RH stock is up, but there are warning signs for investors

Luxury furniture company RH (RH 25.49%) has been dealing with a difficult home furniture market in recent years as the pandemic has drawn a lot of demand for furniture when people are stuck in their homes. However, the company saw its stock rise recently following its second-quarter results as RH (formerly Restoration Hardware) managed to generate revenue growth.

While investors have sent stocks soaring, I believe there are a number of warning signs that things may not be as positive as they seem. Let’s take a closer look at the company’s results.

Revenues are rising, but some metrics are troubling

For the second quarter, revenue rose nearly 4% to $830 million, well above analysts’ expectations of $824.5 million.

Gross margins fell 230 basis points to 45.2% and adjusted operating margins fell from 20.2% to 11.7%. This is the first warning sign: The company appears to have significantly increased its marketing spend to show modest revenue growth, crushing operating margins in the process. Adjusted earnings fell 62% to $33.5 million.

Another area of ​​concern is the large increase in inventories, which went from $737.7 million a year ago to $917.3 million, a 24 percent increase. Some might argue that the company is stocking up for the holidays, but remember that this is a year-over-year comparison, and the company only grew sales by less than 4%. It’s generally not a good sign to see inventory and sales rise this far.

The company also saw a 35 percent increase in its accounts payable to $496 million from $366.6 million earlier in the year. And its deferred revenue and customer deposits rose just $19.7 million, or 7 percent, to $302.5 million. This could be an indication that RH is extending the time it takes to pay its suppliers.

The company made a big push in Europe with some big new store openings. But how well these stores are doing is uncertain. On the earnings call, the company said it’s still learning from these openings and hasn’t opened them in the order it wanted, which seems to indicate it’s not doing great. Given that new store openings are often met with increased interest and traffic, this is not a good sign.

Looking ahead, the company lowered its full-year revenue growth guidance. Revenue is now expected to rise 5% to 7%, down from a previous forecast of 8% to 10% growth. It forecast demand growth in the 8% to 10% range, down from a previous forecast of 12% to 14%. (Demand is the dollar value of orders placed.)

For the third quarter, RH estimates revenue growth of 7% to 9%, with demand growth of 12% to 14%.

Image source: Getty Images.

Time to avoid the stock

CEO Gary Friedman has a reputation for making bold moves. For example, in 2017 he made a big bet on the company, taking on debt to buy back more than half of the company’s stock. It was a gamble, but it paid off.

More recently, Friedman is betting on a boost in Europe. But this isn’t a typical European retail push — the company is opening huge, grandiose stores in markets where it has no presence and likely minimal brand recognition.

Entering the luxury furniture market in Europe is no easy task, but the company has done it all, spending a massive amount of money and taking on big leases in the process.

From a valuation perspective, RH trades at a forward price-to-earnings (P/E) ratio of 24, based on analyst estimates for the next fiscal year. For a company that has struggled to grow revenue, that’s a pretty expensive valuation.

Data on RH PE ratio (1 year ago) by YCharts.

Given its valuation and the warning signs noted above, I’d stay on the sidelines with RH stock. The company has benefited from big bets in the past, but that doesn’t mean its European expansion will be a success.