RH (RH -1.47%) is a luxury home furnishings retailer with a stock that's been a big winner since 2017. But the stock has struggled recently, down 40% over the past year. The market can be very short-term-minded, creating buying opportunities for patient investors.
Admittedly, RH seems to be going through some challenges. But I will show you why these headwinds shouldn't scare a long-term investor away from the stock and why RH will eventually return to the winner's circle again.
A mixed bag of challenges
RH is a luxury brand for home furnishings; it sells furniture, lighting, fixtures, textiles, and other goods. When it was starting out, RH used to be called Restoration Hardware and was a retailer of low-quality goods. But current CEO Gary Friedman has spent recent years reimagining the company as a luxury brand with showrooms and galleries instead of stores and with higher quality, more expensive products.
The pivot in strategy has scored significant returns for investors. The stock was trading around $30 per share in 2016 when the shift started and is up tenfold, even after the stock's drop over the past year. So why has the stock market now turned against RH?
The business is going through several challenges, and Friedman was very clear about these challenges during the company's recent earnings call. For starters, the company's costs are soaring across the board. In recent months, inflation has been in the high single-digits, the highest in decades. This impacts raw materials like lumber, which are a significant component in building RH's products.
The company's cost of goods sold rose in 2021 to 53.5% of revenue, from 50.6% in 2020. In other words, profit margins are taking the heat for higher material costs. This even translates to shipping containers, which have more than doubled in price from two years ago.
Additionally, supply chain issues are causing problems for the business as well. In the 2021 fourth-quarter earnings call, Friedman noted how he doesn't believe that supply chain issues have gotten any better and that some parts are 10 to 12 weeks behind.
And the pain isn't over; Friedman said the company isn't optimistic about the economic outlook, mentioning the Russia-Ukraine conflict and potential for a recession as other factors weighing on the company's outlook. While revenue grew 32% year over year in 2021, management's 2022 revenue guidance calls for just 5% to 7% year-over-year growth. In other words, you have a company dealing with a ton of headaches and slowing growth. No wonder the stock isn't doing well.
Is RH a good business? Look at the financials
But is all this noise a sign of a low-quality business, or are these just bumps in the road? If you zoom out to when the company began its shift in 2016, you'll see how much operating margin and free cash flow have grown. In other words, the business itself is many times more profitable, and it creates cash profits that can help organically pay for growing the company.
Increasing margins are also a sign of pricing power, arguably the most critical aspect of any luxury brand. Is there anything special about a brand without pricing power? I don't think so.
RH has also taken a creative approach to engaging its customers, creating a membership club with 434,000 members. Customers can pay an annual fee for a membership with perks like exclusive discounts on products. This is a crafty way to generate recurring revenue for the business without having to broadly discount products and tarnish the luxury appeal of the brand.
What the stock offers you at this price
RH can be a tricky stock in valuation because the company has become more profitable and changed so much over time. I would argue that higher margins would mean a higher valuation for the business.
You can see below how the stock's price-to-free-cash-flow ratio (P/FCF) has fluctuated. P/FCF is like a price-to-earnings ratio, but with cash profits instead of net income, the bottom line profits after all non-cash adjustments. At a P/FCF ratio of just under 23, it's almost valued the same as back in 2017, when the company's turnaround was in its early days.
That's not to say that the stock can't go lower. RH is dealing with a perfect storm of short-term obstacles, and the markets can be unpredictable in the short term. However, the stock's current price could be a great starting point for long-term investors.
The company has grown revenue an average of 12% annually over the past five years, and investors will want to see growth return to that pace as headwinds fade. If RH can execute moving forward similar to what it's done throughout this transformation, shareholders stand a solid chance of being very happy down the road. I think that once the market gains confidence back in the economic outlook, RH could be a stock that rebounds pretty quickly.