It can pay to follow what the top investors in the world are doing with their money. While you shouldn't blindly follow others into investing ideas, searching the public filings of seasoned capital allocators can be helpful in sourcing new ideas for your portfolio. And the investor that people pay most attention to is Warren Buffett, CEO and chairman of mega-cap stock Berkshire Hathaway.
So it was interesting when in 2019 the company bought up a sizable position in RH (RH -1.60%) at around $200 a share. The purchase was a major success with RH's stock soaring up to over $700 a share in 2021.
However, in 2022 RH's stock has taken a tumble and is now down 39% year-to-date, potentially providing an opportunity for investors to buy a stake in a Berkshire Hathaway favorite on the cheap. Is it time to buy shares of RH stock? Let's take a look.
Image source: Getty Images.
What is RH?
RH, formerly known as Restoration Hardware, is an upscale home furnishings company. The brand has been revitalized in the past decade by CEO Gary Friedman, who took over the business in 2001. Since 2010, the business has tried to "scale the luxury mountain," as management describes it, moving to a wealthier and wealthier clientele instead of being a normal, mall-based retailer. The company did this by redesigning its stores as upscale galleries to differentiate itself from home goods competitors like Pottery Barn.
This focus on quality has helped RH retain a group of loyal customers across the United States. As of the end of 2021, the company had 459,000 RH members, who get discounts on products and access to special promotions by paying a flat fee of $175 each year. RH members drove 97% of sales last year in the core RH business, making them vital to the health of this business.
Since RH is only going after people who can comfortably afford things like a $1,000 patio chair, don't expect the number of RH members to get much higher than 1 million, at least in the United States. But that is OK given how much money these wealthy clients can spend each year.
Short-term headwinds, long-term ambitions
RH reported its Q4 2021 earnings on March 29. Revenue looked good, growing 11% year-over-year to $903 million with an operating margin of 24.1%. Operating leverage has been the big story for RH over the past decade as it has transformed into a luxury brand. Back before 2018, operating margins were only around 10% or below, but have now steadily risen to close to 25%. Over the long term, CEO Friedman thinks RH can achieve operating margins of 30%+, which would be similar to those of other luxury brands like Louis Vuitton and Hermes.
RH Operating Margin (TTM) data by YCharts
The stock dropped after the report and has been on a downward trajectory over the past few months because of worries around inflation and the impact of rising interest rates on the home furnishing market. Specifically, Friedman said on the conference call that the company has been hit with supply-chain price increases and delays. It also saw a 10%-12% decrease in demand at the start of the Russian invasion of Ukraine. He speculates that rising interest rates and the potential of a recession could negatively impact the business. This creates a lot of uncertainty for RH over the next few quarters.
But if you take a longer view, things look potentially bright for RH over the next few years. The company has more room to open galleries in the United States -- and even more in newer markets like Europe with its proven, upscale home goods model. On top of continued retail expansion, RH is planning to expand its brand to hospitality, travel, and food. For example, it is testing out five-star restaurants at a few of its galleries, has bought private jets for its RH members to travel in, and is launching a hotel in New York City called the RH Guesthouse. These new initiatives are ambitious, but if successful they could open up RH's business to grow from $3.76 billion in revenue last year to tens of billions in annual revenue a decade from now.
So should you buy shares?
As of this writing, RH has a market capitalization of approximately $8 billion. Last year, it generated $927 million in operating income and $477 million in free cash flow, giving the stock a price-to-operating income (P/OI) ratio of 8.63 and price-to-free cash flow (P/FCF) of 16.8. Both metrics are rather cheap compared to the market average, making the stock look attractive on a trailing basis. But on a forward basis, things could look worse over the next few years depending on how you think inflation and supply-chain troubles could impact the business.
Short-term headwinds aside, RH stock could be a great buy at current prices if you believe in the long-term vision to expand out of retail and into food and hospitality. There is a lot of uncertainty about expanding into new categories because it is unclear how consumers will respond to these restaurant and hotel concepts -- and that does add some risk to the investment.
But if RH can execute on its vision and get to $10 billion and 30% operating margins, the business will be doing $3 billion in operating income sometime in the future. I don't know exactly what the business would be valued at with those financials, but there's a high probability it would be higher than the $8 billion it is valued at today.
