Restoration Hardware's luster is too bright

After climbing more than 50%, does the stock have any upside potential?

By InvestorPlace Dec 14, 2012 3:07PM

Bathroom remodel copyright Digital Vision, PhotolibraryBy Will Ashworth

iplogoHas this ever happened to you? You buy a stock through a company's IPO, then it lays an egg releasing poor earnings within months of its coming-out party. I haven't read any studies about the frequency of such occurrences, but I'm sure it happens a fair bit.

That's why investors might have been jittery over Restoration Hardware (RH), which went public Nov. 1, then six weeks later announced third-quarter results.

Whew! They were excellent.

Technically, Restoration Hardware ended the third quarter as a private company (Oct. 29 quarter-end) but it was the first opportunity to present its financial situation on a publicly traded basis. Regardless, investors see a company that is full of promise and firing on all cylinders. So it's time to pile in, right?

Not necessarily.

First, lets get the Q3 earnings report out of the way. Restoration Hardware's revenues increased by 22% year-over-year with same-store sales growth of 29%. Its websites and catalogs grew 24% in the quarter, with online sales delivering 44% of its $284.2 million in overall revenue.

You have to love any retail business with that kind of online presence because it definitely helps on the bottom line. Excluding one-time items -- such as $2.8 million for the investigation of former co-CEO Gary Friedman's relationship with a female employee -- RH adjusted net income in Q3 was $2.7 million, 145% higher than in the same quarter a year ago.

For the first nine months of the year, its adjusted net income increased 95% to $13.6 million. In fiscal 2007 -- the year prior to Catterton Partners acquiring Restoration Hardware for $175 million cash and the assumption of $111 million in debt -- it lost $52 million on revenue of $722 million.

When you consider that RH finished the third quarter with 516,000 square feet of retail selling space, or 25% less than in fiscal 2007, Catterton and all of the company's employees have delivered a winning transformation.

Not only is Restoration Hardware transforming financially, it's also changing the way it does business. It's moving from a mall-based retail footprint to full-line Design Galleries averaging 21,500 square feet, approximately three times the current average. RH feels that by utilizing this larger store concept, over the next seven to 10 years it can realistically double the amount of selling space in the U.S. and Canada.

In the first nine months of fiscal 2012, Restoration Hardware increased its sales per square foot by 36%. Assuming it reaches its goal of doubling its selling space in seven years, its revenues could easily be $2 billion or more. Based on that kind of buying power, it's not unreasonable to assume its operating margin will meet or exceed Ethan Allen's (ETH), which is currently 6.6%. If so, you're looking at earnings per share of $2.70; thus, a forward price-to-earnings ratio (albeit 2019) of 13.

Now this is where it becomes a difficult investment decision.

Like many IPOs, Restoration Hardware got off to a hot start, rising 30% in its first day of trading and another 18% from there over the following month. In total, RH shares have gained 53% on their IPO price of $24. However, fast starts are often followed by a period of underperformance, usually brought on by a mediocre quarter or two. It's not unusual for new issues to be trading below their IPO price within 12-24 months of going public.

Restoration Hardware's six weeks of gains have given it an enterprise value of 22 times EBITDA, compared to 12 times for Ethan Allen and eight times for La-Z-Boy (LZB). At the IPO price of $24, you were at least looking at something comparable with Ethan Allen.

I really like what management has done with Restoration Hardware. However, it has only rolled out three of the larger concept stores. While early indications are very positive, there's no guarantee that things will continue to go its way. Therefore, unless you're planning to own Restoration Hardware for the long-term -- say three to five years -- I'd hold off buying its stock until it's below $30.

Then you'll at least be paying a fair, if not bargain price.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

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