Description

RH (Restoration Hardware) has rallied dramatically off its lows of $24 in part due to an extremely aggressive share repurchase program. In the past year alone, the company has repurchased over 20mm shares, representing about half of all shares outstanding. We believe company repurchases accounted for around 15% of shares traded on most days, and far more than that after taking out volume attributed to quant funds and short term traders. This, combined with a high short interest in the stock, has contributed to a short squeeze and elevated borrow costs. The repurchase program has now been completed, and the company is now highly levered at 5.6x net debt/EBITDA. With borrow costs and availability normalizing, timing appears appropriate for new short positions.

Going forward, we expect the company to trade more on fundamentals. RH currently trades at 13.1x 2017E EBITDA and 26.2x Pro Forma EPS (Pro forma for the lower 21mm share count and higher interest rate). We note that this number, along with consensus estimates, doesn’t include the interest cost of $650mm of 0% convertible debt due 2019 and 2020 that converts between $116 to 118. Assuming the converts are rolled into market interest rate debt would add approximately subtract $1.1 from EPS, making the stock trade at 45X 2017 earnings.

Peers like WSM trade at 5.7x CY EBITDA and 13x CY EPS, even though WSM has exhibited greater earnings stability and a more consistent operating history than RH.

We also find the current elevated multiple unsustainable given various company and industry wide concerns:

·         The company’s business trajectory is uncertain: RH significantly underperformed its peer group in 2016, with sales decelerating to -2% (organic) from +13% in 2015, and margins contracting sharply. Part of the issues were self-inflicted, including product manufacturing issues, elevated customer service costs, and holiday assortment issues. However, beyond these issues we believe there was a clear change in underlying customer demand. While it appears that business momentum has improved in recent quarters, timing shifts and easy comparisons make the ultimate trajectory of the business uncertain.

·         Restoration Hardware has a distinct brand aesthetic, which makes its product appeal narrower and subjects its furniture to fashion risk. Certain other high end furniture brands such as Pottery Barn or Ethan Allen carry more styles and appeals to a broader group of customer tastes. We believe part of the strong growth the company experienced up until 2015 may be due to the company’s products being well positioned for furniture fashion trends, and the subsequent slowdown in 2016 may also be related the cooling of these trends. We also believe that trending furniture styles have solicited more competition, with other retailers adopting similar looking product, making it more difficult for RH to own the look that they are uniquely known for. We’ve anecdotally observed several competing retailers now selling product that we distinctly associate with the Restoration Hardware look.

·         The rise of Wayfair, a pure play online furniture retailer growing 50% in 2016, has structurally changed the competitive dynamics for furniture retailers. Historically furniture has been underpenetrated online and brick and mortar retailers have faced limited competition from this channel. There have also been recent reports that Amazon is making a more aggressive push to sell furniture by investing in distribution infrastructure focused on heavy items like furniture and appliances.

·         Recent earnings reports appear to show signs of stabilization/reacceleration in the business, however, upon closer look, results are not as favorable as they appear. While revenue growth was up 23.4% y/y in Q1, much of this growth was due to steeped up inventory liquidation efforts including the opening of several temporary outlets. Excluding the impact of inventory liquidation and an acquisition, management acknowledges that revenue growth was only 9%. However, even this overstates the improvement in the business:

o   A timing shift in the mailings of their Interiors catalog from spring of 2016 to fall of 2016 shifted revenues away from 2016 into Q1 2017. This, along with the mailing of a new RH Modern catalog (no mailing in 2016) also benefited revenues in Q2 2017.

o   The results in Q1 2017 look less favorable when you consider how easy the comparison in Q1 2016 was. Q1 2016 included many one item costs associated with one time “customer accommodation” along with other unusual items. Excluding all these items, operating income would have been 22.8mm in Q1 2016 instead of the 0.7mm adjusted number that was reported, making the 8.3mm of operating income they put up in Q1 of 2017 look much less favorable.

o   Bulls may consider the company’s current stepped up inventory liquidation activity to a temporary issue depressing 2016 and 2017 margins. Consensus 2018 numbers assumes a significant recovery of margins. We are skeptical that such aggressive discounting, which is quite evident on the company’s website and email communications (both of which are major sales channels for the company) has not pulled forward some demand from future years or tarnished the company’s premium brand. 

Risks:

·         If management really intended to artificially distort the market price of RH stock with an aggressive repurchase program, they may have other tricks up their sleeve that will further squeeze shorts. Did they intentionally lower full year guidance on the 6/1/2017 earnings report to lower the share price so they could repurchase more shares cheaply? Do they lowball guidance so they could raise it on their next earnings call (beyond the amount that would need to be raised accounting for the lower shares outstanding), allowing them to sell their stock at elevated prices? These are pure speculations on my part, and I have no special insight into the management team’s intentions and I have no access to the management team.

·         Although borrow costs and availability is normalizing, borrow is still tight and expensive.

·         The company’s business initiatives, such as the new Modern collection, may be successful in driving an improvement in business trends. 

Catalyst

Normalization of supply and demand for RH shares in the market.