Arhaus (ARHS) Earnings Call Transcript & Summary

All right. We're in business. Hi, everyone. Good morning. It's Simeon Gutman of Morgan Stanley's hardline, broadline and food retail analyst. Welcome to day 1 of our Global Consumer and Retail Conference. I'm pleased to introduce Arhaus represented by Michael Lee, CFO. It's an interesting crossroads with a housing home improvement, home furnishings world that is stagnant, but starting to show some signs of life. This is an eclectic growth story with a neat mix of showrooms and product. And it feels like it's getting the short end of the stick from the market in terms of valuation. So -- to start off, I'll ask a question. Oh, we will be taking audience questions at the end if there's time. I also want to just read an important disclosure for important research disclosures, please see www.morganstanley.com/researchdisclosures.

And with that, I'm going to ask the first question, sit down and have a chat. Michael, to start off for anyone in the audience who may be newer to the Arhaus story, can you give a high-level overview of the business? How would you describe what differentiates the brand in the home furnishing landscape?

All right. Well, thank you for that. And I just want to say upfront, I agree with you, we're undervalued. Thank you, Simeon. But yes, I'm happy to give a quick overview of Arhaus. We are a high-end, high-growth furnishings brand with a resilient business model and a very affluent client base. We designed nearly all of our products in-house, and we have an ecosystem of artisans and craftsman around the world, relationships that our CEO, John Reed, has built up over many, many years, and in some cases, many decades. And -- through these relationships, we have incredible control over design and craftsmanship, allowing us to bring luxury products to our clients at a great value. And one little known fact is when you come to an Arhaus showroom, nearly 90% of the products, in fact, I think a little over 90% of our products, you can't find anywhere else, right? These are exclusive products to Arhaus, which makes the shopping experience one of discovery. With respect to our clients, our clients are really interesting. I would call it a differentiator for Arhaus. They're very engaged in the Arhaus brand, and they tend to be affluent, they tend to be very design forward and they prioritize quality and long-term investment above all else. And we continue to see very healthy demand. We get asked all the time, what's going on with the high-end consumer, what's going on with cancellations, what's going on with engagement levels? And it continues to be very positive. In fact, one of the things we've noticed in our business when we team up our affluent clients with one of our interior designers, which we provide to them for free, free of charge, the order values on those transactions tend to be 4x greater than orders when there is no interior designer involved. So it's a real driver of our business. So we see a lot of growth ahead. We reach our clients through our omnichannel platform. We have over 100 showrooms across the United States. We operate multiple showroom formats, but I'll save that for later. We also have an e-commerce business. We have an in-home design program, and we have a growing trade business. And when I say trade, just for the next 40 minutes that we're together, trade is a term to describe business that comes to us through a third-party interior designer, right? So this is a client that's hired their own designer and working on a project, and those people oftentimes choose Arhaus because of the depth and breadth of our assortment. So that's our trade channel, which we're really excited about because that's a big area of growth for us. And just in light of the growth, Simeon, we are investing for the future. We see a lot of growth ahead, and we are in the midst of a digital transformation at Arhaus to really put in place a scalable digital platform for growth that will allow us to grow efficiently over time, really targeting to improve EBITDA margins over time and improve our SG&A load over time through really modernization of our tech stack. So we're really excited about that. But -- at the end of the day, we are a very differentiated, design-led brand with a very affluent consumer base. And we've got a proven model that we're really excited about. So we're focused on really scaling with discipline.

Thanks for the overview. We're going to touch on almost every one of those topics.

Okay.

One random one you mentioned -- I mentioned eclectic, you said artisan brands, some of this that John have cultivated over the years. One of the impressions when we were getting to know the brand is then how do these suppliers scale with you. You're growing rapidly, they're unique, they're smaller, they're more crafty. So how -- was that a perception that you had when you came to the business?

Well, it's been interesting. I had the opportunity to go to Southeast Asia a couple of months ago to meet with some of our suppliers. And I was just really struck by the engagement and the partnership. I spent 20 years of my career in the wine business. And one of the things I learned from the wine business is that your business begins and ends with your growers. And there's a lot of parallels at Arhaus in that regard in that our craftsman and artisans around the world are in many ways, our lifeblood to the business. And we've taken a very I'd say, partnership-oriented approach over the years, we don't squeeze our suppliers. We really view it as a partnership. We do collaborate on product design. We do regularly engage with them on product quality, making sure that it hits Arhaus standards. But Simeon, with the recent tariff movements, we've had suppliers completely pick up and relocate across borders for us to support our business. So absolutely, we've seen many examples where they've been willing to invest behind Arhaus to continue the partnership.

'25 has been a better year than '24 for the industry. There are more than signs of life that potentially signs of vibrancy. So looking back at how '25 has played out versus what you expected, what's been the biggest surprise, and if you would be willing to share how that sets us up for 2026?

Sure. Yes. Well, I wasn't in the industry in 2024, but I will say that 2024 was a more challenging year for the industry, just managing through an election year with heightened levels of uncertainty with respect to macro backdrop. But in the last 2 quarters, it's been a real interesting period, a little bit choppy when you think about the volatility of the business, and I'll come back to that in a minute. But when you look at our growth over Q3, it's been pretty impressive. July, we had one of our strongest growth months ever. One of the things we measure in our business is what we call demand, but it's akin to what orders we've received from the customer. And because of our business model, there's sometimes a 4- to 6-week delay between order and receipt. We track orders as a concurrent indicator of demand, right? And then when we fulfill and deliver to the customer, that's when we recognize revenue. So demand is, in some ways, a leading indicator of what's coming to the P&L. And in July, we were up 15.7%, just a real strong growth rate for us in the summer and the summer continued to be very strong. In fact, when you flash forward to September, we do our store-wide sale 2 times a year, once in January, once in September, and September was just an absolute upside surprise for us than that the fall collection was very well received. We released our catalog, our fall catalog, right around that time, and we also introduced our fall collection. We had our biggest month ever in September, and we achieved a number of records during that store-wide sale, which I think are, in some ways, evidence that our strategy is working. We had record levels of newness, and that's been a concerted effort by our product development teams and merchant teams to really lean into newness. So we had record levels of newness, so the clients are voting that we're doing the right thing. We had record levels of upholstery sales. We had record levels of customization. And when we talk about customization, this is an area we're quite proud of, but when you come into Arhaus, into a design studio or into a traditional showroom, and you see a piece of furniture such as a sofa, you may decide, I love the sofa, I don't like the fabric. We can walk you to our fabric wall, and we have the largest assortment in the high-end luxury business for furniture over 600 fabrics to choose from and over 90 leathers to choose from. And we can walk you through the differences between all of these fabrics, and we can have a custom-made sofa to you in about 6 weeks. So that's a great example of our strategy really coming to life. We achieved record levels of customization in September as well. So consumers are really voting for the fabrics that we're offering. We also had record levels of trade business in September as well. So that's a great validation, if you will, that we're doing things right when you have third-party interior designers choosing Arhaus, and coming to us because we have the best selection, the best variety, the best quality. So we're real happy with how our Q3 performed as we flash forward into 2026. We're in the midst of our planning cycle now, Simeon, but we're really excited about what's coming. We are coming into what will arguably be our largest pipeline of new products in the history of Arhaus. Our CEO, John has been really pushing on the teams to innovate and to move more quickly when it comes to new product introductions. And his efforts have paid off. He can be quite motivating in that way. And we've ended up pulling forward a lot of our innovation into the spring because there's so much momentum in the business. So we're really excited about next year.

I want to clarify maybe the cadence of the third quarter. And if you're willing to take a gander on how the third quarter success could translate into holiday season. But you mentioned September was great. We talked on the call that there was some decel in October. You also said your regular sale or event September. Was there anything pulled forward? Did the calendar change and did anything in the competitive environment? Because it still sounds lumpy the way the year, but trending in the right direction.

Yes. If you look at our demand, our comparable demand through Q3, which is essentially same-store comparable sales on an order basis, orders received, we were up 2.8% through Q3. And if you play that out month by month, you will see a bit of a seesaw effect in our business throughout those 9 months. And some of that is the natural seasonality of our business. We grew in January. We had a fantastic January, September store-wide sale. And then business was a little bit softer in February and then March was great. And then in April, we had the big Rose Garden tariff announcements. And hence, we were down a little bit in April. And then we're back up in May and every month since then, it's been a bit of a seesaw. But I think the one that caught maybe more attention during our Q3 call was following a very strong Q3, a very strong September, we had a softer October. In fact, we were down, I think, around 14.8% in October. And a few notables on that. Number one, October tends to be one of our smaller months. And you tend to see that when you follow a big store-wide sale, the following month tends to drop off and those are all for obvious reasons. But we also made a decision as a management team to modify our promo calendar a bit. In the prior year, there was a business decision to extend the September store-wide sales into October. That was kind of a one-off decision, and we talked about 2024 being a tougher year. So I think a lot of it stems from that. This year, we elected to not extend the September store-wide sale through October and to really get even more focused on our programming time lines. But we also did this because with all the tariff impacts, we were looking to October to take some price increases. So it was really us trying to have a clean break between September, a store-wide sale and implementing price increases and not having confusion with consumers on the side of pricing. So look, the business has been choppy, some of which is just driven by the macro backdrop, I mentioned how our consumers are very affluent. They're not necessarily driven by the same things that the average Americans driven by. A lot of their purchase behavior comes back to things like the wealth effect or how much home equity they have. That drives their behavior more than what's going on with GDP. And when the stock market has its ups and downs and you can think about all the ups and downs we had this year with the tariff announcements, we saw a pretty close correlation in our business. So that really contributed to the volatility. We don't expect this volatility to continue forever. But without turning this into a political discussion, it's kind of hard to say. We're, in many ways, bracing ourselves for continued volatility. I think we've proven, Simeon, to be quite agile through a very challenging macro backdrop. But all that being said, I think we still remain very confident about the future ahead.

You mentioned wealth effect home equity. I want to ask about housing turnover, the connection to the industry's demand and able to detect whether we're in the midst of a replacement cycle or industry has been soft, and we're just beginning to see it crawl back out. So anything related to macro and how much of this could be tied to housing?

Well, it's a great question. We get asked this all the time because you would expect that our business would have a very tight correlation with housing turnover. But the reality is that we'd love for housing to turn around and when it does, that will be a further tailwind to our business. But we have many, many demand drivers that go well beyond just the existing home sales or new home sales. As I mentioned, our demand is really anchored in this affluent client, and they just tend to behave differently. And they're much less tied to housing turnover in that regard. They're less tied to things like affordability measures that we look at all the time. Their purchase [Technical Difficulty] in home equity. And they tend to have a long-term point of view when it comes to investments in their home. We're also seeing a very healthy replacement and renovation cycle. That has continued. Even though people are moving less, they are still investing in their homes. So whether it's a light refresh or a full remodel, or a designer-led project for their whole home, we continue to see very strong levels of engagement from our consumers. And then think about and third homes. This is where we have introduced design studios into those key markets where there's lots of second home ownership. We want to be where those clients are to provide them with Arhaus design services. So those are all factors that contribute to the demand that's coming in. I am excited about the housing turnaround. I do think it's imminent. I don't think it's on our doorstep, but we are looking forward to continued improvements into 2026. But I will say, when you think about what brings people in the showrooms, there are many factors on demand that we directly control. And I would point to the fall 2025 collection, clearly a demand driver. We got lots of feedback from our clients on that fall collection. And the innovation, the design, the quality, the warm tones, the burl woods, all the things that further differentiate us from what you might see from our competitors, the customization that we offer continues to be a demand driver. We have our own manufacturing facility in North Carolina, and it's an upholstery manufacturing facility, and that's where a lot of the customization comes from, and we continue to improve cycle times with clients. So that when they do come in and offer and express interest in a customized sofa, they don't have to wait 6 months. They don't have to wait 4 months. We can get them a sofa in 6 weeks. So that continues to be a differentiation. So there's number of things that we're doing to bring people in that are helping to drive demand that isn't necessarily tied to housing turnover, but we would welcome it, that being said.

One more on demand related to what you said bringing people in the buy more, save more at the $5,000 price point and that's been a big success this year. Can you talk about big ticket? Is it outperforming because of marketing programs like that? And how does that impact the overall mix and product margin?

That's a great question. And this is one of our biggest wins this year is the continued strength in our higher-ticket transactions. The combination of large project clients, designer-led projects, trade-led projects as well as the buy more, save more program contributed meaningfully to our average order value. And just so everyone is aware, the buy more, save more program is where we promote to our customers spend X dollars, they'll get Y percentage off their transaction. So it's not priced based on individual pieces, but if they put a project together and reach a $10,000 threshold, they can get 20% off their transaction or 30% off their transaction. That's been very effective in marketing because it doesn't, in any way, impair the value proposition or hurt our brand. It's simply recognizing that when a client comes in and puts down a big order that there's value for that, and we recognize that through discounts. So it's been very well received, and it's really been, I'd say, our anchor promotion for the last 18 months or so. So we've had quite a lot of success with that. But when you go back to the ticket sizes of $5,000 and $10,000, they continue to be very healthy at these transaction levels. And it's all the same factors I've mentioned a few times, right? It's the interior designers, the trade, the promotions. And it's had a big impact on our product mix and doing that. We're naturally weighted toward higher AOVs because of the category that we compete in. We offer large furniture categories, large pieces. But with our upholstery program, the customization, these are higher dollar items, and that continues to drive the AOV upwards as well. And the big ticket items help us on margin. There's no doubt about that. The more product we source from the U.S., the better our margins typically. The more we source from our own manufacturing facility in North Carolina, the better our margins typically. So it's that ability to customize and trade customers up that is really helping us to protect our margins. So generally speaking, it's been a big win for us.

What the market knows about Arhaus and AI is largely a function of what you communicate on quarterly calls, maybe on your website. So to dangle the carrot, all things AI set the record as what Arhaus is doing to implement it. And as a side question, do you think it has a bigger top line or bottom line benefit, more immediate term, in the next 3 years?

Yes. That's a great question. I know it's a big topic. I'm personally a believer in the benefits of AI. I use it, both personally and professionally. So I consider myself to be very well educated on this. But I would say at Arhaus, we're not treating AI as a stand-alone initiative, right? We're treating AI as an enabler to what we're already doing. In the areas of the top line, we're using it to help create more personalized and seamless client experiences in the form of better product recommendations, helping us to target clients and to help support product discovery online. So even when you go into like the design step of your project, we're using AI to help model out different visuals as well. So that's been very helpful for top line, but also customer experience. On the bottom line, look, we're just getting started here. We recently announced a digital transformation. And just as a bit of a back story. I've done a number of these in my career, very large-scale digital transformations, ERP projects and whatnot. And -- as I've jumped into Arhaus and help them to stand up this program, it's been absolutely shocking to me how much more efficient these programs are with AI as the enabler. So we announced a $30 million investment in digital transformation that we'll maybe talk about in a few minutes. But the fact that we're able to accomplish this and the time lines that we've laid out, a lot of it comes back to AI and the fact that the accelerators that they've developed to either write code or to develop change management collateral or to even summarize meetings and action items, it's just been a real enabler. And I see thematically that AI is really just a big enabler that companies are going to deploy over the next couple of years. And we see lots and lots of opportunity, but we're taking a very methodical approach, just like we've taken a methodical approach on building our showroom fleet over the years, we're going to take a very methodical approach with AI and make sure we deploy it to the highest use cases across the business, but ultimately, make sure that we capture some of those benefits.

So this digital transformation, and you were right, that was the next topic. How does it break down between ERP, supply chain, inventory management? The $30 million looks mostly capitalized? Is there a P&L impact? And one more for you, since you've done a few of these degree of risk associated with this one inside of Arhaus.

Sure, yes. Look, this is one of the most important initiatives that we are undertaking as a company right now. Arhaus has grown quite a lot over the last 4 years since our IPO, and we have outgrown our technology stack. And at the same time, we got a lot of growth ahead. So this is a critical initiative to really set us up for continued growth. There are 3 major components to this program. The first one is replacing our core, if you will, our core finance and operating systems. And that's the longest pole in the tent, if you will, with respect to this program. In addition to that, we are implementing new capabilities in the form of transportation management systems and an order management system. And you might ask, well, why are you doing that at the same time you're doing these other projects. Well, there's a lot of integration between the transportation order management systems with the existing core systems. So it makes a lot of sense to do it at the same time. But these projects also drive a really strong ROI. We spend tens of millions of dollars a year on transportation and the uplift in capability that we're going to get from a new transportation management system has real meaningful P&L impact and we want to pull that in as fast as possible. The order management system that we're talking about, there's a lot of complexity to it, but we think it's worth the effort because it's really going to elevate the client experience through their entire purchase journey and allow us to really reengineer in many ways how we service our customers. So we're really excited about that. So some core investments that we're making, but -- for anybody that's read our 10-K or our 10-Q, you also see that we have several material weaknesses in our financial reporting. And one of our big priorities as a company is to fully remediate those material weaknesses and improve our internal control environment across the company. We can't do that today with our existing systems. We can do a lot of things to improve our internal controls and we're doing that. But we can't get all the way to bright with our existing tech stack. So this new tech stack is going to help us fully remediate these material weaknesses in due course. We don't have an exact time line on that. But once these new systems are in place, you should expect to see some progress on that in the future. But it's a priority for us as a company. When you think about the economics of this program, it's about a $30 million initiative over the next 18 months. And Simeon, you're right, the way this gets accounted for is it's mostly capitalized into a cloud computing asset on the balance sheet. And then once the system goes live, you start to depreciate or amortize the asset. So we communicated the $30 million split is mostly next year and the year after. I think we said $2 million this year of cash spend, $12 million next year and $10 million the following year, and then $2 million, $2 million, $2 million after that through this 5-year horizon. So that's how the cash flows will flow. We're projecting to go live with this technology in Q1 of fiscal '27. And at that point, we'll start expensing amortizing the program, and it will get amortized from '27 through 2030, which is the duration of the 5-year license agreement with the software providers. But the good news is, is that by 2028, we expect the benefits to start to realize as well. And we've communicated really 2 major sources of financial benefits. I'll say 3. Number one is, we see SG&A benefits in the business to the tune of around 50 basis points a year of permanent savings by the year 2030. And if you do that math, that's worth about $10 million a year. We think we can start getting that in 2028, so say around $8 million a year in 2028. We also expect to have savings on the transportation side of the house of $4 million to $5 million a year starting in 2027. And then we're going to save on software because we're consolidating our tech stack and [Technical Difficulty] a couple of million dollars of savings in the program for that as well. So we're really excited. This is one where we're going to get it done. We're going to strengthen our controls as a company. We're going to set ourselves up for growth, and we're going to drive some good returns out of it.

How do you minimize execution risk? It sounds like '27 is when it flips on order management, I mean, ERP, these are scary things for retailers. So when will you know that nothing is disrupted?

Yes. Well, one of the things that's really important is you set these programs up the right way. And we have an executive team, 4 executive team members that are sponsoring this program. So me, along with our Chief Information Officer, our Head of Client Care and our Head of Logistics, and we've all got our different experiences with these systems. But over the last 6 months, we've been focused on the foundational work necessary to set these programs up the right way. When you think about where risks are on these projects, it's really around the areas of do you have dedicated teams or not? If you do not have dedicated teams, that's a major risk factor. We have assigned a dedicated team. Do you have a clear scope or not? We have a very clear scope and we debated scope over the last 6 months to make sure that it was very tight, very clear. Do you have executive support on these projects? That's another precursor predictor of success. We have 4 executive team members that are overseeing the project, but we also have a very engaged Board of Directors playing a role of governance on this project as well. And then at the end of the day, another predictor of success is change management, making sure that you're bringing along the organization on the journey to ensure that you have the employee acceptance and the engagement when these things go live. And we have invested in change management as part of this project. And I'll give you an anecdote. I'm not going to quote who said it. Simeon, you just got to take it on faith. But when you do these programs, you have system implementers, right? These are people that third-party consultants that work with the software provider and the client, in this case, it's Arhaus to deploy this technology. And we just had our launch of this in the last month. And the system implementer, the leader came to us and told us after this big 3-week long, 2-week long kickoff event, the best kickoff that he's ever seen. So Arhaus is doing this the right way. That's how we're going to manage risk. And at the end of the day, we don't go live until we have gotten sign-off from the entire company. So we're going to manage this the right way.

Two more topics in our 5.5 minutes for tariffs and B2B. I'll keep them a little separate. So tariffs first, still on our mind, it feels like there's another wave of pricing. This is not furniture-related, but broadly that needs to come. You've talked about $50 million to $60 million of impact in '26 that doesn't seem terrible relative to your top line. Can you talk about puts and takes, mitigation, vendor concessions, pricing, anything and above tariffs?

Yes, it's been a busy year with respect to tariffs. And I'm really proud of the work that the organization has done because we're on track to have a pretty good year overall despite what's been a very volatile situation. Our approach has been very straightforward. We said from day 1, we are going to protect our margins, and we have done that. We've -- we're now starting to see flow-through of tariffs onto our P&L. We took pricing starting in October. We've communicated that we'll continue to look at pricing over the next 1 to 2 quarters to make sure that we protect our margins every step of the way. We've pulled many other levers, Simeon, we had sourcing changes, as I mentioned, I got to meet one of the proprietors of a business that literally picked up shop and moved from one country to another and was in the process of starting up production for us as one of the sourcing location changes that we had to do in order to minimize tariff impacts. So we've got many examples of sourcing diversification, sourcing changes that we've made, been very, very difficult. One of the things that we're really proud of is that Arhaus continues to grow. As we've added new showrooms, as we've continued to grow our comp growth, we've grown our top line and that means we're buying more product from our suppliers. And as we're buying more product from suppliers, they're getting economies of scale. As part of this negotiation process, our partners have shared with us [Technical Difficulty] growth, which makes [Technical Difficulty]. So we've had some concessions in that regard to help offset the tariffs. And then for what's remaining, we're passing it through, and we're doing it in a very methodical, surgical way, this is not a one-size-fits-all approach. We are largely taking pricing where items are impacted by tariffs, which means that for our U.S. sourced goods, we've taken very little price. But in this exercise, we've also taken price down where we think there were too high. And one of the things that's cool about our business being so integrated is we're one phone call away from our sales team to get real feedback on what our clients are saying. And what we continue to hear from our clients is that price is not coming up as an issue, and where it does come up as an issue, we take a look at it, and we make adjustments. But generally speaking, we've been able to make price adjustments where needed to absorb these tariffs. But it's continue wait and see. I don't know if things will change with the upcoming Supreme Court decision, so we take a wait-and-see approach. But in the meantime, we're just running our play and we're going to continue to protect our margins every step of the way.

Last but not least, B2B. It's almost a buzzword across home improvement, home furnishing, it seems like a new channel that makes sense while the traditional channel is soft, but also as a growth strategy over the next 5 years. So talk about -- and have you sized it yet and how you're going building that business?

Yes, we think it's a massive opportunity for us. And I would not say that we're underdeveloped, but I would say we have lots of upside opportunity. And we think about the B2B business really in 2 different ways, right? There's the trade channel that I talked about earlier. This is where an individual hires an interior designer, that interior designer comes to Arhaus. But there's also the contract business, which is a business that comes from businesses that are looking to furnish building. So the Hyatt comes to us and says, we want to furnish a hotel. On the trade side, we are leaning in very hard. We hired a new executive over that team. We are investing in new technology capabilities to support that team with things like clienteling, which is how we engage with the trade. We are working on a new trade member program that we think will be more competitive and will better reward trade people for being loyal to Arhaus and really simplify the way we do business. But it's a big opportunity. More and more of our business continues to shift in that direction. We're just now stepping on the gas and we're going to go and get more business through this new strategy that we're building out. So in 2026, the trade channel is one of our major platforms for growth next year, and we'll have more to share on that at our next earnings call.

Appreciate all the time. Thank you for sharing part of the strategy, digital transformation, AI. Good luck over the holiday season into '26. Thank you.

All right. Thanks. Appreciate it.