter. But aside from a solid beat, we did not expect much in the line of new disclose or thesis-changing information with this print given that the company just executed on its secondary on May 15th (which in itself was just weeks after a delayed 4Q earnings print and subsequent positive preannouncement).  We were wrong -- they gave the thesis some more positive go-juice.

 

Here's what changed on the margin:

      1. First off, RH beat the quarter by $0.03, but took up full year guidance by $0.10-$0.12. Not many companies are doing that these days. RH took up annual revenue guidance by 4%, and 2Q revenue by 7%. None of these things are thesis-changers for us, and in fact, we're still well above these numbers. But they're confidence-builders nonetheless.
         
      2. RH is fresh off the ICSC conference in Vegas and the company had better than expected success in pairing up with potential landlords for new Design Galleries. Not only does it take up the number of Galleries we're likely to see over time (over 50), but we think it also takes up the average size per store. These two factors are a critical on a combined basis as it relates to our margin of safety on the RH growth algorithm (see below). With more favorable availability of sites comes more favorable rents and cap rates -- it's economics 101.
         
      3. RH is launching two new businesses -- again.  Does this sound familiar? In RH's first quarter out of the IPO gate it announced the launch of RH Tableware, RH Objects of Curiosity, and RH Fine Art. Now we've got RH Kitchen and RH Antiquities. Both of these are massively fragmented businesses and present huge opportunities for RH. These are in addition to RH Leather and RH Rugs, two new catalogue drops this fall. #growthaccellerating
         
      4. RH managed to snag Richard Harvey from Williams-Sonoma to be CMO for RH Kitchens and Tableware. The simple fact that RH's share of this category is close to zero today, and they went ahead and hired the person with the best track record in the world in brand-building, sourcing and merchandising in the kitchen space….that's just huge.
         
      5. There's only one new risk that we can point towards…and that's execution. We're looking at a company that should double square footage, triple revenue, and take up its EBIT ten-fold over the next 5-years (seriously…let us know if you want to see our model). In doing so, RH will need to introduce and scale new categories in some of the most fragmented categories in all of retail. Fragmentation is good from a competition standpoint, but it is also usually characteristic of a category is difficult to scale. From a modeling perspective, we can quantify the cost of a new store. We know square footage. We can make pretty good estimates on the new store productivity curve. We can also make assumptions about rents and leverage hurdles for occupancy expense. But what we find very difficult to do is modeling SG&A. We think that we're safe in modeling a 15-20% SG&A growth rate in each of the next 5-years. SG&A might not be very sexy, but we think that this is the biggest and most unknown lever in the model.

 

 

A REMINDER ON WHY WE LIKE RH

We think that RH is to home furnishings what Ralph Lauren is to Apparel and what Nike is to Athletic Shoes. It's the preeminent brand in the space, and sets/leads consumer style trends/wants/needs but with very little fashion risk. From a maturity perspective, we think that RH is 8-10 years behind RL, and 15-20 years behind NKE. Its got the runway. And even though it has such minimal market share across its categories, the competitive set is actually not very strong.

 

One thing that makes the RH model stand out is the growth algorithm over the next 5-years. Specifically…

      1. Square footage is not growing today. The company has perhaps one more quarter where it shrinks and then it starts its' climb. 
         
      2. But our point is that today it is the comp that's driving the model. We can clearly see where that's coming from, we can map out additional sales as new businesses come on line, and we can draw out the comp curves for new higher productivity stores entering the comp base and hitting more mature productivity levels. We're modeling sales per square foot going from $846 last year to just shy of $1,500 in year 5.
         
      3. Ultimately, comps will slow. It's a mathematical certainty. But at the time comps slow we're likely to see square footage growth accelerating to peak rates of growth. Square footage is shrinking slightly today, and should be up at a rate near 20% by year 3.
         
      4. So you see…we can safely model the comp today due to reasons discussed above. Then as that starts to level off, we have square footage ramping up. We can safely model that too. As the second chart shows, that gets us to just over 20% annual revenue growth with comp and square footage flip-flopping their importance to the model as time passes.

 

RH: Turning A Frown Upside Down - 2a 

RH: Turning A Frown Upside Down - 3a