Formerly known as Restoration Hardware, high-end furniture retailer RH (RH 2.28%) has been embarking on a major brand transformation and expansion over the past few years. That earned it a booming stock price during the pandemic housing boom.
However, the interest-rate shock that followed the pandemic has flipped the script. In 2023, sales and profits are on the decline, even as the company spends big to expand its brand. Even Warren Buffett's Berkshire Hathaway, which had bought RH stock back in 2019 and increased its holdings through early 2022, sold its entire stake in the first quarter of this year.
But that didn't stop RH CEO Gary Friedman and his team from zigging when others were zagging. Management decided to spend most of its cash on a massive share repurchase in the second quarter. Was this a genius move or one that put the company in danger?
Unloading the bazooka
In the second quarter, RH spent a whopping $1.2 billion on share repurchases, which retired about 17% of its stock. But the company's financials have been on the decline this year, so it had to spend down most of its cash to do so, dipping from $1.5 billion to just $420 million. This is against about $2.4 billion of term loan debt the company took out in 2021 and 2022.
Meanwhile, that debt has a floating rate. The $2 billion loan has an interest rate of the London Interbank Offered Rate (LIBOR) plus 2.5%, and the next $500 million loan has an interest rate at the Secured Overnight Financing Rate (SOFR) plus 3.25%. Base rates tend to follow the Federal Funds rate, which has spiked over the course of the last 18 months.
Adding to the uncertainty, RH just guided to a down quarter for just $780 million in revenue and a 15.5% adjusted operating margin at the midpoint. That's down from $869 million in revenue in the same quarter last year and $1.01 billion in the third quarter of 2021.
Meanwhile, increased interest expenses will probably reach around $50 million, so the company will probably earn just above breakeven at that guidance.
Clearly, RH management believes business results will improve significantly into 2024. Here's what Friedman had to say about why that will happen.
Picking a bottom in housing?
RH's business is closely tied to the housing market, as people tend to buy furniture when they move, renovate, or redecorate. But none of that has been happening since so many people locked in ultra-low fixed mortgage rates over the past decade and are unwilling to move to take on a mortgage that's now 7% or more. And housing prices haven't come down much or at all, making buying less affordable.
While Friedman seems unsure of any potential rebound, he did say on the conference call with analysts, "[F]rom our view, we're kind of at the end of the worst of it," and that he expects some stabilization in housing next year.
That remains to be seen. It appears that in a best-case scenario, the economy will achieve a "soft landing," the Fed lowers interest rates, and mortgage rates come down, making housing more affordable. And there could be a recession. While that would be potentially bad for housing prices, it could also lead to a lowering of interest rates to get the housing market going -- as long as the recession isn't too catastrophic.
In any case, it appears RH can still be slightly profitable, even in this worst-case scenario, if this is the real "bottom" in housing activity. In Friedman's mind, even if a recovery is in the distance, why not buy all the stock one can right now?
Image source: Getty Images.
But RH's product inflection is the bigger deal
Aside from a potential bottoming in the housing market, it appears the big repurchase is the result of Friedman's enthusiasm over RH's product refresh coming at the end of this year:
Then you've got what we're doing, which is a complete transformation reimagination refresh of the brand that we've been working on now for several years. It's going to be unveiled here over the next several quarters... Regardless of whatever happens to the housing market, we're going to have a meaningful inflection point with the business and the brand. And that's why we deployed the capital. That's why we bought back 17% of the shares, 3.7 million shares.
More specifically, RH just began shipping the new RH Contemporary Collection Source Book and will then send out the new RH Modern Collection Source Book in January. By refreshing the company's galleries with these products over the next several quarters, Friedman envisions lots of revenue growth and a turnaround.
In addition to these new collections, RH will be opening a slew of new stores in Europe. After a year of delay, the company finally opened its grand Gallery at the historic Aynho Park in the English countryside in June. But RH is now accelerating that European rollout, with plans to expand Düsseldorf and Munich this year, Paris, Brussels and Madrid next year; and London, Milan and Sydney in 2025.
And lower "disruptive" pricing?
Interestingly, combined with this product and geographic expansion, RH appears to be lowering prices in an aggressive bid for market share. The company raised prices significantly during the COVID-19 housing boom in an effort to "elevate" its brand. But Friedman acknowledges the company may have gotten "arrogant" and gone too far, which led to the depressed results of the last year or so. He elaborated:
I think we will gain significant market share versus anybody else in our category. And I think the other thing to put into context is just how we think about disruptive pricing from a circular point of view, which I think we've -- in our efforts to elevate the brand, I think we weren't as kind of critical-minded looking at price. I mentioned last conference call, I thought we probably were a bit arrogant looking back. And now, I think we're laser-focused and laser-sharp. So we're going to be very aggressive. We're going to use the size and strength of our platform and the leverage it gives us to be disruptive from a pricing point of view. And I think that's going to make a meaningful impact.
RH is now switching to a more volume-based strategy with what it believes is a superior product at a reasonable price point.
Risks
Obviously, RH management sees the rollout of its new collections, geographic expansion, and perhaps lower pricing driving significant revenue and profit growth next year. But what if it doesn't? There are certainly big risks here.
For one thing, it's possible the housing market won't pick up. This would likely only happen if inflation proved sticky and the Federal Reserve had to raise interest rates even more, leading to even less affordable housing.
Most think that interest rates have peaked, but data could always surprise. And since RH's debt is floating-rate, its interest expenses would rise in that scenario, as well. That's likely the biggest danger here.
The other big risk is that RH will now have much bigger fixed costs with new stores and geographies and have to move product through its bigger platform. Maybe the new collections will catch on as Friedman believes -- but maybe they won't.
RH also seems to be changing its pricing strategy not long after it had insisted on raising prices to be a "premium" furniture brand for the top 1%. The company's shift to drive more volume also invites the risk of brand confusion. In fact, when asked on the call about the company's target margins for the future, CFO Jack Preston couldn't give a real answer, at this point.
As one can see above, RH has a good history of timing its buyback in downturns, and this could prove to be another home-run repurchase. However, amid an uncertain macro environment and a shift in the company's pricing strategy and product assortment, management is taking a big risk.
For RH shareholders, the new collections better be big sellers over the next year.
