Time for RH Investors to Take Profits off the Table

Evolving Strategy Provides Opportunities and Risks

Many retailers have suffered from inertia over the past few years. For traditional brick-and-mortar operators, the lack of change has led to multiple years of traffic declines, comparable-store sales deceleration, operating margin compression, and massive store closures. For example, between 2012 and 2017, no-moat

RH, however, has continued to alter its strategy in recent years, changing its box footprint, adding hospitality, and expanding product categories (Modern, Bath) in an attempt to stay abreast of consumer demands, adjusting its go-forward proposition accordingly. Repeatedly changing strategies tends to make investors nervous, but in the case of retail, that change appears to be a necessity.

We believe businesses that are pivoting rapidly to cater to customer demands are likely to have better growth prospects than those that aren’t. In our sales forecasts. RH leads the pack with expected revenue growth of 8% over the next five years versus 9% over the past three. Those that are not changing (Macy’s, Bed Bath & Beyond) are trailing further behind as they fail to resonate with new and existing customers as marketing and advertising spending falls flat. We forecast

Changes in strategy can lead to operating mishaps, and RH has not been immune. Prior business model edits have led to temporary cash flow compression when the execution hasn’t been flawless. For example, RH Modern launched in 2015 with greater-than-anticipated interest, leaving RH unable to deliver on demand and ultimately hurting profitability as it attempted to rectify issues that included inventory stockouts and delayed delivery times, which put the brand at risk. Throughout 2016, changes to the corporate strategy, such as putting into place a membership model, trimming inventory, along with the missteps at the RH Modern brand, ultimately cost the company around $1 in earnings per share (260 basis points in gross margin). First, RH paid $20 million in the first half of 2016 to improve the customer experience and alleviate production delays stemming from mishaps at RH Modern. This represented a 60-basis-point compression in gross margin and about a $0.30 hit to earnings per share. This hiccup probably left some customers behind, as constraints in the supply chain from vendors’ inability to deliver higher-than-anticipated levels of merchandise led to inflated back orders and permanently lost sales.

We don’t view inventory shortfalls as an imminent risk again at RH, given management’s intention to focus on the core business rather than expand into adjacencies, but we also don’t think the team has diversified enough for RH to have a complete fail-safe against the repetition of history. In 2017, the company still sourced about three fourths of its purchase dollar volume from around 26 vendors, with one vendor accounting for about 11% (for comparison, the largest vendor at Williams-Sonoma accounts for 2%). In our opinion, this increases the risk that inventory delivery could fall short in periods of heightened or unexpected demand. Additionally, 77% of inventory was still sourced from Asia, which could prove problematic depending on the final implementation of trade rules and regulations. However, RH noted in July that only about 25%-30% of products would be arriving from China in 2019, down from an expected 35% in 2018, that would be affected by the recently announced tariffs. If a certain type of product or category generates demand well above expectations, stockouts could become a problem yet again.

The second alteration to strategy was the implementation of the company’s membership model. In 2016, to better control gross margin, RH kicked off a $100 members’ program fee that gave participants a 25% discount on all purchases over the course of the year. Behaviorally, the company anticipated that this would prevent consumers from waiting for sales and provide a more consistent sales cadence and margin, which it has: Sales in each quarter of 2017 didn’t represent more than 27% of full-year sales, down from 31% in the fourth quarters of 2014 and 2015. However, the program led to a downtick in gross margin as the fee was amortized over the full year, leading to 50 basis points of pressure and costing the company $0.23 in earnings per share. As RH lapped the inauguration of the membership model, gross margin began to stabilize in 2017 thanks to fewer promotional periods. We expect better pricing on the sell-through of merchandise as the company can better manage inventory flow and pricing for year-round demand and in order to maximize profitability.

Finally, RH rightsized its inventory base, which allowed it to amend its distribution footprint by eliminating an additional distribution center it had planned to build. As inventory was trimmed, markdowns were taken, hindering 2016 gross margin by 150 basis points, representing $0.46 per share in earnings. These efforts continued through part of 2017, and the reverse logistics efforts have bolstered turns at the business, reducing the working capital intensity at RH. We anticipate that pared-back inventory levels will remain as the team focuses on the core product mix, which should help lower working capital needs and increase returns on invested capital, supporting our fair value estimate. We expect that gains from improving gross margin and inventory hiccups are unlikely to repeat, given the focus management has recently placed on perfecting the core part of the business. In turn, we have inventory days in our model forecast stable at just above 100 over the next five years, down from an average of 170 over the past five years. This is versus an average of 113 at Williams-Sonoma and 135 at Bed Bath & Beyond over the past five years.

Efforts to Reposition Business Led to Material Valuation Changes RH's strategic changes motivated us to make two material increases in our fair value estimate over the last year. The first was to $81 from $55 after the company's investor day in November 2017, reflecting a few different factors. First, RH was set to experience lower capital expenditures (accounting for $14 of our fair value increase), thanks to the company rightsizing its supply chain (inventory and reverse logistics, making working capital more efficient), and embarking upon a more frequent use of a sale-leaseback type model to build out its store base moving forward, freeing up capital demands on the business. As a result, we modeled capital expenditures to average 3% of sales over our explicit forecast, down from 6% over the past five years. Second, better 2017 performance added $5 to our fair value estimate--the company ultimately delivered 14% revenue growth in 2017, up from the 8%-12% growth forecast by management at the beginning of the fiscal year and versus our initial 11% outlook. The remainder of the fair value increase stemmed from enhanced operating efficiency expectations, with fewer distribution centers to manage and improved management of stock-keeping units leading to operating margin expansion. These factors led to significant improvement in working capital categories.

The second material uptick in our fair value was to $97 from $81 in June 2018 as efforts to rightsize inventory and its supply chain began to pay off, leading to better operating margin performance and faster than our forecast previously anticipated. While revenue remains on track to meet our forecast from the beginning of the fiscal year, profitability is clearly ahead of even RH’s initial take on the year and ahead of peak historical levels, which in our opinion warranted a revaluation of our intrinsic value estimate of shares. The biggest swing factor in our second material valuation update was higher gross margin. The gross margin was 140 basis points better than we forecast in the first quarter, at 38%, and should persist over the remainder of 2018 as RH holds price and maximizes the takeaway from its loyalty program. RH’s quest for more profitability over volume in sales should bolster gross margin potential longer term despite top-line growth slowing from historical rates, and even modest gains from our previously anticipated 2018 levels added about $10 to our fair value.

The outperformance of RH’s efforts should continue to drive working capital intensity lower, bringing the cash conversion cycle below 50 days by the end of 2018. We expect this lower level of capital intensity to persist as the team remains focused on keeping the business rightsized, expanding the store base modestly year over year, and operating an appropriate distribution network. The more stringent allocation of capital should help bolster adjusted ROICs to more than 20% over our forecast but may still fall short of the company’s goal of more than 30% by 2021. While we expect ROICs to increase, we don’t believe the company’s competitive positioning has materially improved in the still-fragmented home furnishings industry.

Even With These Improvements, Internal Risks Exist Despite demand driven by general housing metrics and demographics that should be positive in the near term, we think changes to RH's strategy could add top- and bottom-line risk. There is some uncertainty in these unproven growth opportunities, including the alteration of the store format, hospitality, and adjacent category expansion.

First, the company continues to pivot its store growth strategy. While we believe this is necessary to respond to changing customer demand, it does add risk as new financing plans and merchandising layouts will vary from historical experience and their success is unproved. RH has amended its store opening plans twice since 2016 as it adjusted its long-term strategy and its capital demand outlook, with some stores now opening under a sale-leaseback development arrangement, leading to a lower level of capital commitment required for those locations. In 2016, the company lowered its store opening pace to three to five per year from five to seven as it worked to rectify some of the operating mistakes from 2015-16 and preserve cash on the balance sheet. Efforts to slow the growth of the business were to allow RH to focus on its core business to restore brand equity and bring ROICs back above the weighted average cost of capital, an effort we viewed as commendable.

But more recently, RH has backpedaled on this slower pace of store openings as the core business has stabilized, potentially reigniting growth through square footage gains. It now plans five to seven store openings annually, but probably with smaller footprints. RH developed a new prototype design gallery of 33,000 square feet including hospitality (29,000 without), with expense and time to completion a bit lower than the traditional larger gallery of 25,000-60,000 square feet. The larger next-generation design galleries historically took 18-36 months to complete, leaving the company at risk that leases signed at the beginning of the period could begin to generate revenue during periods of economic distress, making returns on each box less certain. Faster time to market could equate to a faster payback period, which should benefit overall profitability. However, the company still expects to open more large gallery boxes in appropriate metropolitan markets, so the duration risk hasn’t fully come off the table.

Also, entering new categories could increase the risk and jeopardize the profit profile at RH, as the business could again miscalculate demand or mismatch products to location. The team at RH has taken a step back on the expansion front over the last two years to restore the right core product lineup, but we could see it seeking out category expansion again, either organically or through bolt-on acquisitions in 2019.

As many growing companies do, RH continues to embark on projects with unknown outcomes, outside the core product competency of the brand. For example, RH has been working on the RH Guest House, a 14-room hotel in New York City’s Meatpacking District. While RH embarked on this project in 2015, it didn’t have approval to establish a hotel from the Landmarks Preservation Commission until March 2017, tying up at least some capital that could have been reinvested into other parts of the business.

Additionally, RH has discussed last-mile efforts frequently in the past and expects that by using its own trucks and drivers, it can improve customer experience while driving down return rates, damages, and deliveries per order. However, building a last-mile infrastructure is a long, arduous, and expensive endeavor that could compress ROICs and margins before benefiting returns.

Technical Factors Could Keep Shares Elevated for a While While fundamental improvements, such as inventory and distribution center rightsizing and housing market strength, have bolstered the intrinsic value of RH's business, we think technical factors could keep the shares elevated over the near term until fundamentals play out over the long term. The key support factors we see as bolstering RH's share price in the near term include high short interest and low active float. Short interest has remained inflated on the stock, independent of performance, in recent years, averaging around 32% of float over the past three years. For reference, Williams-Sonoma has averaged around 16.5% short interest, while Ethan Allen, another higher-end home furnishing retailer, has averaged 13.5% short interest over the past three years.

For RH, short interest has ranged from as low as 18% to more than 50% of float. At its lowest point, summer 2016, RH was facilitating a turnaround and reorganizing its business model, which led shares to fall below $30 from around $100 just six months earlier, allowing many short investors to close out their positions as their thesis prevailed. However, since mid-2016, short interest has been on the rise, posing further short-squeeze risk to the shares, which could support the shares moving higher before descending toward our fair value estimate.

We believe this has been aggravated by low active float in the market, although we think concentration of share ownership could be trending lower as large shareholders begin to trim their stakes in RH, given the recent runup in price. At the time of the last proxy filing in June, the top seven institutional shareholders held 75% of the shares outstanding. We think these shareholders were less likely to trade regularly in and out of their positions, tying up liquidity in shares. Friedman held a material number of shares as well at the time of the filing, locking up further market liquidity.

We suspect these two factors helped shares leap around 30% on the company’s last earnings release, June 11. With daily trading volume that averages around 1 million shares over the last three months and more than 14 million shares trading hands on the day after the financial report, demand handily outpaced supply, forcing the shares materially higher as they changed hands more frequently and shorts covered their outstanding positions. With the shares trading at all-time highs, around $165, in the days after the company’s first-quarter report, we think some investors probably took the opportunity to trim their positions tactically, sending price down slowly since the quarterly report, falling back to around $133 within a month after the financial report.

We believe there is further air to come out of RH’s sails. We anticipate that fundamental housing market factors will eventually normalize, leading the shares closer to our fair value estimate. First, as interest rates continue to rise (30-year fixed-rate mortgages have increased 70 basis points over the past year, according to Freddie Mac), housing turnover could slow; the volume of existing home sales has already contracted in four of the past five months.

Additionally, broad-based housing market metrics, such as growing household formations, rising headship rate, and relatively low interest rates, should also provide some modest growth support over the near term, but the rate of improvement is likely to slow on many of these metrics over the next few years, given our position in the economic cycle and the long duration of economic expansion the United States has already seen. We factor this into our housing starts number, which peaks at 1.9 million in 2021 before slowing to 1.5 million in 2027. Our top-line growth peaks at 10% for RH in 2019, with more than 6% stemming from square footage growth, before slowing to a high-single-digit rate through 2022.

As growth in the category normalizes over economic cycles, we anticipate that sales in housing-related businesses will grow at a single-digit clip as housing sales growth remains constrained by labor (for new inventory builds), rising interest rates, and falling affordability. We have factored this growth into our outlook for RH, which should easily be able to deliver rising sales with current economic support as well as footprint growth, contingent on appropriate merchandising and marketing. In total, we project RH’s total sales can grow 8% annually over the next five years, down from a 16% average over the past five years, supported by around 7% store and 9% direct-to-consumer growth spurred by total square footage that rises more than 40% through 2022.

As RH’s top line increases, we think expense leverage will ensue. We forecast gross margins will rise over the next decade to 40% (coming off depressed margins that averaged 34% in 2016-17) as RH benefits more slowly from improving occupancy costs and merchandise margins, while the selling, general, and administrative expense ratio leverages about 75 basis points from 2017 levels to below 28% on higher sales, lower advertising, and better source book optimization ahead. Ultimately, this generates operating margin of 12% in 2022 in our base-case assumptions.

Overall, as we weigh the positives (housing economics remain strong, business fundamentals on the mend) with the normalized earnings power of the business (we forecast 7% sales and 16% EPS growth on average beyond 2018), we believe there could be downside to the current share price, hence our 1-star rating. Although shares could remain elevated or increase in response to factors outside the company’s control, such as high short interest forcing a squeeze and low active float, we still believe that over the long term, the fundamentals of the business will normalize in line with housing market metrics and overall furniture and home furnishing demand, pushing the share price back toward our $97 fair value estimate.