RH: Q1 Results Strong, Near-Term Outlook Appears Challenging

Investment Conclusion

RH (NYSE:RH) reported strong F1Q2022 financial results. The outperformance was driven by significant upside in revenues and higher product margin fueled increase in gross margins. Operating margins improved on a year-over-year basis, and were consistent with those currently being associated with luxury brands. However, it is important to note that the uptrend in sales was driven by more rapid delivery of the backlog, rather than strong customer demand. Customer demand continued to suffer fueled by the spending pullback associated with RH’s key client group due to: increased volatility in equity markets, record-high housing prices, and the uptrend in the Federal Funds rate. Late in the first quarter, RH launched its Contemporary Collection in some of its design galleries and online. In addition, the firm debuted its World of RH, new e-commerce portal, which integrates all of RH’s businesses, including products and services.

Over the next two quarters, based on our thesis of persisting macroeconomic challenges in the U.S., and tough comparables related to the extraordinary sales expansion RH enjoyed during the pandemic, we expect the company to generate softer revenue growth, despite the launch of RH San Francisco, and the introduction of the Contemporary Collection. However, we anticipate that margins will increase driven by solid sales associated with the Contemporary Collection, which is priced at a considerable premium to RH’s legacy furniture collections.

For the last quarter, we expect a sequential boost in sales, due to the launch of RH England in September, and gathering momentum in transactions related to the San Francisco design gallery and the Contemporary Collection. Moreover, as most Source Books will have been mailed by the end of the third quarter, SG&A spending will revert to FY2021 levels, reflecting in further margin expansion during the fourth quarter. Nevertheless, the rebound in sales and margins is unlikely to be sufficient to highly impact financial outcomes for the year. Therefore, although earnings and free cash flows will still advance, their rate of growth will possibly be below that evidenced over recent years, in our assessment.

Longer-term, RH is well-positioned to expand the business, to include not only its current focus, high-end furnishings and hospitality, but also real estate development, entailing the construction and marketing of fully-furnished luxury homes, condominiums, and apartments, with integrated services. Ancillary business projects planned include, fee-based: architecture, interior design, and landscape design services; guest houses to accommodate travelers; and luxury yacht and private jet charter services.

As per management, the market opportunity for this future RH ecosystem is between ~$7 trillion to ~$10 trillion. If RH can manage to capture even 1% of the market opportunity, potential revenues would be in the $70 billion to $100 billion range. In addition, as customer perception of RH as a luxury brand advances, as more and more of RH’s planned projects reach fruition, the firm’s products are likely to become price elastic. Therefore, at some point in the future, RH will probably be positioned to price its products at even higher premiums to industry averages than it currently enjoys, driving substantial increases in margins. As a flow-through of the uptrend in revenues and margins, earnings and free cash flows will surge, over the long term, in our opinion.

Based on the above-described scenario, we are confident that RH will meet and exceed our conservative 10-year normalized revenue growth rate of 10%, and 10-year straight-lined operating cash flows margin of 15.5%, incorporated in our 10-year Discounted Cash Flow model. Therefore, we are maintaining our prior 1-year Price Target of $570/share and reiterating our Buy Rating. Given that we have not included earnings from proposed long-term projects that have been announced but remain in emerging stages of development, in our estimates, there is an opportunity for substantial upside to the Price Target, as the ventures evolve.

(Please go through our initiation report “RH: Transformation Story With Significant Growth Potential” and related notes for our long-term opinion on the stock).

Key Takeaways From The First Quarter

F1Q2022 Results Summary. For the quarter, revenues were ~$957 (+11% on a year-over-year basis), ahead of consensus estimates of ~$925 million, and earnings per share were $12.16 (+190% compared to F1Q2021), above analyst projections of $5.23. Net income for the period came in at ~$201 million, reflecting an increase of 54% over the prior year’s first quarter. During the period, operating margins decreased by 40 bps to 21.4%. Free cash flow declined 24.2% to ~$107 million from ~$141 million reported in F1Q2021.

Contemporary Collection To Take Center Stage. RH’s newly launched Contemporary Collection is the company’s most luxurious offering providing immaculately designed and crafted furniture, lighting, and upholstery. The firm plans to make it a focal point of all its design galleries, devoting ~1/3rd of the square footage of its stores to the collection. In addition, to appropriately stage the new merchandise, RH is renovating portions of its design galleries including its flagship store located in New York City. The Contemporary Collection has been rolled out online and at RH design galleries in New York and San Francisco, with plans to have the offerings available at a majority of RH locations by September.

Considering that the new launch is the company’s first in three years and that the offerings are priced at between 30% to 35% premium to the Modern Collection which currently accounts for a majority of RH’s sales, we expect the Contemporary Collection to generate strong sales figures out-of-the-gate. Overall, we are pleased with the quality and aesthetics of the new introduction, and view it as top-of-the-line in high-end furnishings. Therefore, the Contemporary Collection is likely to rapidly overshadow RH’s prior offerings as well as that of the competition, deriving significant revenue growth over the next few years, in our judgment. Based on our thesis that the Contemporary Collection is likely to be highly appealing to customers, we expect strong customer demand to reflect in solid market share gains for the company.

Significant Capital Resources To Fund Long-Term Growth. Management indicated that RH is likely to deploy its strong balance sheet to develop the firm’s long-term prospects. Specifically, RH plans to utilize its solid financial position to acquire real estate assets to accelerate its luxury home-building business. Recall that last year the company announced plans to enter the $1.7 trillion housing development market, beginning with real estate development in Aspen, where efforts to build premium residences and a guest house, are in the initial stages.

We believe that deploying funds to benefit from a likely downturn in home prices (if an economic recession unfolds) is the right strategy for RH as it positions the firm to secure the best inventory at discounted prices, which will reflect in even higher margins, than the typical already high margins associated with luxury real estate, once the projects are monetized.

Guidance Further Reduced. Management now expects FY2022 revenues to decrease by 2% to 5% (compared to an expansion of 32% during the previous year), down from 5% to 7% stated in the F4Q2021 Earnings Report. In addition, adjusted EBITDA is projected to come in between 21% to 22% (versus 25.6% in FY2021), below the prior estimate of 25% to 26%.

For F2Q2022, RH now anticipates revenues to decline by 1% to 3% compared to a growth of 39% in F2Q2021. In addition, management guided to an adjusted operating margin estimate of 23% to 23.5% versus 26.6% generated over the previous year’s same quarter.

We believe that management is being conservative, consistent with their historic “under promise and overdeliver” approach. Therefore, we expect second quarter and full year actual results to come in ahead of projections.

Balance Sheet Remains Strong. At the end of F1Q2022, RH had a cash and cash equivalents balance of ~$2.24 billion and long-term debt of ~$2.38 billion on its balance sheet. During F3Q2021, the company recapitalized its debt, raising $2 billion through a term loan. Moreover, RH has $444 million remaining on a revolving credit line, and $500 million raised through an additional term loan in May, providing it with ample liquidity. Given these factors, we believe the firm is unlikely to renege on its debt-related commitments.

Bottom Line

RH is bound to struggle over the next few quarters and maybe next year due to the challenging macroeconomic climate. However, simply considering the potential luxury housing business, the growth prospects are massive. In addition, the core furnishing segment, appears well-positioned to develop into a business catering to the top economic bracket. Given the success the firm has achieved in transforming from a kitschy furniture store to a luxury brand that is featured in top magazines focused on design and architecture, we would strongly wager that under Gary Friedman’s leadership, RH’s businesses are likely to go from strength to strength.

Therefore, although, we cannot guarantee that recessionary trends might not result in further pullback in the company’s stock price, we recommend gradually building a strong long-term position, in order to partake of the significant business success likely to come RH’s way.