EUR 850.00 For Business Accounts Only

Morningstar | RH Updated Star Rating from 05 Sep 2018

No-moat RH delivered another solid quarter of earnings growth, lapping SKU rationalization from the year-ago period, curating better merchandise and harnessing pricing prowess across the business. The company reported an adjusted gross margin of 42.1%, up 800 basis points year over year, marking the highest level since RH’s IPO, helped by the stability the membership program has provided and the rising brand awareness the firm has captured aided by the success of its hospitality business. However, management has articulated that it would build on profitability at the expense of sales (forfeiting discounting), and this in turn has led to a more tepid top line outlook over the second half than either we, or consensus had estimated. In our opinion, shares have faltered in response to this, with sales anticipated to be 2.5% lower in the third quarter and 2% lower in the fourth quarter than the company originally guided to prior, and 5% below our second half revenue outlook.

We don’t plan any material change to our $97 fair value estimate as we expect the inclusion of second quarter results to push our updated 2018 earnings per share guidance into the updated expected range of $7.35-$7.75 (raised from $6.34-$6.83). This doesn’t alter our long-term prognosis for the business, which includes average high-single digit top line and mid-teen EPS growth in 2019 and beyond. This also incorporates operating margin around 11%, lower than the low to mid teen outlook RH is calling for by 2020, as we expect the industry to remain competitive, although we admit the firm is building a differentiated model which should help it sustain its topnotch profitability in the industry. That said, we still view shares as overvalued, trading at 19 times our 2019 estimate.

Second-quarter results indicate that RH is staying focused on its execution, architecture, and cash goals, which should drive the company closer to the high-quality, sustainable growth it is seeking to achieve beginning in 2019. While 4% adjusted top-line growth (to $642.7 million) in the period was a bit slower than the 6% we modeled, profitability was stellar, with adjusted operating margin of 12.3% (up nearly 600 basis points). The adjusted SG&A ratio rose around 220 basis points, hindered by new accounting rules that require catalog costs to be expensed as they are released, rather than amortizing the expenses over the useful life. We expect expenses to tick up ahead, as the company spends marketing on the fall source books before paring back and capturing further operating margin expansion in the final quarter of 2018.

As the company seeks further growth opportunities ahead, it is expected to resurrect its line expansion path, launching RH Beach House and RH Color in 2019. We revisited the successes and struggles of prior line expansions in our August report, "Technical Factors Lift RH Shares, but Fundamentals Should Prevail," noting that not all endeavors were as smooth or easy as initially perceived. We do think experience and diligence learned from prior hiccups should help prevent material financial forecasting errors in these startups and could lead to wider brand awareness and broader penetration across customer demographics for RH, bringing the company closer to the $4 billion-$5 billion in revenue goal (which we have RH accomplishing in 2024).

Finally, we plan to maintain our Standard stewardship rating on RH after its change in financial leadership. Prior CFO Karen Boone announced her resignation in mid-August to attend to personal affairs, with Ryno Blignaut taking over the CFO position. Blignaut has held the CFO position in a prior role, and we believe Boone and CEO Gary Friedman have positioned the company to capture rising return on invested capital metrics. We don't anticipate any major changes to the financial directives that are currently under way, particularly those that have improved working capital efficiency at RH, which should boost ROICs around 400 basis points in 2018, to a high-teen rate.