Conclusion: RH remains our highest conviction long idea in the Retail space, with ultimate earnings power of $11 per share and a stock price in excess of $200. The company’s 4Q print supported our thesis in many ways. But despite all the positives around revenue outlook, store growth, and margin upside, the biggest growth in the quarter from our perspective was not found in a line item…it was in the CEO.
When we talk to investors about RH, almost every single critic lists Gary Friedman as a chief concern now that (former Co-CEO) Carlos Alberini has left the picture. In investors’ minds, Gary was the product guy, and Carlos did everything else. That’s an incorrect view, but like it or not, that’s the perception. Well, this quarter Gary literally sounded like a different person. He spent more time talking about ROI, capital deployment and managing risk in the business as he did talking about product and merchandising. The only question to be answered is whether this is just a temporary Gary we’re seeing in the immediate wake of Carlos’ departure, or if this marks a structural change to how he approaches his role. Critics will claim the former. We think it’s the latter. Time will tell, but there’s no disputing the change as it appears today.
We’re not making any material changes to our estimates. We still think that the company will have a far better year than it’s guiding. As much as that should make the stock continue to grind higher, the real upside comes from earnings expansion as this growth story plays out – which literally begins in April/May with the redesign of its product line, launch of its Sourcebook (all 3,200 pages of it), and the opening of the new store in Greenwich (which kicks off a mini-burst of square footage growth).
As for valuation, the name seems expensive at face value, but is it? This is a 45% EPS grower that’s trading at 22.7x our 2014 estimate (Nike trades at a higher multiple and earnings are shrinking). That translates to about 10.5x EBITDA. By the end of our model we’re looking at less than 6x earnings and 3x EBITDA. If you care to look at it a different way, let’s look at the EV to total addressable market value. Not a perfect metric, we agree. But it gives a sense as to the value of the company relative to the underlying business opportunity. We chart that stat for a host of retailers and it’s pretty clear that RH is the cheapest of the bunch – by a long shot.
Here’s a few things from the quarter that we found notable.
1. We need to address the hiring of Doug Diemoz as the Chief Development Officer. While we’ve never quite heard of that title before, that doesn’t mean that it can’t be effective for RH. As focused as Gary is in steering the ship, the reality is that there are a lot of areas for growth where Gary simply does not have the bandwidth to pursue. Now he’ll have someone who reports directly to him that can explore these opportunities. And of course, Diemoz is part of the Williams-Sonoma alum club – along with Gary, Richard Harvey (Kitchens), and Ken Dunaj (COO). (We’d put CFO Karen Boone in there too from her Deloitte audit days).
2. ‘Always Innovating’ One thing we particularly liked was when Gary noted that people who are going to nit pick over timing of costs and revenue by quarter will perennially be disappointed with RH because “we will always be innovating.” There are other companies that have that same mindset – such as Nike and Ralph Lauren. Both have a dominant founder/leader who sets the tone inside the organization, and both have never been afraid to invest in the business even when it was not popular at the time by Wall Street. Both companies have emerged as superb stewards of capital over time. RH has the exact same feel to us as those other companies.
3. Holiday: One thing that we underappreciated in the quarter was the company’s reliance on Holiday. It’s markedly less than WSM, but some of the weakness on the top line was driven by the company’s gifting categories. Those weaknesses were attributed to a medley of weather and self-inflicted wounds the latter of which was focused on the company’s decision to send Holiday Source Books to only 20-30% of its mailing list. The source book strategy in total is still a work in progress (more on that below), but what strikes us is how data dependent the company is. There are still some wrinkles to iron out in the system, but the company is working through different strategies in order to maximize return on ad dollar spend.
4. Source Book Strategy: This spring’s 3200pg Source Book is exactly 2x what it shipped last Spring. The raw page count seems excessive, but it makes sense when you consider the breadth of the company’s product assortment in 2014. Add to the existing categories RH Rugs, RH Leather, and one unknown and you have the real core of RH’s product offerings – the one exception being Kitchens which isn’t scheduled for rollout until 2015. We estimated that the company saved about $40mm by eliminating the Fall Source Book. Some of those costs will be transferred to the Spring book, but when you consider cost savings from production and shipping, net-net the company is coming out ahead on this one. The reality is that the company won’t be mailing out the full assortment to all of its customers. When you look at the numbers from 2013, customers received about 40% of the assortment. That number will probably be even less as the company tries to leverage the shopper data it has collected over the past few years to target specific consumers with specific assortments. On top of all that you have UPS delivering the mailers this year which may increase shipping costs, but will ensure a targeted and on-time roll out of the books in 2014, with better data for the company to analyze.
RH: DURATION REVIEW INTO THE PRINT
Takeaway: There will be puts & takes on the 4Q print. But the multi-year catalyst calendar starts in April. Beware getting beared-up over 1Q guidance
Conclusion: They’ll be puts and takes on the 4Q print. But the multi-year catalyst calendar starts in April. Beware getting beared-up over 1Q guidance. We stand by our positioning on RH that we presented in our last update conference call/deck in early February. Specifically, we laid out how we’re thinking about the name across multiple durations. See the links below to both the slide deck and audio presentation. Our general view by duration is as follows.
TAIL Duration (long-term): One of the most powerful growth algorithms in all of Consumer. The company should earn around $1.70 this year, and we think that over 5-years that number approaches $11. Common perception is that RH is building a bunch of palaces and hoping that people will show up to shop. We think about it the other way around…they are creating assortments of product across multiple categories in the home space, and are subsequently taking a massive piece of a category where they only have 2-3% share. Yes, bigger stores are a part of this, which is critical to support the kind of product extensions we’ll see from RH. Currently, the Legacy 9,000 sq ft stores only house 20% of the SKUs and run at about $750/sq ft. The 25,000 Design Galleries highlight closer to 50% of the product, and they average an ‘per foot productivity’ rate that is 2x the existing core. People often ask us about why RH has the right to expand into new categories of Home. People asked that same question about Ralph Lauren in the 1980s when he expanded beyond neckties and polo shirts. Our full modeling assumptions are in the Deck (link below), but the key is to measure the success by product and design creation and sourcing, not by simply building stores.
TREND Duration (next 3-4 quarters): The trends should accelerate dramatically over the course of this year for RH. First and foremost, the product line is being meaningfully changed for the Spring. With that will come an updated Sourcebook – which the company has not released in the better part of a year. At the same time, after a full year of not adding a single square foot of space, RH will be adding four new stores throughout this year. In April/May we’ll see the much anticipated opening of Greenwich, CT, the store in the Flatiron District in NYC, then in the Fall we’ll see Los Angeles and Atlanta. As noted above, the actual stores are not as important to us as the product that goes behind them. But this year, the calendar is lining up nicely with a product refresh in the Spring and then four large stores immediately following, That’s about 12% growth in square footage. That might not sound huge for a company that will be looking at a 30%+ growth rate in square footage within two years. But it matters to us given that it has not grown square footage since before 2008.
TRADE Duration (Immediate-term): The TRADE duration was a slam dunk when the stock was in the $50s. The reality is the Street got beared up because just about every retailer was missing numbers due to weather and whatever else is going on out there in the economy. But with RH, 47% of it’s sales are dot.com, which are weather proof, and the category in itself is not very ‘at-risk’ due to snow. Think about it…if you want to go shopping for clothes, you might pick up a pair of jeans. If it’s snowing, that purchase is probably dead. But if your kids need new bunk beds, are you going to bag the purchase just because it’s snowing? No. We have some useful stats on the topic in the Deck. We’re not very worried about the actual number that RH reports. The company has extremely good visibility with its top line. The same factor that the Street beats this company up so often for – the long lead times in its shipping window – also gives the company great visibility into its top line for an extended time period.
The big question is around comp guidance for the first quarter. The company already noted that the first quarter would be its weakest comp of the year – due to the timing of the product refresh and catalog drop. The Street knows that. The consensus is printed at 11%, and we think that the whisper is for something in the high-single digits. Could guidance for 1Q be in the single digits? Yes – with no product refresh, a 41% compare vs last year, and the strong possibility that some 1Q purchases were pushed into 2Q,the upcoming quarter will be the weakest of the year – as management already indicated. What we can say is that with the tremendous delta in our estimates versus the Street over our modeling horizon – and with how good the TAIL and TREND calls are lining up, we’re not going to get too bent out of shape figuring out if people are going to freak out over guidance that was already largely given.
MATERIALS: CLICK HERE
AUDIO REPLAY: CLICK HERE