Arhaus: Not Bad, But Expensive Premium (NASDAQ:ARHS)

Arhaus (NASDAQ:ARHS) is a high-end furniture retailer with 80 showrooms in the US. The company went public in November 2021 and has shown growth in 2022 (albeit a big portion of it is explained by inventory management).

In September 2022, I wrote an article on ARHS with a Hold rating, given the company’s operating leverage, uncertain economic outlook and what I considered a not sufficiently low multiple. I provided an explanation of the company’s advantages, and a simple model to project earnings under different contexts.

In this article I delve more on long term capital allocation, the effects of the GFC in furniture retailers, and the current situation in ARHS.

I still consider ARHS price expensive, mostly because the business is still too young to have shown ability in capital allocation (the only justification for an earnings premium), the industry does not have a particularly high ROA, and current multiples imply high growth ahead. I believe the market is looking at the wrong numbers in terms of demand growth.

Note: Unless otherwise stated, all information has been obtained from ARHS’ filings with the SEC.

Business basics and recap

If you would like a much more detailed explanation of ARHS’ costs, competitive characteristics and operations, please visit my article from September 2022.

Capacity to build a brand moat downstream: ARHS has the capacity to build a brand because it sells directly to consumers. This is an important positive for the long term.

Interesting competitive position upstream: ARHS manufactures less than 20% of the products it sells, and sources products from artisans and small producers. In my opinion, the company has the upper hand in these negotiations. The company could also eventually absorb some of its providers upstream. In terms of employees and real estate, ARHS participates in commoditized markets.

Leverageable business: Retailers have the capacity to leverage by leasing their biggest capital expense, stores. They still need to invest in inventories, equipment and remodeling though. ARHS has no direct financial debts, but has a leverage ratio (assets to equity) of 5.6, because of leases.

Partly financed working capital: ARHS’ customers have to pay 50% of the order price as deposits, which finances inventory and manufacturing costs. Working capital still requires cash (I’ll show that inventories have been rising faster than demand) but this helps reduce capital requirements and risk of inventory excess. Unfortunately, customer deposits may be a characteristic of a supply constrained market, where retailers have the upper hand. If the market slows down, customers may ask for lower deposit requirements.

Overstated growth: ARHS’ revenue is growing at 50% levels as of 3Q22 and 9M22, however demand for its products has been growing closer to 15%. The difference is explained by the accumulation of orders in 2021, when supply chains were constrained. Because ARHS records revenue and income when the furniture piece is delivered, it built deposits in 2021, understating revenue and demand. My model for demand is not revenue, but rather revenue plus the variation in deposits.

Modified margins: ARHS registers a portion of its lease costs in COGS when they should be registered at the SG&A level, which is generally more fixed. After moving those costs, I arrived at a gross margin of 45% (400 bp higher than reported), and SG&A costs of $350 million yearly.

New macro considerations

No signs of demand slowdown at the ARHS level: One of my main fears was the possible collapse of net income with a slowdown or decrease in demand given the operating leverage of the business (lease payments, lease cancellations and salespeople wages). As of 3Q22, the company has not shown signs of that deceleration. Remember that I do not calculate demand as revenue but rather revenue plus changes in deposits.

	3Q22	2Q22	1Q22	4Q21
Demand	$305M	$268M	$294M	$242M

Click to enlarge

Demand is not slowing down at the aggregate level either and is not bubbling: FRED data shows that demand is still strong at the market level and that it is still below 2019 levels. The data below is expressed in dollars, meaning unit volumes are much lower than during the pandemic, considering the ~20% price increases since 2020.

A 35% demand decrease is a good expectation for a catastrophic crisis: The GFC can be used as a proxy of a tremendous demand shock. Data from FRED shows that demand fell 35% in that period. ARHS’ peers RH (RH) and Haverty (HVT) suffered 13% and 32% falls, respectively.

Demand may be persistently lower in real terms, putting pressure on fixed assets: The two charts above show that the industry never recovered the dollar volumes of the pre GFC or pre pandemic periods. Considering the price increases, unit volumes are much lower. This puts pressure on manufacturing, warehousing and showroom utilization, given that these move with volume, not price.

Capital allocation is difficult to judge for ARHS: With only one year of financial data, it is very difficult to judge ARHS’ capital allocation. Are the new stores located in areas where it can win market share? Are they incrementally profitable? Arhaus more than doubled its manufacturing, warehousing and distribution capacity in the last two years, with the effects on costs not yet distinguishable. This item is not a negative but not a positive either, I cannot pay a premium for ARHS’ earnings considering that management has good capital allocation abilities because there is not sufficient evidence yet.

Capital allocation policies like new warehouses and manufacturing facilities are particularly dangerous in a context like this, where unit volumes are not growing. They also lock the company into decisions that may not be optimal in the future. For example, ARHS’ inventories are growing faster than demand and showroom count, probably because the company is filling those warehouses and distribution centers.

Management shows some signs of conservatism: Management has increased CAPEX this year and incremented the company’s lease obligations. However, it has not continued its plan to open five to seven showrooms per year. This year showrooms increased from 79 to 80. This is a sign that it is taking things with caution.

SG&A has grown at a similar speed to revenues: One of the positive drivers of a retailer (on the upside) is the relative inelastic SG&A expenses. If these fixed costs (like leases or employees) are spread across higher unit volume or price volume, then the company can increase margins. Although the company’s margins are higher than last year, this is more related with recognition of 2021 demand than with SG&A effectiveness.

Price considerations and conclusion

An excited market: The company updated its revenue guidance for FY22 (by 4%, I don’t know if that required an update), and the stock price jumped 13% in a day. Given the magnitude of the revenue update, the stock movement seems violent. It seems that expectations are high for ARHS.

A profit model: The biggest update to the cost model I proposed in September is SG&A costs. These have increased to $90 million quarterly before lease adjustments. This drives the annualized figure to about $410 million from $350 million considered in September. I keep my estimate of 45% adjusted gross margins.

With that in mind, ARHS would generate $95 million in net income without growth ($1.2 billion * 0.45 gross margins – $410 million SG&A, and the result * 0.75 to account for 25% taxes). This year the figure will probably be closer to $110 million given lower SG&A costs at the beginning of the year.

Considering a $1.65 billion market cap, this implies a P/E ratio of 17.7 against those $95 million earnings, considering a no growth 2023. Against probable FY22 earnings it still trades at a P/E ratio of 15.

In my opinion, that kind of multiple can only be granted to companies that show superior capital allocation or market perspectives. Relating capital allocation, there is still no sufficient evidence supporting ARHS’ management. Regarding market perspectives, I have shown that furniture has not done great after the GFC, particularly in unit terms.

For those reasons, I believe ARHS is still a pass. This does not mean the company or the stock is going to do poorly, or that I don’t like it. Rather, it means the uncertainties ahead are not sufficiently discounted in current prices, or conversely, that current prices are more optimistic than what I believe based on the evidence I have.