Restoration Hardware Is Poised for Success

Restoration Hardware (NYSE: RH  ) has had an incredible year of growth, up 120% since its November 2012 IPO, and trading at roughly 40 times forward earnings. Should this "rich" valuation be taken as a sign of irrational exuberance? The high earnings multiple seems to have many investors clamoring for the exits, as seen in the recent 10% sell off after Q2 earnings. Are the good times over for Restoration Hardware? In a word-no.

Bullish case
First let's examine why the future's so bright for luxury home goods retailer Restoration Hardware on a macro level by looking at the entire sector. It's no secret that the home goods industry is closely tied to the housing market, and the housing market has been on a tear over the past year. The Case-Shiller composite 20 index tracks real estate value changes over 20 metropolitan areas, and the growth has been quite impressive. While the index is not a perfect corollary to Restoration Hardware, it does stand as a strong indicator of growth in the home goods sector. 

Case-Shiller Home Price Index: Composite 20 Chart

Yes interest rates are ticking up and some believe this could negatively impact the home goods sector, but historically they are still very low and unlikely to have much of an impact unless rates rise precipitously. A 30 year fixed mortgage is averaging around 4.5% which, excluding the last 2 years, is lower than anytime since 1971. Considering that the target customer base for Restoration Hardware has an average household income of 100k, a slightly more informative measure in the mortgage market would be to look at jumbo loans (mortgages exceeding 417k in most areas and 625k in expensive areas). Jumbo loan origination is on pace to reach $216 billion, having its best year since 2007. These macro indicators point to a strong future for Restoration Hardware as a luxury home goods retailer.

Competition
Names like Williams-Sonoma  (NYSE: WSM  )  (owns Pottery Barn), and Ethan Allen  (NYSE: ETH  )  are the closest thing to competitors and both have had very respectable years, up 28% and 7% respectively YTD. Both Ethan Allen and Williams-Sonoma have benefited from the housing recovery. Cautious investors have pointed out that Restoration Hardware's forward p/e ratio of 40+ should be more in line with Williams-Sonoma's forward p/e ratio of 17.5, but this ignores several important factors. Restoration Hardware is a high-growth company and has more potential than its peers.

Both Ethan Allen and Williams-Sonoma are looking abroad for growth prospects, apparently having reached market saturation stateside. Neither competitor has major plans to alter their total store count or square footage in North America, but both do intend to slowly expand into Asia and Europe. Ethan Allen's last quarterly earnings showed fairly tepid growth with same store comps at 2.5%, and sales growth flat. Ethan Allan's overall earnings are up but the growth strategy going forward is not inspiring, consisting of increased direct mailings and increasing web traffic. Meanwhile Williams-Sonoma has a surging West Elm brand with same store comps at 26%, but it also has a much larger underperforming Williams-Sonoma brand to deal with which is hurting the stock. The Williams-Sonoma brand had -0.4% comps and plans are in place to close 15 stores next year. On the bright side the company sees high growth opportunities in Australia and the UK.

Growth stocks engender optimism and excitement that creates momentum that may or may not prove to be wise. Either way the forward p/e ratio should not be expected to be in line with sector peers. Restoration hardware is still implementing its strategy to expand operations significantly in North America. To put it in perspective Restoration Hardware has 70 stores while Ethan Allen has 296, but both look small compared to Williams-Sonoma's 590.

Luxury retailers invest heavily into information regarding store locations. While you won't find either of Restoration Hardware's co-CEO'S talking publicly about it, they want their stores in close proximity to high net worth individuals and geographic regions with high median income households. The business models of Restoration Hardware and its pees differ, but given that Williams-Sonoma has found so many suitable locations for its luxury brands it stands to reason that Restoration Hardware can expand its operations substantially. Although none of that matters if sales per square foot fall as Restoration Hardware expands.

Growth
The crux of Restoration Hardware's growth strategy is focused on real estate growth and optimization. Restoration Hardware plans on quadrupling their total square footage while increasing sales per square foot all the while reducing capital expenditures and operating expenditures. Very ambitious indeed.

Pre IPO Restoration Hardware had more stores but with a smaller footprint, averaging 7,000 square feet. Immediately after going public they announced that some stores would be closing and the new "galleries" (read stores) would be averaging 21,500 square feet. Restoration Hardware is also in talks to open 30 new stores with an average of 45,000 square feet of space. Some of these new stores will be in prestigious shopping centers as an anchor tenant, which will give Restoration Hardware advantageous lease pricing. Anchor tenants are used as a draw in large shopping centers to funnel customers into lesser known retailers. This drawing power is rewarded with a reduction in lease rates.  

Additionally, co-CEO Carlos Alberini has also discussed that Restoration Hardware is restructuring many of its existing lease agreements in order to reduce operating expenditures.  By late 2014 Restoration Hardware has scheduled openings of a 65k square foot gallery in Atlanta, and a 55k square foot gallery in Chicago. The goal is open anywhere from 10-15 stores a year after beginning in 2015.

Restoration Hardware is also going to broaden its offerings with RH Atelier, a clothing line to be sold alongside furniture. Restoration Hardware is also making a splash in the Art scene with a NY art gallery. These moves appear to be ancillary to the real growth strategy but do have the benefit of generating press and potentially providing meaningful growth in the future.

Red flags?
On a less upbeat note, Co-CEO Gary Friedman, laid out the new advertising strategy for RH on the most recent conference call, which is that they won't be doing any. I am only slightly exaggerating . Restoration Hardware's marketing department we be replaced with a Truth Group. This new strategy will focus on advocacy that reflect the values and virtues of Restoration Hardware. One example of the advocacy is RH Music which seeks to "cultivate" artists that reflect the RH brand. This new marketing model is a bit unorthodox for my tastes. I appreciate the innovative thinking here but I'm not sold on the idea of shifting advertising dollars to "Cultivate" bands as being a prudent investment. Viewed through the collective prism of RH Music, RH Contemporary Art, and RH Atelier, there does however seem to a theme.

Bottom line
Restoration Hardware is in the incipient stages of existing store restructuring and new store expansion; a rapid growth period that will reward investors. Not only will restoration hardware benefit from the ongoing housing recovery but from taking market share from its competitors. Ultimately consumer style and taste are driving Restoration Hardware's growth, and so far they seem to have a pulse on their target consumers tastes. 





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