Friday, January 4, 2013

The Latest Housing Play

The US housing sector has been one of the best performing themes to be invested in this year, so the recent IPO of luxury home furnishings retailer Restoration Hardware (NYSE: RH) seems to have come at the right time. The stock certainly represents another way to play the idea, however I think the investment proposition here is largely about the company’s internal execution. It's not a pure play on a stronger housing market but it will appeal to growth orientated investors who want exposure to a high growth company with favorable end markets.

A Favorable End Market

Most companies have a pretty similar evolution and RH appears to still be in the fast growth stage. This is somewhat expected of a recent IPO, but what took me back about this company is how much uncertainty there is over the quantum and quality of its future growth. RH is targeting a combination of mid-high teens revenue growth with EBITDA growth in the twenties and EPS growth of around 20. This is wonderful in theory, but investors will price the stock on their level of belief in the company hitting these targets.

So how will RH generate growth and why the uncertainty?

As a high end luxury retailer, it is set to benefit from a gradual recovery in housing, particularly within this kind of high end led recovery. It is an indisputable facet of this recovery that income and wealth outcomes are becoming more polarized. The rich are getting richer and prospects are looking good for those servicing them. I’m not saying it’s right, but I’m not denying the fact of it all.

Restoration Hardware’s Growth Plan

As for RH, it is planning to expand locations and introduce new channels and concepts to the market. With regards to the former, the company argues that only 25% of its existing offerings are currently displayed with sharp increases in sales predicted once retail space is expanded to accommodate more of its offerings.

Similarly, a combination of new distribution centers, increased automation and utilization of its ‘center of innovation and development’ will ensure increased operating efficiencies as well as reduce the time to market. Development costs are expected to reduce along with increases in operational leverage from introducing new sales channels. Many of these initiatives will be completed in 2013 so investors can look forward to these growth drivers really kicking in at the start of 2014.

New Sales Channels, New Challenges?

I think its new sales channel plans deserves consideration. It is all very well to promise increased gross margins from selling more from categories like fine art (and therefore reducing the share from lower margin items like furniture), but the company needs to deliver. RH is planning to expand its own standalone galleries (the art sold in its traditional galleries tends to be more d├ęcor related) and introduce new categories like tableware and objet d’art. All of which will no doubt be aided and abetted by its internal team of certified interior designers. Moreover, its plan to expand its baby and child furnishing stores is also introducing an element of uncertainty.

Looking across the industry, Williams-Sonoma (NYSE: WSM) and Pier 1 Imports (NYSE: PIR) are both benefiting from the increased willingness of customers to spend on home furnishings. Although these companies' customer base is closer to the ‘mass’ consumer, the overlying trends are the same as with RH. In other words, a resurgent housing market at the high end is trickling down to increased net household wealth in the economy, and consumers are spending more on housing. RH is at the epicenter of the ripples that WSM, PIR and the home goods stores like Home Depot (NYSE: HD) are profiting from. As long as a bellwethers like Home Depot continue to give increasingly positive guidance on the housing market then investors have good cause to favor this theme.

It is one thing to want to play the manifestation of a macro theme, and it is another to invest in a business on the basis of it executing in some new growth concept stores and categories. While RH's management has extensive experience and has generated 11 straight quarters of double digit growth in revenues, the stock price is likely to currently represent the past. The sector may be doing well, but investors only need to take a look at the stock price of Bed, Bath and Beyond to see that that execution is also critical. BBBY simply hasn’t been able to get it right despite improving end markets.

Where Next For Restoration Hardware?

The company declined to give Q4 guidance, which usually means that its actual numbers will exhibit a higher than usual deviation from market estimates. This is not so much of an issue because RH is still in a high growth phase and results will bump around from quarter to quarter. Analysts have it on a forward PE of around 25x as I write.  An interesting stock, but it requires an awful lot of belief in the management to justify buying it for all but the most ardent growth investor.

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