Value Investors Club / RESTORATION HARDWARE HLDNGS (RH)

Description

Short Restoration Hardware, RH. RH is an overvalued retailer that has bulls excited by

the prospect of 25-30% square footage growth over the next two years. The reality is that

the good news of sales growth and margin improvement is already priced in and the

expansion plans are fraught with unappreciated risk that could lead to >30% downside.

While recent trends have been favorable, RH is set up to underperform expectations due

to the potential for execution risk with an ambitious growth plan, the potential for

disappointing results with new store formats, negative free cash flow, increasing

inventories, and a lofty valuation.

The bull story is that RH is “in the early stages of a real estate transformation” being led

by a “visionary” CEO, Gary Friedman, whose “vision statement” reads “to create an

endless reflection of hope, inspiration, passion, and love that will ignite the human spirit

and change the world.” Friedman envisions a long term target of $4-5 billion in sales and

mid-teens operating margins, which, if true, means RH could be generating $8-10 of EPS

sometime in the next 8-10 years. The transformation process involves moving from store

sizes of approximately 8,000 square feet to much large stores of 45,000-60,000 square

feet, which they refer to as Full Line Design Galleries. Given a generally anemic retail

environment where many retailers are pulling back on square footage and struggling with

ecommerce, RH sees opportunity in dramatic square footage growth. The thought

process intuitively makes sense. In RH’s traditional stores of 8,000 square feet they can

display less than 10% of their merchandise. However, in a store that is 45,000 square

feet the can display 35% of the assortment. Management has stated that they typically

see a 50-100+% boost in sales when product is displayed in a showroom, rather than only

being available through direct channels. RH already does almost half of its sales direct,

and management believes that online sales in a given region also benefit from having

more showroom space. And because RH is a rarity these days in wanting to move into

bigger boxes, they are getting better real estate terms.

To management’s credit, the turnaround in the company’s performance since the

recession has been remarkable, but the future is going to look considerably different than

the recent past. The Full Line Design Gallery format is completely unproven, and

management’s estimates for their productivity are rather unscientific, yet the valuation of

the stock implies that they will be a resounding success.

At $93 and 39.6 million shares outstanding, the market cap is $3.7 billion. With cash of

$157 million and debt of $395 million, and 7.1 million options with cash from proceeds,

and .7m RSU the enterprise value is $4.3 billion. Management preannounced

preliminary fourth quarter results in February, so F2014 sales came in at $1.87 billion,

with EBITDA of roughly $211 million and EPS of $2.35, for multiples of 2.3x EV/sales,

21x EV/EBITDA, and 40x P/E, so people are betting there is a lot more on the come.

This isn’t a late stage biotech with a new blockbuster on deck, or anything that

revolutionary. RH is going to have to sell a lot more distressed leather sofas to justify

this valuation.

What’s the worst that could happen to a short? Clearly, this should be at the forefront of

any shortseller’s mind with a high growth story stock that is up almost 300% since its

IPO in November, 2012. Total sales have compounded at 21% since F2011 and

comparable brand sales increased 31% in F2013 and 19% in F2014, while operating

margins have risen from basically 0 to about 9% over the last few years. Its legacy stores

boast much higher sales per square foot than peers at approximately $1,400. Some of the

more bullish estimates on the street are closing in on $5/share in 2017, so it is already

trading at 18.5x some of the more optimistic scenarios. If the new 45,000 square foot

Full Line Design Galleries are somehow able to generate $1,000 per square foot in 2017,

rather than the ~$700 being modeled, then this could add about $200 million of sales and

to be generous add $0.30-0.50 to EPS, but even at $5.50 it is trading at almost 17x EPS

three years out. This seems reasonably priced if everything goes exceedingly well for the

next several years, given that even in the bull cases growth begins to taper to around 10%

and lower beyond 2018, so the risk to the upside is fairly limited . Home furnishing

retailers (BBBY, ETH, PIR, and WSM) trade around 17x and 8.6x 2015 EPS and

EBITDA, respectively.

Management highlights its Full Line Design Gallery that will open in Denver 4Q15 as an

example. The new store will be 45,000 square feet, while the old one that they are

closing is 7,500. Management projects about $31 million of sales for the new format,

while the old one was doing about $10.4 million, so the sales per square foot are

anticipated to decline to about $690 from $1,380. Due to the size of the store, RH is able

to negotiate more attractive lease terms, so the total rent will be just under $2 million

versus $1.3 million for the much smaller store, so rent per square foot will fall to $44,

down from $173, although a typical 7,500 foot RH store might be paying closer to $140

per square foot currently. Overall the square footage is increasing 500% with sales

expected to increase 200% with much lower occupancy costs and other efficiencies, so

management has guided 4-wall cash contribution of $8.7 million versus the old store at

$2.2 million. RH will pursue a similar strategy in other locations, as well, by closing a

smaller store that is more productive on a sales per square foot basis, while opening a

larger format with potentially a much higher contribution margin. The first Full Line

Design Gallery of this much larger size opened in Atlanta in November, 2014, so we will

get news of how this is faring soon. The plan is to open four more in 2H15 and then 5-6

more every year after that, eventually reaching 60-70.

The issue is that these new formats are virtually untested and there is no proof of concept.

During my discussion with management, they were not able to articulate how or why

they arrived at the sales assumptions for these new Full Line Design Galleries. The

performance of new store openings recently has been very good, but not necessarily

indicative of things to come. A few new design galleries were launched that are in the

20,000 square foot range. They are also located in some of the largest cities and most

affluent areas in the country. Initially, management provided sales per square foot for

some of these stores (Houston $2,300, Scottsdale $1,500, with Boston and Indianapolis

around $1,000), but have since stopped providing this information. While these sales per

square foot are impressive, it does not mean that stores 2-3x the size in smaller, less

affluent markets are going to be that successful, so it is unlikely that they will average

anywhere near the $1,000 per square foot posited in my very bullish scenario. There has

also been some concern that these new stores generate a lot of buzz when they open

driving a lot of traffic, but that may wane as the novelty wears off. RH has an enviable

customer base, with the average shopper earning about $200,000 a year. While this is a

great customer to have, it is also a relatively small addressable market, so there will

surely be some large cities and wealthy areas where these types of stores flourish, but it is

hard to imagine a 50,000 square foot luxury furniture store doing well once they the

begin to work their way down the food chain into smaller markets.

The sell-side views this rapid square footage growth as pure upside, without giving much

consideration to the execution risk associated with quadrupling the size of the stores, and

almost doubling square footage by the end of 2017. At that time rent expense will be

approaching $125-150 million annually, which if capitalized (depending on your

assumptions) would add around $1-1.25 billion to the balance sheet, so this is a dramatic

increase in fixed costs and obligations based on a concept that has not been thoroughly

vetted, and yet the valuation seems to imply that it has been proved out and there is no

risk on execution. While it all sounds well and good right now, if Full Line Design

Galleries underperform, they will become a tremendous burden.

RH is free cash flow negative, but should be able to achieve positive free cash flow at

some point. The more important question is when and how much free cash will it

generate? It has burned $160 million since 2011 and $93 million YTD. Management is

indicating that it should be free cash flow positive 12-24 months. It is reasonable for a

high growth retailer to consume capital as it opens stores. However, it seems unlikely

that free cash generation will improve much as square footage growth accelerates in the

next two years because new leases will be signed, new galleries built out, distribution

centers added, and inventories stocked. RH will spend approximately $140 million in

2015 on capital expenditures and this will continue to rise conservatively 10% per year to

fuel square footage growth. Working capital will also continue to be a drain in order to

support growth, so RH will need to tap its revolving credit line.

Growth in inventories has been a significant contributor to the cash burn and inventories

have reached an unhealthy level, even for a high growth retailer. On a quarterly basis,

inventory days on hand grew to 183 in the third quarter, up from 160 yoy. Some

improvement should be expected in the fourth quarter, but it will remain elevated and

most likely increased yoy again. Management is sanguine about the rise, stating that it

was a strategic decision to reduce out of stock positions and lower backorders. There was

also a strategic decision to expand assortment, growing the business “horizontally.” They

acknowledge that they have no history in some new products and categories, so the

inventory level has not been optimized yet. For example, the page count in its Source

Book, i.e. catalog, doubled to 3,200 pages from 1,600 in 2014, so assortment growth last

year was quite a bit stronger than square footage growth. Management anticipates that as

square footage growth accelerates inventory turns will improve. This is still problematic

for a couple of reasons. There is not as much fashion risk or seasonality at RH as at

many retailers, but turning inventory roughly twice a year is still very inefficient and

increases the risk of write-down’s or markdowns, especially if management lacks

historical perspective on some of these items. It is possible that there is some stale

product that is turning much slower than items that are regularly displayed in-store.

Furthermore, the “horizontal” growth of product, and commensurate increase in

inventories, has been an underappreciated driver of sales growth. It is difficult to

ascertain exactly how much, but it was definitely a factor. RH also plans to continue to

drive sales through the expansion of products and categories, so it is unclear that

optimization will automatically occur with more store openings. If management did

curtail this horizontal growth then it could become a headwind to sales growth.

While inventory turnover is much worse at RH than at its peers, in general, asset

utilization is relatively strong, as a result of strong sales per square foot in its legacy

stores. However, since going public fixed asset turnover has been in decline, falling from

11-12x 2011-2013 to 6.5x. This trend should continue as the rollout of Full Line Design

Galleries dramatically increases square footage, leading to lower returns on incremental

invested capital.

The long term operating margin target for the company is mid-teens, but home furnishing

retailers have never sustainably earned 15% operating margins with 10-12% being the

norm for the better managed ones. RH has done a commendable job of late, but even its

own history show what a difficult business this can be, and the low hanging fruit has been

picked, making any further improvement slower, and harder to come by. The high level

of inventories and deteriorating asset turnover also make incremental margin expansion

more difficult. Management targets 6-700bps of operating margin improvement to attain

its long term goal. They believe gross margin will improve 300bps, 200bps of which will

come from lower occupancy cost and supply chain improvements. As discussed earlier,

RH does have a real opportunity to obtain better real estate terms. Management also

expects to drive 100bps through merchandise margin and shipping efficiencies. It is

more difficult to imagine how much more pricing power they have over their customers.

In terms of SG&A, management wants to lower advertising costs by 200bps and

corporate G&A by 1-200bps. As sales grow they should be able to leverage SG&A

spend better, but RH SG&A as a percent of sales is already at the low end of peers.

Also, management does not disclose average ticket details, but furniture has been

increasing as a percent of the mix versus non-furniture. Furniture is higher ticket so this

has also been a driver of higher sales per square foot, but this trend appears to be

reversing as new product introductions are skewing more towards non-furniture, making

it a little more difficult to leverage operating expenses at existing stores. Also, in its prior

iteration as a public company, RSTO typically had gross margins in the low 30s and was

not able to sustain an operating profit.

The macroeconomic environment has also been supportive of RH’s business. Relentless

quantitative easing, along with improving housing and employment, have been a boon to

sales and pricing power. Without wading into the murky waters of making macro

prognostications, I think it is safe to assume that the improvements in the economy over

the next five years will not match those of the last five years, and that interest rates might

eventually go up, and there might possibly even be another recession in the future. One

can only imagine, though, what might happen to the stock if there were a recession and

comps turned negative again with bloated inventories and onerous operating lease

obligations.

Gary Friedman joined the company in 2001 as CEO. Before that he was with WSM for

over a decade, holding various positions, such as COO and CMO. In 2007, as the

housing market fell apart and the business suffered, SHLD made a bid for the company,

which Friedman rebuffed. He ended up partnering with Catterton Partners and Tower

Three Partners to take the company private. As the economy recovered, plans were made

to take it public again. However, Friedman was forced to resign as CEO in August, 2012,

amid allegations of an inappropriate relationship with an employee, but he still

maintained other positions with the company, and less than a year later, following the

IPO, he became CEO again.

Inappropriate workplace behavior notwithstanding, Friedman’s creative approach to

merchandising and showcasing created a lot of value at WSM and RH over the past 4-5

years, although his track record at RH during the aughts was fairly uninspiring. Perhaps

not earning its cost of capital and struggling to maintain profitability is not that

uncommon for furniture retailers, but there should have been quite a tailwind from the

housing boom in many of those years.

Interestingly, Carlos Alberini was hired from GES to act as Co-CEO in June 2010.

Alberini’s role was to focus on operations and enforce financial discipline, while

Friedman pursued his vision and merchandising. However, Alberini left in December,

2013 to become CEO of Lucky Brands. Prior to Alberini joining RH, Catterton brought

in Deborah Ellinger as president, similarly to provide a counterbalance of economic

reality to Friedman’s free wheeling style, but she also left shortly after joining. RH no

longer has an operational disciplinarian of this caliber, although its current COO has been

with the firm since 2006. In 2008-2009 as the country faced the worst recession since

World War 2 and most other retailers were retrenching, RH made a bigger bet on moving

towards more higher end, luxury products. “I said if we’re going to go down, let’s go

down in style” isn’t something you hear a lot of great capital allocators say, but it is what

Friedman said, according to a Bloomberg article from 2/27/14. Fortunately for RH, the

bet did pay off, as the Fed took unprecedented action and economy had a V-shaped

recovery, at least for a good portion of those earning over $200,000 per year. The rest is

history. It is a cautionary tale though, that the private equity sponsors felt the need to

have more operational adult supervision to counteract this go for broke mentality, and all

the more so given that RH is on the cusp of a major real estate transformation that will

double square footage by mid 2018. And it is worth noting that Friedman never ran a

public company profitably until he had this support.

Most insiders do not share Friedman’s confidence in the business and have been selling

heavily. Friedman actually made a sizeable purchase in September, 2014, although he

was a massive seller in 2013 at lower prices, but he does remain a major shareholder with

2.3 million shares. Alberini just thus far in 2015 has sold approximately $22 million

worth of stock. RH’s CFO, COO, and several other directors have also been active

sellers in recent months, effectively eliminating their skin in the game. RH’s private

equity sponsors exited their remaining stakes in late 2013.

As mentioned earlier, the upside risk appears limited given the valuation and the

constraints on growing a retail business, but usually I have a much easier time defining

the downside to stocks I am short. I have a high degree of confidence that the new

format rollout will experience some growing pains and that the inventory issues will

eventually be realized, but it is rather difficult to pin down exactly when. Specifically,

with respect to inventories, they grew $162.3 million yoy in the third quarter, in relation

to sales growing $88.9 million. As a thought experiment, if one assumed that half of the

$73.4 million increase needed to be written down, it would wipe out the $36.7 million

EBIT in the quarter, so setbacks on inventories could be meaningful to the bottom line.

In the normal course of business without out execution problems RH should be able to

improve its operating margin a bit more, but the long term target still does not appear

achievable. Pricing in some slower growth, lower sales productivity at Full Line Design

Galleries, and other manageable operational challenges, RH could earn about $4 in 2017,

which at 17x and discounted back to today would give you a price of $51 per share today.

Another way of thinking about it is to assume that RH achieves the midpoint of

management’s long term sales target of $4.5 billion, but struggles to meet operating

margin target, instead earning 11%, which is towards the high end of its peer group. In

this case, at 17x discounted back would also get you about $51 today. And there is

potentially more downside if there is a significant earnings miss if the real estate

transformation is a failure, or if inventories are written down or pressure margins

materially.

All of which, is a long winded way of saying I think the stock is worth about $50 today.

Obviously, Mr. Market will not recognize this in the near term until the wheels really

come off the story, but I do think that F2016 and F2017 will end up coming in closer to

$3.45 and $4, given the challenges and risks I highlighted, rather than the consensus

$3.84 and $4.94, so I think the stock can trade down to the low $60s with the potential for

bigger disappointments. In the unlikely event that the stars align and the real estate

transformation looks like it will be a complete success I could see the stock rising to

$105-110, or 20x ~$5.25 in 2017.

Risks to the short include: ~30% of the float is currently short, which is actually down

from about 35% at the end of 2014. However, it is an easy borrow. Also, if execution is

stellar and square footage and margin growth happen faster than expected or exceed

expectations, there could be more upside in the stock.

With the stock priced for perfection and unrealistic growth expectations, increasing lease

commitments, operational risks, excessive inventories, and negative free cash flow RH is

a compelling short.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Disappointing real estate transformation performance

Slower growth/missing estimates

High inventory levels pressuring margins

show sort by

			2015	2016
Price:	94.00	EPS	0	0
Shares Out. (in M):	40	P/E	0	0
Market Cap (in $M):	3,720	P/FCF	0	0
Net Debt (in $M):	238	EBIT	0	0
TEV (in $M):	4,000	TEV/EBIT	0	0
Borrow Cost:	Available 0-15% cost