In this post, we provide an update on RH’s business, as well as some commentary as it relates to our 86-page Research Report released in March 2023. We use these Business updates as extensions of our larger report and thus hope they help our subscribers get caught up on the story, but we also acknowledge they are inherently going to be more short-term focused. We will try to balance that out by reminding readers of the longer-term business opportunity and injecting history when relevant.
Before we get into the recap though, we want to provide some quick background on RH for those that are newer to their story. For those familiar with our RH spiel, you can skip to the Business Update.
Preamble.
RH started life as a specialty retailer of hard-to-find antique hardware (think Victorian doorknobs and vintage wooden chests), but the slow-moving nature of such products and their lack of ability to advertise to draw foot traffic, pushed Stephen Gordon to add an eclectic mix of cheap tchotchkes (think mini guitar Christmas ornaments, dog bone shaped cookie cutters, and games like the “Mr. Wizard Science Set”).
He rightly figured that a higher frequency item (cheap gifts and novelties) would increase store traffic and he hoped that this would help keep Restoration Hardware “top of mind” so a customer thought of them when they were in the market for a lounge chair or bed. However, instead Stephen Gordon faced the King Midas problem: they increased traffic at the cost of decreased conversion. The weird and cheap items marred their image as a quality home goods retailer; few consumers would shell out $2k for an antique chest that was adorn by toys and Moon Pie snacks. They may have been successful in drawing a steady stream of looky-loos, but after the novelty wore off, same store sales slowed and an aggressive expansion left them near bankruptcy.
It was at this time, in 2001, that Restoration Hardware’s turnaround leader, Gary Friedman, became CEO. The turnaround of Restoration Hardware is perhaps one of the most underappreciated turnaround stories in business history. The stores were literally selling dog food and now they have in-store restaurants that generate over $10mn a year in sales. Their entire footprint was cookie-cutter box stores in traditional malls and now they occupy ornate, museum-like Galleries that can exceed 70,000 square feet. When Gary Friedman started at Restoration Hardware, he walked away from a $50mn option package at William-Sonoma and instead used his savings to participate in a desperate equity-injection to stave off imminent bankruptcy of a failing retailer. Maybe you thought Elon Musk trying to build the first new successful American car company in a century or create reusable rockets was crazy, but in the brutally competitive world of retail, Friedman trying to turn a floundering, broken box-store concept into a luxury retailer is just as crazy.
(You can read more about RH’s history in our full report, which has a 30-page history section. We published the first 10 pages of it for free here).
Now let’s fast forward to today: September 2023. They are about 22 years into this turnaround and have moved from negative operating margins to consistent profitability and since 2020 margins have bobbed around high teens to 25%. Sales are up over 10x, to around ~$3.5bn. But while they made impressive strides in climbing the luxury mountain, they do face setbacks. Covid overhangs, weak home sales, and high interest rates are several of such.
Now with some perspective of where they have come from and the two-decade slog to build a luxury brand, we can properly weigh investor concerns of the quarter.
Business Update.
A quick note: We generally avoid stock price commentary because we believe stock price movements are low on signal and high on noise—and frankly it also makes most pieces age poorly (Does anyone care about what RH’s stock did in the days that followed 2Q18?). However, large movements can help some investors gauge stock expectations, which can be an indicator of when it is worth doing more research, especially for those investors with an innate contrarian disposition.
When RH reported 2Q23 earnings, their stock fell 20% after hours to $310. This continues their longstanding pattern of being extremely volatile: YTD RH has been up as much as +60% and down as much as -10%. Gary Friedman had some entertaining comments on the call calling out the stock speculation. (He also notes that they bought back 17% of their shares outstanding, marking one of the biggest share count reductions in years—will pick back up on this later).
Revenues for 1H23 are down -21% y/y. They ever so slightly raised the floor of their 2023 guide from $3-3.1bn to $3.04-3.1bn. This is still down from 2022 and 2021 revenues of $3.6bn and $3.8bn, respectively.
2022 was the first time in their history since going public (the 2nd time) that annual sales contracted. 2023 will mark the second time. While Friedman had noted in prior calls the macro factors, in this call he admits that some of this was self-inflected too. In his 2022 letter (excerpt below) he calls out record interest rates and luxury home sales dropping 45%. There is no doubt that Covid and the fiscal and monetary policy embarked on in its wake caused all sorts of economic volatility—in 2021 RH added almost $1bn in sales, by far the most of any prior single year.
While RH still has a tough macro backdrop to blame for their sagging sales, instead they shifted the focus to their lack of product introductions and their “arrogant pricing”.
In 1Q23 Gary Friedman notes how hard it was to discern their pricing power from having elevated the brand and it just being an easy money environment.
He goes on to remark that they lost market share as a result of their high prices and stale product categories. They are fairly unclear though on what “arrogant pricing” translates to in terms of a new pricing strategy. Instead, they talk about improving their “value propositions” and gaining market share with their new collections.
We think the cryptic commentary is partially strategic as a luxury company cannot broadcast that they are too expensive without erroring their brand positioning. They aren’t going to blanket cut pricing, but rather are going to likely be more competitive in terms of pricing on the new collection. We did see some elevated promotional activity on closing out some old products, which may seem hypocritical given Gary Friedman’s many comments on wanting to avoid promotional activity. However, there is a difference in having regular annual sales to spur demand and clearance sales to close out left-over old product.
In the past they have used new collection launches to take pricing up. When they launched the Modern Collection it was priced 50% higher than their existing product collections and then they increased it a further 35% with the Contemporary launch. This shows how they previously used new products to readjust their pricing in a more discrete way. It is much harder for a consumer to compare the price of a collection of new items to a collection of discontinued ones. The new collections likely are a mix of more competitively priced items and some that maintain their current prices or increase them (they noted some prices would rise).
In the 3Q16 earnings call, then CFO Karen Boone said “we have not introduced any meaningful newness in our core business or made any significant changes to our legacy store floor sets in over 16 months”. It’s somewhat ironic that just 2 quarters earlier, she noted in the prepared remarks that they “continue to face headwinds in the markets impacted by energy and currency. There is a clear slowdown across the luxury market where we compete”. There seems to be a pattern of not knowing what to attribute poor sales to (RH is hardly alone here though).
Covid of course was an extreme of whatever mild macro factors were experienced in 2016. During Covid it seems that many businesses could not discern what they were doing right versus just general macro factors helping everyone out. The same way an investor can never know if a stock price movement is a signal of other investors seeing an improving business model or just noise, a company cannot tell whether a couple slow quarters is macro or business related. However, on a longer time horizon, true market feedback is unavoidable. Good managers that are close to their customers will learn the truth quick enough and can adjust accordingly—and in the first half of 2023 RH is trying to do just that.
They just started mailing their 604-page RH Interiors Sourcebook, which is large even for RH standards, and they are following up with Contemporary and Modern Sourcebooks shipping in October and January, respectively (they note these will be 70-80% new).
The need for periodic product refreshes is why on our Business Breakdowns appearance we noted that RH can be “cyclical on top of cyclical”—there are the typical macro factors (home sales, interest rates, consumer spending) that impacts RH, but also the cycles of their product lines. While home furnishings aren’t anywhere near as faddish as apparel and many styles can be timeless, they still need to introduce some change to keep interior designers interested and feel current for customers.
Gary Friedman believes this is going to drive business improvements with an inflection in the first half of 2024 (or an “inflection point peak” as he puts it). On the call he says “it’s really the biggest repositioning of the business we’ve ever went through. Yes, I think the best work we’ve ever done”.
These aren’t just empty words though. They bought back $1.2bn of stock YTD and in just the past quarter alone they have shrunk shares outstanding 17%. The last time they made such an aggressive repurchase was around 2016 when the business was going through another large transformation.
(Side note on tracking shares outstanding: It can be quite confusing monitoring RH’s share count because the change in stock prices dictates what is considered an anti-dilutive vs dilutive security. Additionally, Friedman had a large option package that he exercised which moved diluted shares into basic shares. When the 2022 proxy statement came up it was hard to see how the ~$1bn stock buyback they did impacted their share count because basic shares did not move much at all. We created the table below to help show how shares have moved around. This last quarter it is much clearer that they shrunk their share count because there wasn’t a big change in the dilutive securities impact.)
The reset of their product assortment and corresponding promotional activity is weighing on their gross margins, which were 47% for 1H23, down 510bps y/y from 52%. Interestingly, Waterworks (the high-end kitchen and bath hardware brand they owned since 2016) reported an unchanged gross margins of 54% for 1H23, which further suggest these are RH brand related issues.
While this gross margin compression is a key factor pressuring their operating margins, bigger picture, they have expanded gross margins over 1,000bps since 2015. Also note that the contraction in gross margin in 2016 was partially owing to SKU rationalization of older products after launching a 540-page Modern Sourcebook. Looking longer term, there is no reason they cannot get back to 50% gross margins or higher, but the focus in the interim is on improving the consumer value prop so they have a more sustainable business (recall that in our Consumers’ Hierarchy of Preferences Piece, we talk about how businesses can extract value today or continue to improve their value prop and their consumer surplus, which in turn improves the expected lifetime of the business. RH is basically trading short term margins for a more sustainable consumer value prop).
We would not extrapolate their current price repositioning as evidence that they cannot continue to elevate their brand or expand their margin over time. Though we also don’t want to be too cavalier about the elevated promotional activity: if we saw this continue with their new collections, that would be problematic and concerning. Until then though we think of it more as an indication that RH still has a lot of climbing to do before they get near the top of the “luxury mountain”.
Helping improve their image, especially internationally, was the launch of RH England. On the call they gave more color on the rationale for having a 73-acre estate that is 90 minutes away from London launch the brand in Europe. Friedman talked about how it was drawing very “high-profile” people to set up appointments there, as well as brought in many inbound request for collaborations.
In our report, we talked about how their ornate and unique properties helped simultaneously showcase their products while acting as advertising. They created buzz for the RH brand and many people went out of their way to see the new Galleries, which was even more true when they added hospitality experiences to them in 2015.
Gary Friedman has long been critical of people who thought ecommerce was more profitable because the online stores do not have to pay rent.
The England Gallery is just the latest expression of his opinion that a well-designed and thoughtful space will drive conversation about that brand that serves as unpaid advertising—and since the articles and social media posts are not advertisements, they tend to work even better than if they were paid ads or sponsored content. This has been a key part of their strategy as they have grown sales >10x since Friedman took over with fewer stores (albeit much more square footage per store).
It was interesting to hear him say though that they expect the “majority of revenues to be driven by [their] interior design and trade businesses”. The interior design trade has been an area they have tried to disrupt, which to be clear they still are trying to do, and they expanded on their plans on the call for the “world’s first consumer-facing architecture, interior design and landscape architecture services platform”.
However, it shows that they have more of a frenemies relationship where ideally a consumer knows about RH and wants to utilize their design services (which means they buy 100% RH products only). In reality though, many consumers still hire an interior designer first and let them make purchase decisions. (In the report we elaborate on some perverse interior design incentives and how RH is trying to circumvent them).
In order to improve their position in the value chain by becoming a consumer’s first stop in their purchase journey, RH is continuing to build out their design services and they announced the plans for 40 stand-alone design studios. They have several smaller stores (likely from their legacy footprint) that are just 2,000-5,000sqft. These small stores that offer design services generate $5-20mn and seeing that helped them believe they can launch “Design Studios” in 40 new locations. This new format will be incremental to their prior North America sales target of $5-6bn. The first of which will be in 2024 in Palm Desert.
Other new store openings include Dusseldorf & Munich are opening in 2023 with Paris, Brussels & Madrid in 2024 and London, Milan & Sydney in 2025.
Recall, they still haven’t finished transforming their North American footprint either though with a full 36 of their 68 Galleries categorized as “legacy”. These legacy stores have a smaller footprint with less of a presence and significantly lower sales. They are slated to open two more Design Galleries in the US in 2023 and an additional two early in 2024.
The new store launches and Sourcebooks have weighed on operating margins, which they expect to be just 8-10% for 3Q23. The marketing cost of the Sourcebooks added about $50mn of expense (or lopped off 6-7 points of margin for the quarter).
In 1Q23, they estimated adjusted operating margins of 14.5-15.5% and called out global store openings as compressing margins 150bps. Even adding that back though it is still lower than the 20% or 25% they experienced in 2022 and 2021, respectively. Which only is annoying because they spoke about a 20% margin floor and then caveated in 4Q22 with “Yes. I think you’ve got to think about a 20% margin floor, not in the worst housing market”, essentially defeating the purpose of calling out a floor. Honestly, we think this is more of an issue with giving guidance at all rather than the guidance being off.
Nothing worth forecasting can be forecasted, and anything that can be forecasted isn’t worth forecasting. Yes, when you are running a high end, highly discretionary, non-essential, durable goods business that is met with all of the weirdness of Covid and the related monetary/ fiscal policy, it becomes harder to forecast. Yes, some of this is RH’s fault too for getting “arrogant” with pricing (the gross margin compression of ~300bps explains most the difference).
The narrative shouldn’t really be why aren’t margins above 20% and instead just look at how they have trended up over time.
We don’t think anyone knows (Gary included) if RH will ever be able to get to an operating margin profile of the true luxury players (30-35%+). This is why we like to invert the question: what operating margin would you need to assume to make this an acceptable investment? What sales figures are you comfortable assuming and over what time period?
They have guided to $5-6bn in North America with a potential for International to be as large as $20-25bn. With ~20mn diluted shares, that is a market cap of $6bn today. Adding net debt (including leases) gets us an EV of $9bn. In our Report we run the reverse DCF to show what the implied return is under various assumptions. Members Plus also get access to our excels where they can change the inputs. (Of course, there are many risks too and our report covers those as well.)
Thank you for reading our 2Q23 RH Business Update. You may have noticed we switched up our style in this “earnings recap”—if you enjoyed it please like or share it so we know to write more like this.
We also recently released an RH podcast that goes through the full story and history much more in depth—check it out on here (Apple Podcasts, Spotify).
We will let Gary have the last word.
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