RH (RH) continues to fine-tune its new store presentation, attempting to remain relevant by catering to evolving consumer demands. With many traditional brick-and-mortar retailers struggling to capture rising ticket and transaction rates given the lack of product differentiation and ease of substitution across many categories, RH has focused on bringing the experience economy into its locations through restaurants, open spaces, and differentiated aesthetics. However, the persistent level of change has led to hiccups in the business’ operating model, and we don’t think the company is immune to more of them as its long-term strategy evolves. Furthermore, we think the support for the core RH business still stems from housing market dynamics and consumer sentiment. Despite the company’s meaningful steps in a financially positive direction, we believe much of 2017’s 181% gain in the stock price stemmed from share repurchases, correcting working capital metrics that had struggled, and a change in real estate and capital structure strategies--improvements that are unlikely to repeat--rather than a materially different level of demand for RH’s furniture. While technical factors could keep shares elevated over the near term, including short interest and low active float, our longer-term prognosis for top-line and operating margin potential for the business leads us to believe the shares are currently overvalued, and we would suggest that current investors 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 Gap (GPS) closed 180 (18%) of its North America namesake locations, while its operating margin contracted 350 basis points to 8.9%. No-moat Macy's (M), which closed 125 Macy’s and Bloomingdale’s locations (15%), also suffered an operating margin decline of 140 basis points to 8.2%. And no-moat Bed Bath & Beyond (BBBY), which closed fewer stores but continues to struggle with its turnaround, suffered even more; its operating margin tumbled to 6% in 2017 from 15% in 2012, a 900-basis-point degradation. We think these companies have been not only affected by the shift to e-commerce but also hindered by the inability to reposition nimbly to cater to evolving consumer preferences.
Jaime M. Katz, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.