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RESTORATION HARDWARE GOES UPSCALE AGAIN TO SHAKE SLUMP

By Brad Berton

A profitability restoration plan is finally in place, says Gary Friedman, CEO of Restoration Hardware, a long-troubled home furnishings chain. And it should start bearing fruit this year, he promises.

The company’s merchandising strategy is once again focused on exclusive, high-margin core goods, and its brain trust is making considerable progress on resolving some persistent supply-chain problems. Meanwhile, the Corte Madera, Calif.-based chain’s catalog and Internet sales are growing quickly, Friedman told analysts in March on a fourth quarter 2005 earnings conference call.

Accordingly, Friedman says, the numbers are sure to improve steadily. “Now that our concept is in place, we should see consistent growth,” Friedman said. “We believe there’s a meaningful opportunity to increase comparable-store sales over the next several years.”

Further, the ongoing enhancements of the supply-chain system will generate “several hundred basis points of operating-margin gains in the years ahead,” he said. Following Restoration’s March release of its first outdoor-furnishings catalog, he projects that catalog and Internet sales revenues will be up 25 percent in the first quarter, on top of 50 percent the comparable quarter a year ago.

Wall Street expects Restoration’s net income to be somewhere between $5.5 million and $8.5 million this year, which will be welcome news to the chain’s justifiably concerned stockholders and landlords.

The company posted a full-year loss for the year ended Jan. 28 of $29.3 million (including a noncash, fourth-quarter charge of $27.9 million for tax-related reasons and some $70 million in losses for most of the past six fiscal years). Restoration eked out a slight profit of $1.7 million for 2004 only.

Though some are skeptical about Restoration’s long-term prospects, Friedman’s management team remains optimistic that this renewed emphasis on its high-demand core lines will enhance the bottom line.

“We feel we’re very well positioned in all of the categories we’re competing in now,” Friedman said on the conference call. “And we should continue to gain market share in the categories we’ve positioned ourselves around.”

The company did not respond to requests for an interview with SCT.

Restoration’s core offerings include cabinet and door hardware, bath hardware and accessories, bed and bath textiles, window treatments, lighting and select furniture. Flemish mirrors sell for up to $799. On the lower-price end is a set of six cheese plates decorated with New Yorker cartoons, for $9.99.

Friedman has made a believer of Crystal Lanigan, a specialty retail analyst who covers the 109-store chain for D.A. Davidson & Co., in Lake Oswego, Ore. Among the factors Lanigan cites for profitability ahead are an increase in exclusive merchandise and the number of already closed underperforming stores.

Despite “prolonged weakness” in furniture, furnishings, housewares and hardware retailing, Lanigan says Restoration’s long-term prospects are promising. She predicts that the company will earn about $5.7 million this year.

Now that the bulk of Restoration’s smallish gift and accessory items have been edited out, as much as 80 percent of current sales come from mostly high-margin merchandise “that wasn’t relevant four years ago,” Friedman says. He acknowledges that customers have yet to embrace the dramatic merchandising revisions to the extent the company hoped, but they will come around, he says. Though same-store sales were off a bit during the holiday season, management says it had expected a dip in comps and is set on waiting things out.

“We expect positive comps to return in the first quarter, and we think we’ll be a positive-comping company while we continue growing our direct-to-customer business,” Friedman said. Even after years of enhancements, the chain still has problems keeping stores adequately stocked with furniture and other items. But Friedman says new inventory control measures will help. “We anticipate real improvements [in 2006] in inventory turns and in-stock percentages,” Friedman said. Among this year’s key tasks are the upgrading of Restoration’s order-management platform, which will include installation of ordering terminals in stores, and a warehouse-management system.

But one retail consultant sees Restoration’s slumping stock price as an indication that Wall Street is not convinced of the chain’s long-term viability. The stock has languished at below $6 on the Nasdaq for much of 2006, only a quarter of what it went for when the company went public in 1998, when shares briefly traded for $35. The 52-week high was $9.02 last July, but with the exception of that spike, shares have mostly been in the $3 to $7 range for four years.

“To me, that says Wall Street sees a 50-50 chance of them going bust,” said Howard Davidowitz, chairman of Davidowitz & Associates, a New York City-based retail consulting and investment banking firm. “It could go either way.” Friedman is highly respected for orchestrating the Pottery Barn furnishings chain’s success in the late 1990s, but Davidowitz isn’t ready to declare him the savior so many had anticipated when he arrived to right the Restoration ship in 2001.

“It ain’t saved,” said Davidowitz. “It’s still in survival mode.” The Friedman team’s merchandising strategy lacks sufficient freshness and imagination, he says. “They’ve been moving the deck chairs around, but they’re still on the Titanic.”

Granted, Pier 1 Imports and The Bombay Company, Restoration’s chief publicly traded competitors, have likewise been facing questions about their survival, says Davidowitz. But all three in past years had captured shoppers’ imaginations with distinct merchandise and formats, and yet none has been able to maintain a compelling edge of late, he says.

By contrast, modest-price department stores JCPenney and Target seem to be gaining tremendous market share in the furnishings arena, Davidowitz says. “They’re working with designers on exclusive lines in those categories,” he said, “and hitting some home runs.” Now Costco is moving into the category too, he says, and even Wal-Mart has marked it as an area of opportunity.

Nevertheless Lanigan maintains a “buy” recommendation on Restoration’s stock. She says she sees the chain growing to somewhere between 150 and 175 units ultimately. New CFO Chris Newman told conference callers the chain will not open or close any stores this year (though a few more outlet units are possible), but Lanigan sees Restoration returning to “double-digit annual square-footage growth” as profitability improves.

Friedman says he aims to return the chain to the early and glory days just after the IPO. “They had merchandise no one had ever seen,” Davidowitz said of those days. “And it jumped out of their stores at tremendous margins.”

But with management’s failure to keep exclusives on the shelves, bankruptcy became a much-discussed option amid the company’s cash crunch and red ink. Shares deteriorated to penny-stock status even as the domestic economy still boomed during the 2000 holiday season.

Enter Friedman, who took a look and decided that “noncore” would equate to “nonrelevant,” then embarked on his move back to core exclusives and away from the impulse-type merchandise he likes to call “discovery items” — low-price, mass-market gifts and accessories.

Discovery-type items now account for less than 20 percent of the chain’s merchandise — down from nearly half.

The stores were remodeled last year to reflect this shift, with particular emphasis on perimeter walls that now feature core textiles and lighting merchandise that are always in stores. When Friedman took over, accessories and impulse-type items still covered 85 percent of the perimeter wall space.

The changes showed up dramatically during the third quarter of last year. Though sales transaction volume was down 24 percent from a year earlier, the average ticket was up 34 percent. Friedman says the revised model is more predictable and should smooth out profits over the course of each year without the “peak” activity that impulse items and accessories generate during the holiday season.

Lanigan agrees. “We believe the company’s multiyear turnaround initiatives are likely to contribute more consistent sales and profitability,” probably starting in the second half of this year, she said. She does have some reservations about Restoration’s supply chain, noting that, despite the ongoing overhaul, one in five deliveries is late and merchandise is out of stock more often. But she says she is encouraged that management is boosting production at domestic facilities, working with vendors on better inventory management and increasing delivery capacity.

Morgan Keegan & Co. analyst Laura Champine says the primary glitch disrupting the supply chain is the failure of its furniture-making subsidiary, Michael’s Furniture, to keep up with demand — despite a 40 percent year-over-year increase in output.

Though Restoration’s financial performance of late has disappointed Champine, she says management’s merchandising overhaul will ultimately pay dividends. “Gary Friedman’s manipulation of the product assortment has been well received by consumers.”

For his part, Davidowitz questions whether the merchandising approach can produce consistent profitability. “[Friedman] has been unable to come up with a merchandise mix that’s captured anyone’s imagination, and their sales are going nowhere if you look at the comps,” he said.

Davidowitz also thinks Restoration needs to keep its stores looking fresh with continual adjustment of sales floor arrangements every two or three months. “You need some imagination here,” he said. “You need to offer a reason for people to come into the store.”

Friedman acknowledges that the ongoing challenge is to keep improving supply-chain efficiencies while honing the merchandising model and making it more productive as well. Meanwhile, top brass continues coming up with initiatives to improve both the top and bottom lines, he says.

“We’ve got a lot of growth ideas as it relates to category extensions, brand extensions and market extensions that we’ll be unveiling over the next year or two,” Friedman said. “Now we’ve got a real business, so it’s a matter of building on it, refining it and making it stronger.”

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