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Morningstar | RH Updated Star Rating from 13 Jun 2019

No-moat RH’s business has generally tracked stock market fluctuations, and the firm’s first quarter was no different. With the S&P 500 rising 8% over RH’s fiscal quarter, sales trended positively from last quarter, up 7%, ahead of our 5% forecast. With equity markets still elevated, management expects another 7% sales mark for the second quarter, ahead of our 4% projection. Recall, fourth-quarter results fell short of expectations, with flat sales growth, as the S&P dropped 9% in December, leading to a sales decline of about 10% around the third week of December that bled into January. In response to its solid results, RH raised both its top and bottom line outlook, now calling for sales of $2.64 billion-$2.66 billion (from $2.59 billion-$2.64 billion and above our $2.61 billion estimate) and EPS in the range of $8.76-$9.27 (from $8.05-$8.69 prior versus our $8.38 estimate) for 2019. Given that a significant part of the increase expected in our model stems from RH’s repurchase of 2.17 million shares in first quarter, we expect a mid-single-digit lift to our $122 fair value. This hike should render the shares modestly undervalued even after a more than 20% pop post-report.

With high-price (above $750,000) existing home sales stabilizing in April and mortgage rates continuing to drop, the macro landscape is supportive of RH’s near-term top line potential. Our five-year outlook for RH generates some of the best operating margin metrics in the home furnishing industry (at 13% by 2023), helped by 7% average top line and 13% average EPS growth, modestly lower than the company’s long-term targets calling for 8%-12% sales and 15%-20% EPS growth. For reference, we expect narrow-moat peer Williams-Sonoma to generate 9% and no-moat Bed Bath to mark 3% operating margins in 2023. Despite many opportunities for growth at RH, we think a modest discount to growth guidance is warranted given the firm’s synchronized performance with equity markets along with late cycle concerns.

We highlighted no-moat RH in our June 2019 report “Spring Selling Season Heats Up but Our Housing Outlook Cools,” as shares were then trading at around a 26% discount to our fair value estimate. Our positive outlook was due to more robust than category average sales growth expectations over the next decade, attributable to the company rolling out its new store footprint tailored to local demands (with large-format galleries in metropolitan markets and smaller prototypes for secondary markets) and expansion concepts to boost brand equity (beach, ski, color). We think the shares have traded down recently not on fundamentals, but in response to China sourcing exposure, which RH had been shifting since before tariffs were implemented; China sourcing should represent about 30% of products in 2019, down from 46% in 2017. Given commentary that RH has renegotiated costs and raised prices to mitigate these concerns, we suspect part of the rerating of shares today was in response to the company’s ability to defend profitability despite its wide exposure to the region.

And not only were sales ahead of our forecast as we noted above, but so were profit and cost metrics, also helping support the share price rise. RH’s adjusted gross margin came in at 39.1%, up 110 basis points and helped by the exit of less profitable and nonstrategic businesses and promotions. The SG&A metric was also better than we forecast at 27.3% down more than 100 basis points, but we anticipate it will deleverage over the second half of 2019 as the company invests further in the business to elevate the brand. Overall, this generated an 11.8% adjusted operating margin, putting RH well on its path to its mid- to high-teen operating margin goals (which our model falls short of at around a 13% normalized operating margin). RH discussed numerous opportunities, including hospitality, design, international expansion, but we note these expansions generally come with a cost to scale, and that tempers our profit upside over our explicit forecast.