An Under-the-Radar Growth Opportunity In a Booming Home-Improvement Space

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

While many prefer Home Depot (NYSE: HD) as the investment of choice in the home improvement space, I've found three reasons why a small, relatively unknown company might present more upside moving forward. 

The Key Metric in Any Retail Assessment

Many would agree that success in retail is defined by the ability to grow existing stores. A company can always create new stores in new locations to boost sales. However, it is harder to get new customers in the door of existing locations.

In order to effectively grow existing stores, a company must be highly competitive, with great marketing tools. The Home Depot has seen success in this area – and is expecting further success in 2013 with a 4% rise in same-store sales.

With total U.S. economic growth expected to be somewhere between 2% and 3% in 2013, Home Depot’s 4% growth looks impressive. However, it hardly compares to Restoration Hardware (NYSE: RH), a company expecting same-store sales to increase 26% year over year in 2013.

As same-store sales rise, a company creates more revenue per store. In theory, that can also help it increase both margins and returns on investment. These gains are often tied to the company earning more profit per dollar after store-related costs, which remain unchanged regardless of revenue growth. As a result, for a still-small company such as Restoration Hardware, same-store sales growth can become instrumental in creating long-term value for shareholders.

Just in case you don’t know, Restoration Hardware is a home improvement store, much like Home Depot.But rather than simply selling wood, lawn mowers, and tools, it sells “design.” The company offers luxury brands and provides ideas via catalog to customers who wish to remodel their bedroom, patio, or their entire house. These large purchases create high revenue-per-customer, which has allowed the company to grow through word-of-mouth; new customers want their neighbor’s living room, or want to remodel with luxury.

Room vor Outside Expansion

The Home Depot is a massive company, operating 2,257 retail stores domestically in all 50 states. While this is good for the company in gaining a large market share, it can be bad for its growth prospects.

Once a company is fully expanded, it has to rely on same-store sales growth and overall economic growth to grow year-over-year revenue. A company such as The Home Depot cannot build 10 stores and see a noticeable impact to its fundamentals, because it is already so large.

One the other hand, Restoration Hardware has plenty of revenue to gain from expansion. For the past three years, Restoration has operated just 71 retail stores and 13 outlet stores -- and for 13 consecutive quarters, it has seen double-digit growth.

Due to Restoration Hardware’s explosive same-store sales growth, the company has not expanded. However, according to its last quarterly report, it is exploring 20 potential new markets. With Restoration Hardware being a trendy store preferred by the wealthy, it could see great growth in markets such as New York or in Chicago. This outside growth represents an opportunity that Home Depot cannot offer to its investors.

Assessing Value

The Home Depot has produced revenue of almost $75 billion during the last 12 months. Therefore, it controls a large piece of the home improvement pie.

Restoration Hardware has created sales of just $1.19 billion during the same period -- but because of its growth – one might assume that it’s a pricey stock. However, Restoration Hardware trades at just 1.75 times sales compared to Home Depot’s 1.57 times its last 12 months of sales. The difference is that Restoration Hardware is growing its top line by more than 25%, while Home Depot is expected to grow just 4% in 2013.

With Home Depot being a large stable company, and Restoration Hardware being an aggressive growth company, we have to compare metrics that apply to both companies. Currently, Restoration Hardware is not profitable.

It has an operating margin of almost 2% for the last 12 months – but has invested the majority of its money back into the business. Therefore, the price-to-sales ratio is a comparable metric that is relevant in valuing both companies. In my opinion, the fact that Restoration Hardware trades at a price-to-sales ratio that is close to Home Depot -- but with six times the revenue growth -- is very encouraging for Restoration Hardware’s future performance.

Conclusion

Restoration Hardware is expected to become profitable next year. It operates in the same industry but is very different from Home Depot. While Home Depot might continue to produce strong annual returns, my belief is that Restoration Hardware presents a rare investment opportunity.

Restoration has great existing-store sales growth, room to expand, and is cheap on a sales basis. While these three areas of strength are not enough to justify a long position alone, they do provide a good starting point. Do your own due diligence to determine whether Restoration Hardware might make a good addition to your portfolio.

The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.


Brian Nichols owns shares of Restoration Hardware. The Motley Fool recommends Home Depot. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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