This quarter served as another milestone for RH in its march towards $11.00 in earnings, and additional proof for us that this is perhaps the best idea in all of US retail. The after-hours move to $80 is nice…we’ll definitely take that. But it’d be a mistake to lose sight of the very real potential for this to be a $200+ stock over a 3-4 year time period. The EPS CAGR RH will need to get there is over 40%, and our research says it’ll get there. What multiple is fair for a 40% EPS grower that earns $11? Let’s say 20x, conservatively. If we’re right on earnings, we can build to a stock well above $200. In other words, the call is not done. It’s really just beginning.
Think about it like this. RH went over six years shrinking its real estate footprint. But starting next quarter, it will go on a 5-7 year tear as it executes on its store growth strategy. Next year alone, we should see square footage grow in excess of 40%. And it’s doing this while it simultaneously executes its category expansion plan – such as kitchens, which alone should be a $2bn business. Our point is that it’s easy to get hung up on a given quarter with this (or any) company, and this quarter the stock is definitely getting its due. But if you look at a the story bigger picture, you’ll see that it consolidated for six years, and now should gain share of the market at an accelerated rate for another six years. The bottom line is that it seems a little short-sighted from where we sit to think that just because the stock is hitting new highs that the opportunity is over.
*Note: We’ll be issuing another RH Black Book in two weeks where we’ll be conducting a deep dive into specific drivers around the company’s new Design Gallery growth initiative. Stay tuned for details.
Our Take On The Quarter. As it relates to the print itself, it was pretty much spot-on with our model. The comp was exactly in line with our 18%, though revenue was slightly better due to better new store productivity. Gross margins were also a touch better due to better merchandise margins, and less ‘dead rent’ (see below) than we conservatively expected. That accounted for an extra $0.02 above our Street-high $0.16 estimate. We’re sticking with just about every assumption in our model, and remain well ahead of the Street this year, and every year thereafter.
We’ve got to note Gary Friedman again (he was a positive callout last quarter). There are still so many ‘Gary-Haters’ out there. We kind of get that you can’t radically change the perception of someone’s persona overnight. But we think it’s impossible for anyone that is ‘anti-Gary’ to be intellectually honest and not admit that the guy has tremendous command over virtually every part of the business – from stores, to product, to personnel, to cash flow (yes, cash flow). From the get-go, he laid out his vision and he took control of the narrative that he wanted to tell. So many CEOs default to playing defense to Wall Street’s agenda. Gary set his own, and we found it convincing. If you want a polar opposite scenario, look at Lululemon, which will have reported by the time most people read this. Both companies are about $1.5bn in sales, both are in unusually high growth categories for US Retail, and both can grow by a factor of 3x within 4-5 years. Our confidence that RH gets there is 90%+. Our confidence in the current LULU management team is closer to 10%. To mention both CEOs in the same sentence is almost laughable (note: LULU can get there, but we need to see serious change – they should look to RH for guidance).
In case you missed the call, here are some of the more notable callouts on key margin components.
For the balance of the year there are 4 key drivers on the Gross Margin line.
1) Pricing initiatives: With the product refresh starting to hit the P&L in 2Q, RH will benefit from the anniversary of its 2013 pricing initiatives while also getting a little boost by taking price on the new assortment.
2) Mix & Shipping: The company isn’t going to realize the full benefits of mix shift until the new Design Galleries account for a more meaningful percentage of the company’s square footage and Kitchens is added to the mix in Spring of ’15, but management indicated on the call that furniture’s penetration as a percent of sales was starting to flatten out. This, along with RH’s new source book strategy should help with shipping leverage, with more of the benefit weighted towards the back half of the year.
3) DC leverage: The company will anniversary the opening of its Dallas DC and Ohio shelf stock facility in 2Q, and will benefit from DC occupancy leverage in the 2nd half of the year.
4) Pre-opening expenses: The company will face some headwinds from retail occupancy deleverage in the back half of the year as it ramps up spend to facilitate 2015’s class of Design Galleries.
Biggest call outs here are fixed cost leverage and ad spend.
1) The company will leverage fixed and corporate costs, with headwinds in 4Q due to lower incentive compensation expenses in ’13 that will not recur.
2) As for Source Book costs, our math suggest that worst case the Source Book cost an extra $52mm this year when compared to last – taking Source book spend as a percentage of sales up 230bps. But, when accounting for the company’s 12 month amortization curve and the benefit realized in 1Q from the company’s change in strategy, the books add an incremental $35mm or about 140bps to SG&A for the year. That doesn’t include inestimable costs associated with marketing spend that the company will lap in the back half of the year which will help to further mitigate the dollar impact.
HERE’S OUR NOTE FROM EARLIER THIS WEEK OUTLINING SOME OF THE RISKS TO THE MODEL
RH – Where Can We Be Wrong?
Takeaway: RH is our favorite idea. It remains massively misunderstood. But let’s keep it real and vet all the areas we could be wrong near term.
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.