RH: Investment Thesis
AM Wednesday June 12, in my article, "RH: Expect A Strong Q1 Beat - Trigger For A Massive Short Squeeze", I conservatively estimated -
- RH (RH) would surprise the market by reporting Q1 2019 adjusted EPS in the range $1.52-1.64, up 25-35% on Q1-2018. This compared to a consensus estimate beat of 16.5%, per Yahoo Finance website (see Figure 1 below); and
- RH internally generated cash flows, together with utilization of already approved borrowing facilities, would enable the redemption of 2019 senior secured notes in cash, thus avoiding dilution from issue of ~3MM additional shares.
- RH would also beat consensus EPS growth estimates for the full year, FY 2019, for the same reason it was always going to beat Q1 consensus growth estimates.
The first blow to the shorts materialized PM Wednesday June 12 -
Analysts' consensus estimates were exceeded, when RH reported Q1 2019 adjusted EPS of $1.85, up 53% over Q1-2018, after close on Wednesday, June 12. This beat had the predicted effect of a dramatic increase in share price, in after hours trading. As per figure 1 below, RH closed Wednesday June 12, at $94.89, up 1.76% on the previous days close of $93.25. By close of after hours trade, RH shares were up another 25.56%, up 27.76% on the previous day. But, in my previous article, I wrote, "...it offers the prospect for 36% to 62% capital gains..", and that level has not been reached yet. RH finished close to its high in after hours trade, and I think it is reasonable to assume momentum will carry it higher, when trading resumes on Thursday June 13. But RH has yet another rocket to fire at the shorts, sometime in the next few days.
Consensus growth estimates for Q2 and FY 2019 will see a surprise increase, when a simple oversight is corrected -
Consensus growth estimates on Yahoo Finance, and maybe elsewhere, are being understated, due to a simple oversight. Comparative figures for FY 2018 are not being restated for FY 2019 accounting standard changes, and the standard 26% tax rate changes. The restatement of 2018 results is mandatory for RH, in their comparatives reporting. RH did restate its Q1 2018 comparatives for Q1 2019 reporting, contributing a significant part of the surprise increase. When analysts' consensus estimates of growth are correctly displayed for Q2 2019 and FY 2019, there will be more surprise increases in estimated growth rates. At present, Yahoo Finance is showing consensus estimate growth of negative 1.6% for RH FY 2019 EPS. RH announced higher FY 2019 EPS guidance for RH, in their Q1 2019 earnings release yesterday, of around 8.8% for Low and 6.7% for High case. So, the uninformed market would be thinking revised positive EPS growth in single digits. But when Yahoo correct their comparatives for the restatement of FY 2018, the growth rates will be 20.3% for the Low case and 27.3% for the High case. I believe this provides asymmetric/risk return, as the share price is only likely to go up when those rates are published as the correct growth rates.
The next blow to the RH shorts is imminent -
Due to lending, borrowing and shorting, institutions reported holding 25.6MM shares at March 31, 2019, when, excluding insiders, there were only 15.80MM shares in the float. And, that is only institutions. Goodness knows how many more shares are owned by individuals. And, how many more shares have been loaned, or borrowed by individuals. This is like a game of musical chairs. When the music stops, there will only be so many chairs (shares) to go around. When RH announces it has redeemed all of the 2019 secured convertible notes in cash, that will dash any remaining hopes of shorts of there being another 3MM shares (chairs) to go around, when the music stops. The 2019 notes mature on Saturday, June 15, 2019, and settlement is required soon after.
RH remains a strong buy -
As mentioned above, in my previous article, I wrote, "...it offers the prospect for 36% to 62% capital gains...". That was based on a share price ~$92, and estimated fair value range of $125-149, based on fundamentals. At the after hours closing price of $119.14, that still leaves room for additional 5% to 25% increases in share price, to reach estimated fair value. I also wrote, "The potential for a short squeeze could result in a far greater increase in share price." This time, the short squeeze will not come from RH. There are hedge funds which will be quite happy to get in early and buy at a price that is in the range of estimated fair value, with the knowledge their buying will assist to create a short squeeze, from which they can profit handsomely. The potential for super profits, well above fair value, remains in place. RH remains a strong buy.
Analysts' Consensus Estimates For EPS Growth - Where They Went Wrong, And Why EPS Growth Estimates Are Still Greatly Understated
When I wrote my previous article, I absolutely knew RH would have to report a result far worse than the lower end of its guidance, for it not to significantly beat the consensus estimates for 16.5% earnings growth (see Figure 1 below), by a wide margin. I also recognized it was almost inevitable, notwithstanding the irrationality of Mr. Market, if RH beat consensus estimates by a wide margin, there would be a favorable reaction, and there would be an increase in the share price. And, I knew this based purely on RH guidance. This was a clear case of asymmetric risk/return due to the market not picking up on the obvious. Where the consensus estimate for quarter over quarter earnings growth went wrong was failing to carry out the calculations to restate the Q1 2018 adjusted EPS to the same basis as used for RH's Q1 2019 adjusted EPS guidance. Effective beginning FY 2019, RH adopted lease accounting standard ASC 842, in place of ASC 840. Also, for calculating adjusted earnings (non-GAAP), RH adopted a standard 26% tax rate. RH provided guidance for Q1 and FY 2019, both under ASC 840 and ASC 842, and with a standard 26% tax rate (see here). But, for 2018, RH merely provided assumptions on the likely effect of the lease accounting changes, in terms of percentage point movements, because the actual workings had not been finalized.
RH Q1 2019 comparatives -
I provided a restatement of Q1 2018 adjusted EPS, in my previous article, as per TABLE 1 below.
My calculation, based on RH guidance, of restated Q1 2018 adjusted EPS of $1.21, per TABLE 1 above, is precisely the same as used by RH in their Q1 2019 to Q1 2018 comparatives. From the data from Yahoo Finance, in Figure 1 below, it can be back-calculated the Q1 2018 comparative EPS used was the as-reported Q1 2018 EPS of $1.33, per TABLE 1 above ($1.55 consensus estimate divided by sum of 1 plus 16.5% consensus EPS growth rate).
Source: Yahoo Finance
RH FY 2019 comparatives -
A similar error to the Q1 error has occurred for RH FY 2019 analysts' consensus EPS rates for FY 2019. In Figure 1 above, it can be back-calculated the FY 2018 comparative EPS used was the as-reported FY 2018 EPS of $8.54, per TABLE 2 below ($8.40 consensus estimate, divided by sum of 1 plus negative 1.6% consensus EPS growth rate). The correct divisor is the restated FY 2018 EPS of $7.28, per TABLE 2 below (my calculations based on RH assumptions on necessary adjustments per notes to TABLE 2). It can be seen from TABLE 2, RH guidance for FY 2019 EPS growth, properly calculated was 15% to 24%, far above the negative 1.6% EPS growth estimate per Figure 1 above.
RH revised guidance for FY 2019 -
Per RH Q1 2019 earnings release, guidance for FY 2019 has increased as shown in Figure 2 below -
Per Figure 2, the revised guidance for FY 2019 is for Adjusted diluted EPS of $8.69 to $9.27, compared to restated EPS of $7.28 per TABLE 2. This gives growth rates of 20.3% for the low case, to 27.3% for the high case. If Yahoo Finance were to continue to report growth rates based on the reported FY 2018 adjusted EPS of $8.54, it would show FY 2019 EPS growth rates in the range of 1.8% to 8.5%. When the market comes to realize the real growth rates guided for RH for FY 2019, are in the range of 20-27%, rather than low to mid single digit percentage increases, it would be reasonable to expect a positive move in the share price. I have not completed a restatement for Q2 2018 adjusted EPS, but expect a significantly better growth rate, than the negative 12.4% shown in Figure 1.
RH Can Meet 2019 Senior Secured Notes Redemption In Cash - Another Blow To The Shorts
Warning: Before reading this section, please understand I am not qualified to interpret legal documents, nor to give legal advice, and what I write is not intended as legal advice, and should not be taken as legal advice. It is recommended you seek financial, and legal advice, before acting on any information contained in this section.
The terms and conditions for redemption of the 2019 senior convertible notes, are found in an Indenture, a link to which is provided in an appendix to the FY 2018 10-K. The indenture is a complex legal document, with the complexity increased by the inclusion of provisions to protect the position of note holders from detriment through dividends, and a range of other possible detrimental events. No such detrimental events have occurred, so these provisions are now irrelevant. The key elements relevant to the calculation of the redemption value of the notes are summarized in TABLE 3.1 below.
The above sample is to show the calculations necessary to place a value on the 2019 notes for purposes of redemption, in cash or in equivalent shares. The daily VWAP shown is for illustration only. It shows a VWAP equal to the price at which the redemption value would calculate to the $1,000 face value of the notes. In that event, if RH elected for cash settlement (settlement method is entirely at RH discretion), the total cash redemption would be the ~$350MM face value of the notes. I cannot identify the relevant provision, but if the average daily VWAP, over the 45-day cash settlement period, is less than $116.09, I would be fairly certain the face value of the notes would still have to be redeemed, so the cash redemption amount would still be ~$350MM
If the average daily VWAP, over the 45 day cash settlement period is greater than $116.09, that would increase the amount RH has to pay to redeem in cash. To understand if this is the case, I need to know the actual VWAP for each of the 45 days. Per the notes indenture -
"Daily VWAP" means, with respect to any Note as to which Cash Settlement or Combination Settlement is applicable, for any Trading Day, the per-share volume-weighted average price as displayed under the heading "Bloomberg VWAP" on Bloomberg page "RH.N <equity> AQR"
I do not have access to the above information on Daily VWAP, but I can make a close approximation as per TABLE 8.2 below -
The daily VWAP for any day cannot be less than the low price, nor higher than the high price for any day. The average of the 45 days of daily VWAP falls between $98.39 and $102.22, neither of which is above $116.09. The amount for RH to redeem the 2019 notes in cash will be ~$350MM, representing face value.
RH: Intent to repay the $350MM required to redeem the notes in cash -
From p2 of the Q1 2019 earnings release,
In the first quarter we completed multiple debt financings totaling $380 million and amended our credit facility, which in aggregate added $420 million of new liquidity, supporting both further purchases under our share repurchase and the planned repayment of $350 million of convertible notes due June 15, 2019 and $300 million of convertible notes due July 15, 2020. We will continue to be opportunistic as it relates to the capital markets and the repurchase of our shares. Our net debt is currently 2.8x TTM Adjusted EBITDA and we project that we will end the year with net debt to TTM Adjusted EBITDA of approximately 2.0x.
Redemption of the notes in cash will avoid the issue of ~3MM additional shares. This will deliver a further and critical blow to shorts - dashing expectations of 3MM additional shares coming onto the market to enable them to cover.
Summary and Conclusions
Following yesterday's increase, I see RH share price has fallen back to ~$117 in pre-market trade. That is below my estimated fair value range of $125-149. Back on January 28, 2019, Citron Research published an article on Seeking Alpha, "RH The Most Compelling Story In Retail - Price Target Of $250". With the strong earnings outlook for RH, much stronger than when the share price broke through $160 in 2018, and with the crowded short interest, that article may prove quite prophetic.
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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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