Luxury home furnishings company RH (RH -14.00%) has a lot going against it. Inflation is soaring, consumers are squeezing their wallets, and home sales are slowing down. Wall Street hasn't missed a beat; the stock has sold off, falling more than 60% from its high.
But are these signs of a failing company or of a temporary storm with bright skies ahead? Here is why RH stock could eventually increase 10x from where it currently sits.
Anything that can go wrong has gone wrong
RH could be in the dictionary under the description of discretionary spending; the company manufactures and sells a variety of luxury home furnishings, fixtures, textiles, and more.
The company sells very high-end stuff; a leather couch can run you as much as $10,000. I'm sure that's a beautiful couch, but these products aren't in typical household budgets.
You can see three metrics below that combine to spell pain for RH's management team. You have soaring inflation creating rising costs on core materials like lumber while simultaneously squeezing consumer wallets. Then you have mortgage rates that have risen to multi-year highs and plunging consumer sentiment, which means that few people are excited about the economy right now.
This is not good for a business that sells products people want but don't need. Management recently lowered its guidance for 2022 to reflect this reality. RH now sees sales falling between 2% and 5% from 2021, while operating profit margins will come in between 21% and 22%, a notable decline from 2021's 24.7%.
Management noted that luxury home sales fell 18% year over year in the first quarter of 2022 and could continue slowing, with rates still projected to rise throughout the year.
Looking past a bump in the road
Clearly, the current market conditions are not ideal, but don't assume that RH isn't a good business because it faces some adversity. RH's CEO, Gary Friedman, has been evolving the company into a luxury brand since 2016, and you can see below that it has successfully grown sales and free cash flow during that time.
Discretionary products can be cyclical businesses, meaning they have periods of growth, like when the economy is doing great and consumers are spending money, and periods of contraction, when times are tough and people are tightening their belts.
Some of the economic conditions consumers face now are the worst in decades (like inflation), so one could argue it's fair to cut RH some slack for its stumbles. Of course, RH might not succeed over the long term; nothing is certain. However, a multi-year track record of growth should probably at least mean something. Investing sometimes requires a leap of faith, which is why portfolio diversification is critical.
A 10x opportunity?
Analysts believe that RH will grow earnings per share (EPS) by an average of almost 9% annually over the next three to five years. That would be a respectable growth rate, but it would still take a while for an investment to appreciate tenfold.
But the stock is down significantly right now, pushing the company's valuation down. You can see below that the stock's price-to-earnings ratio (P/E) is now in the single digits, its lowest since the COVID-19 crash in March 2020.
The P/E ratio hit one extreme by exceeding 60 in 2021 and has now fallen to the other end of the spectrum. The long-term valuation will likely be somewhere in between. Still, even if it's only 20, there are a lot of investment returns to be had if the valuation simply reverts to that long-term average.
Investors could see something along the lines of 15% annual returns, made of 9% earnings growth and another 6% from the valuation. In that case, the stock would double every five years, giving you a 10-bagger in a little more than 15 years.
The returns could be higher, or the company could fail to execute over the long term; there is always the risk of the unknown in investing. However, RH has proven it can grow over the past several years, and it seems ripe for long-term returns once it gets past these short-term challenges.