Month: October 2022

RH is a good example of a very well-executed turnaround and operational improvement driven by a strong owner operator. The company has been able to introduce a new omni-channel retail model in a traditional industry, with customers attracted to the company’s design galleries, a desirable place where they can have an immersive contact with the company’s products. However, at the current stage I am not convinced about the potential of the business for a number of reasons:

•  RH’s business model is strongly related to the housing market and as such might face further difficulties: the furniture industry is strongly correlated with the housing market and current outlook is challenging due to potential deterioration in macroeconomic sentiment.
• RH’s growth over the last 5 years was fueled also by a strong price increase: the company has aggressively increased its price points and significantly expanded its selling space. As such, future growth may be more difficult to achieve.
• RH’s business model is closer to traditional furniture retailers than personal luxury goods companies: RH business while characterized by higher margins than its closer peers, is still very dependent on high inventory, low sales productivity ($/sqm) and limited gross margins. This translates into a lower operating leverage and lower resilience and flexibility to adjust to costs inflation.
• RH’s current valuation does not seem particularly cheap compared to historical levels and other luxury players: the company is currently trading at ~8x EV/EBIDTA which is in line with the furniture sector long-term average. The company’s discount to personal luxury players is also in line with its historical levels 

Company overview and history:

RH (market cap $6.7bn) is a premium luxury furniture company operating in the US. The company was founded in 1979 by Stephen Gordon, it was listed in 1998 and in 2008, on the verge of bankruptcy, it was taken private by L Catterton and its current CEO, Gary Friedman (who today holds a 21% stake).

•  After the take private, the company went through a transformation to reposition itself towards high-end furniture and started to replace its old-style stores with “design galleries” offering customers a more immersive and refined experience of RH products. The company went public for the second time in 2012 and has had some initial success, driven by its new positioning.
• In 2016, RH started to restructure its operations and has since been very successful in streamlining and optimising the business.In In addition, the company continued to shift its positioning towards the luxury world with the aim of becoming a lifestyle brand. In recent years, RH has further expanded itself by opening restaurants on the terraces of some of its stores to drive traffic and announced other luxury initiatives such as a high-end guesthouse and a yacht.
• 2020 represented the perfect time for the company: operations, particularly inventory management, and (by consequence) profitability were much improved, while sales soared as furniture companies were strongly supported by pandemic tailwinds. Share price surged to ~3 times the pre-covid levels.
• 2022, back to reality: The broader market correction brought the stock back down to its pre-pandemic levels with the fear of a recession weighing on the company’s performance. Supply chain issues further deteriorated the situation.

POSITIONING IN THE MARKET

• The global furniture market is a large (+€500bn) and very fragmented market with small local players competing in specific niches.
• Premium and luxury segments represent a sizeable part of the market (~25%) with higher profitability levels and a brighter outlook compared to their mass market counterpart.
• In particular, the luxury market (~€50bn) has shown strong resilience during COVID-19 and bounced back in 2021 to levels beyond those of 2019.
• Unlike personal luxury which is more retail focused, luxury furniture still strongly relies on wholesale (~70% of sales).
• RH has gained share in the fragmented $118 billion (U.S. Census) domestic furniture and home furnishing market in recent years, curating differentiated offerings from specialized global artisans. The firm has broadened its brand awareness by expanding into underserved categories including modern, teen, and hospitality, where few peers have scale, helping capture incremental market share from boutique competitors.
• Brand equity should remain stable given the pace of tailored store buildouts, category expansions, and consistency of pricing, but the diverse end-market expansions RH is pursuing could make it difficult to capture a cost advantage.
• Entry into $200 billion hotel industry and $1.7 trillion domestic
  housing market should help support high-single-digit top line growth.
• RH’s e-commerce business helps enhance brand awareness. I believe RH’s focus will be to strategically expand its global presence over the next decade via a wider set of luxury product offerings (yacht, plane), alongside a multipronged gallery strategy set to suit local market demands.

 CURRENT SITUATION

• Higher interest rates, slowing housing sales, and fears of a recession are all taking a toll on RH. However, those things are temporary, and this company has proven itself an extremely profitable leader in a space that will never go away. People aren’t going to stop furnishing their homes, and RH will be there to grab that revenue in the years to come.
•  RH was one of the first retailers to report rapidly slowing consumer demand in March 2022. This hints at a unique risk factor for RH investors, the company’s luxury consumers are heavily dependent on asset prices. A prolonged bear market would likely take a heavy toll on demand for RH’s bold vision.
• Over the next two quarters, based on my thesis of persisting macroeconomic challenges in the U.S., I expect the company to generate softer revenue growth, despite the launch of RH San Francisco, and the introduction of the Contemporary Collection.
• However, I anticipate that margins will increase driven by solid sales associated with the Contemporary Collection, which is priced at a considerable premium to RH’s legacy furniture collections.
• RH is well-positioned to expand the business, to include not only its current focus, high-end furnishings, and hospitality, but also real estate development, entailing the construction and marketing of fully furnished luxury homes, condominiums, and apartments, with integrated services. Ancillary business projects planned include, fee- based: architecture, interior design, and landscape design services; guest houses to accommodate travellers; and luxury yacht and private jet charter services.

GARY FRIEDMAN

• Despite macro headwinds and ferocious competition in this fragmented market, I believe its much more important than in any
  other investment case to understand the visionary behind RHs reinvention.
• He is credited with turning around RH, which was on the verge of bankruptcy when he joined in 2001.
• Gary, a retail veteran, started at Gap as a stock clerk and eventually worked his way up to managing 63 stores in Southern California. He then spent 13 years at Williams-Sonoma Inc. where he led Pottery Barn from a $50 million tableware business to a furniture brand with sales of more than $1 billion.

VISION

Sell a vision, not a product: a crucial step in the company’s transition to more premium furniture was the switch in real estate strategy from traditional-looking retail stores to its “design galleries”.

• These are much larger shops (>30k square feet vs 8k square feet for legacy retailers), creating an immersive shopping experience, located in historically significant buildings in top metropolitan cities.
• Compared to legacy retailers where less than 10% of product range was displayed, in the new design galleries >30% of the company’s product is showcased. As a result, this creates a better customer experience, incorporating also hospitality elements such as rooftop restaurants and wine bars.

The transition has allowed for better economics with the improved sales levels compensating for the extra cost.

• The company’s operating model was successful with new design galleries driving strong sales growth and margin expansion.
•  However, the business and supply chain complexity greatly increased and the company started to have inventory problems.
• In fact, while the company was growing at a double-digit rate, return on inventory was not improving (as it should thanks to economies of scale) highlighting an operational issue. At the same time, RH was also burning a significant amount of cash.
• After RH’s IPO, RH demonstrated double-digit same store growth from 2011 to 2015.
• However, with same store- sales growth decreasing and eventually reversing in 2016, the inventory problems started to become evident.
• Sales growth was the result of the company’s large range of products but that also led to poor inventory management.
• When the market realised this issue, the company lost more than 70% of its value

CONCLUDING REMARK