Description

Nondescripthandle had an idea to short RH equity a couple weeks back that has worked, though it was tough to get borrow and the cost was high.  I think what is a better upside/downside idea right now is to short RH 0% due 2019 converts.  

You can read nondescripthandle’s post to get the background, but here’s the gist - RH’s aggressive $1b buyback funded by secured debt and working capital liquidation - reducing shares outstanding by 50% - has definitely caused a short squeeze in the equity.  As borrow has started to become more freely available and cost has come down, the equity has fallen from its recent highs.  Yet, the RH 2019 convert is still trading at 87c yielding 7.7%.  

The market gets that the leverage has increased - net debt on foward sell-side EBITDA of $200mm is around 5.4x, and if you include build-to-suit leases that are capitalized on the balance sheet it’s 6.5x.  In fact, to do the last $100mm buyback, the company went to Apollo (lender of close to last resort) and borrowed at L + 8.25% on a 2nd lien basis.  Along with this Apollo loan, 1st lien borrowings, and an aggressive liquidation of working capital (primarily inventory), the company was able to reduce the shares by 50%.

Here’s where the capital structure stands after the company finished its repurchase in early July.

The unsecured convertible notes (two issuances, one due mid 2019 and one due mid 2020) have been primed by ~$400mm of 1st lien debt and $100mm of 2nd lien debt, and net debt has gone from 1.7x to 5.4x in 2 quarters because of the repurchase.

Here are my estimated sources and uses for the buyback:

What is not as well understood is how dangerous this exercise was from a liquidity perspective.  By the guesstimate above, the Company generated $177mm of cash from working capital in 2Q (ended July).  Given that inventory is the only line item that could possibly withstand such a large swing (see working capital balances below), I estimate that at least $150mm of inventory was liquidated off the balance sheet this quarter.

The company had $430mm of liquidity as of the end of the 1st quarter.  The 1st lien revolver availability is governed by the lesser of i) commitments of $600mm, or ii) borrowing base availability, which is a function of inventory, receivables, and as of the latest amendment in June trade name appraisal value (value of brands of RH up to a maximum of $50mm).  The borrowing base availability is provided in the 10Q/Ks.  

Because inventory is the main asset that governs the borrowing base, it’s easy to calculate the estimated impact on liquidity.  Historically, the borrowing base was roughly ~70% of book value of receivables and inventory.  If I reduce inventory by $150mm from 1Q to 2Q, the borrowing base will go down from $492mm in 1Q to $398mm in 2Q before adding in availability from trade name value.  

One further limitation on availability is a springing fixed charge coverage ratio (FCCR) maintenance covenant test of 1:1 if availability is less than 10%.  As of April, the company disclosed in its 10Q that had the company been required to meet that ratio, it would have been in breach of the covenant.  Given that since then the company has borrowed $500mm of secured debt, the denominator of that test has only increased so it’s safe to assume they can’t meet it today either.  Thus, the last 10% of the revolver is not accessible.

The situation can be summarized like this:

• A retail company that does over $2b of annual sales with 80+ retail stores now has liquidity of roughly $125mm heading into a traditionally seasonal working capital build, when historically it has been accustomed to operating with well north of $500mm of liquidity

• This company has $650mm of convertible notes that need to be addressed by the time the company files its 2Q19 10Q in early Sept 2018 (effectively 12mo from now).  The 2019 converts will become a current liability by then and the company will need to show it can refinance both the 2019s and 2020s given no lender will lend them money to refinance only the 2019s.

• Based on the 2nd lien credit agreement, it doesn’t seem like the company has much more secured capacity, and given how hard the stock is to borrow that means the company is shut out of the traditional convertible bond market.

• The 2nd lien was raised at 9.5%, yet the junior unsecured converts trade at 7-8%, as if there’s 0% of refinancing risk.

Trade - short RH 0’s due 2019

Downside

The conversion price on the 2019 is $116.09.  There’s easy cheap protection in the scenario the stock goes above the conversion price (which I only see happening in a Porsche/VOW scenario) with $115 strike call options.  You probably don’t need to go all the way out tot maturity as this will likely be dealt with in the next 12 months.

Should the company be able to improve EBITDA and get leverage down to a manageable level (4x), I’m sure they will be able to refinance these bonds in the unsecured market at 7-8%.  In that case, the downside is 13 points.

Upside

Given the low liquidity of the company, the poor fundamentals (company had to revise guidance downwards after 1Q18 results in April), and high leverage, should EBITDA come in worse than the $200mm sell-side estimates, the company could have serious refinancing risk in 12 months time.  Plus, should the trade creditors get worried and tighten terms, that could have a very negative effect on the retailer as well.  In a scenario where there’s refinancing concerns, these bonds could easily trade to 70, providing almost 20 points of downside.  In a bankruptcy situation, the recovery of these bonds could be south of 50 given the amount of operating leases this company has (>$100mm of annual rent expense) and the fact that the 2020 bonds have subsidiary level guarantees while the 2019 bonds do not.  

Catalyst

• Worse than expected SSS, inventory rebuilding and capex take up all the cash generated from the business and company has to discount aggressively to drive sales like they did in the past when RH Modern and Teen/Baby were failures and margins get hit
• Liquidity concerns make trade creditors tighten terms
• Credit market seizes up just as they need to refinance converts
• Luxury goods market weakens