Source: RH Website
Summary Investment Thesis
RH: Reasons for high short interest -
There have likely been a number of reasons contributing to the large short interest in RH (RH) shares. These include -
- The possible dilution from new share issues, if RH does not have the cash to redeem its $350MM of senior convertible notes falling due in mid-June 2019.
- The threat of 25% US tariffs on Chinese imports, and its potential adverse effect on RH earnings.
- First quarter guidance forewarned of an adverse impact of ~8% reduction in adjusted EPS, due to a change in the accounting treatment of leases.
- Effects of possible negative trends in the stock market on the high end housing market.
- In conjunction with the offering of the 2019, 2020 and 2023 secured convertible notes, RH entered into convertible note hedge transactions with counterparties (the “hedge counterparties”). Both these hedge counterparties, and the note holders, have reasons to hedge their own positions, by shorting RH shares.
RH: Shorts are very exposed to a potential short squeeze -
- At May 23, 2019, RH had 18.36MM shares outstanding. Insiders hold 2.56MM of these shares, leaving a free float of 15.80MM.
- Although the free float is 15.80MM shares, share ownership filings show institutions hold 25.60MM shares, 9.80MM more shares than the free float.
- At March 31, short interest was ~7MM shares, By May 15, short interest had dropped to 5.89MM shares, but still 37% of the free float.
RH: Reasons for mispricing
- Despite the fears of the market, RH has the capacity to meet the redemption of the 2019 senior convertible notes, either wholly in cash, or mostly in cash. Whether the redemption is in cash, or shares, or a combination of both, is entirely at RH's discretion.
- In the unlikely event RH elects to settle the 2019 senior notes, wholly in shares, the dilution effect of ~3 million new shares will be in second quarter, so first quarter EPS will not be affected. The full year EPS almost certainly will not be affected by dilution. With 2.2MM shares already repurchased in first quarter, RH need only repurchase another 800,000 shares in the remainder of 2019 to fully offset shares issued to redeem the 2019 notes.
- The market seems to have missed the announcement by RH, hidden deep in a 10-K/A filed on May 31, of repurchase in Q1-2019 of 2.2MM shares, and the implications flowing from that.
- Fears that RH might face a liquidity crisis, or heavy dilution, are groundless, based on closer inspection of the facts.
- Analysts' estimates for adjusted EPS, and EPS growth rate will be exceeded by a wide margin, when RH reports Q1 results. Firstly, the repurchase of 2.2MM shares in Q1 2019 will lower weighted-average diluted share count, thus boosting Q1-2019 diluted EPS. Secondly, Analysts are understating Q1-2019 compared to Q1-2018 estimated EPS growth rates, by using Q1-2018 EPS, as reported, as the denominator. No adjustment is being made to Q1-2018 reported results for the change in basis of reporting, reflected in the Q1-2019 guidance.
- Yahoo site shows analysts' consensus estimate for RH for Q1-2019 of EPS $1.55, and EPS growth 16.5%, implying Q1-2018 EPS of $1.33. But Q1-2018 EPS, adjusted for changes in basis of reporting in 2019, will be ~$1.21. Expect first quarter 2019 adjusted EPS, when reported on Wednesday, to show a strong beat, in the range of 25% to 35%, over comparable earnings for first quarter 2018, far above what the market is expecting.
- The 25% tariffs on Chinese imports, effective May 10, will have no effect on first quarter. Based on my detailed analysis, the 25% tariffs will have little effect, if any, on FY 2019 earnings previously guided for by the company.
- Most, or all, of the above information will become apparent, when RH releases its Q1 2019 earnings, and holds its earnings call after market close on Wednesday, June 12, 2019. The combined effect of the foregoing can be expected to create a short squeeze, and a steep increase in the share price, from opening of trade on Thursday June 13, 2019.
- Expect the unexpected, RH shares could reach, and possibly far exceed, the 2018 high of $164.49.
RH 2019 adjusted EPS, when reported on Wednesday, is estimated to show a strong beat, in the range of 25% to 35%, over comparable earnings for first quarter 2018, far above what the market is expecting.The opportunity, is to buy shares in RH at current price levels - firstly, because they are far below the estimated fair value range of $125 to $149; and secondly, because a likely short squeeze will almost certainly drive the share price well above fair value, which would be an opportune time to exit, with a substantial gain. The current share price, at ~$92, is ~26% to 38% below estimated fair value, so there is limited downside risk. Buying ~$92 provides a potential gain of 36% to 62% on cost, if and when shares reach fair value level of $125 to $149. Of course, if I am correct in my assumptions, the share price should move higher in the near term, resulting in much higher percentage increases on an annualized basis. Detailed discussion follows of all the relevant factors, under the headings -
- RH: Company Description
- RH: Ability To Generate Cash From Operations
- RH: Ability To Avoid Dilution
- RH: First Quarter 2019 Earnings Beat
- RH: Full year FY 2019 Earnings Beat
- RH: Share Valuation
- RH: Available Shares And Short Interest
- RH: Concerns On The Impact Of 25% Tariff Increases, Are Overblown
- RH: Risk Of A Share Market Downturn On RH Sales Of High End Furnishings
- RH: Summary And Conclusions
1. RH: Company Description
From the company's FY 2018, 10-K filed with the SEC on March 29, 2019,
RH (“we,” “us,” or the “Company”) is a leading luxury retailer in the home furnishings marketplace. Our curated and fully-integrated assortments are presented consistently across our sales channels in sophisticated and unique lifestyle settings that we believe are on par with world-class interior designers. We offer dominant merchandise assortments across a growing number of categories, including furniture, lighting, textiles, bathware, décor, outdoor and garden, and child and teen furnishings. We position our Galleries as showrooms for our brand, while our Source Books and websites act as virtual extensions of our stores. In 2015 we began to introduce an integrated hospitality experience, including cafés, wine vaults and barista bars, into a number of our new Gallery locations. We believe this has created a unique new retail experience that cannot be replicated online, and that the addition of hospitality is helping to drive incremental sales of home furnishings in these Galleries. Our business is fully integrated across our multiple channels of distribution, consisting of our stores, Source Books, and websites. As of February 2, 2019, we operated a total of 86 retail Galleries consisting of 20 Design Galleries, 43 legacy Galleries, 2 RH Modern Galleries and 6 RH Baby & Child Galleries throughout the United States and Canada, and 15 Waterworks showrooms throughout the United States and in the U.K. As of February 2, 2019, 6 of our Design Galleries include an integrated RH Hospitality experience and we plan to incorporate hospitality, including cafés, wine vaults and barista bars in many of the new Galleries that we open in the future. As of February 2, 2019, we operated 39 outlet stores throughout the United States and Canada.
RH Galleries - Designed To Impress
2. RH: Ability To Generate Cash From Operations
It is useful to review RH's cash flows over the last 5 years, per TABLE 1.1 below.
Comments on TABLE 1 -
- There is no accounting standard defining free cash flow [FCF], but I have included in TABLE 1.1, the calculation that is used by RH, and is typically used in calculating FCF from operations. I have also included an alternative FCF which excludes cash flows from changes in working capital. I believe this alternative FCF calculation is a more appropriate measurement of FCF for RH, in the long-term. For the years 2014 to 2016, net cash inflow from operations totaled $17.3MM, and cash outflows for working capital totaled $175.1MM. The difference of $157.8MM had to come from financing cash flows, and in fact, total working capital build to the end of FY 2016, came mainly from financing cash inflows. I therefore do not regard the 5 year $120.1MM total reduction in working capital as coming from operations, and contributing to FCF.
- Five year total Net cash flow from operations, $301.0MM, plus Financing cash flows - other, $942.1MM, total $1,243.1MM. We could say these cash inflows have been used for the greater part of the share repurchases of $1,250MM.
- We could also say the five year total cash flows from working capital decrease, $120.1MM, has been used for the greater part of the investment cash outflows of $120.5MM.
- The balance of funding for share repurchases and investment cash outflows has come from a reduction in cash of $7.6MM.
The outlook for RH free cash flows ("FCF") in FY 2019 -
RH has guided for FY 2019 FCF of $250-275MM (p29 Form 8-K Mar. 29,2019), up $87-$112MM on FY 2018 FCF of $163.8MM, per TABLE 1,1 above. Here is what the CEO had to say about FY 2018 FCF (p4 Mar 29 8-K) -
Fiscal 2018 free cash flow of $163 million fell short of our expectations largely as a result of the lower revenues and higher inventories due to softer sales and receipt timing, plus the $50-$60 million in assets sales we anticipated closing during the quarter the timing of which were also impacted by the market volatility. We are currently reviewing multiple offers for our Yountville property at attractive cap rates, and expect to finalize the sale in the first half of this year. In addition, we are now being advised to maximize the sale price of our Edina Gallery by holding off on accepting offers for the property until the Gallery opens this fall, which means the transaction would close in the second half of 2019.
Starting with FY 2018 FCF of $164MM, and assuming reversal in FY 2019 of the $41MM increase in working capital in FY 2018, and adding sale of properties for $50-60MM in FY 2019, takes FY 2019 estimated cash flows up to $255-265MM. Just those two items would achieve the target for FY 2019. But with FY 2019 being a year of consolidation, it can be expected there will not be the same level of capital expenditure on roll out of new stores in FY 2019. Net income for FY 2019 is also guided to be $5-20MM above FY 2018. Taking all of that into account, the $250-275MM FCF guidance appears quite conservative. TABLE 1.2 below shows how RH might apply its available sources of funds to redeem the 2019 convertible notes in cash, and to repurchase shares.
TABLE 1.2 TABLE 1.2 above, shows RH likely has the capacity to redeem on June 18, 2019, the $350MM 2019 notes obligation, wholly in cash, in addition to the repurchase of $250MM in shares in Q1 2019. I believe the estimates of FCF through the first half, and for the full year, are likely considerably understated. Capital expenditure in the first half may be quite minimal, compared to the $40MM allowed for in the estimates in TABLE 1.2. As per Note (3), at the foot of TABLE 1.2, the reasons for unexpected higher working capital at end of Q4 2019, should not apply in first half of FY 2019. The reversal of this effect on working capital could result in $40MM or more additional FCF in first half 2019. Exercise of options by RH employees provided net funds of $34.5MM in FY 2018. No allowance has been made for exercise of options in FY 2019 in the TABLE 1.2 estimates. Finally, if RH does not have sufficient cash available at the date for redemption, it has the option to settle in part in shares. Part redemption in shares will not cause dilution in FY 2019, as RH has already repurchased 2.2MM shares in Q1 2019. To the extent RH might settle in shares, it still has the option to subsequently offset those share issues, by repurchasing additional shares as funds become available. And RH Chairman and CEO, Gary Friedman, who owns over 30% of the company, has another non-dilutive, non debt incurring option available to him, in the unlikely event a liquidity crisis should arise.
RH has another source of non-dilutive, non debt incurring finance -
While not a component of FCF, there is another avenue for the company to receive cash funds through the exercise of stock options by employees. Net proceeds from exercise of stock options in FY 2016, 2017, and 2018, were $1.7MM, $19.1MM, and $34.5MM, respectively. Per page 32 of RH May 31, 2019 10-K/A , as of February 2, 2019, the CEO held 2,245,710 issued shares, and 4,976,826 vested and exerciseable options. Of the options, 2,976,826 are exerciseable at $46.50, 1,000,000 at $50.00, and 1,000,000 at $75.43. All but 666,668 of the stock options are free of selling restrictions at May 23, 2019. The CEO did not exercise any stock options in the 2016 to 2018 fiscal years. If availability of cash became critical, it would be open to the CEO to provide cash to the company by exercise of some of his options, which have a total gross exercise value of ~$263MM. It would require the CEO to have a means to fund the exercise of options, but it should be noted his current issued shares have a market value of $200MM, at current depressed share price levels. The shares underlying the options have a present market value of ~$443MM. I am not suggesting there is any intention on the part of the CEO to exercise any options. But it should be a comfort to shareholders to know the CEO has the ability to quickly introduce additional cash into the company, in a manner that involves no regulatory requirements or constraints. There would be no impact on diluted share count, as all the CEO's options are already vested, and counted in diluted shares for EPS calculation purposes.
RH: Conclusions on availability of cash to meet commitments in FY 2019 -
TABLE 1.2 shows, even if the entire redemption of the $350MM face value 2019 convertible notes was in cash, that should be achievable. If insufficient cash was available, that would not present a liquidity problem, as RH can elect to redeem partly in cash and partly in shares. As discussed further below, under the terms of the 2019 notes indenture agreement, there is also a likelihood that less than $350MM cash would be required to redeem the 2019 notes in full.
3. RH: Ability To Avoid Dilution
TABLE 2 below documents the underlying assumptions for FY 2019 diluted share count, both in respect of RH guidance, and my adjusted calculations, where actual data has proven to be different to the assumptions underlying RH guidance. I can calculate RH assumed weighted-average diluted share count for Q1 2019 was 25,240 shares. I do this by dividing RH guidance for adjusted net income by guidance for adjusted EPS, to arrive at 25,240 shares. Similarly, I can determine FY 2019 assumption is for 25,330 shares. Having determined the weighted-average share count assumptions, I can then turn to the table provided by RH, per Figure 1 below, to determine RH assumed an average share price of ~$140 for both Q1 2019 and FY 2019. Per TABLE 3 below, I am able to determine RH average VWAP in Q1 2019 fell within a range of ~$126-130 (the VWAP for any day cannot be above or below the high and low price for the day). Referring to Figure 1 below, and interpolating between the $120 and $140 average stock price, I determine RH Q1 2019 estimated weighted-average share count should be reduced from 25,240 to 24,940,
RH: Conclusions on potential dilution in FY 2019 -
TABLE 2 shows Q1-2019 weighted-average diluted share count will definitely show a reduction due to the repurchase of 2.2MM shares in Q1 2019. TABLE 2 also shows, even if the entire redemption of the 2019 convertible notes was in the form of 3MM shares, that would leave ample cash to repurchase shares to offset the additional shares. Together with the 2.2MM shares already repurchased in Q1 2019, an additional repurchase of only 0.8MM shares would be required, to completely offset shares issued for the 2019 notes redemption.
4. RH: First Quarter 2019 Earnings Beat
RH guided for Q1 2019 adjusted EPS of $1.47 to $1.58 based on assumed weighted average diluted shares of ~25.24MM. Based on additional information from RH (see TABLE 2 above), actual weighted average diluted shares for the quarter will be in the region of 24.36MM, 0.88MM lower than used by RH in their guidance. That will effectively increase underlying guidance by ~3% to 4%, to $1.52 to $1.64. When it comes to reporting earnings on June 12, RH will almost certainly report against RH Q1 2018 adjusted earnings, taking into account changes in reporting, first introduced in Q1 2019. These adjustments are the change to the accounting standard for leases, ASC 842, and the adoption of a standard 26% assumed tax rate for adjusted earnings reporting. TABLE 4 shows these two adjustments are estimated to reduce the comparative earnings for Q1 2018, from $33.45MM to $30.65MM. That, together with the lower share count in 2019, will increase the Q1 2019 over Q1 2018 growth, to 25% to 35%. When earnings are reported, after market close, on Wednesday June 12, RH will be able to announce another massive earnings beat at Q1 2019 earnings call.
An important thing to understand here is, I am only using RH's own assumptions, and actual data they have subsequently provided, as well as actual data in the public domain, such as actual share prices available from Nasdaq. The figures in TABLE 4 are essentially based on RH guidance.
TABLE 4 - RH Q1 2019 Guidance Review And Q1 2018 Comparison
The figures shaded in blue, are my estimates of adjusted EPS for Q1 2019 and Q1 2018 that will be reported by RH on Wednesday June 12. My estimates are based primarily on data sourced from RH. For example, the adjusted net income range of $37-40MM I have used in my estimates in TABLE 1, is identical to the $37-40MM used by RH in its guidance. If I were to estimate a different range of adjusted net income. it would likely be higher than $37-40MM, for the following reason -
RH Guidance For Q1 2019 Revenue Growth Is Possibly Overly Pessimistic -
RH completed the rationalization of its warehousing and distribution systems, and opened four new Design Galleries during the course of the 2018 year. The first full year profit increase from these initiatives will be realized in FY 2019. On a year over year comparison basis, the greatest uplift will be for Q1-2019 versus Q1-2018. RH started Q1 2019 with 1,089,000 of leased selling square footage, up 11% on the 981,000 available at the start of Q1 2018. Expect a strong beat, when first quarter 2019 earnings are announced.
5. RH: Full Year FY 2019 Earnings Beat
For similar reasons given for Q1 2019, expect a strong earnings beat for full year FY 2019. RH guided for adjusted FY 2019 EPS of $8.05 to $8.69 based on assumed weighted average diluted shares of ~25.33MM. Based on additional information from RH, and other assumptions reflected in TABLE 5 below, it is estimated actual weighted average diluted shares for FY 2019 will be in the region of 24.46MM, 0.87MM lower than used by RH in their guidance. That will effectively increase underlying guidance by ~3 to 4%, to $8.34 to $9.00. When it comes to reporting earnings in March 2020, RH will almost certainly report against RH FY 2018 adjusted earnings, taking into account changes in reporting, first introduced in FY 2019. These adjustments are the change to the accounting standard for leases, ASC 842, and the adoption of a standard 26% assumed tax rate for adjusted earnings reporting. TABLE 5 below, shows these two adjustments are estimated to reduce the comparative earnings for FY 2018, from $223.7MM to $190.8MM. That, together with the lower share count in 2019, will increase the FY 2019 over FY 2018 growth rate to 15% to 24%, compared to the 11% to 19% growth guidance from RH. When earnings are reported after close on Wednesday June 12, RH could announce a lift in guidance for FY 2019.
Again, the important thing to understand here is, I am only using RH's own assumptions, and actual data they have subsequently provided, as well as actual data in the public domain. The figures in TABLE 5 are essentially based on RH guidance.
TABLE 5 - RH FY 2019 Guidance Review And FY 2018 Comparison The adjusted EPS figures shaded in yellow, are per RH's guidance in their 8-K filed on March 28. The figures shaded in blue, are my estimates of possible revised EPS guidance to be announced by RH on Wednesday June 12. My estimates are based primarily on data sourced from RH. For example, the adjusted net income range of $204-220MM I have used in my estimates in TABLE 1, is identical to the $204-220MM used by RH in its guidance.
6. RH: Share Valuation
RH 52 week high and low share prices are $164.49 and $85.93, respectively. Current share price of ~$92 is near the low. The company has provided some outstanding returns for shareholders, over the last 4 to 5 years, as shown in TABLE 6 below.
The only way an investor can realize a return from an investment in shares is through receipt of dividends and/or gains on sales, regardless of company performance. RH does not pay a dividend, so all of the high rates of return shown above, are a result of share price growth. For many companies, share price growth over the last 4 to 5 years comes from multiple expansion. TABLE 6 shows, in the case of RH, multiples are not expanding, they are shrinking. That is due to income and EPS growth. Company performance is strong. TABLE 6.2 below, compares RH P/E ratio to those of its peers.
TABLE 6.2 TABLE 6.2 shows a range of share price estimates from $108 to $153. That is a gain of 17% to 66% above the current share price ~$92. I consider the share price range from $125 to $149, represents a conservative estimate of fair value range for RH. The mid-point of $137.00 compares closely to a target price of $137.50, per the Nasdaq summary for RH, and the high price estimate of $149, is ~10% below RH's 12 month high of $164.49. Excluding Floor & Décor Holdings, RH has the highest P/E ratio among its group. But, on a forward P/E ratio basis, RH has the lowest P/E ratio, reflecting strong growth in earnings, going forward. RH long-term net revenue growth target is 8% to 12% annually (see here), consistent with the 10% average yearly growth rate from FY 2014 to FY 2018, per TABLE 1.1 above. RH is top among its group for Value, Growth, and Profitability, based on SA Essentials quants data, further justifying a higher P/E ratio than its peers. RH also has a very healthy EV/EBITDA ratio at 7.48, at the bottom end of the range amongst its peers. But, RH share price will have little to do with P/E ratios, if and when the market comes to believe RH 2019 guidance will be met, and the redemption of the 2019 notes is completed. Short interest has reduced from 7.04MM at April 15, to 6.28MM at April 30, and to 5.89MM at May 15, 2019, reflecting shorts covering as the share price has fallen. But, even if all that reduction of 1.15MM has gone to reduce excess numbers of shares held by institutions, the excess would still be in the region of 8.6MM shares. When the music stops playing, there will be a rush to cover, and the share price can be expected to rise steeply, and far above the range of $125 to $149.
7. RH: Available Shares, And Short Interest
- At May 23, 2019, RH had 18.36MM shares outstanding, per p1 10-K/A filed May 31, 2019. Insiders hold 2.56MM of these shares, leaving a free float of 15.8MM.
- Although the free float is only 15.8MM shares, share ownership filings show institutions hold 25.60MM shares, 9.8MM more shares than the free float. Investopedia provides a succinct explanation for what is playing out here, which could end up a bit like musical chairs,
Let's assume that company XYZ has 20 million shares outstanding and institution A owns all 20 million. In a shorting transaction, institution B borrows 5 million of these shares from institution A and sells them to institution C. If both A and C claim ownership of the shares shorted by B, the institutional ownership of XYZ could be reported as 25 million shares (20 + 5), or 125% (25/20). In this event, the institutional holdings may be incorrectly reported as more than 100%.
- At March 31, Short interest was ~7MM shares, By May 15, short interest had dropped to 5.89MM shares, 37% of the free float.
8. RH: Concerns On The Impact Of 25% Tariff Increases, Are Overblown
Much of the increase due the 25% tariffs can be offset by negotiating lower purchase prices with the Chinese suppliers. The tariffs only apply to the portion of product sourced from China, and RH have been gradually reducing their dependence on China from 46% in FY 2017 to 41% in FY 2018 (see p6 FY 2018 10-K). In the Q&A to the Q3 2018 conference call, (see SA transcript) a further reduction to 25% to 30% in 2019, was discussed. RH has gross profit margins of ~40%. so cost of goods sold is ~60% of sales. But the purchase price of goods is only one component of cost of goods sold. There is inward and outward freight, warehousing, and a whole host of other costs to deduct to get back to the actual buying price of the articles being sold. In the case of Chinese imports there is also the cost of ocean freight, insurance and other charges that the tariffs are not levied on. Analysts' Corner has crunched the numbers, and after taking into account all of these factors, the overall impact on total company cost of goods sold is likely to be a 2 to 3% increase, which will only take effect in the second half. RH is a luxury brand and 2.5% on a $48,000 order would only increase the cost to the buyer to $49,200 hardly noticeable. If prices go up by 2 to 3%, to offset cost increases of 2 to 3%, and volume of goods sold goes down by 2 to 3%, as a result of the price increase, the profit result is virtually unchanged. Over the last few years, RH have been growing margins, even if this meant a headwind for revenue growth, and they have been very successful in this respect as shown in TABLE 9 below.
TABLE 9 shows RH increased gross margin by 3 percentage points in FY 2017, and by 5.1 percentage points in FY 2018. The assumption for FY 2019 is for a much smaller 0.6 to 0.9 percentage point increase in margin, which takes into account the impact of a 25% tariff increase, as confirmed by the CEO, on the RH Q4 2018 earnings call -
And then on the tariffs, yes. We're architecting the business like the tariffs are going to 25%, right. So if they don't, there's opportunity. And I think it's good news if they don't.
RH Pricing Power
Also on the RH Q4 earnings call, the CEO, Gary Friedman provided valuable insights into how RH has been able to grow margins, when other retailers are struggling with margins. It is useful to repeat what was said here, because this ability to achieve high gross margins is key to RH's success.
...the great thing about interior design is there's massive leverage, right. So you talk about making human capital investments. We don't have to build distribution centers. We don't have to buy more product. We don't have to create a whole lot of complicated systems to run the business. We don't need a new finance department. We don't need a new supply chain. It really leverages everything, right. So it's really among the highest return on investment opportunities we have in the company. So you'll see us continue to focus on that for a long, long time. And what else is very different than -- and the competitive advantage we have, if you haven't seen New York, you should go see New York. But when you present goods the way we do, the whole gallery becomes like the design office, right. And so if you think about the interior design trade, like, most interior designers don't have a physical presence at their work. We have the most compelling and extraordinary physical presence of our work in many of these new big galleries. And so the credibility that gives us, the ability to walk into a gallery like ours and see great work, see great interior design and inside great architecture is a proof point, right, versus an interior designer that you met through a friend that doesn't have any -- can show you a few pictures, right, but you can't see or touch the work. And by the way, they don't sell any products and you can't aggregate orders and you can't do all the things that we can do. So it's a massive opportunity. Again, when you think about it long term and big picture, and no one's really doing it at our level and the way we're doing it. And yes, I know other furniture stores and retailers have design services, but walk into their stores, tell me if that inspires you, do you want your house to look like that, right, when there's a bunch of Christmas [indiscernible] all over the tables and it's all junked up, and it looks like a store, right, with shelves and products all over the shelves. And it doesn't -- like I wouldn't trust them to be an interior design resource for my house. So I think what we're building, physically building is this kind of proof and calling card to the business, and it's really powerful, so.... Things you get for free, you sometimes take advantage of. So we think strategically as we build capability we become better that it becomes a true business. And we run it like a business and we charge for it, and we charge for installation and a lot of things that we're doing today. So we see a lot of opportunity there to drive revenues and margin.
A factor that does not seem to have been considered is customer expectations on price following announcement of a 25% tariff increase. Customers might be delighted to only pay 5% more, when they had expectations of paying 25% more. Customers are unlikely to know if the items they are buying are sourced from China or elsewhere, and a 2 to 3% increase across the board might be achievable without any undue effect on volume. And, of course, as far as FY 2019 is concerned, almost half of RH's fiscal year will have gone by before goods from the first shipment attracting 25% tariff will reach stores and be available for purchase. If the recent steep decline in RH share price is based on the potential adverse impact of the 25% tariff on Chinese imports, the market is very much mistaken.
9. RH: Risk Of A Share Market Downturn On RH Sales Of High End Furnishings
RH reported a noticeable impact when the share market dropped steeply in December 2018. Revenue growth was impacted, but RH still increased gross margin percentage, and reported Q4 2018 adjusted EPS up 78% on Q4 2017. Here is what RH had to say, in their Q4 2018 earnings release, on how stock market fluctuations affect their core business,
Our record fourth quarter and fiscal 2018 results demonstrate the strength of the RH brand, the power of our new business model, our focus on managing the business with a bias for earnings versus revenue growth, and our continued success revolutionizing physical retailing. We raised our guidance for the fourth quarter after the close of market on December 3rd. Despite the severe stock market volatility that occurred through the rest of the month, with the Dow dropping 799 points on December 4th on its way to losing over 4,000 points -- making it the worst December for stocks since the Great Depression – we exceeded our guidance for adjusted operating margins, adjusted operating income and adjusted net income.Our core RH business, which has historically tracked to stock market fluctuations, experienced a sales decline of approximately 10 points beginning the third week of December which persisted through the remainder of the fourth quarter leading to a $13 million shortfall to the mid-point of our revised revenue guidance in December. On a comparable 52-week basis, adjusted net revenues increased 5% to $2.51 billion. Adjusted gross margins expanded 500 basis points to 40.1% and adjusted operating margins increased 510 basis points to 12.1%.
Bolding by author.
Figures 1.1 and 1.2 below, show the movements in the Dow and the S&P 500 for the three months of RH's Q4 2018. The steep downturn in the share market, in December 2018, can be seen in each of the graphs.
Figures 2.1 and 2.2 below, show the movements in the S&P 500 and the Dow for the three months of RH's Q1 2019.
If the health of the Dow and S&P 500 indices provide a measure of the health of RH's sales revenue, then investors can look forward to good news at Q1 2019 earnings call. As an aside, one of my Analysts' Corner subscribers who is a senior executive in the furniture manufacturing industry in the US advises me, "...they are blowing us away with orders we can barely fill. Same across all our customers. This economy just hit high gear - which can't be bad for FND RH and SNBR."
10. RH: Summary And Conclusions
The company has consistently beaten guidance and analysts' consensus estimates over the past several years. The current low share price is almost certainly due to various elements of uncertainty around 25% tariffs, and their effects on profits, redemptions of the 2019 notes, and RH cash position. Closer analysis shows there is little risk in these areas, certainly nothing to cause such a large fall in share price. That fall in share price provides an opportunity to buy now, and potentially reap large rewards, similar to or greater than investor D in TABLE 3 above. RH at current share prices appears to present little downside risk. On the other hand, it offers the prospect for 36% to 62% capital gains, if FY 2019 adjusted EPS estimates are met and the shares just trade at a P/E ratio of 15 to 16.5 times FY 2019 adjusted EPS estimates. The potential for a short squeeze, could result in a far greater increase in share price.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
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