Investing in turnaround stocks can be difficult, often doesn't work out, and sometimes the stock has the potential to go to zero. But when they do work out, they can generate absolutely massive gains.
One interesting situation out there is RH (RH +1.61%), the furniture giant that is transforming its business, even as the housing market remains practically frozen. After shares boomed to $744 at the height of the 2021 pandemic housing boom, they've since crashed by about 75%. Debt has gone up, and the housing market has yet to bounce back.
Still, can RH pull off a turnaround, leading to a multibagger? The answer is yes...but with a big caveat.
NYSE: RH
Key Data Points
RH's bold and daring vision
In 2017, the company rebranded as RH, dropping its former name, Restoration Hardware. CEO Gary Friedman's new brand vision included selling more expensive furniture to fewer, wealthier consumers, while making RH stores into large-format, "design galleries." Management also set out to extend its newfound luxury brand to boutique hotels, restaurants, and travel services, as well as geographically into Europe.
At first, the brand elevation went very well. As you can see below, RH's revenue grew, while operating margins expanded from about 10% in 2015 to over 24% during the pandemic.
RH Revenue (TTM) data by YCharts. TTM = trailing 12 months.
However, as you can also see, margins have compressed back down to just under 10% today as revenue has declined, leading to a deleveraging effect. So, while the strategy shift to higher-priced, higher-margin furniture worked to an extent, RH is still not immune to the ups and down of the housing cycle.
But a big bet has put the company somewhat at risk
In 2022, interest rates and inflation went up, along with mortgage rates. That froze the market, as homeowners with existing low-rate mortgages were unwilling to sell, while high rates also dampened remodeling.
Amid the downturn, management decided to take on debt to repurchase $1 billion in stock in 2022 and another $1.25 billion or so in 2023. That big buyback helped retire a little more than 25% of shares outstanding at what management thought were bargain prices.
The problem with the large buyback is that RH also loaded up its balance sheet with debt, which now totals about $2.55 billion, against just $46 million in cash. Although the company also has an additional $367 million in borrowing capacity under its credit facility, the balance sheet could become a problem if the housing market doesn't recover.
So far, the downturn has lasted longer than management thought. As a result, shares now trade well below the prices at which management made the repurchases.
"Worst housing market in 50 years"
On the recent conference call with analysts, CEO Gary Friedman called the housing market the worst in 50 years, citing this amazing statistic:
In 1978, there were 4.09 million existing homes sold when the U.S. had a population of 223 million. Contrast that to 2024, were 4.06 million existing homes sold with a population of 341 million. And it illuminates just how depressed the housing market has been this year.
Later in the call, Friedman admitted that he had wished he had waited longer to repurchase stock, as the length of the downturn had surprised him despite his decades of experience:
I've been doing this for 40 years now. I've never been in a third year of a down housing market. I think every one of them have been 12 to 18 months.
Friedman also admitted that the company is paying more in interest than he'd like and that it could engage in sales of some of its real estate in sale-and-leaseback activities to generate short-term cash. The fact that management feels the need to potentially sell assets is probably not a great sign.
Image source: Getty Images.
But there's hope for multibagger potential
Management may have a bit of egg on its face regarding the premature buyback, but there are also some hopeful signs. For one, last quarter's revenue was up 12% relative to the year-ago quarter, albeit off low levels. While net profits were close to zero, that was due to a ramp in selling, general, and administrative costs, which seems like it could be dialed back if needed.
Looking ahead, management sees revenue growth of 10% to 13% this year, with adjusted (non-generally accepted accounting principles, or non-GAAP) operating margins of 14% to 15%, and free cash flow of between $250 million and $300 million.
That would be a great first step in RH's recovery, with reassuring profitability even as the company continues to invest in seven new design galleries this year, including in Paris, France, and six other U.S. locations.
Still, at an enterprise value of about $5.1 billion, it will take much more than that to see a true multibagger turnaround. Furthermore, the company's debt load still makes it vulnerable to a prolonged housing freeze. And full-year guidance already anticipates a pickup in activity and profitability in the second half -- which may not materialize.
So, at a big-picture level, RH could see massive upside if the housing market recovers, and we are past due for a recovery. However, the change in the interest rate environment, tariffs, and broader economic concerns have made this downturn unique. If the downturn is a more prolonged, secular phenomenon, things could get dicey.
For the growth-oriented investor, RH is a high-upside, levered bet on a housing recovery. But it comes with substantial risks. Those willing to make that bet should take care to make the allocation relatively small in their portfolios.
