RH Stocks Soar, But There Are Warning Signs for Investors

Luxury furniture company HR (NYSE: RH) RH (formerly Restoration Hardware) has faced a tough market for home furnishings in recent years, with the pandemic accelerating demand for furniture as people were stuck at home. However, the company saw its stock surge recently after its second-quarter results as RH (formerly known as Restoration Hardware) was able to generate revenue growth.

Even though investors have driven the stock higher, I think there are a number of warning signs that things may not be as positive as they seem. Let’s take a closer look at the company’s results.

Incomes are increasing, but some indicators are problematic

In the second quarter, revenue rose nearly 4% to $830 million, well above analysts’ expectations of $824.5 million.

Gross margins fell 230 basis points to 45.2%, and adjusted operating margins plunged from 20.2% to 11.7%. That’s the first warning sign: It appears the company has sharply increased marketing spending to post modest revenue growth, squeezing operating margins in the process. Adjusted profit plunged 62% to $33.5 million.

Another area of ​​concern is the sharp increase in inventory, which rose 24% to $917.3 million from $737.7 million a year ago. Some might argue that the company is stocking up for the holidays, but keep in mind that this is a year-over-year comparison and the company only grew sales by less than 4%. It’s generally not a good sign to see inventory and sales growth that far apart.

The company also saw a 35% increase in accounts payable, from $366.6 million at the beginning of the year to $496 million. Additionally, its deferred revenue and customer deposits increased by just $19.7 million, or 7%, to $302.5 million. This could indicate that RH is extending the time it pays its suppliers.

The company has made a push into Europe with the opening of new large stores. But it’s not yet clear how well those stores are doing. On its earnings call, the company said it was still learning from the openings and that it didn’t open them in the order it wanted, which suggests they’re not doing so well. Given that new store openings often generate increased interest and traffic, that’s not a good sign.

Looking ahead, the company lowered its full-year revenue growth forecast. It now expects revenue to grow 5% to 7%, down from a previous forecast of 8% to 10%. It expects demand to grow in the 8% to 10% range, down from a previous forecast of 12% to 14%. (Demand is the dollar value of orders placed.)

For the third quarter, RH expects revenue growth of 7 to 9 percent, with demand growth of 12 to 14 percent.

Image source: Getty Images.

It’s time to avoid actions

CEO Gary Friedman has a reputation for being bold. In 2017, for example, he made a big bet on the company by taking on debt to buy back more than half of the company’s stock. It was a risky bet, but one that paid off.

More recently, Friedman has been betting on a foray into Europe. But this isn’t a typical retail foray into Europe: The company is opening huge, grandiose stores in markets where it has no presence and where its brand awareness is likely minimal.

Entering the luxury furniture market in Europe is no easy task, but the company has gone all out, spending huge sums and securing big leases along the way.

In terms of valuation, RH is trading at a forward price-to-earnings (P/E) ratio of 24, based on analyst estimates for the coming financial year. For a company that is struggling to grow its revenue, this is a fairly expensive valuation.

RH Price-to-Earnings Ratio (1-Year Forward) data by YCharts.

Given its valuation and the warning signs mentioned above, I would remain on the sidelines on RH stock. The company has benefited from big bets in the past, but that doesn’t mean its European expansion will be a success.

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Geoffrey Seiler has no position in any of the stocks mentioned. The Motley Fool recommends RH. The Motley Fool has a disclosure policy.