With shares up 95% over the last five years, RH's(NYSE: RH) stock has slightly outperformed the S&P 500 index, which has risen 88% over the same period.
And while the company faces near-term challenges like high interest rates and a slow housing market, its long-term thesis remains intact. Let's dig deeper to see if the company can maintain market-beating performance over the next half-decade.
What makes RH unique?
Founded as Restoration Hardware, the company now known as RH started as an affordable hardware and fixture business in major U.S. cities. But its big pivot came with the arrival of CEO Gary Friedman in 2001. Friedman understood that wealthier people have bigger homes and spend "exponentially" more to furnish them. He shifted RH's strategy from knickknacks to high-value items to serve this clientele.
Branding is crucial in the luxury goods business, perhaps as much as quality or design. Under Friedman's leadership, RH has invested deeply in brick-and-mortar at a time when most of the retail industry embraced digitization. The company has turned its flagship stores into galleries, with some featuring high-end restaurants and bars. It has also created a membership program where VIP customers can receive product discounts, complimentary interior design services, and financing for an annual fee.
The end goal of all these efforts is to increase operating margin, a metric that soared for much of Friedman's tenure before running into a roadblock in 2022 as macroeconomic challenges started to mount.
RH Operating Margin (TTM) data by YCharts
Can RH bring back its once-incredible business model?
While management might disagree, RH has arguably reached the limits of its luxury transition. And attempts to move further upmarket could lead to diminishing returns by potentially hurting sales volumes or customer satisfaction. There is inherently a smaller pool of wealthy buyers, who will probably be more discerning about their purchasing.
In the near term, RH's biggest growth opportunity will probably come from macroeconomic factors outside its control, like interest rates, inflation, and the strength of the housing market. There are some signs that things might be slowly improving.
Image source: Getty Images.
Second-quarter revenue rose by a modest 3.6% year over year to $829.7 million, while adjusted earnings per share (EPS) fell from $3.93 to $1.69. None of that is impressive. However, management is optimistic about the future, projecting third-quarter revenue growth of 7% to 9%, which could be the start of sustainable recovery over the next few years.
The macroeconomic picture is also improving, with the Federal Reserve expected to cut its benchmark rate in September. Analysts at Morningstar believe the federal funds rate could go as low as 2% by the end of 2026 compared to an average of above 5% this year. The lower rates will stimulate homebuying and credit card purchases, which are key drivers of consumer spending on RH's furniture and home decor.
What will the next five years have in store?
Over the next five years, expect RH to benefit substantially from the improving macroeconomic situation and the fruits of its transition into a luxury brand. And while the stock is expensive, with a forward price-to-earnings (P/E) multiple of 39 compared to the S&P 500 average of 23, it can grow into its valuation if operations rebound.
That said, investors shouldn't underestimate the risk of an economic downturn, which would probably derail RH's recovery. J.P. Morgan puts the probability of recession at 35%. And RH's discretionary products would likely face an outsize negative impact in a weak economy.
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Will Ebiefung has no position in any of the stocks mentioned. The Motley Fool recommends RH. The Motley Fool has a disclosure policy.
