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Morningstar | High End Customer Weakness Slows RH’s Top Line Cadence, Tempering the 2019 Outlook

Pointing to equity market volatility and weakness in the high end housing market, no-moat RH lowered its 2019 top and bottom line outlooks materially, sending shares tumbling. The firm now anticipates 3%-5% sales growth and earnings per share of $8.41-$9.08 in 2019, versus its preliminary, prior forecast calling for about 10% sales growth and $9.30-$10.70 in EPS (representing a 6% haircut in sales and 13% haircut in EPS at the midpoint). We plan to moderate our previous forecast which included sales of $2.7 billion (just above the $2.635 billion RH anticipates on its high end) and EPS of $9.46, but we don’t expect any material change to our $122 fair value estimate, supported by an operating margin still set to rise to 13% this year, from 12.1% in 2018. In our opinion, near-term pressure from the core business could be mitigated by innovation in beach, ski and color the company is making, helping it reach a wider consumer cohort than it currently caters to while supporting the core brand image, ultimately leading RH back to its longer-term company goals.

RH reiterated its long-term goals calling for 8%-12% revenue and 15%-20% EPS growth, largely in line with our prior five-year outlook which incorporates 8% sales and 14% EPS growth. Given the niche customer cohort RH caters to, we have constrained our terminal sales growth to 6% and EPS growth at 12%, as we expect the firm will prudently trade sales for sustained profit growth. We think the company has done a tremendous job over the past few years cleaning up its operating model and freeing up working capital, which has reduced its cash conversion cycle to below an estimated 60 days in 2018 from 130 days in 2016. In our opinion, this has led to more focused reinvestment in the business, generating double-digit ROICs that have surpassed our WACC estimate (11%) for two consecutive years.

While top line performance in the fourth quarter lacked growth, was flat year over year, with store revenue rising 3% and direct revenue contracting 3%, profitability was stellar, with the company posting a topnotch adjusted operating margin of 15.9%, marking 470 basis points of expansion. Not only did the adjusted gross margin expand by 100 basis points to 39.5%, but the SG&A ratio contracted by more than 360 basis points (to below 24%) as the expenses of repositioning of the business have begun to roll off, with sizable SKU rationalization largely behind the firm. In the quarter, we suspect RH gained share, with flat sales against a market that declined about 1%. However, we think the company held its share for full 2018, with the company capturing total 2018 sales growth of 3%, in line with that of the average monthly furniture and home furnishing sales growth offered by the Census.

Outside of disappointment surrounding lower top-line guidance, RH highlighted its second impairment taken on Waterworks, which provided a 70 basis point drag to the company’s operating margin, although the team has made note it plans to pivot the business and attempt to restore double-digit EBITDA margin performance to the segment (which is not broken out). Given that Waterworks remains a small part of the overall business, we are not significantly concerned about near-term issues at the brand.

We are maintaining our Standard stewardship rating on RH, after the second change in CFO in as many years. The company articulated that acting CFO Ryno Blignaut would be stepping down from his position in response to health concerns rather than any due to any conflict with management. As a result, at the beginning of March, the company appointed Jack Preston to the CFO position. Preston has been with the firm for more than five years, most recently acting as SVP, Finance and Chief Strategy Officer. With prior investment banking experience, Preston comes with solid experience to fill the role.