Restoration Hardware's Inflection Point Could Be Here

In the latest one-year period, shares of Restoration Hardware (RH) - Get Report are down almost 60%. But in the last month the stock has jumped 32% off the bottom. The stock even broke through $35 a share, a level that seemingly provided resistance. Is there a major inflection point ahead?

In September, I said I would wait for clear signs of a turnaround.

On Sept. 8, Restoration Hardware reported second-quarter earnings of 44 cents per share, 15 cents better than the consensus estimate. Revenue rose 7.2% to $543.4 million.

Despite the decent quarter, management lowered guidance for the third quarter. The company said earnings are expected to be between 13 cents and 18 cents per share, vs. the consensus estimate of 41 cents. Management foresees revenue of $520 million to 530 million, about $15 million lower than the previous estimate. The company said its newfound ability to ship products faster pulled revenue into the second quarter that had been earmarked for the third quarter.

In addition, management said it is making changes that are depressing its business model in the short term, but will lead to a much better 2017. The company is reducing inventory and rationalizing SKUs. It is also heavily investing in its RH Modern brand. The company even promised to unveil some of "the most significant initiatives in the history of the company" and believes it "will create a major inflection point beginning in the fourth quarter of fiscal 2017 and build momentum into 2017."

The Source Book release was pushed back from spring to fall to give the company extra time to revamp the entire catalog and better match the new RH Modern look.

Previously the company had blamed the poor results on weakness in the oil patch, the strong dollar, a slowdown in spending by the high-end consumer and supply chain problems.

Restoration Hardware is expected to end fiscal 2016 with 107 "galleries." Most RH Galleries are 45,000 square feet in size, and the company is adding restaurants, wine vaults and coffee bars at the four galleries that are slated to open in 2017 after a successful test at the Chicago location.

If Restoration Hardware can put together a strong quarter, I think the momentum will carry the stock higher. Analysts think the company will report earnings of 16 cents on $527 million of revenue.

Looking forward to next year, if sales simply stay flat at $2.1 billion, the company should be able to leverage its operating expense. Analysts are expecting Restoration Hardware to lower its spending on the rollout of the RH Modern brand next year. If the company can do that, operating margins would bounce back to the 9% level. Analysts are looking for operating margins of just 6% this year. With a 9% operating margin and a rebound in gross margins to 36% (from 33%), the company could add as much as $1 to earnings per share, earnings about $2.73 next year vs. the $1.73 this year.

Of course all that's speculation right now. For the time being, I will stay on the sidelines and wait for the company's results. If Restoration Hardware can prove to investors that it has greatly improved in the fourth quarter, the shares will go higher.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.