Restoration Hardware: The Actual Root Of Its Problem

| About: RH (RH)

Summary

Restoration Hardware has sold investors three excuses for its problems that make no sense.

Restoration Hardware's problem is actually demand related, and there is a very simple solution.

Despite its problem, the investment outlook for RH stock is bullish.

RH's problems are temporary. There is still huge upside in North America and an untapped global market.

As a Restoration Hardware (NYSE:RH) bull, I really hate to write negative takes on the company, or question what management is telling us. However, sometimes it is necessary, with it much better to be informed than the alternative. Nonetheless, even after considering the likely root of Restoration Hardware's problem, and understanding that what management is selling might not actually be accurate, most should still conclude that RH stock is a great investment.

After Restoration Hardware's stock crushing warning back in February I wrote an article explaining why its excuse that lower oil prices and volatility in the stock market as a cause for its disappointing outlook does not make sense. Fast forward to its actual earnings release last week, which sparked a positive reaction for the stock price, and the company is once more noting those two factors as headwinds to its business. However, it is also emphasizing shipping delays, specifically to its strong performing RH Modern business. Notably, RH Modern is seen as a major catalyst for RH stock going forward, with many believing that the newly launched business can one day create north of $1 billion in annual sales as its own entity under the RH umbrella of businesses.

While the company did mention this back in February, shipping delays, there was an added emphasis on these delays one month later. My guess is because oil prices have become more stable and markets have recovered the big losses from earlier this year. Hence, if it were truly the uncertainty surrounding oil prices and losses in the stock market, which I said was a bogus excuse, then RH would be upping its guidance, right?

Instead, it is really selling investors the delayed shipping angle. The problem with Restoration Hardware choosing delayed shipping as an excuse, or any company using that excuse, is if the problem really is a delay, then that means guidance should impress. Specifically, if shipping issues hurt Q1, then when delays start to improve, then those lost sales from Q1 should add to future quarters, thereby pushing guidance higher. In other words, the company creates just as much revenue, but realizes it at a different time in the fiscal year due to these delays. Importantly, the word "delay" is by all accounts associated with the word "temporary".

However, that's not what RH is telling investors. The company had been saying that 2015 was a bridge year and that growth would accelerate to 20% in 2016 and beyond, up from 13%. Nowadays, the company is guiding for net revenue growth in the "low- to mid-single digit range". That said, I already explained why Restoration Hardware's excuse back in February made no sense, and because guidance represents such a big reduction from last year, its shipping delay excuse makes no sense either. Therefore, I think we can conclude what the company is apparently scared to say, the problem is demand! It is not oil prices, the stock market, or a shipping "delay".

Here's my theory on why RH is suddenly having these issues.

RH had such a remarkable three year stretch that I don't think management considered the possibility that demand could decline or had peaked. When RH was expanding with new businesses, like RH Modern, and its 7,000 square foot stores were overflowing with customers, it probably seemed like the good days would never end. But, the problem with furniture is that consumers tend to use it for many years, and its targeted high-end clientele is a relatively small number of consumers throughout the country. Therefore, RH may have had the right idea to constantly reintroduce new product categories like Modern, Teen, and Outdoors, into existing Legacy stores that replaced older inventory, but at the same time its older inventory and businesses needed to be replaced with new inventory and businesses to create repeat customers. A combination of both old and new does not necessarily mean higher overall demand.

When RH started rolling out these superstores, with 6-8x higher product assortment, and was expecting sales to double in these stores, management must have thought that demand would grow with square footage. Management must not have considered that its customer base is niche, and customers who bought a kitchen table last year will likely only return to buy something that is new, or when a new business is introduced. It has since encountered a problem where demand has diminished as a percentage of square foot. This is likely because it is trying to sell goods that have been popular in years past, goods like couches, silverware, and bedroom sets that can be used for 3, 5, even 10 years in some instances. Hence, RH needs to phase out those goods, and replace it with new businesses in new demand; throwing it all in a big store is not the answer.

Of course, this is just my theory for why Restoration Hardware's mega store rollout plan is not actually going to plan, but I think it is a logical theory that management will notice sooner than later. There is a reason that demand is sky high and inventory flies off the shelf every time that RH enters a new business with different concepts, and that's because it has repeat customers who are filling their homes with RH products, but have no need to buy three or four couches year-after-year to drive the company's sales higher. As a result, RH is having a hard time meeting the goals it set when it increased product assortment in those 30,000-50,000 square foot mega stores, up from 7,000 sq. ft. on average.

Thankfully, RH's retail transformation is in its infancy, and the company has already said it will slow the pace of New Line Design Galleria (superstores) rollouts. Hopefully, it will notice soon that revolving products and concepts in existing Legacy stores is the way to go, and that it can still drive sales higher via the use of its popular Sourcebooks (i.e. catalogs) to drive higher sales in older businesses and categories. If so, I still believe that RH is a force to be reckoned with in home improvement retail, and can be a terrific investment from this point forward.

Nonetheless, there is one more thing investors should keep in mind about RH, and it's important. Despite all of its unexpected struggles, this is still a mid-single digit growth company with long-term growth upside, and a RH stock that is very cheap. Currently, RH stock is trading under 14x next year's expected EPS, and that's based on a $3.18 EPS that is much lower than the $4.86 that analysts expected just 90 days ago. In other words, the bar is set very low, a level that RH should clear easily. Not only that, but the company's revenue growth outlook is very conservative, a bar it should also clear. Therefore, when you consider the low expectations, the cheap stock, and the high likelihood that management figures out the actual root of its problem, there is no doubt that RH stock is still a buy, and a great long-term investment at that.

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.

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