One of Warren Buffett's favorite business attributes is a winning brand. That's because an amazing brand is a means for attractive financial attributes: high margins, pricing power, loyal customers, and the ability to grow around the world.
While Coca-Cola and Apple are two well-known Buffett favorites, Buffett's Berkshire Hathaway also owns a smaller position in an ascendant brand with ambitions to reach the heights of an Apple or a Coke.
What's even more intriguing for investors? The company just announced a stock split and is down 55% from its highs, opening up a potential big opportunity.
3 reasons to buy RH
Either Buffett or one of his lieutenants, Todd Combs or Ted Weschler, bought 1.2 million shares of RH (RH -14.00%) back in 2019, when prices were well under $200 per share. The buy turned out to be a solid purchase, as RH subsequently took off, hitting an all-time high of $744 in mid-2021. Of course, based on the recent tepid guidance for 2022, the stock has fallen more than 50% to around $336 per share as of this writing.
The recent plunge notwithstanding, why did RH go up so much over the past few years? Basically, CEO Gary Friedman's vision for the brand has proved successful thus far. Friedman has transformed the business once known as Restoration Hardware from a mass-affluent market furniture brand into a high-end luxury brand renamed RH that commands pricing power and higher margins.
In his recent shareholder letter, Friedman wrote: "Every luxury brand, from Chanel to Cartier, Aston Martin to Aman, Louis Vuitton to Loro Piana, Harry Winston to Hermès, was born at the top of the luxury mountain. Never before has a brand attempted to make the climb, nor do the other brands want you to."
Friedman has closed the traditional mall-based stores and opened up huge, museum-style "Design Galleries" in recent years, while upping product quality and raising prices. RH has also transitioned to a membership model, whereby loyal customers who pay an annual membership fee receive discounts across all RH brands and have the feeling of belonging to an exclusive club.
At the end of 2021, RH had 459,000 members. And in just two years, revenue has taken off. But perhaps more importantly, the operating margin has doubled -- a sign of brand strength that company's luxury bet is working.
Growth possibilities are tantalizing
With the transformation well under way, management isn't slowing down. RH has pointed to two important ways it's extending the brand: geographically, and to other products and experiences besides furniture.
On the first point, RH is set to open its first design gallery in Europe. The Gallery at the Historic Aynhoe Park will open this year, in what's being billed as a "17th-century, 73-acre estate in the English countryside." Along with this year's opening, RH has also secured sites in France and Germany, and it's in negotiations for other sites in Italy, Spain, and Belgium.
The reason Buffett's investment in Coca-Cola in the 1980s was so successful was that Coke was about to spread very far internationally, which was something investors underappreciated at the time. With the opening of RH England this year, RH may be on the cusp of doing the same.
Perhaps even more audacious, RH is expanding its brand from furniture into hotels, restaurants, and private yachts and jets. This year, the company will open its first RH Guesthouse in New York; will have two new restaurant concepts across San Francisco, New York, and England; will make its two private Gulfstream jets available for charter; and will christen RH3, its luxury yacht available for charter in the Mediterranean or Caribbean.
RH is being aggressive here in extending the brand. While risky, if it works, the company will become much more than just a furniture store and could generate impressive growth for years as its addressable market expands.
Its CEO has motivation and incentive
Finally, another reason to like RH is its motivated CEO. Friedman is the visionary behind this change. As of the last proxy statement, he owned some 28% of RH's stock, based on the value of stock options that are no longer subject to restrictions.
Not only that, but a majority of Friedman's potential compensation comes in a four-year stock option vesting plan. The most recent four-year plan took effect in May 2021, and it pays out based on the value of the stock over the next four years. The option strike price is $385 per share -- notably, that's higher than the price today -- and the price target thresholds, at which one-third of the awards become exercisable, are $500, $650, and $800 per share. The stock must maintain a 10-day average price above these levels for 20 straight trading days to trigger the options.
Given that the CEO is highly motivated to get the stock above those levels in the next few years and that the stock is only around $335 today, that's another positive indicator.
Reasons for caution
Of course, there's a reason RH is down so much. On the recent earnings release, RH missed revenue expectations, but more importantly, Friedman issued very cautious guidance, projecting only 5% to 7% growth for 2022 -- a big deceleration from the 32% growth seen in 2021.
Friedman noted on the conference call with analysts that inflation is very high and RH's costs are going up, especially for shipping. Not only that, but when Russia invaded Ukraine, Friedman also said RH saw an immediate 10- to 12-point decline in demand, which has persisted. A recession would certainly test RH's revenue, but the company hasn't been through a recession in its current form as a luxury brand.
Will well-off people continue to buy furniture at this pace in this environment? Will the housing market cool off from the red-hot growth in 2021? Did RH merely pull forward its demand as housing demand went up during the pandemic? It's hard to say.
Another risk is that RH took out a $2 billion term loan last October, and that loan has a variable interest rate based on the LIBOR benchmark international interest rate for short-term loans, plus a 2.5% premium. While that cash could give RH the flexibility to buy back shares or retire some convertible notes, I don't think management anticipated that interest rates would go up as sharply as they might, given recent commentary by the Federal Reserve. In any case, it looks as though RH's interest expenses are set to rise this year. While it shouldn't be too much of a problem, given the company's high margin, it's another risk to monitor.
Adding it all up
When factoring in Friedman's unexercised options and the current stock price, RH's market cap is around $9.11 billion today. RH made $689 million in net income in 2021, but a lower $477 million in free cash flow, as the company had to pay up for inventories. So the stock now trades at 13.2 times net income and 19.1 times free cash flow.
That's a pretty cheap price for a luxury brand, if RH can achieve its ambitious goals. Yet while RH may look attractive here for long-term investors, higher costs and lower demand could make for a rocky 2022, and perhaps a difficult 2023 if there is a recession.
In summary, the short term looks treacherous for RH, but over the long term, the current price could be a bargain if Friedman fulfills his vision. In any case, this consumer discretionary stock has made it on to my watch list after its precipitous decline.