RH: The Perils Of A Crowded Short

Summary

• Despite a well argued short thesis, the Masters of the Universe have lost money shorting RH.
• A very high short interest, combined with strong institutional ownership/support and share buybacks, has goosed shares of RH.
• RH is a dangerous short.

Please note: this piece was originally published on July 11, 2017 at 6:20 AM on my premium site, Market Adventures. On that morning, RH shares opened for trading at $61.25. I am sharing this piece on the public site as it should give the Masters of the Universe pause when it comes to shorting stock with highly elevates short interests as a percentage of their floats.

As I am very intrigued by high short interest shorts, measured as a percentage of their float, this morning, I write to discuss Restoration Hardware Inc. (NYSE:RH). SA Contributor, Ioannis Tsoutsias, CFA, wrote an interest piece on June 12, where he shared his short thesis. Generally speaking, I am a fan of Ioannis’s work as I find that it is logical and offers a nice blend of qualitative and quantitative analyses. However, I happen to disagree with this short due to the setup.

Incidentally, on June 12th, the day Ioannis’s report was published, shares of RH opened for trading at $50.53. Despite his well-argued and logical short thesis, if you had blindly followed Ioannis's short recommendation then, at least of through yesterday, you would have found yourself upside down 10 points if you had shorted it at the June 12th opening price.

For perspective, my article isn't an in-depth review of the merits of RH's business model nor I do I disagree with Mr. Tsoutsias's overall thesis, per se. Instead, my point is that I have no idea why the Masters of the Universe (MOTU) enter into these crowded short bets. The volatility in shares of RH is yet another case in point that it is simply too hard to be short any stock when the overall market is already super bearish towards the name.

If we look at the short interest data, the MOTU were aggressively adding to their short bet from August 15, 2016, through March 31, 2017. As you can see, short interest leaped from 10.68 million shares on August 15, 2016, and hit a high watermark of 18.24 million on March 31, 2017.

Source: GuruFocus

Not surprisingly, as the MOTU were building their short position, from August 15th - March 31st, notice how RH's stock traded in a channel from as low as $25 to $40, with lots of volatility. As shares of RH recently hit $69 and they still closed above $60 in yesterday's trading session, the "second-wave shorts," as I recently phrased in my latest GNC Holdings Inc. (GNC) piece, lost money in this crowded short trade. And, we know they actually realized losses because some members of the MOTU clandestine organizations actually covered 5 million shares.

Source: Google Finance

Moreover, let's isolate the time period of March 31, 2017, through May 31, 2017, as this coincides with when the MOTU covered 5 million shares. Over that time period, RH's shares increased by 27%.

With the benefit of hindsight, RH shares hit a low watermark of $24.41 in late February. Whether or not RH’s stock stepped over a bar of low expectations is academic, and the trading volume signaled a distinct bottom.

Source: Seeking Alpha

Here is the 27% return from March 31, 2017, through May 31, 2017.

Source: Google Finance

For more context, despite the shorts covering 5 million shares, as of June 15, 2017, RH was still the 9th most shorted stock as a percentage of its float, just behind GNC.

Source: WSJ

Now, what has helped RH - and has been noticeably absent for us when it comes to GNC - has been the steady institutional ownership. As you can see, some big shops own a large percentage stakes in RH (at least of March 31, 2017)

Source: Yahoo Finance

Another factor helping fuel the short squeeze, despite the clear overvaluation and questionable business model, is that RH has been aggressively buying back its own shares.

Check this out - on December 2, 2016, RH had 40.8 million shares outstanding.

For context, as of May 31, 2017, RH only had 33.147 million shares outstanding. In other words, management bought back 7.65 million shares.

Ultimately, this buyback strategy will probably backfire, as RH doesn't have the internal free cash flow generation to justify the aggressive share buybacks, so it had to lever up its balance sheet to fund it. That said, it goes to show you that it is stupid for the shorts to attend a theatre in a venue that is very crowded and that doesn't have good lighting or enough emergency exit points.

In terms of RH, as a company, its profitability deteriorated in the full year earnings period ending January 28, 2017.

The Street is forecasting a big rebound in earnings this year, but the jury's still out.

Source: Yahoo Finance

As Ioannis points out in this chart that he created, RH trades at a big premium to Williams-Sonoma Inc. (WSM).

WSM owns "west elm" which is somewhat similar to RH.

Moreover, I looked at Urban Outfitters (URBN), which owns 225 Anthropologie stores. Arguably, Anthro's brand is urban hipster and sells some higher end furniture, yet it still trades at a much lower multiple than RH.

Takeaway

On an enterprise value basis, I am in agreement with the shorts that RH is overvalued and that it faces lots of competition, yet I wouldn't short it. That said, I definitely wouldn't touch the stock from the long side, at least at current valuations. However, I wrote this piece to showcase to readers how foolish it is for the MOTU to short a stock when its short interest as a percentage of its float gets above 30%.

On June 1, despite RH missing analyst estimates, in only a few weeks’ time, RH's stock price quickly recovered and was trading north of $60 on June 26th. I would argue that GNC has far better fundamentals and is actually executing a turnaround. I still have no idea what the MOTU are thinking when it comes to GNC.

Analyst’s Disclosure: I am/we are long GNC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.