Can This Retailer Continue Its Winning Streak?

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

Restoration Hardware (NYSE: RH) is having a wonderful year. Its stock is up 117%. It started its furious rise at the beginning of May, and most of its yearly gain was made since then. When you see a pace like this, a natural question comes to your mind: Is this sustainable?

The home-furnishing retailer has taken advantage of the favorable market situation and posted good growth figures in its quarterly report back in June. Investors have cheered the report and have pushed the stock sky-high. At current prices, the stock is trading at 37 forward P/E. Although Restoration Hardware operates at a high end of the market, we can compare its valuation to other furnishing stores of similar market capitalization, such as Pier 1 Imports (NYSE: PIR) and Williams-Sonoma (NYSE: WSM)

Premium goods, premium valuation

Pier 1 trades at 15.5 forward P/E, while Williams-Sonoma trades at 18.5 forward P/E. If Restoration Hardware were to trade at 20 forward P/E, it would have had to double its earnings. First, why do I choose 20? If the stock trades at a big premium to its peers, it has high growth expectations. At one point in the future, the company would have to meet them, or the stock would be slashed. As Restoration Hardware had high growth momentum, I chose a forward P/E number which was higher than its peers' numbers but still close to them.

Restoration Hardware has raised its full-year 2013 revenue growth guidance to a 23%-27% range. If profitability stays the same, the company would be able to double its earnings in just three years if the company manages to grow in line with its expectations. Plausible? Yes.

Let’s go to the price-to-sales ratio. Restoration Hardware trades at 2.05 P/S, Pier 1 trades at 1.48 P/S and Williams-Sonoma trades at 1.31 P/S. If Restoration Hardware were to double its revenue, it would be trading at 1.02 P/S at today's prices. I guess that such a low P/S would not happen, and the price of the stock would rise from current levels.

Growth prospects

What does this comparison mean to investors? Restoration Hardware is expected to post good growth, hence it is trading at a premium to other stocks in the industry. The company has stated that it would add two new catalogs to its offerings this fall, continuing to expand its offerings.  Pier 1 and Williams-Sonoma are similarly valued compared to each other. Both stocks have experienced growth this year. Pier 1 is up 22%, while Williams-Sonoma is up 37%. Pier 1 is trading 10% below the analysts’ mean target price. Williams-Sonoma shares have surpassed analysts’ target price by 6%. All in all, both stocks seem fairly valued. I do not see where these companies would get that extra growth that is needed to outperform the market. You can expect these stocks trade more or less like the S&P 500.

Restoration Hardware is in negotiations to open stores in over 30 markets in North America. The cities it plans to target include New York, Chicago, Miami, and others. In addition to that, Restoration Hardware states that it is going through the process of redesigning the real estate that it has. Once the transformation ends, the company hopes it would drive more sales per square foot. Going in the opposite direction from other retailers that put more emphasis on digital, Restoration Hardware moves to bigger stores and larger catalogs. As of now, the strategy is working well. These facts paint a picture of a growth story, but one important thing has just happened that raises some questions. 

Restoration Hardware has just announced its secondary offering of shares. The market did not like the news, and the stocks dropped 3.8% on the day of the announcement. The company would not receive the money gained from the offering. All the money would go to existing large shareholders, who are selling stock. This means they are fixing their profits. It is not a good sign from an investor's point of view. 

Bottom line

Restoration Hardware has set the bar high. In the coming earnings reports, the company would have to meet expectations. Otherwise, the stock would be punished. I think that the stock is fairly valued. At the current state of things, I can see more downside then upside, especially in the short term. The stock has gone up fairly quickly, and now it presents very healthy profits to those who invested in the company prior to May. By the way, insiders seem to think the same way too, given the secondary offering. Some of other investors would be considering their exits at the smallest hint that the growth is slowing down. 

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Vladimir Zernov has no position in any stocks mentioned. The Motley Fool recommends Williams-Sonoma. 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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