Key Issue 1: Real estate transformation underway
Restoration Hardware is currently undergoing a massive real estate transformation. The company is in the early innings of a shift from small, 7,000 foot stores to large, 35,000 - 60,000 square foot "full line design galleries" (FLDGs). The company eventually hopes to triple or quadruple its square footage over time as it adds 70 of these massive stores throughout the country.
Let's first talk about the financial benefits of this transformation. One of the most reliable ways for a retailer to drive sales gains is to increase square footage through store openings. This isn't necessarily a reason to start opening as many stores as possible (as retailers should still consider other factors such as return on investment). However, sales gains driven by square footage growth gives investors increased confidence that the company can achieve its near-term financial expectations because square footage growth is largely under management's control.
Starting this year, investors will increasingly see the impact of the full-line design galleries. Restoration Hardware currently only has about ten of these full line design galleries, but plans to open up 4-6 FLDGs each year. As they open up these stores, management will gradually close the older, traditional 7,000 square foot stores. The net impact is square footage growth of 20%+ each year (vs. 8% square footage growth in 2014).
As a result of this massive square footage growth, you see consensus estimates for RH's total sales growth to remain elevated at ~17-20% despite a gradual slowdown in comparable brand revenue growth (which is akin to comparable store sales for a retailer, but inclusive of online sales). As these large stores stay open longer, they should benefit comparable brand revenue growth as well (as younger stores tend to grow at faster rates).
What gives the company confidence that they can open huge stores at a time when e-commerce is forcing retailers to downsize their store footprint? One part of the answer lies in the fact that their stores are performing extremely well. Restoration Hardware has posted some of the highest comps in the industry, with comparable brand revenue growth of 25%+ from 2011 to 2013. This compares to industry growth of mid-single digits during that time frame. Clearly, consumers are responding strongly to Restoration Hardware's merchandise - which can't be said for other retailers in the home furnishings space.
Another reason Restoration Hardware has confidence in opening large stores is their direct-to-consumer channel. About half of RH's sales come from their catalogs that they send to consumers. These catalogs are huge with over 1,000 pages. You may have received some of these catalogs in the mail or seen the outrage online, where people have complained that they are a waste of paper. Despite the large inventory of merchandise, the company is unable to showcase all of this merchandise due to their small legacy stores. In fact, management notes that their stores show less than 20% of their overall merchandise. However, with sales data from their catalogs, management knows that certain items would do well in stores. Additionally, management also knows that these items often times do even better when shown on the floor, as items displayed for the first time see a 50% - 150% sales increase.
With several different metrics showing that consumers love the merchandise, real estate has become the bottleneck that has prevented sales from growing faster. As a result, management is very focused on opening larger stores that showcase closer to 35% of their total merchandise. These stores also bring several other benefits such as increased brand awareness and margin expansion. RH has focused on opening eye-catching stores that increase the brand awareness and draw customers to the store. Additionally, because so few retailers are looking to open larger stores, the company has also received very beneficial terms from real estate owners, which has benefitted the company's margins and capex requirements.
With so much of the company's strategy driven by its real estate expansion, investors are completely focused on the performance of the company's initial set of full line design galleries, as it will be a key determinant of the company's future profitability once the expansion is done (detailed later). While it's still early days, the stores have performed well, driving RH's stock higher. Key issues going forward will be the continued performance of these stores and the company's ability to continue to open large stores with beneficial terms (it's not easy to find large, vacant spaces in great locations).
Key Issue 2: Merchandise expanding, but could RH Modern cannibalize existing sales?
Another key component to the real estate transformation is Restoration Hardware's merchandise. With consumers reacting positively to the brand's look and feel, management has been expanding the brand into different home categories. Over the last several years, evidence of the merchandise growth could be seen in the catalog's page count growth, which has expanded from several hundred pages to over a thousand pages. The company has entered categories such as leather and rugs, and the company continues to look at other categories where the brand might be positively received.
Going forward, management plans to roll out RH Modern and RH Teen in 2015. Beyond that, management has noted that there are numerous adjacent categories that they are examining, including RH Kitchen. Should these concepts prove successful, they will be rolled out to the larger stores and could drive further sales gains.
What gives the company confidence that they can continue to roll out new concepts? The home furnishings industry is over $140 billion in size, and management notes that the high-end of the market represents roughly half of this spend. Within this $70 billion portion, the industry is highly fragmented with no clear leader. With an opportunity of that size and few major competitors ahead, RH believes they can become that leader in the space.
One potential issue with RH Modern is that it could cannibalize the company's existing merchandise given the similarity in the customer profiles. Management expects RH Modern to be 65-85% incremental to sales, but investors will be watching the performance of the line to see if the sales benefit is lower due to higher than expected cannibalization.
Key Issue 3: What does this company look like in the future?
With all of the different moving pieces, and given how early we are in the story, investors are curious about what Restoration Hardware's financial profile might look like at the end of the transformation. Management has guided to long-term targets of $4 - $5 billion in revenue and operating margins in the mid-teen range. Depending on your assumptions, this would get you to potential earnings of $7 - $11. Using these earnings estimates, it's not difficult to see the huge upside potential remaining in the stock - using an 18x multiple on $9 of EPS would imply a $162 price target (compared to its current $100 price), for example. Again, it's early in the story. The company will need to show continued execution along this trajectory in order for investors to reward the stock. As a result, the key will come back to the performance of the FLDGs and whether the stores can remain as productive as management believes they can. With a NTM PE of ~30x, expectations are high and any slip ups could have a harsh investor reaction.