Restoration Hardware – Taking The Road Less Traveled

restauration-hardware2.0Overview:

Restoration Hardware Holdings, Inc. is a retailer in the home furnishings marketplace offering furniture, lighting textiles, bath ware, decor, outdoor and garden, as well as baby and child products. It operates an integrated business with multiple channels of distribution, including galleries, source books and websites. The company was founded by Stephen J. Gordon in 1980 and is headquartered in Corte Madera, CA.

RH Modern

This is an entirely new business that was unveiled at the end of last year. RH Modern has multi-distribution channels and has its own 540-page Source Book. The line will target the growing number of people who are drawn to modernist design, whether their aesthetic is rustic, classic, or contemporary modern. The depth of business spans to nearly every part of the home – from living rooms to dining rooms, bedrooms to bathrooms, and pools and patios. This assortment is the first brand to offer this groundbreaking breadth of furnishings. Most of the RH Modern is developed with some of the world’s most talented designers- including furniture collections from Barlas Bayar, Anthony Cox, and Thomas Bina; lighting from Jonathan Browning and Fortuny; modern rugs by Ben Soleimani; outdoor offerings from Leo Marmol and Ron Radzine. Gary Friedman said “From antiques to architecture, from the environments we work in to the devices we work with, there is a modern sensibility that is influencing what we see and how we live in the world. While the market for modern furnishings has always been somewhat small, the convergence of these trends creates an opportunity to develop a much larger market.”

To date, RH Modern has been more of a headwind than a tailwind due to a barrage of supply issues. The production delays have been big trouble throughout 2016 but seem to be worked out heading into Q4. The design of the new line is differentiated from current furniture offerings. Statement pieces include inviting platform and canopy beds; oversized ottomans; low, sophisticated sofas and sectionals with integrated accent tables; tactile carpets; dramatic sculptural lighting; floating lounge chairs and vanities; and stunning window and bath hardware.

The new brand has its own unique website and a significant physical presence, including a standalone RH Modern Gallery at the site of RH’s former gallery on Beverly Boulevard in Los Angeles, the entire ground floor of the Flatiron Gallery in New York, plus entire floors in the Company’s next generation Design Galleries in Chicago, Denver, Tampa and Austin. The freestanding RH Modern Gallery in Los Angeles is completely redone into a contemporary structure – indoors and out – featuring a modern sculpture garden with soaring palm trees. RH Contemporary Art – which has been integrated into RH Modern – will be showcased in each location with original works from a global roster of artists, creating the feeling of both a home and a gallery. RH has invested in integrating this brand into its existing portfolio. As most of the issues are behind the company this brand may provide a boost going forward.

Transition from Promotional to Membership

In Q1, RH announced the introduction of the RH gray card. This is their new membership program. For a $100 annual fee, the RH Grey Card provides 25% savings on everything. This includes all brands – RH, RH Modern, RH Baby & Child, RH TEEN, and RH Contemporary Art. RH Chairman and CEO Gary Friedman said “We want to shop for what we want, when we want and receive the greatest value. So rather than navigating countless promotions, we’re changing things…because time is the ultimate luxury.” In addition to the 25% off all regular merchandise, Card Members will also receive 10% savings on all sale merchandise, complimentary interior design services, eligibility for preferred financing plans for the RH Credit Card, dedicated concierge services to manage orders, and early access to clearance orders. This Card is expected to make shopping with RH more simple. Gary Friedman added that “Our lives are filled with complexity – and we long to break through the clutter to find simplicity.”

I really like this approach by RH. Not only does it simplify the shopping experience, but also, it encourages repeat business. The Company is taking a page out of the Costco playbook. I believe this membership model will be a long-term success. However it has caused near team margin pressure. In Q2’16 the Membership deferral resulted in a 80 BPS margin deleveraging. This deleveraging showed up again in Q3’16 as the company will not recognize the revenue up front.

The Membership Card will encourage customers to spend a minimum of $400 in the store. This is where customers break-even. $400*(-25%) = $300 + (Membership fee $100) = $400. Pretty simple, although it becomes harder to understand the read on how this stacks up to the old promotional model. Obviously, there won’t be many product offerings that are on sale with the new model. If a Card Member spends $2,000, they will save $400 net, so this will equate to a 20% promotion in the old model. The discount that any customer can achieve on regular priced merchandise is capped at 24%.

SKU Rationalization

In the Q2’16 earnings press release, Gary Friedman mentioned the current headwind of SKU rationalizing. Over the next couple quarters, this will continue to result in margin deleveraging. However, in the long-run these expenses will result in a smoother shopping experience. Once the SKU count has been optimized, this investment will be a tailwind for operating margin.

Source Books

This year, RH decided to delay the roll-out of their Source Books from spring to fall. This decision has created a drag on the stock. This decision will likely continue to put pressure on sales in Q3 and early Q4. Last year the Source Books shipped in Q2 and this year they won’t ship them until late Q3 or early Q4. The last major marketing initiative from the Company was in Q2’15 when they shipped the 2015 Source Books. The new Source Books have been completely redesigned and rephotographed. The redesign was done by art director Fabien Baron, who also designed the RH Modern book. The new books present the brands in a completely new format.

RH Austin, The Gallery at The Domain

I visited RH’s Austin Gallery to better understand the customer experience. From the moment that you walk in, the experience is unique. The ascetics of the Gallery are completely different than any other store. The store was very fresh and bright. I was told that RH management has painted the walls in every store white (from grey) in order to make the furniture standout against the background and brighten up the store. It worked, it gives the furniture a good look.

One of the biggest takeaways from my visit was the fact that the Company is in the middle of a massive product refresh cycle. I was told that they are about half way there. In total, about 80-90% of the product will be refreshed. The rollout of Modern into Gallery’s is well underway. About one-third of the store will be made up of the Modern product. The Modern brand is differentiated from the legacy/core brand. The two-thirds of the store that will have the core brand furniture are also being refreshed. The new product has new looks and finishes that have not previously been in stores. The refresh should improve store productivity. The design team member that helped me said Modern has been very popular among customers.

This Gallery had its grand opening on September 16, 2016 and traffic has been steady. The product refresh is beginning to peak interest from customers and it is driving repeat business. Slowly rolling out the Modern and the core brand is resulting in customers coming in more frequently to see the new furniture. Once the Source Books are sent out at the end of Q3, RH expects traffic to improve.

Gary Friedman’s Vision

Restoration Hardware shows off its innovation every step through the shopping experience. The first step for RH management was to blur the lines between retail and home. When you are in an RH Gallery, you certainly do not feel as though you are in a retail store. It feels like you are in a home and you are more relaxed. The second step for management is to add an element of hospitality into the mix. RH Chicago has a courtyard cafe where customers can eat while they shop. The cafe sits in an atrium that is filled with natural light. The store also has a pantry and coffee bar where customers can get hand crafted coffee drinks.

Gary Friedman wants to activate all five senses (sight, sound, smell, taste, and touch) during the shopping experience. Traditional retail experiences are boring and offer no natural lighting. RH Gallery’s provide a unique experience that can not be replicated online or at any other retailer today. While RH is not the first retailer to have a cafe or restaurant, they are the first to integrate the restaurant into the shopping experience. This strategy has worked tremendously well and the Company will begin to integrate it into new Galleries. In 2017 RH will add it to RH San Franciso The Gallery at The Historic Bethlehem Steel Buliding, RH Nashville The Gallery In Greenhills, RH Palm Beach The Gallery At City Center, and RH New York The Gallery At The Historic Meatpacking District. This will make five locations with the next generation shopping experience. Gary Friedman calls it “The most significant retail transformation in the history of our industry.”

Below is a picture of the Saks Fifth Avenue at Cherry Creek prior to it closing. This is the location of RH Denver, The Gallery at Cherry Creek.

Saks

RH purchased the land, tore down the Saks store and built RH Denver, The Gallery at Cherry Creek. A picture is shown below. Which store would you rather shop at? Easy decision.

RH Denver

Traditional mall and anchor stores are windowless boxes that have no fresh air. RH believes that customers will shop at brick and motor stores but you must provide them with a differentiated experience. Current mall and anchor stores lack imagination and have not innovated.

Waterworks

On April 12th, RH announced that it had acquired Waterworks for approximately $117 million in cash. Waterworks is a luxury bath and kitchen brand with fittings, fixtures, furniture, furnishings, accessories, lighting, hardware and surfaces. It is comprised of the Waterworks, Waterworks Kitchen and Waterworks Studio. Products are sold through 15 showrooms in the U.S. and U.K., boutique luxury retailers and online. The premier luxury bath and kitchen brand was founded in 1978 by Barbara and Robert Sallick, and has been led by Chief Executive Officer Peter Sallick since 1993. This acquisition “creates the first fully integrated luxury home platform in the world – offering a complete collection for every room of the home, in every channel, to both design professionals and consumers” according to the April 12th press release. Peter Sallick and Ralph Bennett, President, will continue to lead the Waterworks brand along with the rest of the leadership team from their headquarters in Danbury, Connecticut.

Waterworks is the only complete bath and kitchen business offering fittings, fixtures, furniture, furnishings, accessories, lighting, hardware and surfaces under one brand in the market. Ralph Bennett, Waterworks President stated, “We believe RH is the most significant brand being built in the home market today, creating extraordinary opportunities for us to collaborate and benefit from their unique and growing platform. As a combined organization, we look forward to extending and expanding our passion, product offer and commitment to outstanding service to our incredibly valuable clients.” Gary Friedman shared the enthusiasm by saying “There are certain brands that define their categories, like Hermès, Tiffany, Apple, Range Rover and Ralph Lauren, and we believe that Waterworks is one such brand. We have long held great admiration and respect for the esteemed brand and business the Sallicks have built, and feel honored and privileged to be partnering with the entire Waterworks team, as we combine forces to further redefine the industry.”

RH’s Executive Compensation Plan

RH’s executive compensation plan is built around three pillars.

  • It’s closely aligned with the performance of the Company, on both a short-term and long-term basis;
  • linked to specific, measurable results intended to create value for stockholders
  • tailored to achieve the key goals of our compensation program and philosophy.

RH’s executive compensation programs are aligned with stockholders’ interests. Performance-based compensation is tied primarily to annual earnings before taxes and long-term stock price performance.

Compensation Committee

The Board of Directors has established a compensation committee that is generally responsible for the oversight, implementation and administration of the executive compensation plans and programs. The compensation committee annually reviews and approves RH’s corporate goals and objectives. The core function of the committee is to review annual salary levels along with short-term and long-term incentives. The committee ensures that appropriate overall corporate performance measures and goals are set and determine the extent to which the established goals have been achieved and any related compensation earned. The executive compensation plan is aligned well with both short-term and long-term incentives. However, it doesn’t look like the compensation committee is doing the heavy lifting in setting up this plan as they have hired Willis Towers Watson as a compensation consultant. Charlie Munger has said “I’d rather throw a viper down my shirt front than hire a compensation consultant.” In short, the compensation committee could probably do without a compensation consultant.

Leadership Incentive Program

The Leadership Incentive Program, or “LIP,” is a cash-based incentive compensation program designed to motivate and reward annual performance for eligible employees, including named executive officers. The compensation committee considers annually whether LIP bonus targets should be established for the year and, if so, approves the group of employees eligible to participate in the LIP for that year. The LIP includes various incentive levels based on the participant’s position with the Company. Cash bonuses under the LIP link a significant portion of the named executive officers’ total cash compensation to overall performance. The LIP bonus for named executive officers is based on achievement of financial objectives, rather than individual performance. Each named executive officer is provided a target bonus amount equal to a percentage of the eligible portion of such officer’s base salary. The target bonus amount is based on the Company meeting the target achievement level for the relevant financial objectives. The compensation committee and/or the board of directors establishes the target achievement level at which 100% of such participant’s target bonus will be paid (the “100% Achievement Level”), the minimum threshold achievement level at which 20% of the participant’s target bonus will be paid (the “20% Achievement Level”) and the achievement level at which 200% of the participant’s target bonus will be paid (the “200% Achievement Level”).

The compensation committee, either as a committee or with the board of directors as a whole, sets the financial objectives each year under the LIP, and the payment and amount of any bonus depends upon whether RH achieves at least a certain percentage of the financial objectives under the LIP (at least 20% for fiscal 2015). The compensation committee generally establishes such objectives for the Company at levels that it believes can be reasonably achieved with strong performance over the fiscal year. For fiscal 2015, the performance metric for the LIP was based on adjusted net income (“Adjusted Income”), which is defined as consolidated income before taxes, adjusted for the impact of certain non-recurring and other items that are not considered representative of ongoing operating performance. For fiscal 2015, the compensation committee approved the following targets under the LIP (based on approximately 30% earnings growth):RH A

The following table sets forth the bonus targets as a percentage of the eligible portion of the executive’s base salary under the LIP in fiscal 2015. For 2015, the compensation committee determined based on discussions with Mr. Friedman, to provide him increased bonus targets in lieu of increases in base salary in order to better align his compensation with our overall financial performance. Consequently, the compensation committee approved an increase to Mr. Friedman’s bonus target as a percentage of base salary from 100% to 125% at the 100% Achievement Level, and from 200% to 250% at the 200% Achievement Level. No changes were made to the bonus targets for the other named executive officers.

RH B

Adjusted Income for fiscal 2015 for purposes of the LIP was approximately $184 million, which reflected the compensation committee’s determination that certain other extraordinary or non-recurring items should also be excluded from determining Adjusted Income for purposes of the LIP. Accordingly, the compensation committee approved payment of the bonuses earned under the LIP for our named executive officers, other than Mr. Dunaj, as follows:

RH C

Equity Compensation

In 2015, the compensation committee approved grants of stock options and restricted stock units to the named executive officers, as follows:

RH D

The stock options were granted at an exercise price of $87.31 per share which was the price of the common stock on May 6, 2015, the date of grant. The options vest at a rate of 20% per year over five years on each anniversary of the date of grant, expire in 10 years. Management is really going to have to get this thing in gear for them to be able to exercise these options. The stock will need to nearly triple.

Gary Friedman’s Stake

Mr. Friedman, has consistently maintained a significant equity ownership interest in the Company and beneficially owns approximately 15.1% of the Company’s common stock. Today his stock is worth about $200 million. However, just one year ago his stake was worth more than $540 million. Tell me he isn’t motivated to turn this thing around.

Q3 Earnings Commentary

RH reported Q3 earnings on December 8th and beat on the top and bottom line. However, they guided down Q4 which caused the stock to sell off 18% on Friday. So is this an opportunity? I say yes. The reasoning for the guide down was a bit of a surprise. There was a mix of issues that contributed including bad holiday inventory, membership model transition, delay in source books, and SKU rationalization. As the Company moves into 2017 they will lap the issues related to the launch of RH Modern and move past the timing issues related to RH Membership. The SKU rationalization is causing a $0.40 hit to EPS, RH Modern production delays are causing a $0.30 drag, and the membership timing issue has caused a $0.25 headwind. However, I think the Q4 guidance is awfully conservative and Gary Friedman said so on the conference call. Friedman said “I think I’d characterize it, I think we’re being conservative in Q4 today. So, because we just don’t have visibility in the builds, right? It could be a little better, but today, based on where we sit, we thought it was right to take a conservative view based on how we saw the rest of December and January.” This didn’t stop analysts from slashing Q4 estimates and even 2017 numbers.

Bear Case

The bear case assumes a normalized growth rate in the low single digits, only slightly ahead of GDP growth. This case assumes management will have to continue to invest in their supply chain and will never get back to prior peak operating margin of 9.8%. This scenario suggests that RH would pull back on opening larger-format galleries and the rate of high-end income growth slows which would impact the amount of new customers entering its TAM. In this scenario, RH would have to lower price points due to a sluggish demand environment.

Valuation

As mentioned, the stock tumbled 18% on Friday and analysts have cut estimates. I also cut Q4 numbers but I didn’t move my 2017 estimates down as much as other analysts. As the source books have now been shipped, I think we will see some of Q4 sales show up in Q1.

IS Estimates

The DCF analysis I performed, suggests a stock price in the range of $35-$50. The scenario used implies a more normalized growth trajectory for the business relative to management’s current long-term plan to double revenue and reach a mid-teens operating margin over time. I assume a 5-year CAGR of 5.3% and a 9.0% operating margin in FY21 which assumes that RH will double EBITDA over that time period to $330M from $165M expected in FY16.

Enterprise

Per Share

Using a terminal EBITDA multiple of 7.5x, we are looking at a stock price in the range of $35-$50 and a $42 price target at the midpoint, implying 31% upside from current levels. I believe a 7.5x multiple is appropriate given its most direct home good peer, WSM, which is viewed as a bellwether in the space, has a five year historical EV/EBITDA average of 7.5x. I note that WSM is currently trading at a discount to its five-year average at a 6.5x EV/EBITDA due to a number of uncertainties regarding competitive threats to its long-term growth.

Bottom Line

RH is taking the road less traveled. In a time when retailers are shrinking their store counts, RH is looking on providing a differentiated shopping experience that can’t be replicated online. I believe it makes sense to shop online for many products. However, I don’t think home furnishings are in that category. RH’s stock is hated by pretty much everyone which makes it interesting to me. If you exclude the hedged shares, the stock has a 24.2% short interest. I believe RH will achieve its conservative Q4 guidance even if it’s from low quality liquidation sales. In my opinion, this might be enough to force shorts to cover and that could rally shares higher in 2017. In the next few weeks, I wouldn’t be surprised if the stock moves lower. I will add to my position below $30/share.

Disclosure


Long RH

 

 

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