RH is our top long idea in Retail by a country mile, and we remain convinced that the company will see earnings grow from $1.71 last year to near $11.00 in five years time. If we’re right on that earnings number, which we think we are, we think that this is ultimately a $200 stock. We don’t think this is just a square footage growth story (which is impressive in its own right), but rather one of the biggest market share stories in retail today. In effect, we think that RH is doing to the high-end home furnishings space what Ralph Lauren did to apparel on 1980. The parallels are staggering. For more details on the long term opportunity, check out our latest Black Book.
Looking more near-term, we feel really good about RH heading into the 6/11 print. Demand remains strong, the Sourcebook appears to be well executed, the May/June store openings are on track (Greenwich/NYC), the company’s on-line business appears to be tracking quite well, and EPS expectations for the quarter appear very doable (we’re at $0.16 vs the Street at $0.11).
Given our comfort level around the print and the year, at this point we’re hyperfocused on one thing…where can we be wrong?
Here are some factors that we think about as it relates to the print and guidance. To be clear, after vetting these factors we still come out positive. But let’s lay it all on the table such that there are as few surprises as possible.
- Buying shallow. When the company launches a Sourcebook, it usually does so with a redesigned product line, which is exactly what it did with its goliath 16-lb book that was distributed to customers via UPS from mid-May through early-June. But given the ever-growing breadth of RH’s product line – the company has a tendency to go very shallow with inventory around the book. The strategy is simple…let consumers tell you over the course of 2-3 months which items they like the best, and then go very heavy on inventory for those items in the subsequent three quarters. But that could mean lighter guidance on revenue in the upcoming quarter. For the year, it is a strategy that clearly maximizes gross profit dollars and ROIC. But there could be a shift between 2Q and 3Q.
- Deferred Revenue. The RH-haters out there love to talk about the company’s deferred revenue as customers wait 10-weeks or more for custom items (keeping in mind that RH does not get paid until the customer takes delivery). In 2Q14 we could see an uptick in deferred revenue around non-custom items due to the strategy around buying shallow that we outlined in point #1. It could provide ammo for those RH bears who want to poke holes in the company’s revenue recognition. We’re not worried about the economic reality -- -but just the perception based on how some people will take it.
- Margin Weakness. With any new assortment, margins will usually be lower given that the company will not have hit its own costing hurdles to lower its COGS on high volume. The margins will be better on the product 3-4 quarters out when RH focuses its inventory spend on key items and gets additional volume discounts. Initially, it will be buying some items that might not be as popular as it otherwise planned. That leads us to think that there’s the potential for a margin ramp throughout the year – though they could potentially be lighter this quarter.
- Dead Rent. RH is officially in growth mode. It opened the Greenwich store successfully in May, and will open the FlatIron store in NYC in a few weeks. Then there’s Atlanta and Chicago in 2H followed by a meaningful acceleration in 2015. It takes between 6-12 months to complete a store. The bigger the store, the more time it will take. And make no mistake, the stores are getting bigger. While the company is overseeing construction, it is paying rent – and a lot of it. It’s known as Dead Rent, and it has never been a part of the RH equation as it has been in store shrinking mode. But there will be a meaningful ramp in rent over the next 12-18 months, and we’ll see some of it this quarter. The company is getting great deals, which helps. For example, the Greenwich store just opened up at $1.1mm in annual rent. That seems like a lot, but it is replacing a store up the street that is 1/3 the size where they pay $1mm in rent. That’s only $100k extra for about 15,000 extra square feet. The ROI is astounding. But as it relates to quarterly occupancy costs, there is clearly some overlap. We think we’re accounting for all this correctly. But it is an area where we could be wrong on the near-term earnings flow.
- Flatiron Comp. The store that is ‘opening’ in the Flatiron district is really not opening at all. It’s a renovation of the most profitable store in the fleet. As this store opens up with an extra 13,000 square feet attached to it (on a base of 9,000), it’ll be yanked out of the comp base for 14 months. Sales will still be recorded, of course, and will show up on the top and bottom line. But the reported ‘brand comp’ will not include this store. That has the potential to cause some confusion in comp guidance.
- Amortization of Sourcebook Costs. The company amortizes its Source Book costs on a 12 month time period over the expected ramp in revenue of the book. This is a meaningful number – our best estimate is that it’s about $50mm this year, or about $0.75 per share (not disclosed). That dwarfs the ‘Dead Rent’ costs. The ROI on this book remains extremely high. But any change in accounting – from a curve to straight-line, or even to a longer duration than 12 months – would muddy the numbers. Karen Boone (CFO) is borderline religious about this accounting, so we’d be floored to see any change. But if there was, it would certainly be outside the realm of things we’re expecting.