RH: Don’t Call it a Furniture Company

Jul 20, 2023

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Overview

Once notorious for selling tchotchkes along with its furniture, the company formerly known as Restoration Hardware has gone from the brink of bankruptcy to the ascension up the ladder of luxury. The company, which today goes simply by RH, is headed by visionary owner-operator Gary Friedman. While prior to Gary’s almost unfathomable turnaround RH was a furniture company, don’t let Gary hear you say that. As per Mr. Friedman, RH sells spaces, not furniture, and in doing so has turned a failing retailer into a nearly $7B enterprise on the path to doing something that has never been achieved before - climbing the luxury mountain.

Credit Where It’s Due

As I’m sure consistent readers know by now, I like to give credit where it’s due when I get a lot of insights and/or information from a singular person or source. In researching RH, Speedwell Research has provided a ton of value on these fronts. Below is a link to their Substack, as well as an RH specific interview they did with Business Breakdowns (who are excellent in their own right).

A (Very) Quick Aside

In analyzing RH, I applied mental models used by three prestigious investors. In laying out the thesis around investing in the company we’ll simultaneously explore the mental models put out into the world by these investors, while giving them the credit they deserve (though certainly don’t need).

Track Record - Charlie Munger

Maybe known better by most for his lack of words, Charlie Munger has many quotes and mental models that are invaluable in both investing and life in general. One of these models is the idea that the best way to know what someone will do in future is to look at what they have done in the past, or their track record. In this sense few compare to Gary Friedman. From a mailboy turned protégé at Gap, to supercharging the growth at Pottery Barn, conjuring up the West Elm brand, and most recently the remarkable turnaround at RH there are few people on Earth with a better track record in the retail space than Gary Friedman. When Gary joined RH it was a dying concept. In 2001 the company was doing less than $400M, in revenue, laden with debt, and on the way towards bankruptcy. Enter Gary Friedman. Gary left a massive pay package at Williams-Sonoma to take a chance on turning around this dying retailer. To date it has been more successful than even he could have dreamed of. Besides simply changing its place in the industry and the mind of consumers (which we will discuss later on), Gary has turned RH into an absolute force, doing nearly $3.8 and $3.6B in revenue in FY21 and FY22 respectively - I think it's safe to say his track record is pretty good.

Consumer Psychology - Warren Buffett

The other half of the Berkshire Hathaway dynamic duo is a man who needs no introduction. This year I attended the Berkshire Hathaway meeting for the first time, and of the many gems that were dropped by The Oracle of Omaha one that I found particularly interesting was a comment about buying businesses just to understand the consumer’s psychology around a given product or service, as understanding how customers think is the most important understanding for a company. In this arena Gary is a true master. Before deciding to dig into RH I did some scuttlebutt on whether or not people really appreciate the RH brand, a concept I was skeptical of given the difference in the ability to show off and display the brand of the products as opposed to other luxury items such as cars or clothing. The feedback was a resounding appreciation for the brand and its place within the worlds of both luxury and furniture. When you dig into the company you quickly notice Gary’s disdain for being described as a “furniture company.” Instead he prefers to say things such as the company is “selling spaces,” an “arbiter of taste,” and “luxury at scale.” While some may remain skeptical, Gary is brainwashing consumers into believing that RH is a luxury brand - and its working. I’m sure most, if not all, readers have heard the classic saying that “perception is reality.” Gary is creating a perception in the minds of consumers that RH is a luxury brand, which in turn makes this into a reality.

Destination Analysis - Nick Sleep

Maybe the least known of the three investors referenced, though quite successful in his own right, Nick Sleep achieved much of his investing success by applying a concept known as “destination analysis.” Destination analysis is the idea of seeing the destination you want to arrive at and working backwards from there. Gary applies this concept exceptionally well, and I would encourage any investors or potential investors in the company to do the same. This concept helps you keep your eyes on the prize and see the long term vision, rather than getting caught up in day to day noise. In the case of RH the destination is to elevate the brand to be positioned as a global luxury giant.

What They Do Right

By now I’m sure many readers are thinking something along the lines of, “All of this is great, but how will RH actually achieve this?” While there is no magic formula here, we’ll explore the various things the company is doing to put them on the right path up the mountain.

High Touch Points

As we briefly touched on before, the original iteration of RH sold an assortment of tchotchkes in addition to furniture. The reason for this was to increase foot traffic and drive further consumer engagement, as furniture is bought very sparsely, often with long periods of time between purchases. While today RH no longer sells these tchotchkes, RH has been extremely creative in increasing consumer engagement and mindshare. From seemingly little things such as their famous Source Books, to more extravanagent measures such as the RH yacht, and having some of the United States’ top grossing restaurants, just to name a few examples, RH has made sure to stay top of mind with their customers.

Make Money on Advertisements

Tying in certain aspects of the prior point, RH implements one of my favorite strategies in business - being paid to advertise. This concept is very easily understood through the lens of their restaurant concept. Take their NYC gallery as an example (don’t let Gary hear you call them stores). Sitting on top of the gallery is the RH Rooftop Restaurant, a destination for many New Yorkers and one of the city’s top grossing restaurants. In order to get to the restaurant you must either walk up every level or take a completely see-through elevator to the room. Either path you choose to take you see every level of the gallery on both the way up and the way down. This has the effect of serving as an advertisement for the products, doing so in a way that is not only free for the company, but extremely cash generative due to the success of the restaurant.

Interior Designers

Throughout every floor of its galleries RH has stationed interior designers. These designers are key in delivering a luxury experience. Rather than simply walking around and deciding what furniture to buy, RH interior designers guide customers through the journey of creating a space. This makes the RH experience much more Louis Vuitton than Pottery Barn.

Membership/No Sales

Another key to the RH story, the company does not run sales, instead offering discounts through a membership program. First let's focus on the negatives of discounting. Discounting comes with various issues. As a luxury brand it dilutes your brand equity, temporarily impairs the customer experience, and it is extremely detrimental to margins. Brand dilution speaks for itself, but we’ll dive into the other points individually. We’ll start by double clicking on the worsened customer experience. When a company has a sale, foot traffic will increase, leaving the company with two options: add temporary staff, which will never be as knowledgeable or engaged as full-time employees, or keep staff levels normal, which will lead to long wait times for customers. Neither is ideal. Now onto margins. This in itself has various parts, the first of which would be that most retailers chose the option of increasing their headcount during sales, leading to higher costs at the same time their unit prices are going down. Next, is that sales increase impulse purchases, which lead to increased returns. This is a logistical and cost nightmare when moving something as large as furniture. Last, but certainly not least, sales condition customers to wait for them to occur before making purchases. When customers know there will be sales they often wait for them to occur, decreasing revenue when products are fully priced. Now to the more positive side. By having a membership model, RH is able to offer discounts to consumers at any time the consumer wants, without any of the negatives, and simultaneously bringing them into the RH ecosystem and building brand loyalty. It's simply a better model.

No In-Store Take Home

Less than 1% of RH’s revenues come from items that are taken home from the store, with the practice being prohibited with most of their inventory. This comes with two important benefits: a better gallery environment and improved logistics. By not having customers or employees running around, moving large pieces of furniture the customer experience feels closer to an outing at an art gallery than it does picking up pieces in the warehouse of an IKEA. This is far more conducive to the perception of a luxury brand. The second benefit of this policy is the logistics of it. Not having a checkout space or warehouse in the back opens up a ton of space to create the displays featured throughout the galleries. In addition, it decreases the costs of having to move large amounts of large furniture to individual stores. Instead inventory is able to be kept much more centralized, greatly reducing the cost to the company.

Unique Products

Another key to the RH story is its unique products. While with other high-end (though certainly not RH level) furniture companies you can often find knockoffs, you won’t find RH pieces on AliExpress. Similar to luxury clothing brands, RH seeks out artisan-esque vendors rather than large manufacturers. Many of these vendors are small, niche players that do not operate with much scale. RH often becomes by far their largest customer. RH will often provide financing to help these companies expand the capacity of these vendors. This dynamic makes it very hard to find knockoffs or similar products to those offered by RH. In some recent instances, RH has even bought some vendors in-house, which increases the scarcity of its products. This is something I expect to happen continuously more over time, having the double benefit of increasing margins through vertical integration and amplifying the perception of luxury.

Valuation

In putting a value on the company lets start by going back to the concept of destination analysis to set the stage of what RH will look like at a more mature state. Though I am hesitant to take management projections with anything more than a grain of salt, I’ll again backtrack to one of our prior concepts of track record. Gary’s immense track record inclines me to give him the benefit of the doubt in his long-term vision for the company. This vision culminates in $25B in revenue, with what Gary describes as “luxury margins.” No matter how high RH reaches on the luxury mountain they will alway be levered towards housing which is inherently cyclical. This dynamic will fluctuate depending on where we are in the cycle (as can be seen over the last couple of years), making a sales multiple most appropriate when valuing the company. While the luxury sector is in the midst of having a moment, with average price to sales multiples being above 5x (even after taking out a couple of outliers such as Hermès), historically it is closer to the 2-2.5x range. Using the lower end of the range this would put the market cap at $50B. Of course this is market cap, but as investors we care about per-share value. This is hard to judge with RH, though with a major skew to the upside. When the opportunity presents itself, Gary will buy back massive amounts of shares. This is best illustrated in 2017, when in seven months the company bought back nearly 50% of its shares due to a depressed valuation. Even before accounting for the buybacks, if the company were to take another full decade to reach this mature state it would produce a ~14% internal rate of return (IRR), a very good return given the duration, but the optionality of buybacks provides some real juice to the upside.

Summary

RH is a story that will take many years to play out in full, and requires a belief in the vision that Gary has set for the company. That said, looking at the bigger picture puts into perspective the potential for the spectacular culmination of a nearly bankrupt furniture company to climb the luxury mountain and become the first company in its industry to join the global elite luxury brands. This would be a true feat for the company - and extremely rewarding for those with the patience and conviction to take the journey along the ascent.

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