RH (RH, Financial), the luxury home furnisher which is part of Berkshire Hathaway Inc.’s (BRK.A, Financial) (BRK.B, Financial) portfolio, reported lackluster earnings for the fourth quarter of 2022 on March 29, sending its shares lower in after-hours trading.
The earnings report brought the rising costs of the company into the spotlight, with RH guiding for a challenging 2023 ahead. This did not impress investors, which is understandable given they are accustomed to stellar growth from the company in the last few years. Although this year is very likely to be a challenging one for RH, long-term-oriented investors are likely to find the company an attractive bet today.
Deteriorating financial performance
For the fourth quarter, RH reported adjusted net revenue of $772 million, a notable 15% decline from the prior-year quarter. Gross margins contracted by more than 200 basis points, while adjusted operating margins contracted by a staggering 860 basis points, driving the company's profitability lower. The adjusted net income for the quarter came in at $73 million, a sharp decline from $164 million reported a year ago.
Revenue, gross margins, operating margins and net income trended lower for the full fiscal year as well, highlighting the struggles the company had to face in 2022.
Despite the decline, the company’s guidance for 2023 gave investors the most cause for concern. RH now expects revenue of $2.9 billion to $3 billion in 2023, which suggests sales will slump by at least 16%. For a growth company that has attracted premium valuation multiples, a decline in sales of this magnitude is likely to hurt share prices. The company cited several major factors that influenced its projections.
First, mortgage rates have risen sharply in the last 12 months along with the federal funds rate, which has led to a slowdown in home sales. RH is a luxury home furnisher that attracts affluent clients, and the company will be negatively impacted by a slowdown in high-value home sales. According to recent data from the National Association of Realtors, sales of homes with a value exceeding $1 million declined by 29% year over year in February, building on the declines reported in the previous few months.
Second, surging inflation has resulted in higher operating costs for RH, which makes it difficult for the company to expand its operating margins. Supply chain pressures have not fully eased, so despite a slowdown in inflation, costs remain materially higher compared to 2020 and 2021.
Third, economists predict a more than 70% probability of a recession this year according to Bloomberg, which suggests consumer discretionary spending can decline from here. Since RH sells high-end furniture, it would not be a surprise if the company comes under pressure.
As such, RH is moving into the year having to overcome multiple challenges.
The long-term outlook remains bright
Although RH is facing several short-term challenges that are likely to dampen its earnings, investors should ideally focus on the long-term picture for the company.
RH has positioned itself as a leading luxury furnisher in the U.S., which should help it earn returns that far exceed its cost of capital for a long period of time. The current slowdown in the housing market is not permanent, and high-value home sales will likely resume their growth trajectory when the economy enters the next phase of the business cycle. Interest rates, on the other hand, will not remain elevated forever either, though the market is finding it difficult to look past the restrictive monetary policies that have made life difficult for growth companies today.
The United States – and the global economy for that matter – has gone through difficult periods where interest rates and inflation have remained elevated for a few months, only for normalcy to prevail in the end. Given that supply chain pressures are continuing to ease with the reopening of China, cost-push inflation will show some improvements toward the end of this year, paving the way for RH to finally focus on improving its operating margins. Even after deteriorating in the last few quarters, RH’s current operating margin remains almost 1,000 basis points higher in comparison to the average reported margins before 2019. These gains are now being masked by macroeconomic challenges, but in the long run, it will emerge as a stronger, more efficient company aided by the operating efficiencies it realized at the height of the pandemic.
RH’s planned international expansion deserves credit as well, though the market seems to be oblivious to this commendable strategic decision. RH England will open this summer and the company has drawn plans to expand into populous European cities such as Brussels, Dusseldorf, Munich and Madrid in the next 18 months, followed by Paris, Milan and Sydney in the longer term. Europe, which is the most important strategic market for the personal luxury industry, will open new doors to growth for RH in the coming years.
Takeaway
RH's stock came under pressure with the fourth-quarter earnings release. The short-sightedness of Mr. Market presents long-term-oriented investors with a good opportunity to consider taking advantage of the discounted price. Trading at a forward price-earnings ratio of 14, RH looks cheap as the company still has a long runway for growth.
