The price of Restoration Hardware Holdings (RH) soared more than 100 percent since its IPO before it fell by approximately 23 percent over the last two months. The company's debut year has been superb for investors and a return of approximately 120.5 percent has been generated. Riding on the back of recovering home sales and rising income of the affluent population in the US, this seller of luxury home furnishing products has been able to grow its revenues and earnings exponentially over the last few years. The company was able to beat analysts' estimates consecutively for the last 5 quarters, which has resulted in an upward revision of future analysts' estimates.
Despite the recent fall in price, the company's stock price might still continue to rise, as suggested by analysts' estimates. The average analyst target price for RH is $79.33 per share, which is approximately 29 percent higher than the company's current price. RH is expected to grow its earnings at an annual growth rate of 29.43 percent as per the consensus analysts' estimates.
Despite a rosy picture painted by analysts' estimates, the current multiples of the company tend to paint a bleaker picture. The company currently trades at a ttm PE of 47.35x (based on adjusted earnings) as compared to the average PE of 19.06x of its closest peers and a forward PE of 33.9x as compared to its peers' average of 24.3x. The price to cash flow multiple of the company is also at a significant premium as compared to its peers with the stock currently trading at 48.5 times its cash flows as compared to its peers' average of 21.2 times.
Although the company sits on a highly lucrative business with great growth prospects, the high valuation of the company puts some doubt in the minds of investors. This is the reason why I will be gauging the current estimates of the company in order to find out whether or not the current valuation of RH is inflated or if the recent correction in the market has provided a potential entry point for investors.
The company just recorded another excellent quarter of growth with revenues for the third quarter growing by 39 percent and net earnings increasing by approximately 5.6 times YoY. Adjusted net income, which excludes one time and nonrecurring costs, increased 4.9 times from the 2012 third quarter figure.
Over the course of the first nine months of 2013 the company has achieved similar growth figures with store revenues increasing 33 percent and direct revenues increasing 39 percent YoY in 2013. The consolidated total net revenues of the company increased approximately 36 percent. Adjusted net income expanded by 2.6 times and adjusted income margin expanded to 3.2 percent in the first nine months of 2013 compared to 1.7 percent in 2012.The affluent consumers with household incomes of $200,000 or above, RH's target market, were not impacted by the factors that led to a slowdown in the growth of other mass market retailers such as tax increases or rising interest rates.
The company's management has been very keen on sustaining growth at its stores, continues to monitor its store operations closely and close any store that performs below the company's expectations. This is evident from the fact that the company has closed more than 40 stores in the last 4 years and closed 3 more stores during the first nine months of 2013. The management is also very selective in choosing a location for new store openings due to the high cost that it incurs in opening new outlets. Compared to the number of stores closed, the company has only opened 14 new stores from 2009 to 2012 and added only 2 more stores to its network in YTD 2013.The Company has incurred approximately $66 million over the past few years by opening new stores which equates to slightly over $4.1 million per store. Although the strategy of closing stores rapidly and being very selective in opening new stores has led to a decline in the company's average selling square footage of 8.7 percent per year the strategy has been fruitful in generating growth in net revenue per selling square footage which has more than doubled in three years' time.
For the first nine months of 2013 the company's average selling square footage increased 3.8 percent despite a reduction in store count. The net revenue per selling square footage continued to grow during the first nine months of 2013 by more than 31 percent as compared to last year.
The direct segment of the company sells its merchandise to its customers through catalog sales or via its website. During 2013 the company reduced the number of catalogs circulated to its customers but still managed to grow revenues by 39 percent. Over the last few years the major catalyst for growth in the company's direct revenues has been the increased traffic on its website.
Since the economic downturn the high net worth population in the US has not only grown in size but the income disparity between the upper and lower classes has expanded. In 2012 the high networth population increased by 12 percent crossing 3.4 million people while the combined wealth of these individuals expanded by 12.1 percent to $11.8 million. The growth in the wealth of high net worth individuals in the US is expected to increase at a faster pace over the next few years. The wealth of high net worth individuals in North America is expected to grow at a CAGR of 5.7 percent compared to 1.6 percent in the last 5 years. This will result in increased spending on luxury products and lead to an expected growth in the demand for RH's products.
With the company beating consensus estimates by 14.3 percent in the third quarter I believe an adjustment in the price target for the company is required. This is the reason why I have forecasted the company's future cash flows and raised the price target for the company to $82.91 from the analysts' consensus of $79.33.
I have used the free cash flow to firm model for the company's valuation and projected the company's revenues and earnings based on the following assumptions:
- Addition of 1 new store to its network each year over the forecasted period with a particular focus on opening larger stores.
- Growth in net revenue per selling square footage of 17 percent going forward compared to the 30.2 percent growth over the last 4-5 years.
- Direct revenues increasing at a CAGR of 23 percent over the forecasted period compared to the historic growth of 33 percent.
- A slight improvement in the gross margin as I expect the spending power of high net worth individuals (HNWI) will increase and the company introduces more high value products.
- Selling, general and administrative expenses increasing at a CAGR of 20 percent as the company expands its network and expands its supply chain network.
- An increase in the company's interest expense as it increases the utilization of its credit facility and rising interest rates.
Based on these assumptions and the WACC I calculated the forecasted figures and the valuation of the company is shown in the figure below.
To calculate the WACC I have used the levered beta of the company using William-Sonoma (WSM), Ethan Allen Interiors (ETH) and Bed, Bath & Beyond (BBBY) as comparable companies. The market risk premium represents analysts' estimates and the risk free rate is the yield on long-term Treasury securities. The remaining information used to calculate the WACC was taken from the company's most recent earnings release.
The new target price of RH is calculated to be $82.91, providing an upside of more than 40 percent from its current market price. Although I have assumed aggressive growth measures for the company, I believe that these assumptions are completely justified given the company's performance and the expectations of increased spending from the high net worth individuals. Further, I believe that the recent drop in price is nothing more than profit selling on part of some anxious investors. The recent insider buying activity tends to point towards the company being significantly undervalued. Thus I believe that RH is significantly cheap and provides a high potential for handsome returns for investors.
Given that the company is a high growth speculative stock I think there are certain risk factors that may adversely impact investor returns. I have listed them below:
- A sudden slowdown in the company's earnings growth will likely result in a fall in the RH valuation.
- A rapid growth in the cost of opening new stores or costs of operating new stores will hamper the company's profitability and cash flow generation.
- Although the company's management has been very prudent in terms of selecting store locations in the past if management is unable to target high growth markets it may result in a slowdown in the growth of the company.
- Currently the company has had ample space to operate as it did not face much competition in the home furnishing markets as a majority of its peers have targeted lower income households. If another player enters into the market for high net worth individuals the increased competition may result in a slowdown in future earnings growth.
- The company's stock price has been riding positive market sentiments throughout its first year on the market due to an extraordinary performance of the company. In future, if the company misses analysts' estimates the market sentiment towards the company's future growth prospects may change leading to a fall in prices.
Investing in growth stocks has always been risky but this sort of investment does offer high rewards. Currently, RH presents itself as a good investment opportunity as the recent dip in prices gives investors a highly profitable entry point. With the company just beating analysts' estimates I expect the price of the company to increase again and thus I will give a buy recommendation for the stock.