ETD - Arhaus: Quality Issues And Customer Satisfaction Overshadow Strong Growth

2023-10-04 22:49:18 ET

Summary

• Arhaus is an omni-channel retailer of premium home furnishings with a strong brand and healthy balance sheet.
• The company faces challenges such as poor customer reviews, quality issues, and low employee satisfaction.
• Arhaus operates in a highly competitive market, and its sales are sensitive to the financial health of higher-end consumers and macroeconomic factors.

Introduction

Arhaus ( ARHS ) is an omni-channel retailer of premium home furnishings founded in 1986. The company has a strong brand and a healthy balance sheet but also faces several challenges, including poor customer reviews, quality issues, and low employee satisfaction. Additionally, Arhaus competes in a highly fragmented and competitive market, and its sales are sensitive to the financial health of higher-end consumers and macroeconomic factors. For those reasons, I recommend a ‘Hold’ even if the growth prospects are high.

Business Overview

Arhaus is an omni-channel retailer of premium home furnishings founded in 1986. Arhaus offers a differentiated approach to furniture and décor, with products designed to be used and enjoyed throughout the home. The company sources its products directly from a network of over 400 vendors, allowing it to provide higher quality products at more competitive prices. Arhaus operates 85 Showrooms (stores) across 29 states, which serve as an invaluable brand awareness vehicle and drive significant client engagement. The company also has a robust e-commerce platform, allowing clients to begin or end their shopping journey online.

Competitive Strengths

Direct Sourcing

Arhaus's direct global sourcing relationships allow it to provide heirloom-quality products at a reasonable price, as there is no middleman’s markup. Moreover, Arhaus maintains highly adept in-house product design and development experts who partner with vendors to innovate and create highly customized offerings. I believe the direct sourcing network will allow Arhaus to keep higher margins than in previous years and offer the best value to its customers. However, as we’ll see later, there are some issues relating to product quality.

Product Differentiation

Arhaus is a premium home furnishing retailer that offers high-quality, artisan-crafted products with a livable luxury style. It’s differentiated from its competitors by its unique combination of design, quality, value, and convenience. The firm believes that higher brand awareness alongside a strong brand proposition will enable it to grow its market share.

Healthy Balance Sheet and Skin in the Game

The company has no outstanding interest-bearing debt, besides operating and capital leasing. Cash and equivalents represent 43.45% of the total leasing liabilities; thus, I think the company is in a healthy financial position to endure challenging economic and industry conditions. Moreover, John Reed, the current CEO and co-founder, has a 32.17% interest in the company. Consequently, I think the interests of management and shareholders are aligned.

Financial Performance

Arhaus has grown faster than its competitors RH ( RH ), Williams-Sonoma ( WSM ), and Ethan Allen ( ETD ) in the last three years. That’s normal if we have in mind the company is significantly smaller than its competitors (except for Ethan Allen) because it is easier to expand your footprint when you have fewer stores than when you already have too many. However, I don’t think Arhaus will be capable of maintaining double-digit growth in the future, as the industry will grow at a CAGR of approximately 6%, and the competition is tough. Moreover, the pent-up demand made many companies record more robust financial results during the pandemic than pre-pandemic years.

Now, analyzing Arhaus's profitability, the firm shows a higher ROIC than RH and Ethan Allen but lower than William Sonoma (except in 2022). Nevertheless, the company holds the lowest operating margin, so the higher ROIC is a product of a high asset turnover rather than wide profit margins. Additionally, Arhaus only recorded an operating margin similar to the competition in the last year when the demand was high; in a more challenging economic environment, the company will probably be more vulnerable due to its narrower operating margin. However, the business has maintained an acceptable operating margin relative to competition margins in the last two quarters.

Red Flags

In general, the firms in home furnishing do not have positive customer reviews, as customers are more motivated to write about bad experiences than to write about good experiences, in my opinion. Nevertheless, it’s worrisome how Arhaus (a premium brand) is among the worst in every customer satisfaction metric. For example, according to Comparably , its Net Promoter Score ((NPS)) is -64; thus, customers are likelier to tell their known ones to avoid Arhaus rather than recommend it. When we compare Arhaus with its competitors, its NPS is significantly below compared to Ethan Allen, RH, and William Sonoma.

Moreover, analyzing the reviews from Trustpilot , Arhaus scored better than William Sonoma and Pottery Barn but lower than Interior Define, Ethan Allen, and RH. However, an alarming trend in Arhaus's reviews is the numerous complaints about the quality of its products. I only observed this trend in Pottery Barn and Arhaus; for the rest of the companies, the complaints were mainly about difficulties in the supply chain and last-mile deliveries. From my perspective, it’s highly concerning that Arhaus had many quality issues when the company aimed to high-end consumers offering ‘heirloom-quality’ home furnishing.

The firm has taken steps to improve its logistics by opening new distribution centers in Texas (July 2022) and North Carolina (December 2021). However, I believe quality is an issue that needs to be addressed as soon as possible if Arhaus wants to build a strong luxury brand in the consumers’ minds.

In 2022, only one vendor accounted for more than 10% of net revenue , but the top 10 accounted for approximately 60%. Hence, Arhaus needs more bargaining power to force vendors to increase quality without increasing prices from my perspective. However, the company is expanding its manufacturing capacities, which may improve its control over the quality of its products and leverage its bargaining power toward vendors.

The flaws in quality, along with the awful customer service and logistics, make Arhaus one of the companies with the lowest customer loyalty, according to Comparably . Relating to consumer service, on Glassdoor , some reviews stated that employees do not receive any kind of training, which could be a reason that explains the terrible customer service.

Furthermore, according to Glassdoor, Arhaus ranks among the worst in employee satisfaction, below Ethan Allen, William Sonoma, and Pottery Barn. This left Arhaus in a disadvantageous position at the moment of hiring, which, according to the company , is getting more challenging as the unemployment rate remains low.

Risks

Competitive Market

The US home furnishings market is highly fragmented and competitive, with over 22,000 retailers . Arhaus competes with national, regional, and local retailers, department stores, online retailers, and specialty showrooms. The company has outperformed most of its competitors in revenue growth and ROIC; however, the lack of historical financial performance doesn’t assure us it can maintain its current operating margin and ROIC. Furthermore, the company has serious issues regarding the quality of its products, which is critical when you are supposed to sell ‘heirloom-quality products.’

Economic Conditions

Arhaus's sales are sensitive to the financial health of higher-end consumers and to macroeconomic factors that disproportionately impact the higher end of the housing market. The company also believes that the health and volatility of the stock market influences its client purchasing patterns.

Brand Erosion

Arhaus's success depends on its ability to maintain and grow its reputation as a top-quality brand in home furnishings. Damage to Arhaus's reputation could arise from product failures, data privacy or security incidents, litigation, adverse publicity, or a failure to maintain high standards for merchandise and service quality. Hence, poor customer reviews may jeopardize future growth, as potential clients already have a negative image of Arhaus.

Conclusion

Arhaus has a strong brand and a healthy balance sheet. However, the company has several red flags, including poor customer reviews, quality issues, and low employee satisfaction. These issues could jeopardize future growth. Furthermore, Arhaus faces a number of risks, including competition from other home furnishing retailers, economic conditions, and brand erosion. Even if the management states the company can double the number of stores, I will wait until it can solve the quality issues to consider buying its stocks, as brand erosion and stiff competition can compromise future growth. Consequently, my recommendation is a ‘Hold.’

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