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Morningstar | RH Set Long-Term Targets on a Near-Term Trajectory as Profitability Accelerates; Shares Overvalued

No-moat RH offered early insight into its expectations for 2019, along with an outlook for the rest of 2019 which handily surpassed our expectations with respect to profitability. While RH’s sales outlook for the fourth quarter ($680-$690 million) and 2019 ($2.72-$2.82 billion) fit squarely into our forecast for $690 million and $2.72 billion, respectively, its prediction of 13%-14% operating margin performance in 2019 is well ahead of our 2019 operating margin forecast of 11.4% indicating efforts to maximize working capital and proper merchandising are driving profit gains ahead. Bringing next year’s operating margin more in line with the new outlook would increase our $100 fair value by around 10%. Furthermore, we plan to amend our long-term tax rate which could add an incremental $6 (on top of the 10% lift), as we take our 26% rate forecast closer to the 20% RH is set to pay in 2018, raising the total fair value estimate by around 16%, still rendering shares overvalued.

Our long-term prognosis remains largely unchanged for RH. While existing home sales price growth has continued to rise at a mid-single-digit clip, existing home units sold has slowed over the most of 2018. We think a key factor that can support RH’s near-term performance is that the high-priced end of the home sales market has remained healthy, and that any cyclical downturn could come later at RH than some of its other mid-income target market peers. We have a full cycle factored into our long-term outlook, with 7% average sales growth bolstered by the still rising square footage and expansion of adjacent categories. Furthermore, we had operating margin performance bound at 13%, better than numerous peers given the efficiency of RH’s working capital, which was tempered by the low switching costs and pricing transparency that is pervasive across the home furnishing landscape. We expect a modest tick up in this metric as recent profit improvement flows through to RH’s long-term performance.

Better than expected profitability was the key theme in the company’s third quarter as well as throughout its forward outlook. With sales of $636 million just modestly ahead of our $630 million forecast, the majority of the company’s outperformance was in excellent cost metrics. The adjusted gross margin of 40.7% was 70 basis points better than we expected, thanks to more full price selling and improved outlet profitability. The adjusted SG&A ratio was also materially better than we anticipated by 130 basis points, at 30.4%, as cost savings from restructuring the organization are bearing fruit; $28 million in annual savings is expected from the redesign and closure of a distribution center in Baltimore. This led to operating margin performance of around 7% in the quarter, versus our 5% forecast. Furthermore, inventory was up less than 2%, well below the 8% sales growth the company generated, supporting a smaller DC footprint ahead.

All of these metrics have helped RH move its original 2021 targets for ROIC of 30% and mid-teen adjusted operating margin forward to fiscal 2020. Additionally, RH now has laid out new long-term targets calling for 8%-12% sales growth, adjusted operating margin performance in the midteens and ROIC in excess of 50%. At first glance, we’d expect some of these metrics to be difficult to achieve for the competitive reasons mentioned earlier. Also, while management expects it will be able to grow share even in a slowing market, we think the magnitude of demand impact on RH will widely be determined by the breadth and depth of the next economic slowdown.

On a liquidity basis, the company had about $8 million in cash on its balance sheet. While capital intensity has declined, the company has offered its intentions in the past to pay down the $340 million in convertible notes in 2019 and $267 million notes in 2020. This could lead to rising debt service as the company leans on its credit facility to finance the payment. With free cash flow of $280 million anticipated in 2018 before our model update (which should further rise in 2019 barring any economic slowdown), we still think RH will need to access cash in order to pay off its convertible note holders ahead. RH noted it expected net debt/trailing 12-month EBITDA would be around 1.8 times at fiscal year-end.