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RH's Focus on Hospitality, New Galleries to Drive Sales

Zacks Equity Research

RH RH continues to benefit from focus on revolutionizing physical retailing and foray into the hospitality segment. Despite tariff-related woes, the company’s core RH business, solid performance of new galleries (mainly RH New York), and continued expansion of RH Hospitality are adding to the bliss.

A Look at fiscal Q2 Earnings

Last month, RH reported fiscal second-quarter 2019 results, wherein quarterly earnings and revenues handily surpassed analysts’ expectations, and grew 59% and 9.9% year over year, respectively. Despite adverse macro trends and higher tariffs, revenue growth was aided by the core RH business, solid performance of new galleries (mainly RH New York), and continued expansion of RH Hospitality. Also, planned accelerated outlet sales owing to the closure of a 500,000 square foot distribution facility in fourth-quarter fiscal 2018 added to the positives.

Let’s find out whether it can sustain the impressive momentum or not.

Catalysts Driving Growth

Focus on Elevating the Brand: RH has been exhibiting strong profitability, buoyed by focus on improving profit margins, and creating a new and differentiating shopping experience with the addition of hospitality (restaurants and cafes) in new galleries. Focus on elevating the brand and architecting an integrated operating platform has aided RH in becoming one of the few retailers that is expanding margins and growing operating earnings, while driving significantly higher returns on invested capital (industry-leading ROIC was 27.8% as of fiscal 2018).

In the first six months of fiscal 2019, the company’s net sales recorded a 8.9% increase and adjusted earnings grew an impressive 53.8% on the back of significant growth in operating margin and lower adjusted effective tax rate. Adjusted gross margin was 40.7%, expanding 100 basis points (bps) from the year-ago level. Adjusted operating margins also grew 300 bps to 13.4% in the period.

Transformational Initiatives: Over the past three years, RH has been busy in architecting a new operating platform that includes transitioning from a promotional to membership model, distribution center network redesign, revamp of the reverse logistics and outlet business, along with reconceptualization of home delivery and customer experience. These initiatives have helped the company lower costs and inventory levels, while boosting earnings and inventory turns. It expects this multi-year effort to result in a dramatically improved customer experience, continued margin enhancement and significant cost savings over the next several years.

Although weakness in the core business due to market volatility and softness in the high-end housing market continue to pose challenges for RH and other home furnishing companies like Ethan Allen Interiors Inc. ETH, At Home Group Inc. HOME and Williams-Sonoma, Inc. WSM, the company has reiterated long-term targets, as earnings potential and capital efficiency of the new operating model continue to evolve. It continues to expect long-term revenue growth of 8-12% and earnings improvement of 15-20% on an annual basis.

Upbeat View: Despite increase in tariffs and some negative macro trends, RH remains optimistic about business momentum, buoyed by factors that include the recent mailing of the Fall Interiors and soon to be in-home Modern Source Books, increasing contribution from RH Beach House, the launch of RH Ski House, along with new Galleries opening this fall.

In view of the recent trends, RH raised its full-year guidance for net revenues, adjusted operating income, operating margin and earnings during fiscal second-quarter earnings call. The company’s focus on elevating the brand and architecting an integrated operating platform continues to reflect in its profit model leapfrogging past the home furnishings industry. Management believes that it is gradually becoming one of the few retailers that are persistently boosting revenues, expanding margins, increasing operating earnings and driving significantly higher returns on invested capital.

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