There has been much bearish press recently about Restoration Hardware (RH), exemplified by this Wall Street Journal article. We will leave it for others to debate whether RH is expensive on an absolute basis. We believe the question is largely unanswerable, as it depends on RH's ability to grow profitably in the future. In turn, profitable growth in this case is principally dependent upon a continuing recovery in housing, the increasing spending power of high-end consumers and the ability of RH management to execute a series of operational improvements.
We would, however, like to make the case that it is far more rational for long-term investors to allocate money in the home furnishing retailers space to Pier 1 Imports (PIR) rather than RH. PIR offers a far better risk/reward profile than RH, as we hope to demonstrate in this article.
RH and PIR have roughly the same market capitalization. Yet:
- PIR has over 1000 stores. RH has 70 stores and has shrunk from 90 stores over the last few years
- PIR is trading at about 19 times this year's earnings. RH doesn't have GAAP earnings right now. It is trading at about 45 times consensus estimates of next year's earnings
- PIR has greater revenue and greater profit margins than RH
- RH has 11 times the long term debt PIR has
RH bulls explain the company deserves the same market cap as PIR because of RH's greater prospects for future growth.
One of the rationales for RH's high future growth estimates is that RH will be able to gain market share due to the effects of the Great Recession. From the most recent 10K:
As a result of the weakening housing market and economic downturn in 2007, many home furnishings retailers were forced to close stores, dramatically scale back operations or lower prices. Companies such as Bombay Company, Smith & Hawken, Linens 'n Things, Z Gallerie and Levitz declared bankruptcy or liquidated, while many others were weakened. While our sales results were also adversely affected during this period, this disruption also created an opportunity for us to differentiate our brand in the marketplace. We believe we are well positioned to gain market share in the current competitive environment as a result of our compelling combination of design, quality and value
This is undoubtedly a good point. However, one who has even a basic knowledge of the space can't read this paragraph without thinking that a company like PIR is even better positioned to take market share in this environment. RH caters to higher end consumers than most of these retailers. Most customers of the bankrupt brands can't afford RH. They can afford PIR.
This isn't the first time commentators have co-opted the growth prospects of PIR for RH. One of the rationales used to sell RH during its IPO was the phenomenal success of PIR since 2009. And indeed, after all the noise, PIR and RH have the same main driver - they will rise or fall based on growth in housing
But RH's growth prospects come with far greater risks than PIR's do. We will try to outline some of the less talked about ones here.
Risk 1: Hedge fund target
We've seen little discussion in the press of an interesting disclosure in RH's 10K:
Our filings and public disclosures have attracted the attention of a hedge fund manager whose investment strategies we believe include making investments that increase in value when stock prices decline. The fund manager has informed us of the fund's negative view of our Company and business and has threatened to publicize those views. There can be no assurance that this fund manager will not attempt to influence the broader investment community or otherwise attempt to disparage our Company or our brand, which could negatively affect our stock price.
Obviously, such a disclosure presents both a long-term and short term risk. Long-term, the fact that sophisticated market participants feel the stock is overvalued should not be ignored. Short-term, a campaign by short sellers will push the share price down.
Risk 2: IPO hype
RH posted four consecutive years of losses before going public. RH's impressive reported growth since going public can mean only one of two things. One possible explanation is that RH's controlling investors decided to sell a significant amount of their shares right before the value of the shares was going to increase due to growth. This is possible, but odd. The other explanation is that the growth is at least partially the result of management pulling levers to temporarily boost share price as they unload shares. We would like to stress that we are not accusing management of accounting malfeasance, and we are not even saying that the rate of growth we have seen is in any way artificial. We are simply pointing out that growth in the wake of an IPO is always more suspicious than, for instance, the growth PIR has experienced of late, more than 40 years after its IPO. We must, to some extent then, discount RH's growth due to the risk that it is unsustainable.
Risk 3: CEO (legal) insider trading
The CEO of PIR is buying his stock. The co-CEOs of RH are selling their stock. RH bulls will defend the sales, pointing out that the CEOs of RH own a much higher percentage of their company than the CEO of PIR does, and that the RH CEOs are simply cashing in on the hard work they did when the company was private. This is true. But it looks like RH CEO Friedman sold about $18 million dollars worth of stock when it hit $70. RH CEO Alberini sold about $12 million dollars worth of stock when it hit $70. Would they really be selling so much stock if they had a high degree of certainty in the continued appreciation of RH's shares? A couple million a year for living expenses might fit into such a narrative. $18 million does not. We must include an insider selling discount in determining a fair price for RH.
Risk 4: CEO track record
The CEO of PIR, Alexander Smith, has already pulled off one of the most successful turnarounds in retail history. When PIR was selling for 10 cents in 2009, Smith showed impressive respect for shareholders. In addition to closing stores and cutting staff, he sold the corporate headquarters to raise cash. But he wasn't just cutting to cut. He bought back the company's bonds at depressed levels to eliminate debt. He tripled the number of buyers and planners to take advantage of the distress of competitors. The result: PIR has appreciated 11200% since March 2009.
Contrast this with the record of RH CEOs Friedman and Alberini. In August 2012, Friedman, who was 54, had to step down as CEO due to rumors that he had engaged in an affair with a 26-year old female employee. Although such behavior is clearly reckless and detrimental to shareholders, investors have made a lot of money betting on executives with less than sparkling personal lives. We are a little more concerned with what happened next. Although Friedman technically resigned, it isn't clear that he ever actually stopped running the company. He was given the title "Chairman Emeritus" and was still quoted on earnings releases. Less than a year after resigning he was reinstated and became Co-CEO with Alberini. Clearly, this chain of events raises questions about corporate governance at RH and the independence of board members to look out for the interests of shareholders.
We want to stress that we have no insight into the character of Mr. Friedman. The relationship with an employee could have been a momentary failing in a life otherwise played by the book. Likewise, the board could have been acting in the best interest of shareholders by keeping Mr. Friedman involved and eventually reinstating him. Our point is that the events create red flags and uncertainties. RH valuation must include a governance discount for this reason.
Risk 5: The Economy
Of course, both PIR and RH have major exposure to the growth of the economy in general and the growth of housing in particular. Both will grow and prosper if the economy grows and prospers. Yet we believe PIR is far better positioned in case of another downturn. According to their 10K, RH is targeting households with incomes of $200,000 dollars a year or more. Let's say people making $200,000 dollars a year or more belong to the "professional class". PIR is one step down the ladder, targeting the "middle class". In the event of economic prosperity, there will be more consumers in the professional class, but there will also be more consumers in the middle class. Both PIR and RH will win. But in the event of a prolonged downturn, the professional class-RH's customers-will dry up. They will go one step down the ladder, and become customers of PIR.
We admit our scenario is extremely simplistic. But the point is clear. A business model that depends on the middle class is far more robust than a model that depends on the growth of households of $200,000 dollars a year or more.
The unstable macro environment and the political risk of greater taxation on high-income households mean that we must incorporate a target customer discount in our valuation of RH.
We have seen the raving fans of the products RH delivers. RH will likely continue to grow over the coming years. But we believe exuberance in the wake of RH's IPO has created a poor risk/reward profile. PIR is a cheaper and safer way to participate in the growth of home furnishing retailers.