Special Report: Restoration Hardware Has $10T TAM With New European Expansion

Restoration Hardware ($RH) is a luxury lifestyle brand that is expanding its ecosystem of products, places, services, and spaces. This expansion is strengthening its moat making it difficult for competitors to replicate its success.

The company is on track to achieve operating margins similar to those of European luxury goods brands, yet its stock trades at a fraction of their valuation. This suggests that its valuation multiples should start to converge with those of its peers.

RH plans to expand its ecosystem globally, which could multiply its total addressable market to between $7T and $10T in the global luxury home furnishings industry. This is significant growth potential compared to Restoration Hardware's current market exposure of $170B in the US. The company is led by a first-class CEO, Gary Friedman, with a long-term vision, a good track record for capital allocation, significant insider stock ownership, and a tendency toward financial conservatism.

Furthermore, RH has a healthy balance sheet with more than sufficient cash generation to sustain all of its future growth initiatives and a strong cash cushion to tide over a recession. The company's focus on building an ecosystem of interconnected products and services positions it well for long-term growth and success. Additionally, its strong leadership and financial position provide added confidence in its ability to execute on its plans and achieve its goals.

We believe there are numerous near-term and long-term soft catalysts that will contribute to elevating the brand and boosting core furniture sales. We rank them below in order of importance.

In the near term, the company's new Guesthouse experience, the first of which opened in New York, will rival luxury hotels. The New York location, with a champagne and caviar bar, offers privacy and luxury with bespoke experiences.

Guesthouses will be a direct competitor to other hotels in the hyper-luxury market, like Aman, whose suites in New York command $3,000 a night or more. The New York guest house has six rooms, three suites, and one residence, and has already received 76 enquiries for stays, despite not yet having any photos on the website. The company plans to price rooms at $3,500 per night and suites at $7,500, affirming the possibility of 90-95% operating margins per-room, over a more traditional 80% across other hyper-luxury hotels.

The brand is creating bespoke experiences like RH Yountville, an integration of Food, Wine, Art & Design in the Napa Valley, private jets RH1 and RH2, and RH3, a luxury yacht that is available for charter in the Caribbean and Mediterranean where the wealthy and affluent visit and vacation. These immersive experiences expose new and existing customers to Restoration Hardware’s evolving authority in architecture, experiences, interior design and landscape architecture.

In the coming months, RH will launch its highest quality and most expensive products to date with RH Contemporary, the largest collection to date, which represents the next major transformation of the brand's offering.

CEO Gary Friedman addressed analyst concerns about supply chains and consumer responses to the new collections during the call. Management is pleased with initial response to RH Contemporary’s launch earlier this year, but they still struggle to get product to showrooms in a timely manner.

RH Contemporary is unique in that it features products which have never been made at scale before, but have enough demand to be produced in that way. Restoration Hardware expands in cycles, making a big design change every 7-8 years, which requires a recalibration of internal and external supply chains to handle the development and expansion of SKUs.

Investors can look to the launch of RH Modern in 2016, which created $1B in revenue despite some downturn after the company moved to a membership model, and management predicts RH Contemporary will generate even more.

The company continues to focus on larger showrooms rather than just furniture, and elevating its products through architecturally compelling galleries and interior design spaces. Additionally, the company plans to create the first consumer landscape architecture and interior design firm.

Starting in 2023, Restoration Hardware will redesign and remodel all current galleries and open new galleries in Europe and the UK in Summer 2023, at the historic Aynhoe Estate north of London. Aynhoe will be home to a new RH showroom, a Guesthouse, and other spaces.

Looking ahead, RH plans to elevate and expand its RH Interiors and RH Modern offerings, which provide interior design services and modern furniture. The company will also launch a new website, "The World of RH," allowing customers to explore the entire ecosystem.

New collections such as RH Couture, RH Color, and RH Bespoke Furniture are also in development. Finally, the company plans to launch RH Media, a content platform celebrating innovative and influential leaders in architecture and design.

To support these goals, the company has made several management hires, including the acquisition of Dmitriy and Co and the hiring of its founders to create RH Upholstery and the acquisition of Duke Inc, a to-the-trade bespoke furniture workroom. RH Media, expected to launch next year, will highlight craftsmen, innovations, designers, and architects from around the world, and will be led by new hire Margaret Russell, the former editor-in-chief of Architectural Digest and Elle Decor.

Management and Prospects

Restoration Hardware will continue to focus on selling high-end furniture as its core business. In addition, the company plans to expand its offerings and elevate its brand by creating a comprehensive ecosystem. These new initiatives carry a significant amount of execution risk. However, CEO Gary Friedman is an experienced and successful leader with a proven track record of successful product launches and effective capital allocation.

He has demonstrated his ability to drive growth at RH through the implementation of a membership model, the transition to more efficient and profitable Design Galleries, the addition of restaurants in these galleries, and a well-timed buyback of 50% of the company's float. These efforts have contributed to the company's success and value creation for shareholders.

Furthermore, Gary has significant skin-in-the-game, owning almost 21% of the company, which when combined with his extraordinary track record, gives investors confidence in his ability to execute and make new initiatives work.

Financials and Valuation

Restoration Hardware reported better than expected results for the 3rd Quarter 2022, with net revenues up 28% compared to the third quarter of 2019. This marks the company’s 20th consecutive quarter of an earnings beat.

Adjusted earnings of $5.67 per share topped the consensus mark of $4.72 by 20.1% but decreased 19.3% from the year-ago figure of $7.03. Adjusted net revenues of $869.1 million surpassed the consensus mark of $839.1 million by 3.6% but fell 13.7% on a year-over-year basis. Yet, revenues outpaced its revised guidance, backed by its solid promotional moves and long-term investments.

The company's gross margin for the 3rd quarter contracted by 50 basis points, primarily due to fixed occupancy deleverage. Adjusted selling, general & administrative expenses rose 640 bps to 28.9% of total revenues. Adjusted operating margin contracted 690 bps year over year to 20.8%.

Despite widespread discounting from competitors, the company avoided brand erosion and model destruction by not promoting sales aggressively and , resulting in a 28% adjusted operating margin in the quarter, exceeding outlook despite a dramatic slowdown in the luxury housing market.

RH partially rolled back some price increases last quarter and slightly lengthened clearance times. But, costs are coming down and so are prices. Management wants to preserve a good value in the marketplace and with a decline in sales, luxury housing collapsing, and interest rates moving up higher, slightly lower prices remain a strong option. Inventories are still elevated, but as Friedman says, “It shouldn’t surprise anyone, this is the retail business.”

For the entire year, RH now expects an adjusted operating margin within 21.5-22% (compared with 21-21.5% of earlier projection).

The success was driven by RH Guesthouse, RH International, and RH in Your Home, which led to 200 of the 600 basis points of adjusted SG&A deleveraging. Last quarter, SG&A as a percentage of sales was up significantly compared to the previous year due to investments in the launch of RH Contemporary, the opening of RH San Francisco and RH Guesthouse, the development of RH International, and the rollout of RH In-Your-Home services.

However, the company continues to expect business trends to deteriorate in the future as a result of extended weakness in the housing market due to backlog reduction and fed hikes.

For the fiscal year 2022, revenue growth is expected to decline between 3.5% and 4.5%, revised up from a 3.5% to 5.5% loss projection earlier this year. Despite these challenges, the company's long-term investments will enable it to continue driving industry-leading results.

The picture was only slightly better after the Q2 2022 earnings results, which were impressive, beating expectations for both top and bottom line results. There was strong revenue growth thanks to faster backlog relief, a slight beat on operating margin thanks to more disciplined spending on selling, general, and administrative (SG&A) expenses.

Although the guidance cut is disappointing, the long-term fundamental story remains intact. It is very reassuring to see that the issues RH's business is facing are macro related, and not company specific.

Furthermore, Morgan Stanley's recent positive feedback on the new RH Gallery in San Francisco and particularly on RH Contemporary reaffirms our view that this product line will become a major revenue contributor and key driver of gross margin expansion in the long-run.

It is also important to note that the CEO Gary Friedman has been completely honest about his business and the macro environment from the start. We think it was very prudent of him to set expectations right, and this confirms our view that this is a well managed business.

The fact that RH has not repurchased any shares yet is further evidence of management's good capital allocation skills, namely preserving liquidity and prioritizing the health of the balance sheet.

On the latest earnings call, Friedman affirmed that share repurchases were not on the menu, and that holding on to a substantial cash position was far more important. Citing examples like Bed Bath and Beyond ($BBBY), Friedman warned against aggressive repurchases in uncertain economic conditions leading to long-term financial distress.

One of the main risks facing the expansion are macro headwinds, such as supply chain disruptions, rising raw material costs, and slowing economic growth. These factors could negatively impact RH's sales and profitability.

Another risk is the potential for execution issues with respect to RH's new initiatives and international expansion. The brand is entering new markets and launching new products, which could potentially lead to execution challenges and impact financial performance.

Additionally, RH faces intense competition in the European market, which could impact its sales and market share. There is also key man risk, as the success of the brand is heavily dependent on the leadership and vision of its CEO, Gary Friedman.

Lastly, there is a short-term risk of consumer spending patterns shifting away from home-related categories, such as furniture, towards travel and leisure. This could impact RH's sales in the near-term, but may be compensated for by increased demand for Guesthouses and other curated experiences.

Friedman also addressed analyst concerns over the effect of Federal Reserve interest rate tightening on the housing market. If interest rates continue to tighten into late 2023 and early 2024, the luxury housing market will inevitably slow down. Friedman reiterated the need for intelligent (not necessarily conservative) capital allocation throughout this period.

Management affirmed that most of Q3 beat was from timing of sales and faster than expected backlog relief. The company reported a significant amount of backlog to work through in Q2, but has managed to accelerate that progress. On the year, RH is still targeting $3.6B in sales despite a slightly steeper run rate and a “rounding” effect from Q3.

Longer term investments will not be paused, and RH continues to play for the long term, preserving and expanding brand cache, and making intelligent capital allocation decisions. The company continues to stand for design quality and innovation, positioning the company around product, not price.

Comparable Businesses

There are few comparable companies that have attempted to scale luxury furniture at the pace or intensity with which Restoration Hardware has. The closest competitor is Arhaus, a U.S. retail chain that designs and sells home furnishings online and through its retail stores and catalogs.

It is important to note that while Arhaus' furniture may be of high-quality, and their designs similar to RH, they are not a good comparison for a few reasons. Firstly, unlike RH, Arhaus does not have the same ecosystem or luxury lifestyle brand aspirations. They do not have restaurants, guesthouses, or plans to move into the real estate market, nor do they offer private jet and yacht charters.

Secondly, their scale is not comparable to that of RH, with RH having a larger size, footprint, market cap, and sales. RH's larger scale allows for significant operating leverage and superior real estate deals for Design Galleries. Additionally, RH has a higher profitability with a 25% EBITDA margin compared to Arhaus' 15.4% EBITDA margin, indicating potentially more efficient operations.

Concluding Notes

Some investors may be wary of a company so entrenched in a luxury market during such deep economic uncertainty. They would be remiss to believe that the hyper-wealthy are not resilient, however. Restoration Hardware is not just a furniture company. They are a lifestyle brand, focused on delivering quality and exclusivity to a discerning consumer, many of whom analysts have never been exposed to.

This disconnect between the high-spending RH customer and Wall Street analysts is partially responsible for the discounting effect of RH stock. Luxury homes, experiences, and charter travel have been the highest demand categories of luxury goods for nearly a decade.

The business is fundamentally tied to events: buying, remodeling, or redecorating a home. The core of the business is not the person who wants one new item, it’s the client who wants to decorate their temporary home in a familiar way, while their primary residence is remodeled or built, and their second, third, and fourth vacation homes sit unused because it isn’t the right season to stay there yet.

This hyper-luxury, hyper-wealthy market is unchanging. Despite being uncharted territory for a business operating at the scale with which Restoration Hardware does, it remains an extremely lucrative market with few competitors, and lots of opportunity. Restoration Hardware’s ecosystem of Products, Places, Services and Spaces inspires customers to dream, design, dine, travel and live in a world thoughtfully curated by RH, creating an emotional connection unlike any other brand in the world.