We are excited to share with you our latest research report on RH! As always, we’ve released it concurrently with a shorter PM Summary. If you are short on time, we recommend starting there. Please email us at info@speedwellresearch.com for any questions, concerns, or comments. See our full disclaimer on our website.

Founding History.

Stumbling Upon a New Store Concept.

In 1952, in a small town nestled between Lake Champlain and the Adirondack Mountains in Northern New York, Stephen Gordon was born. His family ran three stores in the city, but his parents pushed him to be an educated professional. In 1978 he graduated with a Masters in counseling psychology. He and his wife moved to Eureka, California, and after a short stint as an inattentive therapist, he decided he needed to do something more involved. He started working as a carpenter and bar tended at nights.

A year later, in 1979, he bought a decrepit 3-story Victorian with the intention of restoring it. However, he had trouble finding hardware, moldings, and other fittings that he needed to complete his project. Gordon worked hard to scavenge for vendors that sold these products and realized others must have the same problem. Given his limited budget, he often couldn’t even buy the items when he found them, so he got creative.

In an effort that epitomizes “minimal viable product”, he simply put together a binder of photo-copied images that came from various vendors he found and scratched in prices that were double what the vendors charged. When he made a sale, he then used his small profits to buy the item that he needed. His entire marketing campaign consisted of putting a sign out on his porch that said “Restoration Hardware”. A new store concept was born.

Business History.

Early Struggles.

After 6 months of operating out of his home, he saved up enough to rent a 300 square foot space in Old Town Eureka. But with money tight, he kept bartending at night. His first store was successful enough to justify keeping it going, but not profitable enough to be comfortable. About five years after starting the store, he still had cash flow problems around the holidays, and in one instance even needed to borrow $200k from his in-laws to finance inventory. Their core hardware offerings and an ever-growing mix of eclectic products, from goatskin gloves to English coal miner lanterns, helped the store get on stable enough footing that they could justify expanding. They proceeded to open their next two stores in Newport Beach and Marin County.

In 1994, with five stores and $4.2mn in revenues, Restoration Hardware raised their first round of outside money—$2.5mn from Cardinal Investment. They continued to expand their product offerings and entered the furniture category, where they focused on offering high-quality craftsmanship and sturdy, American-made furniture.

Gordon’s product philosophy was simply to sell things that he liked and thought were cool. Many of the items he picked had a nostalgic “back to a simpler time” vibe with boot scrapers, antique candle sticks, and vintage metal lighters presented alongside oak chests. A lot of their products were idiosyncratic, including items like Dragonfly doorknockers and aluminum Canadian lunch boxes.

Further adding to the store’s personality, he would start narrating products with curatorial labels. For $2.75, you could buy the “My Own Quirky Summer Memories Sandwich Spreader”, which had a similarly quirky description: “I remember a particular sandwich spreader from my summer sandwich-making noon times on a lake-front house on Indian Bay in upstate New York. Being the weird and wonderful or whatever guy I am I always thought this spreader was such a classy way to put mayo on that absurdly squishy white bread”. And for $39, there was a miniature Allagash River Canoe: “There are few memories as dear to me as those associated with my week-long canoe trip on the Allagash River in Maine. Our small-scale replica is beautifully executed and true to form. Ply the rivers of your mind”.

The varied assortment of whimsical, yet vaguely wistful items garnered a lot of curious consumers who could usually be coaxed into an impulsive purchase. The model seemed to be working, and after hiring more experienced managers including executives from Pier 1 Imports and Home Express as COO and CFO, they doubled their store count every year for the next 3 years and ended 1997 with 41 stores.

Total revenues approached ~$97mn in 1997 (prior to including an acquisition of Michaels Furniture Company, one of their larger furniture vendors), which comes out to ~$400 sales per square foot or about $2.4mn per store. Despite decent revenue generation, they were operating at just a ~3% EBIT margin at peak. Nevertheless, investors were starting to focus more on their growth: Restoration Hardware was slated to open 25 stores in 1998 and 30 in 1999. With strong store growth that excited investors and a buoyant stock market, Restoration Hardware looked to raise public funds for their expansion. 

On June 19^th, 1998, Restoration Hardware went public under the ticker RSTO, raising ~$60mn. Their shares were priced at the higher end of the banker’s range, at $19, and jumped +38% on the first day of trading. Investors and analysts at the time were very enthusiastic about Restoration’s model, with a portfolio manager noting that Restoration Hardware had developed a really “superb way of presenting home furnishings and gifts”. Investors thought that the product assortment was unique and promoted an American lifestyle that harkened back to simpler and safer times, with Gordon-created stories allowing them to charge higher prices.

Their retail model heavily depended on piquing consumers’ interest to drive foot traffic in hopes they’d make an impulsive purchase of something they’d never seen before or would see again. They noted that “discovery items and other products are cross merchandised within these core groupings to allow for surprising product combination and to increase impulse buying”. However, there was little they sold that a consumer needed, and it seemed that solving boredom through novelty was its core function.

While their hardware and furniture offerings may have been of high quality, the customers who could be drawn to such items would be turned off by the “Moon Pies”, “Atomic Robot Man” toy, and “Acme Dog Biscuit Mix” that adorned the pieces. As they proudly noted at the time of IPO, “each item must stand on its own and is evaluated on its own merits. The company does not have prescribed price points and finds it equally justifiable, for a merchandising point of view, to offer a vintage, Austrian wind-proof lighter at $5 and a solid, red oak Mule Chest at $1,990”. 

In 1998 they would eke out a small profit of $3.8mn on $211mn in sales in what was becoming an increasingly seasonal business: their only profitable quarter was 4Q—driven largely by holiday gifts. What seemed like a creative way of drawing foot traffic started to be seen as a liability that drove brand confusion and a convoluted consumer value prop.

The novelty of the stores seemed to be wearing off, and in 1999, same store sales (SSS) were just +0.8%, down from +12% and +11% the two years prior. Despite sales per square foot increasing to almost $600, they struggled to make a profit and regularly relied on promotions to push immovable inventory. The furniture they did end up selling garnered too low of a margin, since >80% of products they purchased were from domestic importers (middlemen).

Compounding their issues was their store unit growth, which was described in their 1998 10k as an “aggressive growth strategy”. With cash flow from operations insufficient to open the 30 stores a year they planned on; Restoration Hardware increased their borrowings after their IPO proceeds ran out. In 1999, cash from operations was just $4mn, as their working capital needs to finance inventory consumed most of their cash. Still, they pushed ahead, spending $46mn in capex, which was financed by a revolving line of credit and their remaining cash on hand, which dwindled to just $4.6mn at the end of 1999 (technically, their fiscal year ended one month after the end of the year). After making a small profit in 1998, they were back in the red, losing $3mn on almost $300mn in sales in 1999.

The following year, they added 13 more stores despite same store sales turning negative -1%. Cash from operations improved after reducing inventory on hand (with promotions) to $19mn, but with $23mn of capex, their cash balance fell again. Ending 2000 with just $2.6mn in cash and a quick ratio of 0.33, things were not looking good for the unprofitable retailer with growing debt obligations. The stock traded under $1 per share, down ~95% from its peak; bankruptcy was looking like an ever more real possibility.

Enter Gary Friedman.

Gary Friedman.

Gary Friedman was born in San Francisco in 1957. When he was just five years old, his father passed away, leaving him and his mentally ill mother to fend for themselves. In his mom’s best year, she would make only $5,000 to support them. Food stamps and evictions characterized his childhood, with Gary living in a string of small apartments, none of which they could afford to furnish. He struggled in school with reading “going in one ear and out the other”. However, what he lacked in auditory ability, he made up for in intuition and visual capacity—skills that wouldn’t be apparent until he worked at The Gap.

He started at The Gap as a stock boy folding clothes part-time while attending community college. However, with a D average after his first year, and at the “encouragement” of a professor who told him he was “wasting taxpayer money”, he dropped out. Now fully devoted to The Gap, his work ethic helped him get promoted to store manager. During his days off, he would hang around The Gap’s corporate headquarters to help out, usually folding clothes at “Store One”, which was where they would present the next season’s clothing.

One day, the new President of The Gap, Mickey Drexler, called an all hands meeting in the lunchroom. Drexler went out to espouse the ethos that The Gap would follow going forward, and started asking the audience questions. As Gary would later recollect, a spirit moved him and a rush jolted his body with his hand shooting up as he blurted out an answer. Drexler responded, “That’s right. That’s exactly what we should be doing”, and he asked Gary what corporate department he worked in. Gary responded, “I don’t work here. I am the manager of the Market Street store, and I am here on my days off just to kind of help out”.

Drexler must have been impressed, because the next day, Gary got a request from Mickey Drexler’s secretary to join a meeting at the headquarters with all of The Gap’s top executives. Drexler tasked the 21-year-old Gary to tell them what was happening in this “effing” company. (Drexler would refer to Gary as “effing Friedman”). Gary’s career accelerated, and he was soon promoted to district manager, then regional manager, and oversaw 63 stores.

He felt loyal to The Gap, but an up-and-coming retailer, William-Sonoma, wanted to interview him. To his surprise, the job was for a much bigger position than he had: Senior VP of Stores and Operations. He couldn’t pass it up. Just like at The Gap, he would steadily move up the ranks, first to Executive Senior VP, then President of the Williams-Sonoma and Pottery Barn brands, then Chief Merchandise Officer, then, lastly, President and COO.

While at Williams-Sonoma, he was known for transforming Pottery Barn from a $50mn tabletop and accessory business into a $1bn+ home furnishing brand. He took the lead on introducing “Grande Cuisine” stores at Williams-Sonoma, which included demonstration kitchens, tasting bars, and a food hall of the company’s private label food products, helping drive the brand from $100mn to ~$1bn. He also helped develop the West Elm brand, an in-house-designed furniture and home furnishings brand.

However, Gary was shocked when he was passed over for the CEO job in favor of an external hire, a position he later alleged that Howard Lester (the then-CEO) had promised him for years. Gary remembers Lester saying, “now don’t do anything emotional. You’ve got $50 million in stock options you can’t walk away from”. Right after that conversation, he roamed the streets of San Francisco on a foggy night and saw the glow from a billboard that had plastered on it “He who dies with the most toys is still dead”. He made up his mind to leave the money and move on to the next challenge.  

At that time, Stephen Gordon had been in contact with him about potentially taking over his job as CEO to try to turn around the dying Restoration Hardware. After triggering a debt covenant, Restoration Hardware could be pushed into default at any moment. In March of 2001, after 14 years at Williams-Sonoma, Friedman resigned and took over the reins of Restoration Hardware, a company with its stock at an all-time low and teetering on the verge of bankruptcy.

The Turnaround.

Friedman raised $15mn, $4.5mn of it his own money, to infuse into Restoration Hardware and stave off imminent bankruptcy. Gary’s immediate prognosis of the business: poor merchandising. These so called “discovery items”, that, by design, included the most random selection of products conceivable, may have driven some foot traffic and low ASP sales, but led to cluttered stores, continual discounting of unsold SKUs, and brand confusion.

He would set about curtailing these items that then-represented 50% of their business and cutting the most offensive items, like an “Aqua Troll” sprinkler, that were carried because they were “funny”. However, discovery items were not eliminated outright. In the quote below, we see that they still relied on them, at least initially, to drive traffic, and the pruning process would take years (in 2Q06, he added a gift assortment back into the store after having removed it, and rolled out a separate Restoration Hardware Gifts catalog).

More surprisingly, bringing the furniture mix as a % of sales down was also a part of the plan. Their furniture was 32% of sales in 2002, with margins too low to provide sufficient unit profitability to rationalize the overhead. At that time, they were only importing 18% of their products directly from foreign vendors, purchasing instead from importers who had added a layer of mark-ups. While Restoration Hardware worked on developing direct supplier relationships, they tried to curb furniture sales by emphasizing other higher-margin categories like textiles.

Textiles were just 3-4% of the business by revenue when Gary took over, but in ~2 years they surpassed his goal of having it reach 20% of total revenues. The higher-margin textiles helped support the company while he turned the business around. He would also deliver on doubling the bath business over the same period.

These changes brought Restoration Hardware back from the brink of bankruptcy to achieving their first annual profit in 2004, six years after going public. Gary would later say, “It was not a turnaround, because Restoration Hardware never worked. They went public in 1998, and never made money. It didn’t carry enough of anything to stand for anything”.

With the business starting to gain solid footing, Gary Friedman started to talk more about the Restoration Hardware concept and what he envisioned for it. They would focus on being a “home lifestyle brand, above the current lifestyle retailers and below the interior design trade”.  He set long-term goals of making Restoration a $1bn+ brand with mid-single digit operating margins.

It would be a long journey to rehabilitate the brand and move up-market though. Friedman likes to note that the mall is a “graveyard of short-lived ideas” and that the only way for Restoration to avoid that fate is to build a core business that is strong, sustainable, and offers the customer a predictable promise.

Before signing off the 4Q03 earnings call, he remarked: “So we are all here for the long-term. I spent 11 years at The Gap and then 14 years at Williams-Sonoma. This is going to be my last stop. So, I will be here for a long time, and this will become a really great company long-term. That’s all our hopes and goals”.

However, their profitability was short-lived. In 2005, they lost $29mn, which they attributed to the housing slump. They paused new store openings, which would have been the first store growth since Gary joined Restoration Hardware (note Friedman’s quick response to business shortcomings versus Gordon’s). With the stock tanking from $9 to $3, private equity firms took interest. Catterton Partners, along with Gary Friedman, made a $267mn buyout offer which represented a 150% premium. Before the deal closed, however, Sears took a 13.7% stake in the company and tried to counter with a 5 cent higher offer. However, as the 2008 financial crisis took hold, and Restoration’s performance continued to soften, Catterton Partners was the only interested party, and they lowered their acquisition bid to $179mn.

After a brief respite with the business somewhat working, Restoration Hardware was taken private again to fix the model. After being public for a decade, they had only turned a profit once.

Restoration Hardware Reintroduced.

Despite the macro turmoil, Friedman remained steadfast in his mission to make Restoration Hardware a more upscale lifestyle brand. In the heat of the recession, with consumer discretionary spending plummeting, Friedman would raise prices and finally put an end to the cheap discovery items. Whereas in 1998 Restoration Hardware targeted customers with $75,000 in household income, they would now target those with over $200,000. To distinguish themselves from their earlier history, Restoration Hardware would no longer go by Restoration Hardware – from then on, they would just be “RH”. (That said, some stores still carry the full name).

During this time, they established direct relationships with their suppliers, which helped them not only avoid the middleman mark-up and have better visibility into their supply chain, but also let them work with manufacturers to scale up volumes as needed (which was hard as many were small family-run businesses). In contrast to other furniture retailers and specialty chains, they didn’t design their own products, but rather sought after already-in-production, high-quality, artful pieces. They considered themselves a “curator” in this role, stocking their stores with items they liked. The direct supplier relationship was necessary to scale up their orders, as many of these manufacturers were small firms with neither the capital nor expertise to sell to a large retailer.

Supporting this sourcing and curation capability is their Restoration Hardware Center of Innovation & Product Leadership that sits in their headquarters at Corte Mande, California. This cross-functional department works to develop a product assortment with their manufacturing partners, who RH considers an extension of the product development team. This allows RH to have an ability to direct the product designs while still benefiting from their “artisan partners’” ideas and leaving the actual manufacturing to them.

In 2010, RH hired Carlos Alberini as co-CEO alongside Gary Freidman, tasking him with operations, finance, supply chain, inventory, information technology, and HR, while Gary would focus on the creative functions, merchandising, and marketing. As it was a private company at the time, not much is known about this decision. However, it’s possible that as the company’s revenues contracted during the financial crisis, the PE owners wanted to bring on another, more experienced manager with prior finance experience as a CFO.

Instead of printing <100-page catalogs of their products, they compiled multi-hundred page “Source Books” that they circulated to prospective consumers. Whereas they used to send monthly mailers to capture impulse purchases and display a seasonal product assortment, they now send 1-2 books a year, which can get up to 1,000 pages. (They would continue to iterate on Source Book length and shipping frequency, and ultimately split it between different product lines, but their books continue to be in the hundreds of pages). These glossy Source Books would become a key pillar of their “direct” business, which expands their reach beyond their store footprint. The Source Books both solicit orders and serve as an advertising tool that draws foot traffic to their stores.

The multi-channel approach was synergistic, and their product catalogs continued to grow every year, incorporating an ever-growing selection of goods. Their footprint, however, had remained stagnant, meaning only a small portion of products could be displayed in-store. If you included their newly launched Baby & Child line, fewer than 10% of their product assortment was on display. This presented both a problem and an opportunity, as SKUs with retail space tended to get a 50-150% lift in sales.

To address this, they started opening up larger stores in 2011 and introduced the “Gallery” concept. No longer would their stores be sandwiched between other retailers in a mall, these stand-alone “full line” Design Galleries would be 3x the size at 21,500 square feet. The first two full line Design Galleries were rolled out in Houston and Los Angeles.

In their 2012 S1, they noted that their Los Angeles Design Gallery increased store demand by 85% and direct demand by 30%. When other retailers were planning to permanently slash their footprints in response to the threat of ecommerce, RH went the opposite direction, opening up additional stores that were larger and more expensive. (However, they did let dozens of leases expire on the old store format, dropping their store count to 71 by the end of 2012). It was at the beginning of this second transformation, and after returning to profitability in 2011, that RH went public again.

RH IPOed in 2012 at $24 per share and raised ~$115mn; insiders cashed out ~$30mn. This valuation put their market cap at around $850mn, nearly 5x what they had been taken private at just 4 years earlier. Right before the road show got underway though, the board learned that Gary had been in a consensual relationship with an employee, and he resigned as co-CEO. However, he stayed on as “Chairman Emeritus, Creator and Curator”, where he continued steward RH. Just a year later, he was reinstated as co-CEO, and in 2014, as the sole CEO after Carlos left to run the Lucky clothing brand.

After RH IPOed, they continued to improve on their store concept. While the focus may have initially been to grow the SKUs displayed in each store and elevate their brand through better curated spaces, RH started to move to even more of an extreme to differentiate themselves. As Gary espoused at the time, “Our goal is to transform the traditional retail model from a way to shop to a way to live. Most shopping centers and retail malls are archaic windowless boxes, lacking any sense of humanity. We don’t want to change the face of retail, but rather give it a soul”. RH hoped that moving into more unique and larger locations would generate buzz and become a place that prospective furniture buyers would visit. 

At this time, they also tried several other initiatives to build more brand recognition. Instead of relying on traditional advertising that other retailers employed, RH did things like sponsoring a concert with RH Music and creating an art gallery called RH Contemporary Art Gallery. For the art gallery, they procured a number of art pieces, one of which, the “Rain Room”, ended up in the Museum of Modern Art.

Their art gallery helped drive buzz with the affluent and gave the brand more cachet. Similarly, their concert introduced the brand to thousands of new people. Gary was very open that all of these were experiments, but preferred such creations to basic advertising options: “Will it work? I don’t know. Does an ad in any of these magazines…work? Does anybody have any metrics around that? Somebody show metrics on magazine advertising and tell me how it works. Nobody’s got any effing metrics. So tell me that the concert won’t work. I don’t know if it will or won’t, but I’ll tell you, it’s going to be cool”.

The untraditional advertising seemed to work. Revenues from 2011 to 2013 increased 60%, or ~$600mn, to $1.55bn, despite a smaller total store count.

In 2014, they opened their first “next generation” Design Gallery in Atlanta, which at 43,000 square feet almost doubled the average of the full line Design Galleries (which would be renamed to “large format Design Galleries”). The larger store size and architecturally interesting buildings continued to raise awareness and bolster the high-end design image they were crafting.

In short order, they learned that their push to expand their store size actually led to better real estate terms. Many of the spaces they would adopt were architecturally significant stand-alone buildings that were in parts of town that needed revitalizing, and real estate owners appreciated the foot traffic RH was driving. Their use of untraditional selling spaces like gardens and roofs lowered their cost per square foot of selling space. In 2014, they noted that they were spending 20% less per square foot than expected, and the average payback period for their new Gallery stores dropped from 20 months to 12-18 months due to lower costs and strong demand.

The bigger stores not only allowed them to display more products but also made their stores a “destination” that customers were willing to travel to see. This meant these locations could be placed outside of traditional malls and away from retail centers, which not only further differentiated RH but got them special lease terms. Because they do not need to be near retail centers (which typically have higher leases), when RH does open a store near a mall, it’s usually because the landlord gave them preferential terms owing to the traffic they generate.

The new, larger sites opened up new opportunities to utilize the space. In 2015, RH decided to experiment with Hospitality experiences. Their Chicago Design Gallery opened with a restaurant in the middle of the building; this meant that restaurant-goers would have to walk through their furniture collection before they could be seated, and often led to customers walking around after their meals to view the well-designed space, even if they were not in the furniture market.

A year after launching their in-store restaurant, in 3Q15, Gary noted that their first endeavor into F&B (food and beverage) was on track to do $5mn annually. At the time, there were literally lines out the door of the store and they received a cascade of positive reviews on both the food and the atmosphere.

At the end of 2015 they introduced another big initiative: the RH Membership card. For $100 (later raised to $175), a customer could become an RH member, which entitled them access to RH’s growing staff of in-house interior designers, a 25% discount, and preferred financing. The in-house designers were an important differentiator that helped them sell curated “spaces”, rather than just furniture. And the member’s discount allowed them to discount items more discretely, disrupt the traditional interior design model, and move away from a promotional model with lumpy sales (more on all of this later).

Also in 2015, they announced a new line of furniture called RH Modern. This would turn out to be not only a big opportunity that extended their product line and attracted more customers, but also the source of many issues that revealed their business model still needed further refining. 

Growing Pains.

Growing Pains.

After having enjoyed several years of 20%+ growth, 2016 revenues grew just +1% y/y. As shown below, while their revenues had increased by several hundred million dollars a year for several years, they added just ~$25mn in 2016.

The drop off in revenue was coupled with deteriorating operating margins, which collapsed from 9% in 2015 to 2% in 2016. Fears were fomenting that the RH turnaround would be short-lived and the business would teeter between small profits and losses indefinitely.

After having enjoyed consistent improvements in the business for several years, they began experiencing severe growing pains at the same time as economic conditions softened, showing the cyclicality of the furniture market. Their 1Q16 earnings call opening remarks started with macro commentary to explain the tepid demand: “We continue to face headwinds in the markets impacted by energy and currency. There is a clear slowdown across the luxury market where we compete”. Later in the year, in 3Q16, Co-President and CFO Karen Boone said staleness in the legacy stores was also to blame: “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”.

This was concurrent with several other issues with the business, including the newly launched RH Modern line having production delays and logistics problems. Rather than limp through these setbacks with a Band-Aid fix, they instead rearchitected their entire platform to permanently address these issues. This resulted in short-term results looking worse than otherwise.

When RH launched the RH Modern line, they increased their SKU count past what the legacy system could handle, and their Modern Source Book came in at a whopping 540 pages. Their new Modern line added hundreds of new products, many of which had different size and color options. The increase in inventory (alongside more promotional activity, which we will get to momentarily) exposed a host of issues with their logistics platform.

First, vendors were not initially prepared for the onslaught of demand. Many of their manufacturers were small operations with a couple million dollars in revenues, which when suddenly increased to tens of millions, led to production issues. This resulted in longer than typical wait times and canceled orders. In order to avoid delays getting worse, they pushed back the shipping of the RH Modern Source Book several months to give their vendors more time to prepare. However, that proved to be an overreaction, because by the end of 1Q16, they had 90% of the line’s SKUs back in stock. The delay in shipping the book cost them around $100mn in forgone revenue, or 5 points of growth, for the year (management estimated on a call).

With their existing distribution centers (DCs) growing to full capacity with the launch of the new line, they were preparing to open new DCs. However, the increased SKUs were revealing extraordinary inefficiencies within their existing logistics operations.

RH was advised when building their original logistics platform that as long as the inventory was in their network, it didn’t matter where it came from. However, they learned that this was bad, and costly, advice, as their existing model led to multiple frivolous “touches” of the product. A sofa ordered in California might ship from the East Coast DC, just to have a reorder of the product hit the West Coast DC right as an East Coast order comes in, resulting in the same sofa being sent back across the country. RH was spending $9mn a year just on DC transfers, a figure that would continue to increase if they kept adding DCs. The solution was twofold: 1) cut down on the number of DCs to better consolidate inventory, which would lead to fewer costly DC transfers and less working capital tied up in redundant inventory, and 2) rationalize their SKUs of older and underperforming products.

However, this solution only solved part of the problem. They also had problems with reverse logistics; the products that were damaged in transit or returned needed to be sold somewhere. At the time, RH was sending these items through multiple logistics nodes, which was extremely wasteful. For example, a returned sofa might first land at a warehouse where it sat for weeks until enough product joined it to fill up a truck and send it to a sorting facility. There, they would sift through the inventory and send 10-20% of the items to a retouching facility that would then direct that inventory back to a DC where it might have to be transferred again or could be sent to a store before ultimately being sold. The items that were too damaged to be retouched would go to a different collecting facility before being distributed to their outlets. This meant that one piece of furniture could roundtrip the country twice before landing at an outlet, just to be sold at a steep markdown.

To solve this problem, they rearchitected their reverse logistics platform to bring returned and damaged items directly to an outlet, obviating the multiple wasteful trips and shortening the amount of time that inventory was held before being sold. To do this, they increased the number of outlets they had, growing from 17 in 2015 to 28 in 2016.

What was often damaging the items in the first place were 3^rd party logistics providers, who themselves often outsourced the delivery. Reducing adverse incidence would help them save on costs while improving the customer experience.

While looking into their last mile delivery operation, they also started to realize that it was poor form for the RH brand to pass off delivery to the same 3^rd parties who serviced lower-end brands likes Wayfair. There was also something discordant about buying luxury products in regal stores like RH’s six floor Chicago Gallery just to have the same delivery experience as a $400 sofa from Overstock.com. While their immediate solution was to contract more with the logistics providers who could consistently deliver without incident, for the longer term, they looked to in-house their delivery operations.

Owning their own logistics network would allow them to increase the service level, reduce adverse incidents, and potentially solve issues with damaged items right in the home. They also believed that having a product expert with the delivery crew could improve the customer experience and provide opportunities to upsell while in the home. This would take years to roll out completely, but they started experimenting immediately.

The second solution to improve their logistics efficiency was to rationalize SKU count. Among those to go was the last of “stocking stuffers” and other lower value items that had polluted their stores. While these products may not have been as offensive as the lawn gnomes they used to sell, as RH moved upmarket, they no longer had a place in their stores.

This came alongside a general pruning of older and underperforming products. Discontinuing these products led to outsized promotional activity though, which not only weighed on gross margins which fell ~400bps y/y in 2016 from 36% to 32%, but also added to the issues with their legacy logistics platform. This is because promotional activity has the impact of clumping together a lot of sales within a smaller period, stressing the system more than if the sales were evenly distributed.

Gary Friedman was aware of the whiplash promotions caused not just to the logistics platform, but also for retail employees and inventory management. Rather than business running at a steady pace, promotional activity led to sudden accelerations and abrupt stops. This led to cascading problems: 1) they needed part-time employees for only a few weeks during the promotions after which they’d have no work for, which led to a decision to either understaff during that period, stay overstaffed for the rest of the season, or undergo a costly effort to rapidly hire staff that were then promptly dismissed, 2) part-time staff couldn’t know the products as well as full-time staff, so the service quality was lower and more experienced staff would be overwhelmed with the influx of traffic, 3)  stores would run out of stock, requiring rapid restocking or rearranging of the store, 4) management’s time would be consumed with demand forecasting and managing inventory, 5) it increased the likelihood of returns and canceled orders, and lastly 6) deliveries both to the stores and customers would be stacked in a short time frame, causing shipping times to increase.  This is before mentioning the damage it does to the brand and the bad customer habits it instills, as it teaches them that the store’s products can often be bought for cheap, which makes them think the items aren’t worth the typical retail price and trains consumers to defer purchases until sales are announced.

Gary saw two solutions to this. The first was the introduction of the RH Membership in 2015 (mentioned earlier). Instead of sporadic seasonal sales, discounts would always be available, but only for members. This meant that consumers no longer felt pressure to purchase items within a small window of time, which resulted in longer sales cycles and a steadier buying cadence.

As far as the short-term impact went though, the 25% discounts were recorded immediately whereas the membership revenues were amortized over 12 months, which resulted in a margin hit. Evidence was mounting that the short-term hit was worth it though: they exceeded 260,000 members in the first year and the average ticket size amongst members was higher than non-members.

The second solution was to continue to emphasize the “Gallery” concept of the store with almost zero items actually stocked in the store. In short order, “Cash and carry”, which is paying in-store and walking out with the item, comprised less than 1% of sales (which was really only when floor models would go on sale). This had several benefits that improved the company operationally: 1) inventory didn’t have to be spread across their store footprint, 2) the store didn’t need to have a cash register counter, which made them look even more distinct from other stores and saved more space for products, 3) employees were freed from standing behind the counter and could focus on helping customers, and 4) employee theft would not be an issue since there was no inventory to steal. 

All said and done, RH estimates that they took $400-500mn of inventory out of the system, which materially improved working capital. Simply put, they built a much better operating model.

However, these changes caused short-term issues that impacted their financials through 2017, and the stock market was unforgiving, sending their stock down >75% from over $100 to ~$25. Investors at the time were unclear how much of the poor results were self-inflicted vs indicative of their value prop sputtering out. They worried that the cyclicality of infrequently purchased high-end durable goods could be especially ruthless, and a worse downturn could lead to prolonged losses. 

While investors may have had their doubts, with short interest exceeding half of all shares, Gary Friedman did not; he continued to be steadfast in his confidence in RH’s value prop and the businesses transformation. With RH stock having sold off precipitously, Friedman launched an aggressive stock buyback, acquiring almost 30% of the shares outstanding in a single year, and shrunk the share count by ~40% in total over this period. This proved to be an extraordinarily savvy move as the business rebounded the following year, with revenues +14% and margins improving as well. (Also, around this time, they bought Waterworks for $119mn, but have done very little with the asset since. More on this in the Expanding RH section).

After transforming their logistics operating model, RH had ambitions of moving higher-end. At the time, they characterized their brand as a “mid-upper tier brand” but wanted to be a true luxury brand on par with a Louis Vuitton. For the next several years, they would set about transforming their legacy footprint into larger and more ornate Design Galleries while continuing to refine their model. They would emphasize interior design services, which were attached to 65% of sales before they stopped disclosing that stat. This made RH even more unique, as they could help service a client on an entire project and sell them a finished “space”, rather than just having them pick out single products.

Meanwhile, they would roll out not only new product collections like RH Contemporary, RH Ski House, and RH Beach House, but also new businesses like Guesthouse, RH Bath House & Spa, and RH Residences. They designed Gulfstreams (RH1 and RH2) that ended up in Architectural Digest and were available for charter. And they set their sights on the international market, which they believe could be 3x bigger than their current business. With a flurry of new products and businesses, and several more that Friedman has teased, like Architectural and Landscaping design services and homes sold completely furnished, RH’s ultimate form isn’t clear. However, what is clear is that Gary Friedman is dead set on “climbing the luxury mountain” and putting RH in the pantheon of greats alongside Kering, LVMH, and Hermes.

From a near bankrupt retailer and purveyor of gimmick items to a bourgeoning luxury brand, RH has not only come back from the brink of bankruptcy, but is thriving. In 2021, operating income surpassed $900mn and operating margins topped 25%; they’ve come a long way since the mid-single digit operating margins Friedman predicted when he took over.

After participating in the buyout and several stock grants, Gary Friedman now owns ~21% of the company, making him a billionaire. A child who grew up apartment-hopping with no furniture is now trying to define the luxury furniture market with the first—and only—luxury home-branded retailer. However, his ambition for RH is to become more than a product category—he wants to create an integrated ecosystem inspired by Apple, while imbuing RH with the same taste-maker status LVMH garners to place them at the pinnacle of luxury.

We will dive into RH’s future ambitions and new initiatives towards the end of this report. For now, we will move to the business section.

Business.

Business.

RH is a luxury retailer of home products across multiple categories including furniture, lighting, textiles, bathware, decor, outdoor & garden, and Child & Teen. RH operates 67 RH-branded retail locations, or “Galleries”, which primarily serve as venues for customers to learn about the brand and receive design services. They also operate 39 outlets and 14 stand-alone Waterworks Showrooms. They currently operate 3 furniture fulfillment centers, 1 small parcel fulfillment center, and ~21 locations for home delivery. RH also sells their products through their Source Books, which are multi-hundred-page catalogs, and through their website, which together they refer to as “direct” sales. Historically, about half of their sales come from the direct channel. However, they think of themselves as channel agnostic, as the Galleries feed direct orders. 

They have two reporting segments, 1) RH Segment, and 2) Waterworks. As shown below, RH is responsible for 95% of revenues (and ~98% of earnings).

They also break out revenues in terms of two product groups: 1) furniture and 2) non-furniture. As shown below, Furniture is 31% of LTM revenues.

They currently have eight design “themes”, each with several collections that are regularly expanded and updated. Below are the Source Book covers for each of their eight lines, which in total constitute over 2,500 pages. Each page may have a dozen different items, many of which come in multiple finishes or sizes, which leads to a wide assortment of home goods across not just furniture, but also lighting, bedding, decor, rugs, and more.

For a sense of their products, see below for select bedrooms from their collections.

RH has grown revenues at a ~15% CAGR since 2009 and ~10% since 2013. Revenue growth is lumpy though, having grown less than 3% three times in the past decade, and more than 32% in 2021 (driven by Covid-induced demand). Demand tends to be correlated with new home sales, as that is the most common time when consumers buy furniture. However, home renovations or furniture replacements can happen periodically in a homeowner’s life without any real provocation. Part of RH’s hope is that as consumers visit their galleries for the restaurants, or just because the dominating building draws them in, that they consider replacing their home furniture even if it wasn’t a prior consideration. 

Outside of the operational issues from rebuilding their logistics platform and other changes we mentioned during the 2015-2017 period, their operating margins have consistently expanded. Operating margins have stayed positive since 2013 and total operating income has increased almost 20x from 2013 to ~$930mn in 2021. However, 2022 revenue and cost pressures have dropped that to $830mn LTM.

We will now dive into the RH Model, emphasizing what makes their model distinct and why it would be difficult to copy them.

The RH Model.

Creating the RH Model.

Restoration Hardware was born with a focus on hard to find, niche items like antique door hinges, Victorian light fixtures, and ornate molding. These types of items are difficult to locate, so simply sifting through hundreds of vendor catalogs to aggregate them was a helpful value prop. The problem, though, was that these were all very niche and infrequently purchased items. It was hard for Stephen Gordon to support occupancy costs with such a limited offering of slow-moving goods. To solve for this, he supplemented Restoration Hardware’s selections with an ever-growing assortment of “discovery items”.

These items served a dual purpose for Restoration Hardware. The low purchase prices and the novelty factor of these tchotchkes were designed to spur impulse purchasing. Each item was quirky and was seldom replaced, ensuring a customer would never see the same assortment and would feel “pressure” to purchase. The discovery items moved much faster than the core items and fit in unutilized spaces, which not only helped bring in incremental revenue and increase their efficiency per square foot, but also helped them create foot traffic and stay top of mind.

As their core hardware offerings were purchased infrequently, perhaps once a decade, it would be too easy for a customer to forget about Restoration Hardware when they needed to buy a doorknob. However, by coupling their core offerings with a variety of novelty items, they created a reason for passersby to browse their store. While this traffic wouldn’t always lead to a sale, Restoration Hardware would remain top of mind for consumers so that when they were in the market for hardware or furniture, they would seek out the brand.

There was some evidence the strategy of drawing a stream of “looky-loos” into the stores through novelty was working; their advertising costs were just ~2% of revenues at IPO, which is less than 1/3^rd of Williams-Sonoma’s. Customers were browsing the stores and telling others about their quirky Restoration Hardware purchases.

However, this incremental traffic and tchotchke revenue came at the total denigration of their brand. Their core home offerings were undermined by dog toys, moon pies, and flashlights, which confused customers. How should a customer feel about spending $4,000 on a rug from the same store that also sells dog biscuits and the “Atomic Robot Man” toy? A strong brand is a promise, and it seemed like Restoration Hardware was promising that the oak chest you bought from them might be of the same quality and aesthetic as the pet toys that adorned it.

The discovery item business created channel conflict by alienating their high-ticket consumers and corroding the consumer value prop in order to solve their CAC issue. When the novelty of the novelty item business wore off, they were left with a tattered brand, a confused consumer value prop, and falling same store sales.

When Gary Friedman joined the business, he still had the same fundamental problem to solve: how do you stay top of mind for the one time in perhaps a decade that a customer buys home furnishings without blowing through a huge advertising budget?

If you think of car manufacturers, they blanket the market with tons of advertising, knowing that these ads are relevant to just a small fraction of those that see it. They do this to make sure that when a consumer is in the market for a car, they remember to check out “Hyundai” or “Chrysler”. However, it is very resource-intensive to advertise enough to ensure you reach these consumers in the small window of time that they are in the market for a car.

Meituan, a food delivery service turned “super app” in China, was perhaps more explicit about this CAC/frequency issue than anyone. Their core food delivery and restaurant review app is high frequency, but the nature of food delivery is that it is a very low margin business. Instead of trying to monetize it directly, they used food delivery as a customer acquisition engine to cross-sell users on lower frequency, higher-margin services like hotel and salon bookings. Booking.com, lacking a similar customer acquisition engine, has to spend billions of dollars with Google Search to get in front of travelers. 

Restoration Hardware tried to couple the high-frequency discovery business with the low-frequency home furnishings business, but instead they repelled customers because of the association they created. They were essentially advertising consumers away from their higher-end products. This was their King Midas mistake: they would increase traffic at the cost of decreased conversions.

What car dealers solve with blanket advertising and what Meituan relied on food delivery for, Gary solved with restaurants and incredibly designed buildings. Their Gallery footprint would act as both advertisements for the brand and draw curious consumers in, while the restaurants gave people yet another reason to make the trek to the Galleries. And the hospitality business is much higher frequency than their core home business, but also profitable in and of itself. Their customer acquisition channel was not only a profit center, but the larger buildings actually reduced occupancy costs per square foot. This strategy not only allowed RH to stay top of mind, with literal lines around the block of their Chicago Gallery, but simultaneously elevated the brand.

Instead of the negative association the “knickknacks” created, the fine dining experience and impressive architecture with curated interiors would build consumer trust in RH as an “arbiter a taste”, while teaching them to enjoy imbibing in the “RH lifestyle”. This all allowed RH to move up from a seller of goods to a seller of “spaces”. But, before that could happen, there were dozens of aspects that needed to come together.

The RH Value Network.

RH’s model starts with the product. RH is first and foremost a seller of home design, and they have to produce products that are relevant, stylish, and resonate with customers. Rather than in-housing the design function though, they work with a vast selection of vendors who essentially serve as their designers. Their scale allows them to not only get exclusive designs but also support small manufacturers who would struggle to sell at scale otherwise. RH is multiples larger than any other buyer their vendors have, often making up 50-80% of their business, which gives them an unusually close relationship with each vendor. This helps RH build a unique assortment of inventory without being forced to take on the manufacturing themselves, while still have the privilege of access to exclusive products and the benefits of the creativity that comes from dozens of independently run businesses.

This puts RH in the position of “curator”, where they can just pluck out the designs they like best from the vast array of different furniture and home furnishing manufacturers. Rather than constantly coming up with new and novel designs, they just take what they like. This model not only supports multiple distinct lines from Contemporary to Ski House, but also allows for the constant introduction of new products without salaried teams of people dedicated to each line. Instead, they collaborate with single designers, who are typically industry-renowned, for each collection. This not only helps them curate top home designs, but also gives the RH brand more cachet.

Attracting such esteemed designers is only made possible by their luxury image, which is strongly linked to their Gallery model. The is because it enables them to showcase furnitureas if they are in museum pieces in museum-like Galleries, instead of shoving products into crammed, undistinguished mall chain stores. The focus on large, architecturally distinguished buildings helps attract designers and piques consumers’ interests, while making the statement that there is something special in there.

The larger Design Gallery size not only acts as both advertising and brand elevator, but also allows them to significantly expand their collection on display compared to a traditional box store. This is vital, as items on display have 50-150% higher sales, but also because it makes clear to the consumer how much wider of an assortment RH has vs other retailers, a differentiator that is hard to make through the web when every store’s webpage has the same screen size. 

The Gallery model has further benefits, the biggest of which is the ability to eliminate store-level inventory all together. Almost like a museum, consumers can look at and feel their home offerings, but can’t walk out with anything. In fact, less than 1% of RH’s sales are “cash and carry”, where the customer walks out with an item. Instead, all orders are shipped directly to them at home from their distribution centers. Eliminating store-level inventory not only saves a layer of shipping costs but makes the business dramatically easier to run as they do not have to shift items around the country to keep stores stocked and employees do not need to spend their time rearranging merchandise. The lack of store inventory also eliminates the potential for theft, reduces inventory damaged in transit, and increases the available selling square footage since there is no backroom of stock.

Incredibly, RH’s per square foot occupancy expense actually decreased as they moved into larger stores. This format allowed them to utilize more of the buildings’ spaces, including nontraditional selling areas like rooftops and outdoor gardens. Such architecturally interesting buildings were usually outside of traditional retail zones, which meant that rent also tends to be lower. Additionally, since their Galleries are traffic generators, real estate developers want to work with them and often give them deals with preferential terms like generous tenant allowances.

The extra space in these larger format locations meant they could add new experiences that would be impossible in a box store, like full-on restaurants, Wine Bars, and Barista Bars. The food and beverage services turned out to be extremely synergistic by drawing traffic into their stores and providing a nourishing reprieve that many consumers appreciated when spending the day making decisions big ticket decisions.

A consumer could, of course, frequent a restaurant much more often than they would buy furniture, making RH’s hospitality business a higher frequency service that helps drive consumer awareness and keep RH top of mind. Instead of spending prodigiously on advertising to remind customers to shop at RH, they use their restaurants to the same effect, with the important caveat that their “top of mind initiatives” are a profit—not cost—center. In fact, their restaurants rank among some of the highest grossing in the country, nearing $10mn annually for the best performing ones. To get to the restaurant though, customers have to walk through the store. And because RH restaurants are usually completely booked, there is a wait time during which guests will browse the store and inadvertently find themselves testing out RH’s furniture.

The increased traffic and visibility from their restaurants and Galleries mean they no longer need to rely on promotions to drive traffic, whereas traditional retailers are forced to use sales and discounts to generate interest, boost sales, and clear out merchandise before it goes stale. However, not only does RH not need to utilize discounts to attract consumer interest, the nature of furniture, which has an indefinite shelf life and is not seasonal like apparel, means promotions can be avoided. This not only has the benefit of easing the administration of inventory stocking at the store level, but also protects the brand as well.

Seasonal discounting behavior can not only habituate consumers to defer purchases until they get a cheaper price, but also “teaches” the customers that see lowered prices on their goods that they are of lower value. Additionally, sporadic sales create impulse purchases of items that a customer is more likely to return and drives up reverse logistics costs. Eliminating seasonal sales improves RH’s brand image, eases inventory stocking issues, and reduces returns.

In place of sporadic promotions, RH has moved to a membership model which gives members better prices. For a $175 annual fee, members receive a 25% discount off all items. This allows them to sell their furniture for cheaper while still maintaining the exclusivity of the brand. While the breakeven for this membership for shoppers is $700 in RH spending, most spend in excess of that (~90% of sales are driven by members, and they have ~half a million members). The membership also creates a higher sense of commitment to the brand. Once a customer becomes a member, they feel they need to take advantage of the membership and their spend increases. Even if they churn after their project is completed, they very likely would have spent more than otherwise.

This is especially true for those customers that utilize RH’s in-house interior designers, which are free for members. At last disclosure, over 65% of shoppers use RH’s interior designers, which not only leads to higher average order sizes, but also moves RH to a better position in the purchase journey. Instead of a consumer hiring an interior designer to tell them what home goods to buy, which may or may not come from RH, they can just go directly to RH and get a free designer, who in turn will design every room in their house if they wish, all with RH products. This further endears the brand to customers who feel like they are getting an exclusive, upscale service complimentary.

Having interior designers that only design with RH products requires a vast assortment of items though. Not only do they need a broad selection in various different collections, they also need multiple sizes to accommodate different room sizes. All of their products are conveniently presented in their thick and glossy Source Books which not only help the designers showcase the products, but also serve as a customer acquisition tool, one that when mailed out is a far better ROI than traditional advertising. Interior designers don’t need to sell themselves because the Design Galleries with fully furnished rooms essentially act as a designer’s “portfolio”, helping convince a customer to trust RH’s design tastes. This allows RH to take a more advantaged position in the customers purchase journey: RH doesn’t sell furniture, they sell “space”.

As the saying goes, people don’t buy the quarter inch drill, they are buying the quarter inch hole. Similarly, consumers ultimately want a great looking space that fits their needs, not discrete pieces of furniture. The growth of design services allows RH to complete the entire job, moving up the Consumer’s Hierarchy of Preferences from serving just one aspect to addressing all of their needs. A consumer doesn’t need to furniture shop; they can abdicate that to RH while they now just need to give their designer a vision (one that is usually inspired by the very Gallery they are sitting in).

Their service doesn’t just end in the store, though. RH has moved to take control of last mile delivery, which not only increases customer satisfaction by having RH-knowledgeable personnel setting up the furniture in their room, but also allows them to cross-sell should there be a missing element in the space when they get there. If a customer utilizes RH for their entire design project, then RH will coordinate to have everything delivered at once, vs coordinating shipments across various vendors and dates. Controlling the delivery service also helps differentiate the brand with a premium service and reduces inventory damaged in transit as well as returns.

However, if there are returns, RH has a reverse logistics platform that can take items directly to one of their 38 outlets, which liquidates inventory quickly with minimal blemish to the brand. The limited handling of each item through the delivery network saves costs and reduces damage incidents, a standard they have applied to their entire logistics platform. Noting the lack of needing next-day delivery, RH has concentrated their distribution center footprint over time. This reduces their capital tied up in inventory and also saves them shipping costs.

From the product assortment to the distinguished Design Galleries, restaurants, membership model, and interior design services with last mile delivery, RH has built a unique model that would be near-impossible for a competitor to copy without ripping apart their existing retail footprint, procurement process, pricing model, and getting lucky enough to attract top quality talent to run a hospitality business and curate dozens of aesthetic, unique collections.

We will now dive into the industry and then their competition.

Industry.

As always, precise TAM estimates are often erroneous, but it is still important to have some semblance of how large the market is. Estimates put the global furniture TAM at around $500-680bn annually. Within that, North America is somewhere around $200-250bn. RH specifically has estimated the North America home furnishings market to be $170bn and competitor Arhaus believes the North America premium furniture market to be $60bn ($100bn globally). Most estimates assume the market will grow at a ~5% CAGR, similar to what has been seen over the past decade.

With <$4bn of revenues today, the TAM figures are large enough that we do not have to worry whether RH will run up against the limits of the TAM any time soon. Additionally, RH is arguably growing the TAM in the high-end luxury segment.

Interior design services are estimated to have a $100-150bn global TAM, representing about~20% of the furniture TAM (using the midpoint). Most interior design services charge both a mark-up on the furniture they purchase from their clients, as well as an hourly fee, which makes it especially hard to pin down an accurate estimate though.

The furniture industry has very opaque pricing, in part to accommodate designers’ mark-ups. Interior designers can usually create a trade account with furniture sellers which enables them to receive steep discounts, typically up to 50%. The designer then “resells” the item to their client, either keeping the full discount as their commission or splitting the difference with their client. Since it’s entirely up to the designer on what to ultimately charge their client, the design showrooms do not list prices on their items. Instead, trade showrooms use “codes” that only those in the trade can decipher. This level of pricing opaqueness allows interior designers to have full control over their end price.

Furthermore, the showrooms usually restrict access to only those in the design trade, further strengthening a client’s reliance on an interior designer. In turn, the interior designer effectively acts as a customer acquisition engine for the furniture sellers, who goes out and gets clients to bring into the showrooms.

RH disrupts this model in three ways:

1) They have clearly labeled pricing, and instead of conspiring with the interior designers, they give members a 25% discount. While RH does provide interior designers with trade accounts discounts, it is the same 25% discount that a member gets. This gives customers price visibility and makes it hard for designers to mark-up RH’s prices (typically, interior designers pitch themselves as being able to get steep discounts that will save a customer money, but in practice, they don’t always pass along much, if any, of the discount they receive. The price visibility from RH limits their ability to do this).

2) RH Allows customers to walk the showrooms without someone in the trade, and even offers interior design services to members for free. RH is trying to “disrupt” the traditional interior designer/retailer model, which has excessive mark-ups, by doing both. It is an interesting strategy, because as RH tries to become a luxury retailer, they are simultaneously lowering prices by cutting out excessive middleman mark-ups. In early RH earnings calls, Gary Friedman focused more on how they could provide higher quality items at lower prices because of their scale and going direct to the consumer. While that model is still in place, they aren’t really lowering prices so much as shifting how much of the price RH captures vs an interior designer. This makes sense because by virtue of an item being “selected” by RH, it is already “curated”. 

3) RH doesn’t use wholesalers and contracts directly with the manufacturer. This not only allows another layer of mark-ups to be eliminated, but because of their close partnership with vendors, they can use their purchasing power to help manufacturers source raw materials cheaper.

Back in 2013 Gary Friedman summarized all of these advantages at a Wells Fargo Conference:

Competition.

Players.

The furniture industry is very fragmented with no single player having a commanding market share. The largest player is IKEA, with an estimated ~$40bn in revenues that puts it around a mid to high single digit market share. The next biggest player is furniture-focused ecommerce platform Wayfair, with ~$12bn in revenues, putting their market share at around 2-3%. The rest are even smaller. We group competition into five separate categories: 1) specialty retailers, 2) independent retailers, 3) furniture brands, 4) platforms, and 5) interior designers.

Within Specialty Retailers, we place IKEA and all the chain-stores such as Williams-Sonoma (>600 stores, owns the Pottery Barn and West Elm brands), Ashley HomeStore (>2,000 locations), Big Lots (closed all free-standing furniture stores, 1,500 stores currently), Bob’s Discount Furniture (~150 stores), Rooms to Go (>130 locations),  Crate & Barrel (>100 stores), and Arhaus (~80 show rooms). The specialty retailers vary wildly in value prop from cheap and low-quality furniture to high-end furniture. Most specialty retailers either 1) white label furniture manufacturers’ products, 2) work with their own vendors to produce products under their brands, or 3) carry 3^rd party furniture brands.

Most of these companies offer different value props than RH and are only competition to the extent that a customer finds some of these cheaper options “good enough” and wants to save money. But that is not the typical RH customer. It is possible that a customer buys RH for their living room and master bedroom, but then moves to a cheaper option like Pottery Barn for their children’s bedrooms.

Within the competitive set above, Arhaus is the most direct competitor to RH. Arhaus is building large galleries (they are 40-50% the size of RH’s largest galleries), focusing on higher-quality design pieces, and offering design services. They have much worse brand recognition though, and do not have a novel strategy like RH’s hospitality business to help improve it. Despite having been in business for four decades, they are earlier in their growth trajectory than RH and generate ~20% the revenues of RH. However, their focus on quality and design makes them a threat to RH. That said, it seems unlikely they will be able to copy most of the RH model. (The TAM is big enough for multiple players here anyway, but we still see RH’s model as unique).

Independent Retailers are smaller “mom & pop” furniture stores, as well as design trade showrooms that sell a variety of different brands and collections. The independents vary in quality and price and typically get most of their traffic from interior designers or locals who happen to be renovating. The highest quality furniture is often found at select independents who will purchase directly from an array of small vendors, giving designers a unique selection to pick from. However, there are multiple layers of mark-ups here, and this model does not scale well. Independents source all of their own furniture from other brands or small manufacturers.

Furniture Brands are companies like LA-Z-Boy or MillerKnoll (who have several of their own furniture brands such as Herman Miller) who sell through various furniture stores or directly through their websites and limited company owned stores. These companies are more focused on the creation and manufacturing of new, popular designs than the retailing of furniture. There is a long tail of furniture brands across every category, most of whom own their own manufacturing and rely on interior designers finding them through showrooms or trade shows. This is why many brands clump together, like at the Pacific Design Center in Los Angeles: designers know there are many different options there to look through, even if they don’t know ahead of time what the options are.

Several furniture brands like Ethan Allen are vertically integrated, owning both their own manufacturing and retail footprint. RH and Arhaus are also vertically integrated to an extent, and you can only buy their brands at their stores, but we categorize anyone who has a retail footprint as their primary means of distributing their products as a Specialty Retailer. In contrast, MillerKnoll’s Herman Miller line can be purchased at many different stores, and LA-Z-Boys can be purchased on Wayfair.

“Platforms” refers namely to Wayfair and Amazon, but could also include Overstock, Etsy, and Facebook Marketplace. These platforms aggregate a variety of 3^rd parties and offer varying levels of support. These options tend to be best for those on a budget and who value convenience. Most of the new items that are sold on these platforms are too cheap to be competition for RH. Marketplaces that offer high quality used items could in theory be competitive, but it is inherently a limited market, and RH customers value the ease of using a designer and are unlikely to be scavenging marketplaces for deals.

Interior designers are a service, but many homeowners will hand over the furniture purchasing decisions to a designer, so they are in the competition set. Interior designers though have different prerogatives than clients and will prefer purchasing furniture that allows them to take mark-ups. The RH model, which does not give designers preferential discounts and offers interior design services for free to members, is fundamentally at odds with the interior designer model. This makes it much less likely that a customer who hires an interior designer will buy from RH. As RH’s brand grows in prominence, they hope customers think of their Galleries the next time they want to redo their homes and visit an RH before going to a designer, which opens the door for them to use RH’s design services in place of hiring someone else. The highest-end furniture though is still clearly going to top interior designers who work with a web of vendors and independents and can get the highest possible quality pieces for a client, which are often custom. For these ultra-affluent clients, it is unlikely they flock to RH anytime soon. (RH does well with millionaires but doesn’t have the product quality and image to reach the ultra-wealthy yet. However, we have heard of ultra-wealthy individuals who would use RH for a 2^nd or 3^rd home, but not their primary).

As we think about all the different types of value props in retail, we wanted to quickly go through the main preferences customers juggle when purchasing furniture.

The Consumer’s Hierarchy of Preferences.

The Consumer’s Hierarchy of Preferences.

These retailers have very distinct offerings, so to see where RH fits in, it’s easiest to first list the different preferences consumers have. We have identified eight key variables that consumers will consider:

1) Design & Fit. What the furniture looks like is a critical factor. There is both the design aesthetic and how well it fits in a space to consider. RH carries multiple colors, finishes, and sizes for many of their items. They also have multiple different “themes”, each with several different collections, which gives consumers a broad assortment to pick from. While furniture design tends to be more timeless than apparel, there are still trends. That said, RH will not necessarily offer products that match those trends. By and large, RH has a “Zara-like” aspect to them where they will very quickly offer a design if it is popular (they commonly get the criticism that they copy many designers too—which was evident in our channel checks and consumer conversations). Their many collaborations with leading designers also help them be on top of the design world.

Another critique they get is that they do not have enough patterns or colors. However, with several collections and the ability to customize pieces with >100 different fabrics, RH has a broad enough assortment to have something for most people. They have also teased several new collections coming out soon, including RH Color.

2) Quality. This pertains both to the actual quality of the goods and their perceived quality. RH ranks high here, especially among new customers who first learn of the RH brand through their Galleries. However, some online reviews highlight issues with furniture finishing cracking more easily than what should be acceptable for their price point. RH typically will allow returns on such items, and their push to control the last mile and offering the ability to call for in-house furniture repairs is aimed at eliminating such issues. RH is one of a few high-end specialty retailers, and if a customer wants something even more premium, they will have to go to an Independent or use an interior designer.

3) Price. This is self-explanatory, but it’s worth noting that since there is limited price transparency in the industry, whether a customer is getting a good deal or not isn’t obvious. Specialty Retailers that position themselves as discount stores, like Bob’s Discount Furniture or Big Lots, clearly convey to the customer their value prop. But the Independents will carry items that are not easily comparable online, and even if a customer finds a similar item, they can always use the excuse that what they carry is higher quality, a claim that cannot be easily contested. Among those familiar with furniture, RH has the perception of being slightly overpriced for the quality of product they offer. However, RH tries to justify their higher price not just on the quality of their product, but with the rest of their full service and the overall “RH experience”.

4) Convenience. There are several aspects consumers consider here, from whether they have enough information about a product they find online to comfortably purchase it to if it requires a showroom visit. For many trade showrooms, consumers have to coordinate an appointment with a designer to see items in person vs having the ability to swing by an RH Gallery any time of day. Many Independents will not have all of their offerings searchable online, whereas RH has Source Books and a very clean website they call “The World of RH”. With RH, consumers do have the option of utilizing their designers to design their entire room vs lugging independent designers around town to a variety of different showrooms and stores to see different products. Some interior designers will visit dozens of showrooms with their clients to put together a room. If you are affluent and want a luxurious space (but not the most luxurious space possible) that requires the least effort and design know-how, RH is the clearest frontrunner.

5) Trust. This refers not just to the trust that consumers will receive an item as it was presented (a common problem with online purchases), but also that the item will be free of harmful chemicals like formaldehyde (a problem with very low-end products). Beyond that, there is the trust of whether a designer is qualified or not, and whether they will rip you off or not. RH has a good reputation on all of the above, sourcing only quality materials, providing transparent pricing, and presenting a “sample” of what the design looks like in the Galleries.

6) Availability. Not every item will be in stock, and delivery times vary. For college students, getting affordable furniture quickly is their primary preference, which is why Ikea does so well with them. For RH, most items in stock will take 2-3 weeks to be delivered, and if something needs to be custom ordered, it can take 3-4 months. Most customers at the high-end care about doing things “right” rather than quickly, so they’re less sensitive to delivery times. If they find a similar item though, they will prefer the option that arrives quicker (this assumes the consumer is using their own designers and not RH’s).

7) Novelty. Some consumers, especially at the higher end, will preference having something others haven’t seen before. If they do care about this, then it is likely they will not want to shop at RH since their items are not very limited, one-off, or custom-made.

8) Ease of Installation. How easy the furniture is to get home and install is something that might dictate where consumers purchase. For college students, being able to transport furniture without needing a moving truck is very important, which contributes to why Ikea is such a popular venue for them. On the other hand, higher end customers are more concerned about whether the delivery will be safely delivered and undamaged. Some furniture comes partially unassembled, so having RH provide in-home assistance to set up the furniture and organize the room is an added perk of using RH.

While there are many different furniture options a consumer has, there is no direct competitor to RH on all of these variables. Most retailers that compete with RH focus on a specific vector and may provide more value on that specific vector, but none of them package the consumer preferences the same way to serve a customer like RH does. RH’s value prop is basically perfect for people who think: “I like nice looking things, but not the typical drawn-out design process, and I have no idea where to begin to make my home look good. Can I give you a lot of money to do this for me?”

Their Design Galleries are essentially walkable advertisements for how a home could look if a consumer relinquishes design control to them. Most RH customers are happy to do so. The design services allow RH to offer a customer a complete “space” and not just furniture items. The hospitality services help a customer stay the entire day at an RH to design a room without needing to leave. And the brand, coupled with high-end showrooms, gives customers confidence that they are getting quality. RH’s customers are not going to be the most price conscious or the most up to date on design. RH’s “job” is to give affluent customers great looking spaces with minimal hassle and a trusted brand—something no one else can claim they are serving well.

Said simply, if you are affluent, you know which car brands are high end, you know what clothing brands are high-end, and you know where to shop for high end watches and jewelry. But what if you want to upgrade your home decor? For most people, there is no single place that springs to mind; RH wants to change that.

Peer Metrics.

We will now go through some public peer metrics to get a better sense of the industry. Below are six public RH peers. While none of the below other than Arhaus operate in the same high-end space as RH, it is helpful to get a sense of how RH’s operating model compares to other furniture companies. (Williams-Sonoma owns Pottery Barn and West Elm, which account for >75% of their revenues).

We used 2021 metrics to compare the companies because furniture demand was especially strong due to people staying home as a result of covid. Theoretically, this allows us to see how much operating leverage each model has. RH’s 25% operating margins are industry-leading, with Williams-Sonoma coming in second at 18%. While RH eliminated promotions years ago, Williams-Sonoma recently curtailed them as well, boosting their operating margins.

This was actually consistent across the entire furniture industry, as they all limited promotions over the past ~2 years because of the Covid demand boom and supply chain issues that delayed re-stocking. It remains to be seen whether all of these other players will be able to maintain their existing pricing strategies in the face of falling demand. If demand falls and inventories are high, retailers are incentivized to offer promotions to clear out stock. If one player starts discounting their furniture, others with similar value props will quickly follow suit to avoid losing market share.

Gary Friedman is cognitive of this dynamic and has spoken about the pressures to discount before. When demand is down and the business is suffering, it is very hard to just sit still and take the pain. It is especially hard when investors pressure management on short term results. The fact that Gary is the largest owner of RH allows him to take a longer-term view and brush off investor pressure, whereas other managers might not be able to be so stoic with their jobs on the line. However, it is possible, if not inevitable, that demand will eventually fall off and other players (not just the public companies listed above, but luxury ones too) will discount their products, resulting in a double whammy to RH’s sales from the initial demand slump and the aggressive competitive response. However, withstanding that pressure is critical to becoming a luxury brand and sustaining their margins in the long-term.

While it seems likely that others will fall prey to typical discounting behaviors when demand softens, RH will likely continue to hold the line on their prices to protect their brand.

Below, we see inventory turns across the public peer set. RH turns their inventory 3x a year, or about every 4 months. This is in-line with higher-end peer Arhaus, but slower than other lower-end players. (Since Ethan Allen owns their own manufacturing, inventory that is “work in process” will inflate their average inventory balance, which reduces turns). To better gauge the tradeoff that RH is making for slower inventory turns and higher price, we created a metric called the Value Capture Index. (For those unfamiliar we introduced this framework here).

As a reminder, the Value Capture Index is essentially how much operating profit a company generates for every $1 of inventory they hold. The idea is that there is a trade-off between (1) a low-price strategy that tends to come with higher inventory turns and (2) a high-price strategy with slower inventory turns. The Value Capture Index allows us to compare competitors who have embarked on different pricing strategies in a fair way.

This is in part because the more inventory-intense a sale is, the higher portion of inventory a company must hold per dollar of sales. We can see the relationship in the exhibit below, which shows that high inventory turnover means a company tends to hold less inventory per dollar of revenue. The importance of this correlation is that a company cannot “game” the metric by just reducing their inventory, since sales would be impacted. (For a more in-depth explanation of this metric, read the initial essay where we explain how sales, margin, and turnover are all related). 

Below is the Value Capture Index applied to public furniture companies. We common-sized all sales to “100” for comparability. We see that RH’s mix of average inventory turns and peer-leading operating margin gives it the highest Inventory Value Capture score at 1.45. This means for every dollar of inventory RH has, they can turn it into $1.45 of operating income. WSM also ranks high despite lower margins because of their slightly higher inventory turns. Arhaus, in contrast, is dragged down by their low operating margin, making only 20 cents of EBIT per $1 of average inventory held.

These figures are the byproduct of RH’s model, which allows them to sell products they don’t have inventory for yet. As RH moves up the luxury spectrum and begins to lean on interior design more, customization becomes more common, and customers place orders months before receiving their goods. This means the inventory they hold is increasingly less often in a warehouse sitting, which reduces how much working capital they have tied up and helps avoid the need to put items on sale. This suggests that their turnover ratio has scope to improve but will be limited by how long furniture sits in transit (after they become the merchant of record).

RH’s margins are largely a byproduct of higher prices. With each new furniture theme, they have taken prices up. RH Modern was priced 50% higher than their assortment at the time, and RH Contemporary is 35% higher than the assortment prior to launching. They have ample pricing power, not just because they are focused on becoming a luxury brand, but because the infrequent nature of purchasing furniture means most people do not know how much upscale furniture costs. As Gary notes, “you are not looking at the price of furniture until you need furniture”. In contrast to lower end players who are primarily competing on price, RH customers do not think of price first, giving RH more leeway to take prices up, as they have for the past several years. Gary Friedman is fond of quoting LVMH’s Bernard Arnault, who says “Luxury goods are the only area in which it is possible to make luxury margins”. In 2020, RH surpassed LVMH’s margins, and said that they can see operating margins approaching 30% (more on this later).

We will conclude the competition section with a snippet from RH’s 1Q21 letter and a quote from Gary Friedman.

Real Estate Model.

Real Estate Model.

At the foundation of everything RH does is their Galleries. We have documented how RH has moved from standard mall stores nestled in between a row of undistinguished boxes to more large and ornate stand-alone Galleries. However, despite the real estate transformation going on for almost a decade, they still classify half of their galleries as “Legacy” Galleries, which were remodeled, but have a smaller footprint and a more traditional store format. The real estate transformation is important because moving from a legacy store to a Design Gallery usually connotes a 2x increase in sales in addition to a 10% direct sales (ecommerce and catalog) uplift.

RH has noted that in Legacy Galleries, they have an average sales volume of $15mn, but they can expect that to increase to $30mn+ with hospitality. Some galleries like Marin do even better, going from $20mn in sales to $50mn+ (disclosure from 2018). In 2018, they estimated that hospitality drove 3-5x more traffic into the gallery. Their best-performing galleries, like the New York Meatpacking Gallery, have surpassed $100mn in sales.

They break up their Design Galleries into 4 different groups of stores:

1) Bespoke Design Galleries. These are their largest galleries that are in top metropolitan markets like the New York Meatpacking and Chicago ones. These are Galleries in large and iconic locations. RH Chicago is around 70,000 square feet and 6 floors, and the Meatpacking store is even larger at 90,000 square feet.

2) Bespoke Indigenous Galleries. These are similar to the Bespoke Design Galleries, except they are in “second home” markets like Palm Beach, Aspen, and the Hamptons. They are similarly housed in large and architecturally distinguished buildings.

3) RH Prototype Galleries. The prototype galleries range around 29,000-33,000 square feet of selling space, including hospitality. They will have assortments from most collections and areas for customers to sit down with designers. The Galleries in Minneapolis, Corte Madera, Columbus and Charlotte are examples of these. As shown below, these are still housed in large and well-designed buildings, but they share more similarities than the Bespoke Galleries. 

4) Secondary Market Galleries. These are smaller galleries that are 10,000-18,000 square feet and intended for secondary markets like Hartford, Oklahoma City, and Milwaukee. The idea was to experiment with a few of these stores in a smaller format to see if there was an untapped market. However, it seems they have since scrapped the plan to open these stores. Below, are 10k disclosures from 2019 and 2020 that show RH has removed the language for their secondary market galleries, making us believe they have shelved this experiment. 

Regardless of what format, each Design Gallery has a payback of <2 years. This is made possible by a new real estate model where RH buys a property and invests in the building’s development, and then completes a sale-leaseback when it’s completed. RH noted the superiority of this model in their 2017 investor day, explaining that it allows them to buy more unique locations and structure a leaseback with lower rent and no % of sales stipulation.

David Stanchak, RH’s Chief Real Estate and Development Officer illustrates how this model’s structure benefits them using the Minneapolis Prototype Gallery as an example. The slide below shows that rent with the sale-leaseback would cost about $400k less annually in rent vs the straight-lease model. This figure could actually be higher, as their galleries continue to grow, and the old lease model takes a % of sales. Even more importantly though, under a traditional lease model, RH would be on the hook for about half of the costs of any property investment. In the example below, RH paid a higher lease rate and covered half of the $30mn required to develop the property, or $15mn.

Shifting to the development model means that while they were initially out $30mn, when they sold the property, they got back their full capital contribution. In fact, they actually made a $3mn profit selling this property (although it is just as possible their contributions exceed the sale price if the market turns). Generally, RH aims for occupancy costs to be 5-7% of sales, which may go up to 8-9% of sales before a store ramps up. However, that is still much less than traditional mall stores where occupancy costs are 10-17% of sales. This lower occupancy cost is yet another benefit of their real estate model. 

RH has steadily been replacing their legacy footprint with their design galleries, adding an average of three a year. Today they have 67 Galleries, which includes 28 Design Galleries, 3 stand-alone Baby & Child and Teen Galleries, and one stand-alone Modern Gallery. The downside to their real estate model is that it takes a lot of time and attention to open a Gallery, and they have opened galleries at a slower cadence than they originally intended. However, that is because they are much more focused on doing everything right rather than everything fast. They now aim to open ~five galleries a year.

We show below that despite their total store count essentially staying flat, RH has added about 1mn square feet of space over the past decade (a small part of this was increasing the number of outlets from 17 in 2013 to 39 today). And even with the large increase in square footage, their revenue per leased square foot has increased from ~$1,550 in 2012 to ~$2,150 LTM. While at last disclosure revenue attributed to stores vs direct channels was split about evenly, this shows that their strategy of increasing store size has helped drive more sales.

With total revenues today around $3.7bn, RH believes just finishing their real estate transformation from legacy stores to Design Galleries could grow their North America revenues to $5-6bn (this was increased from $4-5bn previously). The rough math would be that if you say their Design Galleries are twice as productive as their legacy stores, and about half of sales are attributable to stores, then moving to a full Design Gallery footprint would bring about ~$650mn in incremental revenues, with another ~$175mn from the direct channel lift. This comes out to ~$4.5bn. However, it’s important to keep in mind that some Galleries do much more than 2x their legacy counterparts, and the existing galleries still have scope to improve. Still though, it seems RH would need existing Galleries’ sales per square foot to grow as well in order for them to hit their $5-6bn estimate. We will touch back on this in the revenue build section, but it seems their North America goals are quite plausible.

However, remember that the $5-6bn revenue target is just for North America. As Gary Friedman notes, most luxury businesses only have 20% of their business in North America, and he believes that RH can ultimately be similar. To address the rest of the world, RH is starting to open up galleries internationally and explore ancillary businesses. The international business (and other endeavors) has few proof points so far, but logistically they make sense and seem consistent with their strategy. 

In a later section, we will touch on all of these initiatives.

ROIC and Cash Flow.

Alongside RH’s business improvement has come a dramatically improved ROIC profile. Whereas the business was averaging an ROIC of ~6% from 2013 to 2017, they have averaged 17% over the last five years. While there will be cyclicality in their earnings, which will drive a lumpy ROIC profile, the business transformation has likely led to a permanently higher ROIC base. Their focus on protecting the brand by eliminating promotions means margins will not be traded for market share, which helps protect their returns. However, as furniture is an infrequently purchased durable good, it is typically easy to defer a purchase, which drives cyclicality in the business. But as long as affluent people still want nice things, they will eventually make purchases. We believe it is possible that ROIC has a few years where it is lower than the 20% they put up LTM, but on any 5-year rolling average, it is likely to be at least in the mid-to-high teens. This is especially true as they continue to embark on climbing the luxury mountain and raising their prices, which, when combined with flat inventory turnover, will further improve ROIC. (Achieving 30% EBIT margins on the same invested capital base would improve ROIC ~800bps). 

Above is our ROIC calculations charted back to 2013. We see how ROIC has been driven higher by operational improvements and the business model transformation, which boosted operating margins.

Our ROIC calculation methodology is as follows: Starting with the numerator, we take cash from operations and back out SBC, as well as the amortization of debt discount. While the debt amortization is a non-cash expense, they effectively “pay” for the lower cash interest expense by issuing debt under par and paying for it when the debt comes due. Essentially, this transaction is “financing” what would be a periodic cash interest expense by increasing the amount that will be paid to the debt holder when it is due. Thus, since the benefit is received in the current period, we reverse the add back of the amortization of this debt discount. For the denominator, we include all lease obligations and convertible debt.

While our ROIC calculation starts with EBIT, we have found that GAAP earnings lag free cash flow. The largest difference is that D&A runs about half of what capex is. As they continue to transform their real estate footprint and the larger galleries double sales, this should be considered “growth capex”. However, since some amount could still be “maintenance capex” and since we gave them credit for property sales by allowing the proceeds to offset capex, we fully burdened FCF for all reported capex. (Property sales decreased capex by $24mn in 2019, $25mn in 2020, and zero in 2021). Additionally, we back out deposits for assets under construction, as well as equity investments (the nature of which is namely the Aspen JV, noted later). The net of all of this is lackluster FCF conversion, which has averaged ~ 55% over the last five years. However, operating cash flow (even after backing out SBC and debt discount amortization) exceeds 110%. Assuming growth capex is roughly half of their total capex, FCF conversion is closer to 85%.

We see below that after rearchitecting their logistics platform in 2016 and rolling out their membership program, they had better control over inventory planning and thus inventory as use of cash was reduced. Along with growing revenues >$300mn from 2015 to 2017, they took ~$215mn of inventory out of their system, reducing the working capital tied up in merchandise. This helps explain the big change from negative to positive FCF conversion in 2017. Growth is now much less capital intensive, but there is still room to improve.

Below, we show free cash flow over the last decade. Better understanding the truth about growth vs maintenance capex could create a meaningful difference in long-term owner earnings.

Nevertheless, RH has shown an ongoing and material improvement in ROIC, which we believe will continue to improve in the long run, albeit with some cyclicality. Their free cash flow profile will also improve when they are no longer pursuing so many different growth initiatives, although that could take many years. (As such, we incorporate a 5-year period of FCF being suppressed by growth capex in our reverse DCF).

Before we conclude this section, it is worth touching on Friedman as a capital allocator. We noted in the history section that Friedman was a very savvy repurchaser of their stock when it tanked in 2016-17, buying back almost ~40% of the company over that period. In 2021, when the market was strong, he raised a $2bn term loan, followed by a further $500mn loan to take advantage of buoyant capital markets (it was still floating rate though). In contrast, many competitors were caught flat-footed and had to raise very dilutive convertibles (Wayfair) to get through the change in environment. After buying back some of their convertible notes that were outstanding (which resulted in a GAAP loss of $170mn), they kept the majority of the proceeds on the balance sheet. Other than a $286mn share repurchase, which was partially funded by $154mn of proceeds from Friedman exercising options that were granted to him 10 years earlier, RH has not been aggressive in buying back stock.

Friedman is drawing a distinction to the prior period in ’16-17 where he knew the issues with the business were solvable and within his control, whereas the macro environment changing for the worse could present a longer lasting headwind that they will have to weather. He calls out a number of idiosyncratic factors that helped the business boom over the past couple years that could reverse, including covid-induced moves from the city to the suburbs (to larger homes which require more furniture than an apartment), home sales increasing faster than they have since the 70s, and interest rates climbing faster than most people have experienced in their lifetimes. The confluence of these events on a luxury retailer of nonessential, durable goods could result in a very stark drop in sales, and Friedman wants to be prepared if that is the case. Having the cash ensures survival, which is more important than shrinking the share count another ~10-20%.

Before we dive into the valuation, we will first touch on some of RH’s other initiatives.

Expanding RH.

Expanding RH.

As RH climbs the “luxury mountain”, they are expanding their offerings. No longer a pure furniture seller, they now have a hospitality business, interior design services, and other new offerings. RH calls this “Products, Places, Services, Spaces”, which is an integrated ecosystem of RH branded offerings. Just as they experimented with restaurants, RH continues to introduce new concepts. Friedman likes to draw parallels between what RH is doing with Apple and their fully integrated ecosystem of devices. Similarly, he wants RH to have multiple contact points with consumers, each of which can drive the furniture business and strengthen the overall brand. While the focus of all of these initiatives is still primarily to drive furniture and home product sales, this could change in the future. We will dovetail into various initiatives below, as well as their new push to grow RH beyond North America.

Geographic Expansion.

With RH about 60-75% of their way to their $5-6bn North America target, they have started to think more about opening up in new markets. They have previously noted that many customers have visited RH from overseas and bought 6 figure amounts of furniture in a single purchase, despite having to arrange transportation back home entirely on their own. However, Friedman is conscious of how much groundwork must be done before they can open Galleries and ensure international consumers get the same experience consumers in the US have. The worst thing they could do is open a new market without the logistics apparatus or outlets to deal with returns, and instantly turn off an entire generation of consumers who have no idea who RH is. They are proceeding relatively slowly but are opening RH England in Spring 2023 and have London and Paris locations in the works for a 2024 opening.

RH England. Despite several delays, RH England is slated to open in Spring 2023. This RH Gallery is housed on a 73-acre estate that was built in 1615 and has the same architectural protections as Buckingham Palace. With three restaurants on the property, an orangery, a tearoom, and Europe’s largest herd of white deer to gaze upon during weekend picnics, RH England is doing a lot to continue to lift the brand and give people a reason to visit despite being several hours out of London.

International Opportunity. In addition to this Gallery, they also have Galleries in London and Paris planned, each of which will also have unique experiences, including a rooftop where consumers can sip champagne with the Eiffel tower as their backdrop. These will definitely not be the typical furniture stores. They have also found locations for an RH in Brussels, Dusseldorf, Madrid, Milan, and Munich. And while they are currently focused on expanding internationally in Europe, they have already begun teasing Galleries in Asia.

There are risks with any sort of expansion, especially when it comes to an American company trying to sell luxury to Europeans—there’s no precedent. (Virtually all high-end luxury brands come from Europe). However, it is hard to deny that what RH is building is unique, and it is difficult to see it not appealing to some segment of affluent consumers. We will show how meaningful success with their international operations could be for shareholders in the valuation section, but RH thinks it is a $20-25bn revenue opportunity.

Vertical Expansion.

In 4Q22, RH announced two acquisitions. They acquired Dmitry & Co., a to-the-trade custom upholster atelier (design workshop), which they intend on turning into RH Couture Upholstery. They also announced the acquisition of Joseph Jeup, a to-the-trade custom furniture atelier, which will become RH Bespoke Furniture. With these acquisitions, RH has started moving toward furniture design and production in a small way. This could portend a further manufacturing buildout in the future. Friedman has noted that LVMH needed to control their own production in order to ensure quality, and it’s possible that RH will eventually feel they must do the same. For now though, these acquisitions are in accordance with supporting standalone services and do not seem to have any ramifications for their furniture procurement process.

Brand Expansion.

Brand Expansion.

There are several new initiatives that RH is pursuing with regards to brand expansion, some of which are experimental businesses that have the potential to be standalone profitable, like the restaurants, whereas others are more creative marketing.

RH Guesthouse. In 2022, RH opened their first “Guesthouse”, an extremely high-end and private hotel (although Gary Friedman rebukes anyone who calls it a hotel). The 10-room hospitality experience has a privacy-centric nature, with guests able to access their rooms without going through a large, public lobby. They have a no social media policy, which is designed to keep guests delighted when they see the hotel’s interior for the first time. Each room has two bathrooms, with pantries stocked with fresh food, and a spot saved in their dining room (i.e., restaurant) for guests.

In total, there are six guest rooms, three guest suites, and a penthouse, which Gary uses as his residence when he is in New York. They selectively rent it out, requiring his approval of the guest. Guest rooms start at $2,000 a night, suites are >$3,500, and the residence is $12,000. No children are allowed.

The rationale for RH Guesthouse is to extend the RH brand in a way that elevates it. However, the purpose is not to showcase their furniture. As Gary is quick to note, they have a multi-floor Design Gallery just steps away from the Guesthouse, so it would be redundant if they did. Nevertheless, showcasing RH’s knack for design (even if it’s not specifically about RH furniture) will help them win customers down the line. Similar to the restaurants, this helps them stay top of mind with customers while lifting the perception of the brand.

While the Guesthouse is stand-alone profitable, there is no current intention of making it a main business line. They currently see several opportunities to roll out more Guesthouses at select locations, with another one opening in Aspen (more on Aspen below). Even at full utilization though, the Guesthouses generate about ~$12mn in revenues, which would mean they would need ~80 of them to become a $1bn business. Given the inconsequential contribution to the top line at the current scale, their strategy will continue to be more focused on improving the brand’s positioning in aims of ultimately driving furniture sales. That could change in the future, but without iterating on the Guesthouse model, it seems unlikely to ever be that large of a revenue contributor. 

RH Integrated Ecosystem. In Aspen, RH is building their first ecosystem of RH products, places, services, and spaces. This development is being carried out with a more experienced Aspen developer and they have committed around ~$100mn to the JV. The RH ecosystem will include a Guesthouse, Residences, restaurants, Galleries, and a first of its kind RH Bath and Spa.

Residences. Friedman has noted before that there are a lot more people with money than with time and taste, so he believes that there is an opportunity to provide fully furnished homes and apartments for sale, effectively entering the real estate development business. They are starting this experiment in Aspen with just 6 residences, one of which will be a standalone home. (The RH team previously worked on Gary Friedman’s Napa Valley home, which was then rebranded as “Eight Palms”, and sold as the first home fully designed by RH).

These residences are a small test to see whether RH will enter the residential development market in a larger way. They aren’t the first to test out branded residences though. Many hotels like the Ritz Carlton and Four Seasons have their own residences (usually attached to their hotels) for sale. However, we do not believe there are single family homes created by a single brand at scale.

RH1, RH2, and RH3. RH purchased and designed two private jets (named RH1 and RH2) and a yacht (RH3). While these can be chartered, the real benefit is it has essentially served as advertising. The Gulfstream 650 they designed was featured in Architectural Digest, one of only two jets ever exhibited in the publication.

Aside from the press coverage, the hope is that every passenger that steps foot in one of their private jets or yacht will forever be more impressed with RH, and in talking about their experiences, become unwitting brand ambassadors. RH has also fielded requests from wealthy jet owners to design their private planes, so it could actually be an extension of design services eventually.

Not everything will work though, and they will continue to experiment with different ideas. Back in 2013, they used to talk about an RH clothing line, where the idea was that customers could find cashmere sweaters and the like within bedroom furniture, but they quietly killed it. They also axed their kitchenware line shortly after launching.

Beyond RH.

Beyond RH.

Waterworks. In 2016, RH acquired a ~90% stake in Waterworks for $120mn, but has done essentially nothing with it since. Gary Friedman notes that there are only a few brands that define their categories, and when you get the opportunity to buy one, you jump on it. Waterworks was originally founded in 1978 and focused on bathroom and kitchen fixtures like faucets and showerheads, but has since expanded to other bathroom and kitchen items. In 2021 Waterworks generated $165mn of revenues (or 5% of RH’s total revenues) and $16mn of EBIT (or <2% of RH’s EBIT). Since purchasing the brand, RH has done very little with it as they focus on growing the RH brand. Waterworks has 14 showrooms, a number that has essentially remained unchanged since they were acquired.

In the longer-term, there is an opportunity to grow the Waterworks brand, but Friedman seems torn between the “integrated ecosystem” approach Apple takes, which places the RH brand as the connective tissue, and moving to a more platform-like approach that mimics what LVMH has done with their brand “houses”. With RH still having ample growth runway, it seems Waterworks will continue to be deprioritized. That said, it has latent potential.

Valuation.

Valuation.

In valuing RH, we focus on their core North America business, as other initiatives are not mature enough to confidently estimate cash flow streams. The biggest omission here is their international business, which is still very nascent, but represents a material opportunity for RH that is theoretically easy to estimate cash flows for, as the international model is similar to the North America one.

We choose to focus on the North America business because estimating cash flows from the international business has wide a range of possible outcomes as they have yet to officially start operating. RH has said they believe international could be a $20-25bn revenue opportunity, but it is also possible that the RH brand doesn’t see the same adoption internationally as it has in the US. While we believe they will be able to achieve some level of success from their international operations, they haven’t opened their first gallery yet, so how much the brand resonates is hard to know.

Rather than running a sensitivity analysis that combines high certainty cash flows from the North America business with more uncertain cash flows from international business, we decided to solely run our reverse DCF on the North America numbers. This decision was made in part because, if the assumptions hold, the North America business can rationalize the entire valuation of RH today.

We have a second valuation that attempts to size up the international opportunity. If successful, this could be larger than their existing business, but it is also possible that investors are disappointed.

Today, RH is generating around $3.8bn in revenues, and management has increased their long-term expectations for the North America business to $5-6bn from $4-5bn previously. We run our reverse DCF sensitizing around $4-6bn in revenues, which, at the lower end, assumes nearly zero growth. For the purpose of our DCF, we estimate RH will achieve these long-term goals by 2028. It is worth noting that the valuation is not particularly sensitive to whether the cash flows come a few years later. Below, we show our revenue assumptions for each scenario.

We sensitized the business around 25-35% EBIT margins. In 2021, RH achieved 25% EBIT margins, and Gary Friedman talked about how there was still room for margins to further improve in the longer-term. He noted that many other luxury brands have 35% margins and implied that is where RH could eventually go. Lastly, when running the DCF, we assumed that cash flow conversion would lag earnings for the next 5 years, and slowly ramp up from the current ~64% to eventually 100% in 2029. 

Below, we show the reverse DCF outputs, which range from 11% at the lower end to 18% at the higher end.

Admittedly, our reverse DCF assumptions do not account for cyclicality. We ran other Reverse DCF tests to see what a downturn (-15% drop in revenue) every 7 years with margins compressing 10 points did to the model, and it compressed our return by ~1% annually. If we assume that there is going to be a very rough next few years with revenues bottoming down 35% before slowly recovering, that reduces our expected returns by another ~1% annually.

The relatively small change in annual returns makes sense given any single year or two of cash flows fades to a relatively trivial amount when taking into account the lifetime of the businesses’ cash flows. While the market may react severely to a year of -25% revenues, it likely doesn’t materially dent the lifetime of future cash flows the business will generate.

(If an investor is privy to using P/E multiples, they must be extra cautious to figure out not just what normalized earnings are within a “cycle”, but how much normalized earnings grow over time. At the end of each cycle, RH’s earnings would rebase higher, but the luxury furniture industry does not have a very established cycle, which would make such a task near impossible. This is especially true with RH, who is creating something that doesn’t have any obvious comps. While we can understand the attraction to being able to value on a multiple, we do not recommend doing this for near term earnings. That said, one could take their long-term estimates of $5-6bn and apply a 25% margin to get ~$1-1.2bn in NOPAT, which they could just apply whatever multiple they wished to, and discount back to however long they think it’ll take RH to get there. If it is 7 years and a 15x multiple, then they are looking at a $15-18bn EV before adding back 7 years of free cash flow, which is likely another $3-4bn. At the lower end, that is a 12% return, and at the higher end, it is 15%. We still prefer the reverse DCF method where we can make explicit assumptions and get an implied return).    

An investor will have to decide how comfortable they are making these assumptions, but if we think they will continue to have success transforming their legacy footprint into Design Galleries, then with the corresponding revenue lift that has been previously observed, gets us to at least $4.5bn in revenues, assuming no growth from existing galleries or other initiatives. The higher end of their estimates assumes their growing brand awareness helps drive more incremental sales to their existing Galleries as well, something that has similarly been observed over the past several years.

The international initiatives are still new, but have the potential to be a much larger business than North America. Gary Friedman talks about how most luxury brands have only ~20% of their revenues derived from North America, so if they have a similar geographic revenue composition, their international business could do $20-25bn in annual revenues. While we sensitize the business from $5-25bn, keep in mind that the low end is still assuming a more than doubling of their current business. Given that they haven’t materially improved their Gallery-opening cadence beyond roughly five a year, this is likely a multi-decade undertaking. That said, it seems likely that they will be able to generate something from their international operations—but exactly what that is and when is an open question.

While an investor’s opinion will depend on their assumptions, it seems that at today’s valuation, one can rationalize an investment even if they zero out the international opportunity and consider it a “call option”. In the most extreme scenarios, RH’s international operations could be worth a multiple of their current market cap. However, we would not consider that a base case.

We do not explicitly model RH’s other business initiatives like the Guesthouses, Residences, or design services, but they could also be potential future sources of value.

There are many short-term headwinds to consider, but if RH continues to offer a unique service that consumers value and maintain their competitive position, then short-term headwinds (i.e., housing sales, a softening economy, a moribund stock market, and rising interest rates) are just noise. Of course, it is an investor’s judgement whether the returns they see here properly compensate them for the risks they perceive.

Summary Model.

Below is our summary model. There is a much wider range of outcomes than what we are showing, and the numbers below do not necessarily reflect our opinion of the highest probability outcome. Any annual (let alone quarterly) projections for RH are at an especially high risk of being wrong given the cyclicality inherent in their business. However, we think it is still helpful to see how the business can trend over time, and Members Plus subscribers can adjust the model as they wish.

Model Summary.

Historical Financials.

We will now conclude with the risks.

Risks.

Risks.

1) Key Man Risk. Gary Friedman is clearly integral to the transformation and growth of RH, and losing him could put them on a different trajectory. While RH has plenty of designers and competent operators, Friedman is the vision and soul of RH, and losing him could lead to RH becoming lost. His ~21% stake in the company makes it unlikely he leaves for any competitor though.

2) Prolonged downturn. A prolonged economic downturn could eventually force RH to discount, which could permanently impair their ability to be a luxury brand and demand higher prices. On recent earnings calls, Friedman makes clear that a 30-40% drop in revenue is not off the table given how elevated home sales have been the past two years, as well as a few other unique factors like covid-induced moves from cities to the suburbs (which require more home furniture) and interest rates climbing faster than they have in most peoples’ memories. While RH has resisted discounting in the past, if the environment gets bad enough, it could be hard to resist. Gary Friedman owning a large stake of the company, with Berkshire as the second largest holder at ~11%, helps protect RH from investors pressuring them to make short-term decisions that may look good financially in the short-term at the cost of long-term earnings power.

3) Brand Damage. Whether from a scandal involving their supplies and the materials they use (a la Lumber Liquidators – see our Floor & Décor report for more on this) or from something Gary Friedman does, any brand impairment could potentially permanently impair the business.

4) Brand overextension. High-end consumers often want something that seems somewhat exclusive. If RH becomes too prominent, it is possible some consumers are turned off and seek out less-known luxury furniture. That said, the lack of branding on the furniture itself partially mitigates this risk.

5) Lack of Focus. With many new initiatives, from real estate development to hotels, it is possible RH loses focus on their core business. Additionally, these new ventures, real estate development in particular, bring about a new set of risks in a domain they have little experience in. Investments in these areas, even if not failures, could still result in lower ROIC.

6) AI-Designed Spaces. Technology that allows a user to aim their camera at a wall and see how an item looks next to it is starting to be introduced (Etsy, for instance, lets users see how a picture will look on their wall). Combining this augmented reality function with AI could let a user simply scan their room, instantly get a custom design, and then order those goods in-app. While RH customers will likely still want a higher-end experience, some RH customers may like the ease and expediency in which a design project can be completed.

7) Branded Designers. While the interior design market has remained highly fragmented, there is a risk that a company will become a well-known interior designer brand and reach customers before RH does. While the market is big enough for more than one player, if this company focused on high-end clients and could offer products from various different furniture brands, they could erode the uniqueness of RH’s value prop.

8) Tastes Change. People start preferring different types of furniture, and RH doesn’t roll out lines quick enough to reflect the new customer preferences. Being seen as having “old” designs could hurt their efforts to retain and attract design talent.

9) Competition. There are little barriers to entry in the furniture business, and the generally high margins are likely to draw new competitors. The more competitors that focus on the high end, the harder it will be for RH to win their clients. A player like Arhaus (if not them) could copy the RH model, and even if they aren’t as successful, could hurt RH and their margins.

10) More Established Luxury Brands Enter. There are already several high-end luxury furniture brands, but most don’t have a well-known name outside of the industry. A well-known luxury player entering the market with a full home offering could attract away customers who go to RH predominantly because it is the only luxury furniture retailer they know. Bentley and Fendi have home furniture lines, but they do not have their own stores. A Bentley, Fendi or other luxury brand with their own retail stores could be a formidable competitor to RH.

11) Company is Bought Out. Gary Friedman owns ~21% and Berkshire Hathaway owns ~10%. Any acquisition of the company could come at an inopportune time for investors, who may end up getting a price that is lower than they estimate RH’s intrinsic value at.

Conclusions.

Conclusions.

Thank you for reading our RH report, we hope you found it very informative! Make sure to follow us on Twitter at @Speedwell_LLC and subscribe to our newsletter at https://speedwellsnippets.substack.com/ for periodic updates. Please do not hesitate to reach out at info@speedwellresearch.com if you have any questions or comments!

*At the time of this writing, one or more contributors to this report has a position in RH. Furthermore, accounts that one or more contributors advise on may also have a position in RH. This may change without notice.