RH - A (Very) High Risk/High Reward Retailer

Mar. 09, 2018 8:52 AM ETRH (RH)97 Comments

1.37K Followers

Summary

After one of the most audacious share buybacks in retail history, shares of RH are calming down.
Although management is a bit quirky in their marketing, they make compelling points.
They have a shopping experience that is difficult to duplicate online.
The shares offer a compelling risk/reward situation.

In a previous article on RH (NYSE:RH), formerly called Restoration Hardware, I had discussed the financial engineering that RH performed in 2017. It was a difficult article to research and a lot of the follow-on work was done in the comments section - Restoration Hardware, How to Short Your Own Stock 101. To summarize, RH borrowed (buy selling converts at a high price) $1.15 billion and went on a massive stock buyback operation. As of October 28, 2017, RH had retired 20,220,132 shares - up from 294,888 as of January 28, 2017. Weighted average shares outstanding have dropped from 40,926,450 to 23,535,617 per its 3rd quarter 10-Q.

The Buyback

This buyback created some rather bizarre changes in its balance sheet. When you borrow a ton of money and then buy back your stock that is well above book value, total stockholders' equity plummets. For the 9 months ended Oct. 2017, RH's book value went from $919.87 million to negative $25.27 million. Now that seems a bit strange, but other companies have done this in the past, but under different circumstances. For example, Philip Morris International (NYSE:PM), due to long years of stock buybacks and steady cash flows, also has a negative stockholders' equity. But PM is a mature business with predictable results. RH is/was (depending on your view) a struggling specialty retailer in the middle of a turn around.

The debt instruments are rather complicated, involve various conversion prices, and have warrants and collars to minimize future dilution. Again, I'd point back to my original article for more details on those instruments. But if the CFO, Karen Boone, pulls this off - General Electric (NYSE:GE) will be blowing up her cell phone.

At the end of the original article back in July, my actual conclusion was that I didn't really know what would happen. It looks like neither did anyone else. It had simply levered its balance sheet to the hilt and any future results would be incredibly magnified. The stock was near $70 back then, and it's back in the high $70s now - but what a wild ride it was. See for yourself.

My actual final comments were - "Short term, the trend would be down. Long term, the stock will trade in accordance with its fundamentals."

This is exactly what happened as the stock fell to the mid 40s before rocketing higher on good signs of a turnaround. The shorts were caught in the gap up, slow roasted, then glazed in a move higher past 100. Longs got punished in the move down from near 80 to 45, shorts got rocked for being greedy at the bottom - it was very difficult to trade in real time for anyone. There were a couple of nice articles at the time - one by Richard Pearson - RH Will Likely Spike Much Higher Very Soon - written in early November, and another by Courage & Conviction Investing - RH: Gary Friedman's Machiavellian Crusade Against The Shorts Is Unfolding. Tip of the hat and wag of the finger to them.

But as the squeeze played out, the stock returned to a somewhat normal looking chart and price. I'm not nearly as talented as the above authors regarding picking the timing of short squeezes. I'm more a long-term investor, but maybe now is the time to talk about the potential for RH - you know, as a business?

Oh, those wild and crazy guys (and gals)

First off, these guys are weird. First, they do a buyback that has Webster scrambling to find a word stronger than audacious. Then, they put out one of the more bizarre investor slide presentations I have ever seen. Really, check it out yourself - they start with quotes and pictures from P.T Barnum, go through Charles Darwin, Robert Kennedy, channel their inner Steve Jobs, and end with Albert Einstein. But in very quirky way, they start to make some compelling points… They also have a great Henry Ford quote -

If I asked my customers what they wanted, they would have told me a faster horse. - Henry Ford

The Death of Old Retail

To RH, the (supposed) death of all retail not named Amazon (AMZN) is not entirely due to Amazon. It is because retailers have lost touch with how and why their customers buy. They then give an example - sorry Saks…

Archaic, big boxes, with no windows, light, or as they say "humanity". Their version of retail is different. They now have galleries - think showrooms, that are way beyond the normal retail experience. Here is an example of a few of their stores' fronts.

(source: RH investor slide presentation Nov. 2017)

They include pantries, restaurants, wine vaults, and barista bars. They are clearly targeting the new crowd of upscale shopping. It is an ambitious and novel approach to selling furniture and home accessories. With only 15 Galleries, they claim to have the potential to grow to between 60 and 70 in North America. They make a few interesting points, for example - only 12% of all retail sales are made on the internet, and then they end with this… cue your own background music of choice.

IMAGINE…

A retail store where you valet your car in the front of a 12 ft. high wall of water, inspired by the famous fountain in New York's Payley Park. Where you admire a 70x40 ft installation by the world renowned contemporary artist, Retna. Where you wander through 10,000 sq. ft of tropical gardens featuring artistic compositions of outdoor furniture. Where you navigate three floors of interior installations and imagine the home of your dreams with an interior design professional. Where you savor your favorite coffee drink and a pastry from a barista bar. Where you enjoy a glass of Rose in a dramatic wine vault. Where you dine under the heritage olive trees beneath a soaring glass atrium while listening to the sound of trickling fountains and taking in the sunset in a rooftop restaurant…

NOW TRY TO IMAGINE THAT ONLINE

Well done RH marketers - you make a lot of sense. I told you they were quirky. So that sounds great, but let's look at the numbers. We're in the stock picking business, so we need to get back to work.

Numbers Time

First, the big elephant - that debt.

The company presented the following info on their debt position and the improvement.

DEBT SUMMARY FY2017
$ in millions	Rate	Q2	Q3	Q4E
ABL REVLOVER	2.75%	283	341	210
OTHER SECURED DEBT	4.00%	94	114	114
2ND LIEN TERM LOAN	9.50%	100	-	-
2019 CONVERTIBLE SENIOR NOTES	0.00%	350	350	350
2020 CONVERTIBLE SENIOR NOTES	0.00%	300	300	300
NOTES PAYABLE & CAPITAL LEASES	APX 5%	27	27	27
TOTAL DEBT	1.35%	1,154	1,131	1,000E
TOTAL NON-CONVERT DEBT		404	482	350E
CUMULATIVE FREE CASH FLOW		282	300E	430E
TOTAL DEBT/ADJUSTED EBITDA		6.5X	5.4X	4.2XE

(*source investor presentation slide data Nov 2017)

Their total debt/ EBITDA ratio should continue to improve. Currently, it is expected to be at 4.2x. We should find out shortly when RH reports their 4th quarter and year-end results. Once again, their CFO (and Co-President) deserves a gold star for borrowing over a billion dollars at a 1.35% net interest rate.

From RH's own forecasts, they are expecting free cash flow in Q4 of $130 million. For FY 2018, they are planning on FCF of $240 million. In the first half of 2019, they should have at least $100 million in FCF - for a cumulative total of $470 million. This will be used to pay off their $350 million convertible. For second half 2019, they expect another $120 million in FCF. Combined with first half 2020 of $120 million more, they will pay off the 2nd convertible of $300 million. With this plan, they will still have $60 million left over. This is ambitious as everything must go at least according to plan and with little margin for error. This is the No.1 risk in the stock and cannot be overstated.

They expect to settle these convertibles in cash so there will be no dilution. The only caveat to that is if RH stock reaches $172 or $189 before the respective maturities. But we'll call that a high-quality problem.

Let's say RH can payoff the converts and pull off one of the greatest financial engineering capers in retail history… What's the upside?

From their slide presentation, RH provided a 2018 preliminary outlook.

Net Revenue $2.58 to $2.62 billion with 8%-9% growth
Adjusted operating margin of appox. 9%
Net income of $125-$145 million
Net capex of $65 - $75 million
FCF in excess of $240

The bridge from 2017 operating margin of 6.8% to 2018 of 9%-10% would be as follows

FY 2017 OPERATING MARGIN MIDPOINT	6.8%
GROSS MARGIN IMPROVEMENT	170-220 BPS
SG&A	50-100 BPS
OPERATING MARGIN EXPANSION	220-330 BPS
FY 2018 OPERATING MARGIN	9%-10%

Again, these were company supplied numbers; I didn't make them up.

With a return to a two-coastal distribution system, they project an annual expense savings of $15 million. This is in stark contrast to their previous network design of 1.1 million furniture units spread across 4 furniture DC's, 2 furniture storage DC's, and 1,000 storage trailers. Their projected inventory savings are $400 million versus their previous long-term plan.

The company has shifted to a new membership model that included 380,000 members with membership fee income up 37%. I searched through the entire 10Q, but I could not find a segment breakdown for membership revenue in dollars. If anyone has that, please let me know. It would be a nice metric to track and I could include that better in my future models.

The idea is to be less promotional and smooth some of the high/low points, unlike in the past. This makes good sense to me.

There are currently 23 analysts covering RH. For the current year, they are projecting, on average an EPS of $2.94. For the next year, the numbers rise to an average of $5.49, with the high estimate at $6.21. Estimates have been rising over the last 90 days from an average of $4.97 up to the current $5.49. This is a good sign as analysts are updating their models. Mostly due to rising margins and the stock buyback, EPS are expected to rise at an annual rate of 47.33% over the next 5 years. Current year is expected to climb 131.5% and next year another 86.7%.

Big Box Competition

One of the things to consider is "Hey, can't Walmart or Target just do the same products at lower prices?". To that, I will say yes, -- and no. I'll explain.

I founded a manufacturing operation in the Philippines making melamine dinnerware. I sold that company to a much larger company, whose customers included SAM's, Costco, Lowe's, and The Home Depot. I took over the COO position at the 3,000 employee company. We constantly presented ideas for products to our big box customers.

Here is an interesting secret. The worst thing you can do is go into Sam's and say you have something new. They don't want new. They want to be tried and tested. In outdoor pottery, our market, our entire design team simply went to RH and a few other high-end catalogs, copied their basic designs, and then marketed it to the big boxes at reduced prices. That's it. Not proud of it, but that's the way it works.

But by the time the "Anduze urn" hits the shelves at Sam's (2 to 3 years later) - RH is already moving on the next fashion trend. RH was the trend-setter, we were the generic knockoff. RH has a firm grasp on where the market is going and everyone else just tags along in big box world. I decided working people for $8 a day and just copying successful competitor's designs wasn't the right thing for me, and after two years I left to start my own manufacturing company - and of course write for you. But the main point is, RH leads the way in upper-end retail furniture fashion.

My Risky Conclusion

As the converts get paid down, and the balance sheet deleverages, the risk in the shares will abate. This should result in a higher forward multiple than RH currently enjoys. With a two-pronged attack of earnings increases and multiple expansion, shares of RH could soar. How high? That's a difficult question, but with EPS in 2020 of $8 or more, the balance sheet restored, their unique business model more appreciated - $200 would not surprise me.

But the downside... - If cash flows are not as predicted, the wiggle room forecasted by the company is only $60 million, the downside could be extreme. $10 would also not surprise me. I'm making an investment here based on the upside, say $120 more from here, tempered by the understanding of the downside risk. I will be looking at one very specific metric on this investment in this period (the next few quarters) - and that is, of course, Free Cash Flow. That is the single most important driver of the stock over the next 6-9 months. I will accept no excuses from the company on any FCF miss as there is simply no room for error. They must hit their targets.

Provided that is going well, then I need to see signs that the concept is catching on by examples of their extreme store designs resonating with their target audience. We'll see this through comp numbers, not company comments. Management will always say their concept is great - never heard a conference call where the executive team stated "yeah, were circling the drain." - except maybe the Tile Shops (NYSE:TS) last week, but that's another story ( podcast here) for a different day.

I have initiated a long position in RH - about ¼ of my targeted position size. I'll wait for the next earnings report to make sure things are on track, and then ease into the stock - even at higher levels. If things go as planned, the upside in RH is tremendous. As always, good luck and if you follow along, you can be sure to receive any updates. Thanks, and best wishes.

This article was written by