RH Profitability Crushed by Tumbling High-End Housing, but Margins Remain Best in Class

We plan to lower our $375 per share fair value estimate for no-moat RH RH by around 15%, with the expected contraction in 2023 sales and operating profit accounting for most of the change. RH offered a full-year outlook including sales of $2.9 billion-$3.1 billion, implying a midteen downtick, and an operating margin of 15%-17%, representing a roughly 600-basis point contraction. This outlook is significantly below our 3% sales growth and above-20% operating margin forecast for 2023, which we now plan to adjust closer to the expected ranges. Given rising interest rates over the past year and dire existing home sales of units over $1 million (which have averaged 38% declines over the last three months, according to National Association of Realtors), correlated spending on home furnishings is slowing. That said, we don’t think demand has permanently evaporated or been reallocated to lower-price offerings; rather, we think such spending has been postponed until equity markets (where significant household wealth is held) and interest rates (for mortgage costs) stabilize.

Fourth-quarter results displayed the magnitude of consumer concern at RH, with sales falling 14% to $772 million, echoing a 14% decline in third quarter. Adjusted operating margin declines widened sequentially, down 860 basis points year over year to 16.6%, as expenses failed to lever. Despite the negative optics, however, these results still allowed RH to deliver a full-year operating margin (22%) that was ahead of prepandemic levels (13 % average in 2018-19). And we think 20% operating margins are still achievable in the long term, as international expansion costs normalize and revenue growth returns, allowing for the return of expense leverage. We see no issues with the fundamentals of RH, as the near-term performance is not self-inflicted, but rather a condition of external economic uncertainties. For investors that can weather near-term volatility, we think shares remain significantly undervalued.