May 19, 2016 - 2:29pm EST by
2016 2017
Price: 31.70 EPS 2.66 3.13
Shares Out. (in M): 41 P/E 0 0
Market Cap (in $M): 1,288 P/FCF 0 0
Net Debt (in $M): 40 EBIT 201 237
TEV ($): 1,327 TEV/EBIT 0 0
Borrow Cost: General Collateral

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Short of Restoration Hardware (RH)
Elimination of a sustained discount pricing strategy leads to opportunity to short retailer with a lot of
question marks surrounding its business.
There are multiple examples of a change in discounting strategy (JCP, M, TLRD) leading to short-
term to permanent damage. We cannot think of one counterexample of where this strategy has
We have data that shows that RH’s sales and gross margins will be down materially in 1Q.
RH’s aesthetics and furniture are facing a large increase in lower priced copies being rolled out
by competitors.
RH’s core mid-century modern aesthetic is already long into its trend cycle and unlikely to
remain popular for much longer. The company’s attempts to diversify into other styles might
not be successful.
RH’s new larger store strategy has little data behind it and has thus far led to uneven results.
RH’s returns are not exceptional (ROE 13%), and the valuation is still very high.
Quick background:
Many of you are aware of Restoration Hardware’s recent history so I’ll just give a brief overview and
then discuss parts of my thesis that might add value. RH came back to the public markets in 2012 as a
more furniture focused brand under new leadership. The company quickly made drastic changes, the
most critical one being its move to expand from roughly 7,000 sq. ft stores to stores 2-3x that size to
showcase more SKUs. After some initial success with a few stores, this strategy was put on steroids
when the company started moving into department store spaces as much as 10x the size of the legacy
stores, featuring full cafes. RH’s plan is to fully convert to larger stores over the next 7-10 years. The
idea is also to have a more efficient store and cheaper real estate. Additional big changes include that
RH converted from multiple catalog mailings to one giant merged catalog mailing and that RH started to
expand into additional rooms (bathroom and kitchen), demographics (teen), and aesthetics (modern).
There are also further expansion ideas and plans, including hotels, music and international markets.
RH ends promotional emails (transitions to Grey card)
On March 23, RH announced the Grey card, which is a discount card for $100 annually, entitling the
holder to 25% savings on regular items and 10% on sale items. Prior to the Gray card, RH would run
periodical sales of certain departments. Thus the customer was trained to anticipate and wait for a sale.
RH sent out roughly two emails every three days, advertising sales of approximately 33% off and often
as high as 50%. The idea behind the Gray card is that RH will transform into a club store with a more-
smooth sales pattern. Of course on the flip side it loses a key traffic generator with promotional sales.
The story behind discontinuing promotional discounts always makes logical sense. First example, JC
Penney saw the expenses of mailings and store signage as unproductive when everyday low prices could
be used instead. Second example, Tailored Brands (formerly Men’s Wearhouse) was wary of the
detrimental effect discounts were having on its newly acquired Jos. A Bank brand. Of course, in both of
these cases their attempts to end discounting were disastrous. And these two cases are not the only
attempts to cut back discounting, just the most audacious. Many companies, such as Macys (M), have
tried and quickly reverted. We can only think of one successful attempt at upwardly changing pricing
strategies, and that is Lacoste. Although, Lacoste is not a retail store, just a brand that split away from
Izod in the early 2000s.
RH will say that this is a long-term strategy and that the company is different because of the shopping
experience within its new large stores. The problem is thiswhile the new stores do look beautiful,
there are only a few of them--the vast majority are simply furniture stores. The timing of the plan is
very similar to JCP’s who had barely converted any part of its entire store to mini-stores within its store
and who was years away from instilling a unifying “Town Square in the store when it eliminated its
discounting model. RH’s plan is likely better implemented once it’s near fully converting its store base.
RH’s plan also leaves little flexibility since it will create outstanding discount memberships which might
be tough to undo if the plan flops.
Data indicates falling margins and sales in 1Q:
First we see that visits to RH’s website have gone from raging growth to fairly deep drops in March and
April. We used compete data for this documentation (see chart above.
Next using data scrapes off the internet, we see that RH has actually increased discounting fairly
substantially since March 23 (the end of sales day). We find that the average discount has gone from
35% on March 23 to 41% on May 17, with the discount percentage rising nearly every day. While we
only have data going back to late January, this is near the highest rate of 44% reached in early February.
These sales are pre-Grey card savings.
Restoration’s core aesthetic is under siege; it might not be able to transition well to other looks:
Furniture looks follow fashion in colors and overall aesthetic trends that last for about 5 years. RH has
what is called as mid-century modern look as its core aesthetic. Mid-century modern has been the
hottest look for roughly the past 3 years. While you may think this gives RH another 2 years under the
sun, we recently spoke with a furniture executive who showed us countless ads in industry publications
for mid-century modern furniture. According to this executive, everyone is trying to copy RH, and these
RH copies will be hitting store shelves over the next few months. There is little proprietary about
furniture design, especially when one manufactures in China as RH does.
Ethan Allen, which also has a signature (traditional) look, had poor sales when it expanded into other
styles. It remains to be seen whether RH, now offering new styles with its modern collection, can
successfully transition to other looks outside of its core mid-century modern.
Larger stores lack data and have produced inconsistent returns:
RH has released practically no data on how the company’s new large stores are doing, only saying that
they are exceeding its plan. However, the plan was always seen as a lowball number. If this is truly a
formula that works, we would expect to see the stores with more capex and bigger to do better.
Obviously, there is some room for randomness and the peculiarity for certain markets, but the relative
trend should be identified and present if this is going to be an executable strategy to roll out to 70
stores. Yet, on the limited info that RH gives out on its previous generation of stores, the new Boston
flagship store had the worst performance among the bundle of new stores. The Boston store did about
48% less sales per sq. ft than the other 4 stores (I got this data speaking to them, just under two years
ago) on average. Boston was about twice the size of the other new stores, yet its total sales were the
median of the group. Boston is very significant because it was the company’s flagship at the time. RH’s
job of resurrecting the historical building was so breathtaking that RH’s website featured a video of it
(the only video for a while). So Boston should have performed better compared to the other stores, yet
it may be the weakest link and on a return basis probably is. This store was arguably the basis for the
hype in the company and stock. Granted, Boston was the first major store so maybe management has
worked out the kinks. But given that all the stores are somewhat unique, how can we assume that the
company will execute on its plan as it rolls into 70 stores? If anything a flagship should be the best and
most creatively focused. Another observation worth noting is that the first large stores have been in
large cities, and we wonder how many more can be sustainably done.
What we find within RH are many conundrums about the company and simply a lack of consistent logic.
Here is a list:
The furniture is incredibly highly priced and is above or on par with high end Italian furniture
imports, yet the quality is lacking, according to multiple sources, who believe it’s not built to last
very long.
With the fall in antique furniture prices, you can likely buy authentic antique cheaper than RH
which was designed to mimic that antique.
Despite low quality and absurdly high prices, RH’s gross margin is just 37% (some accounting
differences vs. other retailers).
RH claims by not having designers and manufacturing in-house that it is able to curate from
artisans who others cannot get. These same “artisans” then mass produce the stuff in China.
RH plans on taking advantage of abandoned anchors to roll out its large format stores, yet the
malls that RH would go into do not have Sears and JCP; the Neiman Marcus’s of the world are
still doing quite well and not looking to exit leases.
For a store with such a great experience we found that RH had unimpressive Yelp ratings,
including a full point below competing Williams Sonoma, nearly half a point below Pottery Barn,
and a rating even below Ethan Allen. We note that we did this analysis over a year ago and RH
ratings were actually going down at the time, but we doubt that RH’s recent delivery problems
have helped its ratings.
RH is a San Francisco based company supposedly catering more to millennials, yet it has nearly
no social media presence.
RH services an extremely well-heeled upscale high income clientele, and it does so by repeatedly
bombarding them with emails and store signs for 0% financing.
RH’s expanded offering enabled by larger stores includes from what we can see is largely the
same item in slightly different colors.
While not a conundrum, the CEO and his videos make him appear to be hands down the most
pompous businessman on the planet. Just look, it’s not hyperbole.
Valuation & Returns:
For all the hype surrounding RH, its ROE is just 11.5% over the last 12 months. The company’s ROE has
never hit 15% and has been largely negative since and in the years up to coming public again. The
returns simply aren’t there, and this is despite issuing zero coupon converts. While RH no longer trades
for nosebleed multiples, it still trades for over 12x this year’s consensus earnings which are declining and
we obviously believe are unlikely to materialize. RH also produces nearly no free cash flow. Since RH
runs a very capital intensive business, I would value it at book value or roughly $22.00 a share, but
seeing a floor could be tough if the bottom falls out of its business.
It appears that RH is building a great customer experience at its stores. However, what has really driven
the company’s sales growth has been a combination of strong furniture market (especially at the high
end, very favorable fashion trends) and the roll out of financing. The company’s attempt to end
discounting will likely yield a lot of short-term pain. Though the shares have fallen dramatically in the
 past 5 months, there could be much more to go as the discount changes show up in results over the
next few quarters.
My analysis is more short-term based. Long-term most of what RH is doing does have a logic to it, and
the new stores (at least the ones I have seen) do look beautiful. At the store in Chicago, I saw so many
people with wine on a Saturday, which I thought it was free but was not--the place does millions in café
sales. The other risk is that the discount elimination is simply priced in already and an earnings miss
does not faze the market. Lastly, RH does have some pent-up sales from shipping delays which should
provide bump in the current quarter.


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.


The next two quarters are likely going to be the worst times for RH.  RH should report earnings in the second week of June,

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