The setup -- you have a five minute meeting with the Gary Friedman, CEO of RH. Here are the key critical uncertainties that we think are relevant to the investment thesis today. We did this earlier this week with Target -- one of our top shorts. So let’s keep it balanced and do the same for our top long, RH which we think should triple over 3 to 5 years.
1. Logistics Network -- Today vs. Tomorrow. One of the biggest Bear arguments against RH is its inability to ship product on time and in the right quantity (i.e. a 6-piece living room order could be delivered in 3 shipments over 12-weeks). That not only delays when the company can collect revenue, but could also impact customer attitude towards the brand and its ability to meet delivery expectations. We have no doubt that RH could work through these issues today, especially with its newly upgraded fleet of DCs. But the reality is that RH has been shrinking its square footage base for the past six years. Starting next month, it goes on an explosive run of growth in square footage – from 800k square feet to nearly 3x that amount over a five-year period. So the question here is this…If you are having challenges now as a $1.5bn business over 70 stores and 800k sq feet, how can we be confident that the company can deliver product under a competitive time frame when it is three times the size? Does that mean that instead of having 5 DCs and 7 hubs, it needs to open another 5 mega-regional DCs in the top MSAs? Or another 25 facilities throughout the country? What’s the right answer?
[Note: Though we cannot yet articulate the answer to this question, in our model we assign a capital cost to both the SG&A and Capex lines to account for future capital needed to improve shipping capabilities. We give RH about an extra $80mm per year in capex, while we add an incremental $800mm over 5-years in SG&A – both of which are well North of what is expected for RH to continue on its growth ramp).
2. What’s the Optimal Store Size? The size range in RH’s fleet is daunting. It has Legacy stores at 8,000 feet, Design Galleries at 25,000, and the Next Gen Design Galleries as large as 60-70,000 sq. feet (Atlanta, Vegas). So far, the company has learned that ‘bigger is better’ meaning that the store productivity on a large box eclipsed the Legacy productivity. The math is such that there are 8,000 foot stores operating at $700/sq ft, or $5.6mm annually. But then there are stores like Houston at 22,000 feet that are doing about $2,500 per foot. Yes, that’s about $55mm per store. And that’s not a pipe dream…that’s proven.
The questions then, are a) is it realistic for some of these Next Gen Design Galleries to be running at over $100mm per box? b) at what size do you think you hit a point of diminishing returns with box size? c) you have 65 Legacy stores in the fleet, that you indicated you’ll chop away one by one over time. But the reality is that many of these are solid real estate locations, and your rent terms are better there today than if you were to find new space on your own. Why not keep most of these stores open, and use them to focus on a single category – RH Kitchen, RH Baby & Child, RH Furnishings, RH Whatever…
3. Dot.Com Ratio Shrinking? Today RH has the highest ratio of e-commerce as a percent of total sales (47%) out of any retailer shy of Amazon and Williams-Sonoma (48%), but then the competitive landscape craters from there. Pier 1, for example is about 4%. That’s a pretty huge competitive advantage for RH, in that it has achieved so much success reaching customers who live nowhere near a RH store. But now that square footage will begin to accelerate so meaningfully, the dot.com ratio almost has to come down. If it does not, then it will likely be due to productivity of the new mega-stores coming in at levels we’d find disappointing. We don’t think that will be the case. We’re modeling that e-commerce comes down to 40% over a four-year time period (while still tripling to a $2bn e-comm revenue stream). Our question to Gary would be ‘how small will you let dot.com get as a percent of the total.’ Our sense is that he’d come back with an answer that sounds something like “I could care less where the sale originates – in a store, or online – as long as we book the sale.” We’re cool with that, and largely agree. But it’s a key question to ask nonetheless.
Bonus Question (for those times you get an extra few minutes to sneak in another question)
Fashion Risk. Even your average non-fashionista type with no sense of design could walk blindfolded into a RH-themed room and know within about 3 seconds that it is RH. It just has that ‘RH look’. It’s a look that has been very relevant for three years now. The question is whether a) RH just happens to consistently nail the current trend, or b) it leads consumer trends by sourcing the product it thinks consumers will want, and then merchandises and markets it in a way that the consumer will want to buy it. Our opinion is that RH is an example of ‘B’ – much like what Ralph Lauren has become in the apparel space (seriously, when is the last time Ralph missed a fashion trend? Answer – never). Though we’re kind of answering this question before we ask it, we would like to know more about Gary’s process for driving demand around a given assortment. He alone can offer the best insight on this one for RH.