Restoration Hardware: Be Cautious After Runaway Momentum

| About: Restoration Hardware (RH)

Shares of Restoration Hardware (RH) took a plunge in Wednesday's trading session following the release of its second quarter results on Tuesday after the close.

While operating performance has been great, the increased valuation multiples, lack of GAAP earnings, and runaway momentum combined with excessive payments to its CEO make me wary.

I remain on the sidelines.

Second Quarter Results

Restoration Hardware generated second quarter revenues of $382.1 million, up 30% on the year before. Revenues came in slightly ahead of the company's own guidance of revenues of $375-$380 million.

Adjusted net income rose by 62% to $19.8 million, while adjusted earnings per share rose by 48% to $0.49 per share. Note that this excluded expenses related to the follow-on offering and stock-based compensation expenses. Adjusted earnings came in ahead of guidance of $0.40-$0.42 per share.

GAAP net losses came in at $17.8 million compared to a $17.6 million profit the year before. GAAP net losses were severely impacted by a $59.8 million non-cash compensation charge related to Gary Friedman's reappointment as Chairman and CEO.

A Detailed Look Into The Results

The 30% reported revenue growth was very solid and compares to last year's growth rates of 24%. Growth is almost entirely explained by comparable store sales which were up by 26%, while direct revenues rose by 33% to $177.8 million.

The company operates some 70 stores at the moment, consisting of 62 galleries, 5 full line design galleries and 3 baby and child galleries. The firm furthermore supplies to 17 outlet stores.

Gross margins fell by 260 basis points to 36.4% of total revenues. Margin compression was driven by strategic pricing to drive sales on new products.

Adjusted selling, general and administrative expenses fell by 400 basis points driven by lower advertising expenses and the positive operating leverage of other expenses.

And Looking Ahead

Third quarter revenues are now seen between $385 and $395 million. The company aims for adjusted net income of $11.2-$12.0 million, resulting in earnings of $0.27-$0.29 per share. Revenues are seen up 37.2% on the year before.

Analysts were looking for third quarter earnings of $0.16 per share, on revenues of $365 million.

Fourth quarter revenues are seen between $490 and $500 million. Adjusted net income is seen between $34.3 and $35.5 million, resulting in adjusted earnings per share of $0.81 to $0.84. Fourth quarter revenues are seen up 24.3% on the year before.


Restoration Hardware ended its second quarter with $15.0 million in cash and equivalents. The company operates with $87.6 million of revolving debt under its credit line, for a net debt position of around $70 million.

The company sees full year revenues of $1.56 to $1.58 billion, resulting in adjusted earnings of $1.65 to $1.70 per share. Full year revenues are seen up 32% on the year before.

Factoring in a 8% fall halfway through Wednesday's trading session, shares trade at $70 per share. This values operations at $2.7 billion. this values operating of the firm at 1.7 times annual revenues and 42 times adjusted earnings

Restoration Hardware does not pay a dividend at the moment.

Some Historical perspective

Shares of Restoration Hardware were sold to the general public back in November of 2012. Shares were sold at $24 per share and quickly moved into their thirties to trade in a $30-$40 trading range until May of this year. Shares quickly doubled to highs of $77 in July, doubling in merely three months time, and are currently exchanging hands at $70 per share.

Between the fiscal year of 2009 and 2013, Restoration Hardware stands to increase annual revenues by a cumulative 150% to about $1.57 billion. With exception of 2011, the company has been reporting modest GAAP losses in the meantime

Investment Thesis

Restoration Hardware had a very solid quarter, accompanied with an even stronger outlook for the remainder of the year.

Full year revenues are now seen around $1.57 billion, upped from a previously guided midpoint of $1.49 billion. Adjusted earnings per share are seen between $1.65 and $1.70 per share, upped from a previous guided $1.41-$1.47 per share.

Continued comparable store sales growth should be driven by new and expanded product lines including the kitchen and tableware segment, as well as the introduction of RH Atelier. To cover the larger assortment, Restoration is moving to larger stores.

Seeing these incredible growth rates makes you wonder what kind of fast growing company this is. However, before 2008 the company was losing money, and the acquisition of a private equity firm some five years ago has rejuvenated the product lines, sales growth and earnings. Growth in recent times has been impressive, which should be supported going forward given the expansion in the assortment, and the support in operations.

Back in November of last year, when the company went public, I last took a look at Restoration's prospects. I concluded that margin improvement should drive the valuation going forward. Within their first year as a public company, shares have tripled from their initial price levels, trading in their seventies at the moment.

The strong consumer confidence and continued recovery in the housing market has resulted in a more positive external environment in which the company operates. Shares were valued around 1 times annual revenues and 32-33 times earnings at the time. Given the discount on revenue multiples, I thought that shares looked appealing compared to competitors like Pier 1 Imports (NYSE:PIR) and Williams-Sonoma (NYSE:WSM), given the strong comparable store sales growth.

Unfortunately I didn't act on my own advice. The appeal of the shares has diminished after shares have tripled from their initial levels, and have roughly doubled since I wrote the article.

The lack of GAAP earnings, driven by one-time charges, combined with the runaway momentum make me a bit cautious. The fact that the board allowed a $60 million in stock-based compensation for its CEO makes me wonder if management is starting to lose touch with reality, and is a major red flag.

I remain on the sidelines, having realized that I missed out on a great rally in 2013.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.