Restoration Hardware - Recovery Play, As Waterworks Deal Comes Unexpected

| About: RH (RH)

Summary

Restoration Hardware is a strong luxury brand, facing some real headwinds at the moment.

Investors have been disappointed with decelerating growth, as management promised to focus on internal improvements.

Given this promise, the purchase of Waterworks is somewhat surprising, though I see the strategic rationale behind the deal.

I remain upbeat on the stock, based on the long-term outlook for the brand.

Restoration Hardware (RH) is a luxury home retailer that has been affected by worsening growth prospects. This former stock market darling has come under a great deal of pressure over the past six month. With luxury markets cooling down, growth trends have softened dramatically, putting severe pressure on the shares.

These challenges should keep management very busy, even as the long term prospects for the brand and company look good. In such an environment you normally would expect a focus on internal improvements. While management is probably very focused on this task, it did find the time to expand the business with the purchase of Waterworks.

The Waterworks Deal

RH announced the purchase of Waterworks, a premier luxury bath and kitchen brand. The deal is of high strategic value, as RH and Waterworks combined offer luxury goods for every room in the home.

Waterworks is a very well established and recognized brand, and the company received a lot of praise from Restoration´s CEO Gary Friedman in the press release. Waterworks sells its products in 15 showrooms which are located both in the US as well as the UK. Its products can furthermore be found at boutique luxury retailers as well as online.

Friedman has been very keen to point towards the quality of the business, welcoming the contribution to RH. While the quality of the company and strategic rationale are sound, few financial details have been released with regards to the deal.

Restoration Hardware is paying $117 million for Waterworks. The only clues which were given regarding the financial performance of Waterworks, is that the business is growing and reports double-digit EBITDA margins. As the deal is anticipated to close in the second quarter of 2016, Restoration Hardware does anticipate an unspecified accretion contribution to the full year earnings per share. The actual contribution is anticipated to be fairly limited as the deal value amounts to roughly 5% of Restoration Hardware´s own enterprise valuation.

Adding To A Challenged Core

Restoration Hardware released its full year results for 2015 at the end of March. The company is highly productive as it operates just 69 stores, but they tend to be pretty big. This is complemented by a very strong direct channel which makes up half of total sales!

The company grew its full year sales by 13% towards $2.11 billion. The earnings picture has been somewhat complicated. GAAP earnings were essentially flat at $91.1 million, translating into earnings of $2.16 per share. Adjusted earnings did grow by more than 17% towards $114.7 million, with the discrepancy relating both to the cost of legal claims and amortization of debt discounts. Based on the nature, these items can be regarded as one-time costs, unlike structural costs such as stock-based compensation.

While full year results were pretty healthy, the fourth quarter results did reveal some worrisome trends. Fourth quarter sales growth came in at 11%, a modest slowdown from the full year growth rate of 13%. The real issue was seen in terms of margins. Adjusted margins did fall by 120 basis points in the final quarter of the year, thereby limiting the full year adjusted margin gains to just 40 basis points.

The combination of margin compression and slower sales growth resulted in flat earning growth in the fourth quarter, while full year earnings growth was still quite impressive.

The company admitted that high-end customers were facing some troubles. This is certainly the case in markets and cities which rely heavily on international tourism, or on prosperous energy markets. These two external factors were furthermore complemented by supply issues at RH Modern. With high-end customers paying big bucks for their goods, these delays have been really painful for the business.

Looking Ahead, Valuation Looks Reasonable

Clearly, Restoration Hardware has some issues but these seem to be largely priced in at the moment. As recent as November of 2015, shares still traded above the $100 mark. In the time frame of roughly half a year, shares did fall towards a low of $35 in response to the worsening news flow. Following the fourth quarter earnings release, shares have recovered to current levels in the mid-forties.

At these levels, given the 42 million shares outstanding on a diluted basis, equity is valued at $1.9 billion. The company has some $520 million in convertible debt outstanding, largely offset by cash balances of $480 million. It should furthermore be said that inventory levels have risen by more than $160 million on an annual basis towards $725 million, leaving room to generate cash flows if these inventory levels normalize. While liquidity is still strong, the cash balances are not adjusted for the Waterworks deal as well as nearly $150 million in financing obligations which relate to built-to-lease transactions.

If we assume that the equity valuation of $1.9 billion closely resembles the enterprise valuation, Restoration Hardware trades at 0.9 times sales. Shares now trade hands at 20 times trailing GAAP earnings, while that multiple drops towards 16-17 times earnings if you adjust for one-time costs. While the business has real challenges, that still looks reasonable for a retailer which grew comparable sales by more than 10% in 2015.

The All Important Outlook

Given the clear deceleration in growth trends, the outlook is key. Restoration Hardware sees first quarter sales of $454 million, plus or minus $2 million. This suggest that growth comes in at 7-8% on a comparable basis, but it is important to realize that delays at the ¨Modern¨ unit will hurt sales by roughly $10 million. If not for this item, sales growth is still seen at around 10% per annum.

While sales are still expected to grow, margins are expected to come under further pressure. Adjusted earnings are seen at just $0.04-$0.06 per share, marking a big slowdown from the $0.23 per share reported in the same period last year. While these earnings are lackluster, it should be realized that the first quarter is seasonally very slow, being responsible for less than 10% of the full year earnings in 2015. The delays at the Modern unit are responsible for a $0.12-$0.15 per share headwind in terms of earnings per share, explaining most of the anticipated fall in earnings.

Full year sales are seen up in the low to mid-single digits, and that suggests revenues of roughly $2.2 billion. Based on the Q1 outlook, growth is anticipated to decelerate further into the year. Of course, this revenue guidance excludes the contribution of Waterworks which in all likelihood is less than $100 million per year. What is furthermore surprising is that the guidance does not indicate that ¨delayed¨ sales will be caught up with in the remainder of the year.

This reveals that while the company might be dealing with a relative minor supply issue, the real driver behind the softening revenue growth trends is simply a lack of demand.

The good news is that margins are expected to stabilize into the rest of the year, as full year adjusted earnings are seen flat at best, or down in the mid-single digits. If you correct for the costs associated with the delayed sales, full year earnings would at least be flat compared to last year.

Pullback Provides Opportunities, Despite Short Term Uncertainty

After a great pullback, Restoration Hardware deserves a decent look, even if shares are already up by 30% from the absolute lows.

The company is an absolute authority in luxury home hardware and furnishing business. The great quality of stores and luxury appeal has served the business well, as the luxury market is facing some headwinds. Given that asset prices and luxury real estate prices are not necessarily rising anymore, big spenders have come under pressure. This is certainly the case as North America has been hit by the strong dollar and turmoil in the energy sector.

The good news is that the latter two headwinds appear to be alleviating at the moment, as the long term fundamentals and positioning of the business remains very good. The company remains very aggressive to cater to customers, and is willing to change its own business(model) in order to remain relevant in this fast changing environment. The Waterworks deal makes sense from a strategic point of view, and while the expected 3-5% revenue contribution is fairly limited, it makes strategic sense.

After shares have seen a nice rebound from the lows, most of the immediate upside might have been gone. The real upside can be seen if you believe in the long term growth story which still seems intact. This is based on the great positioning of the brand and a strong management team.

Having been long, I plan to trade around my position in a $35-$65 range. I will add exposure if this volatile stock moves down, and vice versa, provided that the long term guidance remains intact.

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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