2023-12-08 08:24:01 ET
Summary
- RH's stock price fell 8% after the company lowered its profit margin expectations for the 2023 fiscal year.
- RH's third-quarter revenues were down 13% compared to last year, with a drastic decline in operating profit margin.
- The company expects challenging economic conditions to continue to negatively impact performance but anticipates a turnaround in the first half of 2024.
Stock Response to the Earnings
RH ( RH ) released its third-quarter earnings report on December 7th. In the report, the company lowered its profit margin expectations for the 2023 fiscal year. The management team believes that the ongoing high interest rates will continue to negatively impact RH's financial results moving forward. After the earnings release, RH's stock price fell 8% during after-hours trading, reflecting investors' concerns about the lowered earnings guidance.
With 82% of homeowners having mortgages below 5%, and 62% below 4%, we continue to expect the existing housing market to remain frozen until interest rates and/or home prices fall meaningfully.
Financial Results
RH shared that its third-quarter revenues were down 13% compared to last year. While still a decline, this was an improvement from the 20% revenue drop they saw in the second quarter. Their profit margin on sales decreased by 3.1 percentage points to 45.3% during the third quarter. However, their broader operating profit margin fell drastically - plummeting 12.8 percentage points to just 6.8%. This is a much steeper decline than the 4.7% operating margin compression in Q2. Due to the shrinking margins, RH slipped into a $2.1 million net GAAP loss this quarter.
Looking ahead, the RH management team believes challenging economic conditions will continue to negatively impact performance shortly. They decided they would need to offer more promotions for the time being to drive demand. The company still expects its financial results to start turning around in the first half of 2024, anticipating renewed consumer interest by then.
Additionally, the home furnishings market has become increasingly promotional, and we believe that will create a mix shift towards clearance products, pressuring gross margins. In light of the current market, we are delaying the mailing of our RH Modern Sourcebook until the first quarter of fiscal 2024 when demand conditions will likely be more favorable.
We expect our demand trends to accelerate through the first half of 2024 as our product transformation unfolds, in-stocks improve, we complete the reset of our Galleries, and introduce our new RH Modern and RH Outdoor Sourcebooks in the first quarter of next year. We anticipate our inflection point will peak in the second quarter of 2024 as our new collections fully ramp and we begin another cycle of Sourcebook mailings, completely transforming and refreshing the entire brand over a 12-month period.
We have a couple thoughts on RH's latest results:
1. The huge 12.8 percentage point drop in operating margin is concerning - plummeting down to just 6.8% and leading to a net loss. That reveals issues beyond just the revenue decline. Even accounting for the usual retail seasonality patterns, Q3 revenue topped Q1's low point, but operating income was cut in half. That signals operating expenses have shot up and are likely out of control.
2. RH also suddenly tapped the brakes on share repurchases - spending just $45 million compared to over $1 billion last quarter.
And on top of the pessimistic outlook the management shared, it seems they probably don't think the stock price has hit bottom yet even after the recent declines.
3. RH did gain slightly more market share than high-end rival West Elm this past quarter. However, West Elm's parent Williams-Sonoma ( WSM ) increased their profit margin by 2.9 percentage points even while sales decreased. This suggests RH has been less effective than its luxury competitor at controlling expenses and crafting product strategy - especially with the luxury housing market strengthening based on Redfin's data. Luxury home prices and sales have both trended upward since early 2023, yet RH's performance has gone in the opposite direction.
Looking to Q4, RH's outlook implies a 10% revenue drop, albeit with some sequential margin improvement from Q3 levels. Still, that guidance looks worse than William Sonoma's 5% implied sales decline for the fourth quarter. So RH seems poised to continue underperforming compared to its premium peer heading into the year-end holidays.
As a result, we are narrowing our revenue guidance range for the year to $3.06 billion to $3.08 billion, and now expect the adjusted operating margin to be in the range of 13.6% to 14.0%.
Valuation
Looking at valuation, RH's stock doesn't appear cheap right now based on several typical metrics. Compared to sector peers or its 5-year history, the shares are trading at above-average valuations on a P/E, EV/S, or EV/EBITDA basis.
Running a DCF model also signals high expectations still baked into the stock price. If we generously assume RH can get back to and maintain longer-term margins of 8% free cash flow and use a cost of capital of around 15.6%, the DCF suggests a 94% downside from current levels.
So despite the slowed growth and shrinking margins lately, the market continues to value this as a growth stock rather than shifting to view RH as a value or turnaround play. Given the tough macro environment, double-digit revenue declines recently, and lost market share versus peers like Williams-Sonoma, it's really difficult to envision the rapid growth reacceleration scenario that would be needed to justify these valuations.
Even if the consumer backdrop improves and RH's trends start stabilizing over the next few quarters as management suggested, the upside still looks limited amidst these growth assumptions. The risk-reward tradeoff seems skewed to more downside over the next year before we see whether RH can revert to peak profitability.
Risk
RH expects business trends to turn around in the first half of 2024. This outlook seems tied to hopes of the luxury housing sector continuing its recent improvements. It also likely hinges on expectations that the Fed could start lowering interest rates by mid-2024, which would ease economic conditions.
In recent years, RH has shown higher profit margins than luxury furniture competitor William Sonoma. RH subsequently traded at higher P/S ratio multiples accordingly. If it turns out RH's recent underperformance compared to peers is only temporary, the stock could see a positive re-rating in line with that historical premium.
So for investors trying to forecast RH's potential inflection point, it will be key to monitor relative margin trends moving forward. If the company can bounce back to outpacing premium players like William Sonoma in profitability, that lost goodwill with the Street could return as well. The path back to prior premium valuations runs through margins.
Conclusion
In our view, the risk-reward tradeoff for RH doesn't look great right now. The company already underperformed peers last quarter in revenue growth and profit margins. And based on management's Q4 outlook, RH likely continue trailing high-end players like William Sonoma through the holidays.
Expectations for a turnaround hinge on hopes for an improvement in the first half of 2024, so tough sledding may very well continue in the quarters immediately ahead. That dim management outlook is also clear from the sudden slamming of the brakes on buybacks last quarter - cutting way back, even with the stock notably cheaper than Q2 levels when they were aggressively repurchasing shares.
Given that pessimistic signal and the recent history of lagging operational metrics versus premium peers, we are inclined to remain cautious for now rather than bet on the inflection arriving quickly in 2024. If the coming Q4 results show continued underperformance, a downgrade may be warranted based on RH's dimmer competitive position. For investors, it's better to wait and see signs of improvement first before getting more constructive.
For further details see:
RH: Freeze Stock Buyback Amid Chaos