Despite Current Luxury Market Weakness, RH's Growth Initiatives Position It for Success 

Senior Equity Analyst

Jaime M. Katz

RH has gained share in the fragmented $143 billion (U.S. Census) domestic furniture and home furnishing market in recent years, curating differentiated offerings from specialized global artisans. The firm has broadened its brand awareness by expanding into underserved categories including modern, teen, and hospitality, where few peers nationally compete, leading to incremental market share gains from boutique competitors. Brand equity should remain stable given the pace of tailored store buildouts, category expansions, and pricing consistency, but the diverse end-market expansions RH is pursuing could make it tough to capture a cost advantage. Entry into international markets, the $200 billion hotel industry, and $1.7 trillion domestic housing market should help support 8% top line growth over the longer term. 

RH's e-commerce presence enhances its brand awareness, with the ability to market incremental SKUs (bolstered by the World of RH platform breadth). In past years, RH made operational and supply chain changes to improve costs, including adjusting its distribution center footprint and rightsizing inventories. We believe RH's focus will be to expand its global presence over the next decade via a wider set of luxury offerings (guesthouse, yacht), alongside a multipronged gallery strategy set to suit local market demands. 

RH's business model has helped untie significant capital, as the firm utilizes a sale-leaseback model on projects, a reverse logistics plan to liquidate product, and a right sized distribution center footprint (which led to inventory that rose 6.5% between 2016-22 on 68% sales growth). These processes have put RH on the path to achieve a 22% operating margin at the end of our 10-year forecast (in line with its 2022 adjusted operating margin of 22%).

RH demand remains tied to housing and equity market conditions, which have recently affected consumer willingness to spend on luxury home furnishings, supporting our no-moat thesis (this has led to an outlook for a midteens decline in sales in 2023). We forecast adjusted returns on invested capital, including goodwill of 50% in 2032 at RH, versus our 10% weighted average cost of capital.

Business Strategy & Outlook

Although we rate RH no-moat, we believe the brand has built awareness across a selective consumer demographic, thanks to its luxury positioning. However, given the intense competitive landscape that can often be pervasive across home furnishing, we have refrained from assigning RH a moat. Despite a high sensitivity to housing market conditions and a previously evolving brand image, the company has delivered adjusted returns on invested capital, including goodwill, that averaged around 60% over the past four years, fueled by pandemic related demand, and compared with our 10% cost-of-capital estimate. Additionally, the firm has generated positive free cash flow to the firm over the past five fiscal years, after an inconsistent start post-IPO (2012), when consumers had previously waited for sales to purchase big-ticket items at the brand (which we believe has been remediated by the well-received loyalty program and the firm's avoidance of discounting). Efforts to reorganize the business and streamline strategy have helped improve these metrics (with free cash flow to the firm of around $300 million in 2022, by our math), and we expect the company should be able to maintain positive free cash flow metrics, as incremental economics that are extracted from the business are offset by investment into brand building efforts. Still, in our opinion, nonexistent switching costs could weigh on the ability to consistently drive demand and raise prices throughout the economic cycle (a concern that has recently come to the forefront). This is despite our favorable view of the company's differentiated offerings (RH curates from its artisans globally, which helps to merchandise strategically, and operates with an experiential store strategy) and ability to read through proprietary data and purchasing patterns from its direct-to-consumer business. With nearly 70 brick-and-mortar namesake locations (excluding outlet, Waterworks, and Guesthouse) across the United States, Canada (spread across the geography, but centered in high-income locations), and one location in the UK, we suspect the company is continuing to support its brand and consumer awareness. 

Even though we don’t believe RH has yet proven a persistent competitive edge, we think RH is cultivating a loyal set of repeat customers looking for product, as well as ambience and experience, as evidenced by those participating in the firm’s loyalty program (at more than 350,000 in each of the past five years, paying an $175 annual fee). Furthermore, with 15 existing hospitality locations and the expansion of the hospitality footprint in existing and new locations (including guesthouses in New York City and Aspen, among other locations set to open in 2023 and beyond), we expect foot traffic should rise at RH’s brick-and-mortar locations. 

In our opinion, the brand had also been gaining traction with its source books and e-commerce business before merchandising missteps in 2016, but think the firm’s step back to reposition the core business over the 2017-18 time frame was necessary to rectify the company’s profitability profile (adjusted operating margins rose to 22% in 2022 from 5% in 2016). However, our primary concern is that consumers can still search online for similar products at more competitive prices, bounding our upside outlook. For example, narrow-moat Williams-Sonoma is one of RH's closest publicly listed competitors, with more than half of its sales from the direct channel, and similarly catering to an upscale demographic through its Williams-Sonoma and Pottery Barn brands, but we think online-only no-moat Wayfair could also chip away at sales in more commodified categories. Williams-Sonoma has had a consistent merchandising strategy in recent years (given that it hasn't pivoted its organization materially), thanks to the consumer data on transactions it has captured for more than two decades, which has helped it garner a narrow economic moat. We still believe companies like Bed Bath & Beyond (now tied up with Overstock) procure a significantly lower proportion of their sales directly and target a lower-income demographic, so we don't view them as competitive threats jeopardizing RH's big-ticket sales. 

Numerous categories that RH peddles are commodified (lighting, textiles, hardware, and more), underlying our no-moat rating, with ample domestic brick-and-mortar and online rivals, including department stores and home improvement companies, which frequently entice consumers with coupons and discounts. We believe RH's brand and perceived quality carry weight with consumers, but we view the core consumer as often swayed by economic conditions, particularly in the housing and equity markets. For example, the company was forced to be acquired by private equity during the 2008 housing downturn and suffered a $7 million net loss in 2010 (admittedly the business model was materially different during the Great Financial Crisis than it is currently). It was further driven to reduce initial 2019 guidance in response to the equity markets' downtick at the end of 2018, and rescinded preliminary 2020 comments as a result of COVID-19. In tandem with equity market volatility at the end of 2018, RH experienced a sales decline of around 10% in the final weeks of December, which persisted into the market rebound in January 2019, postponing sales. In the first quarter of 2020, as a result of COVID-19, RH's sales contracted 19%, although the core business (inclusive of baby and teen, excluding outlet) fell just 11%, faring significantly better than the industry. Most recently, the equity market volatility and softening of luxury housing demand has led RH to forecast a midteens decline in sales in 2023. We think examples of rapidly slowing demand like this indicate that industry demand can become volatile during periods of economic distress. The company has historically had gross margins that were below Williams-Sonoma and Bed Bath but handily surpassed them in 2019-22. It should be able to remain handily above its home furnishing peers moving forward, given the increasing level of sales that could stem from the membership program and hospitality, as well as improved pricing as a result of inventory management initiatives (SKU rationalization, reverse logistics implementation) we do not expect to unwind. We will be watching the persistence of such metrics to determine whether the firm has developed a durable competitive advantage.

None

Economic Moat

RH operates as a holding company which operates the business through its subsidiary Restoration Hardware, Inc. It offers furniture, lighting, textiles, bath ware, decor, outdoor and garden, as well as baby and child products. The company operates an integrated business with multiple channels of distribution including galleries, source books and websites. The company was founded by Stephen J. Gordon in 1980 and is headquartered in Corte Madera, CA.

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