Home Depot Earnings Have Strong Implications For RH Stock

| About: Restoration Hardware (RH)

Summary

HD quarter proved that consumer spending is quite high for home improvement retail.

An assumption of poor consumer spending has weighed significantly on RH stock.

It is time to buy RH stock.

It has been a rough year for retail stocks, and especially home improvement retailers. Stocks in this sector and industry, respectively, have fallen due to concerns of lower consumer spending, and also speculation that higher interest rates will prevent consumers from making upgrades to their home. Restoration Hardware (NYSE:RH) has been among the hardest hit, down 50% from its peak last year and down 35% this year. However, after Home Depot's (NYSE:HD) strong quarter, the concerns that have weighed on RH stock are proving to be inaccurate.

Home Depot is the Walmart (NYSE:WMT) of home improvement retail. Its performance acts as a good gauge for how the industry is performing, with HD being the largest company in home improvement retail by a mile. Therefore, when Home Depot's U.S. comparable sales grew 9%, versus an expected 5% rise, it sends a strong message to the rest of the industry that home improvement retail is stronger than analysts and economists had predicted, and that higher interest rates are not having a big effect on consumer spending.

That said, Home Depot managed to grow total revenue 9.6%, giving it a two year growth rate of about 18% during the fourth quarter. What's incredible is that HD has not added many stores during this two year span. The growth is mostly from increased traffic and higher consumer spending. The fact that HD forecasts total revenue growth of up to 6% this year is very encouraging for investors, and a good indicator that consumer spending will remain high.

Nevertheless, Home Depot's strong performance could have great implications for both Restoration Hardware's business and RH stock. Sure, the two companies are different, with HD being a more diversified retailer of all things home improvement, and RH more of a designer and retailer for high-end consumers. However, both companies operate within home improvement retail, and RH stock's big losses make it quite appealing.

Like HD, RH investors have not heard any bearish guidance from Restoration Hardware management to spark its big losses. Up until this point, all stock losses in RH have been speculative, an almost irresponsible assumption that a 50 basis point rise in interest rates would weigh significantly on store traffic. What investors have apparently forgotten is that high-end consumer spending is not typically tied all that closely to slight increases in interest rates. Furthermore, the fact that existing home sales in January surged 11% adds to the notion that consumers are not yet changing their spending habits, not with homes.

In retrospect, RH is still guiding for revenue growth around 20% this year following the company's bridge year in 2015. The company is also guiding that total North American revenue will grow from $2 billion now to upwards of $5 billion as its transformation to a larger storefront and expansion plan continues. The company also expects operating margins to rise from 10% to the mid-teens as this transformation occurs.

After stock losses of 50%, RH now has a market capitalization of just $2 billion, and that is far too cheap for a company with its rapid revenue and margin growth. In fact, if RH hits its revenue goal with an operating margin of 15%, then it is trading at less than 3x peak North American operating income. Notably, that does not account for international expansion, an opportunity that RH will likely pursue long-term.

Therefore, when you incorporate the seemingly strong home improvement retail industry with RH stock's beaten down price and bullish growth guidance, you arrive at a formula for large investment returns in RH stock. What Home Depot's Q4 did was act as confirmation that consumer spending and home improvement retail remains strong. For a beaten down stock like RH, with low investor sentiment, such confirmation is very important.

Disclosure: I am/we are long RH.

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.