Restoration Hardware Has Huge Upside Potential

By Markets Fool.com

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Image source: Restoration Hardware.

Restoration Hardware(NYSE: RH) was at one time a stock market darling. The high-end home-furnishings retailer more than tripled from its 2012 IPO to its peak last year above $105. However, since then, things have unraveled for the stock after a series of unforced errors and macroeconomic effects pushed the stock down nearly 70% from its all-time high.

Now, after beating earnings estimates for the first time in three quarters last week, the stock may be on the mend, solving some of the issues that plagued it earlier.

A year to forget

The retailer's troubles began on Nov. 13 last year, the day of the Paris attacks. TheS&P 500lost more than 1% that day, prompting a 6.5% drop in Restoration Hardware shares. The retailer, with its select clientele, is sensitive to tourist spending, as well as to foreign currency exchanges and other factors that could be affected by terrorism.

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The stock slipped again on its December earnings report, as revenue growth slowed to 10% and the stock slipped 14% over the span of a week. At this point, Restoration Hardware had been a dependable growth stock and had just turned its 23rd consecutive quarter of double-digit revenue growth.However, investors seemed to believe the deceleration boded poorly for the year ahead.

In early 2016, the stock continued to slump, falling along with the broader market as shares fell 35% until it gave preliminary guidance on Feb. 24, which sent the stock down 26% in one session as investors' prior fears seemed to be confirmed.

While sales continue to grow at a steady pace, earnings were flat and well below guidance as the company said that market conditions had changed significantly.CEO Gary Friedman cited three problems in the quarter. First, shipping delays caused RH Modern orders to be unfulfilled, meaning revenue grew more slowly than orders. He also noted issues in markets affected by currency and energy prices, as sales in Canada, Texas, and Miami were particularly slow. Finally, he also believed there was a pullback in spending from the high-end customer in part because of the stock market correction at the time.

By then, much of the damage to the stock had already been done, as it traded near $40 for the next few months. In May, the stock fell further following a management shake-up and plummeted in June on another disappointing earnings report. Management cited the same excuses, including energy and currency fluctuation, a slowdown in the luxury consumer market, and shipping delays. Shortly after, the stock touched an all-time low at $24.75, but it has regained more than 40% since then.

Where the company stands today

During the course of the stock's plunge, the company implemented a number of significant changes. It introduced RH Modern, an entirely new line of furnishings that the company says combines "a fresh and compelling minimalist aesthetic with the comfort and quality that define the RH brand." It also transitioned from a promotional model to a membership one with the introduction of the Grey Card, which provides a 25% discount on all RH merchandise for a $100 annual fee.

Much of Restoration Hardware's recent problems may be attributed to transitions in its sales model and the rollout of RH Modern, especially the shipping issues, which seem to have passed. The strong dollar and drop in oil prices have also complicated the transition.

In its most recent quarter, results topped expectations, sending the stock up as much as 13%, as the company was able to ship products earlier than anticipated, pulling revenue from the third quarter into the second.It's now attributing a reduction of $0.90-$1.00 in EPS for the full year because of this year's temporary costs and sees full-year EPS of $1.60-$1.80.

CEO Gary Friedman has touted the response to RH Modern and to the Grey Card, and he has demonstrated his retail wizardry before saving Restoration Hardware by casting it as a high-end brand.

The transition is still a work in progress, but if the company pulls it off, the stock could double or triple, as Friedman has set a long-term goal of $4 billion to $5 billion in revenue, double from where it is today. Nearly 40% of the stock is sold short, but that also provides an opportunity for bullish investors, as the stock could easily pop in a short squeeze.

Restoration Hardware's success isn't guaranteed, but for risk-seeking investors the potential reward is well worth the risk.

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Jeremy Bowman has no position in any stocks mentioned. The Motley Fool recommends Restoration Hardware. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.