Careful Before You Lounge Here

 | Dec 13, 2012 | 10:00 AM EST  | Comments
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After the close Wednesday, Restoration Hardware (RH) reported third-quarter earnings of $0.07 per share on revenue of $284.2 million. Revenue rose 22.2% year over year, in line with previous estimates. Same-store sales grew 29% on top of a 36% comps figure last year. It earned $1.7 million in the quarter, compared with a loss of $4.8 million last year. Since Restoration's public offering Nov. 2, the stock has risen approximately 14%.

Restoration Hardware is no stranger to being a publically held company. The high-end furniture retailer had been public until mid-2008, when a pair of private-equity firms had acquired it. The company ran into trouble because it expanded too quickly and found lots of ways to lose tons of money. The timing here turned out to be fortunate, because the company ultimately avoided reporting all sorts of nasty financial results during great recession. For example, between 2008 and 2010, sales fell 13%. The last full year the company was public, it managed to lose $51.9 million on sales of $722.2 million.

During the company's hibernation, management restructured Restoration Hardware. It reduced the number of stores to 73, down from 102 in 2008. The remaining stores were renovated, and the company began to shift the focus towards larger "gallery" stores, where more furniture could be showcased. Gallery stores are typically three times the size of its existing stores. Restoration Hardware also enhanced the quality of its merchandise, trying to position it into the luxury-furniture market and to build a true lifestyle brand. It is now building flagship stores in affluent communities such as Boston; Greenwich, Conn.; and Scottsdale, Ariz.

Previously, the company designed and manufactured a small quantity of furniture. Now, it merely curates a large number of pieces produced by Chinese furniture makers. That speeds time to market, reduces inventory and lays off the manufacturing headaches to someone else. Management believes these changes, as well a $60 million investment into its supply chain and back-office operations, will dramatically improve profitability.

The furniture patch is a low-single-digit-growth business, and it's highly competitive, especially at the high end (defined as those catering to households earnings more than $200,000 a year). It seems to me Restoration Hardware is trying to position itself above Ethan Allen (ETH) and compete head-on with Baker Furniture, which is usually the first stop right before a customer buys custom-made pieces.

The stock already factors in a lot of good news. I've seen price targets as high as $43, or about 42x fiscal 2013 estimates of $1.02. But I would be reluctant to pay that kind of a premium for a company that has shown, in the past, that it can't make money.

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