Imagine this scenario with me for a second:
On April 26th of this year, you bought shares of RH (NYSE:RH) -- an upscale furniture retailer formerly known as Restoration Hardware. Between then and now, the company's market cap has advanced a healthy 30%. At the same time, however, your shares have more than doubled -- up 120%!
A perfect storm of variables collided within a very short seven-month window: a new business model, a stock in short-sellers' cross-hairs, an outlandish compensation package, and a board willing to take on heavy debt.
The result is something almost never seen among retailers in the age of e-commerce: a stock that has produced remarkable results without concomitant growth of the underlying business. Is this the result of ingenious opportunism, greed-fueled stock manipulation, or a combination of both?
I'll let you decide.
RH limped to the finish line at the end of 2016. The company's stock fell over 60% that year as the company's attempts at winning over e-commerce customers faltered. CEO Gary Friedman didn't help things either, as he seemed to turn to excuses that blamed every factor possible...except for himself. When the New Year rolled in, short-sellers had piled on: 36% of shares outstanding were sold short.
But Friedman had a plan. While not abandoning e-commerce entirely, the company's focus would pivot -- unexpectedly -- toward brick-and-mortars, with a $100 membership card to boot. Here's how he explains that contrary stance today:
"Many of the strategies we are pursuing -- opening the largest specialty retail experiences in our industry while most are shrinking...moving from a promotional to a membership model... and refusing to follow the herd in self-promotion on social media platforms... are all in direct conflict with conventional wisdom.
We believe when you step back and consider; one, we are building a brand with no peer; two, we are creating a customer experience that cannot be replicated online; and three, we have total control of our brand from concept to customer, you realize what we are building is extremely rare in today's retail landscape, and we would argue, will also prove to be equally valuable."
Given Friedman's recent track record, the market wasn't impressed with this stance. And that's where our seven-month window opens.
The timeline of events
- April 29, 2017: According to a later earnings report, RH completed a previously authorized $300 million share repurchase by this date. The effect was an almost 20% reduction to share count.
- May 3, 2017: RH announces a new compensation plan for Friedman. In it, he is offered stock options worth a total of at least $75 million over four years if RH stock's 20-day average trading price hits three different milestones: staying above three $100, $125, and $150 per share. Shares trade for less than $50 per share when announced.
- May 4, 2017: RH announces plan to repurchase $700 million worth of stock. At the time, the entire company is valued at $1.7 billion. Approximately 46% of shares outstanding are sold short.
- June 1, 2017: First quarter earnings are announced. Revenue jumps 23% while comparable brand sales show an increase of 8%. Despite this positive news, shares lose 25% on RH's outlook. Approximately 39% of shares are sold short.
- July 14, 2017: RH announces that it has completed its entire $700 million share repurchase. This reduces the shares outstanding by another 36%. For the entire year, the share count has almost been cut in half. Shares sold short now exceed 60%.
- September 6, 2017: RH announces second-quarter earnings. Revenue advances 13%, adjusted earnings jump 47%, but -- most importantly -- free cash flow booms to $282 million (from a loss of $149 million the previous year). This comes thanks to a combination of inventory reduction and positive business results. Shares jump 40% on the news, and approximately 47% of shares are being sold short.
- November 15, 2017: RH raises its adjusted net income guidance for the rest of the year. At the time, roughly 40% of shares are sold short. The stock jumps another 25% on the news.
Here's what that scenario looked like:
Where does that leave us?
For all the financial maneuvering, Friedman is very close to accomplishing his first milestone of a $100 price-target. That would net him over $4 million. But I'm willing to wager he isn't going to leave the $70 million-plus on the table.
RH's underlying business is gaining momentum, and Friedman believes that the Design Galleries in major U.S. cities can expand their sales while operating costs come down companywide. RH's most dangerous loan -- $100 million, with an interest rate over 9% -- has already been paid back.
Attention now turns to the convertible notes the company has coming due by 2019 and 2020. In total, they amount to over $550 million. Can the company pay them back? Right now, RH has just $22 million in cash versus over $1 billion in long-term debt and obligations. And in the next fiscal year, free cash flow is expected to cool notably and end up in the range of $240 million. That's because this year's surge was charged by a dramatic inventory reduction -- a one-off event.
The stock currently trades for just 20 times expected earnings for next year, and less than 10 times expected free cash flow. That's a pretty fair valuation, especially when you consider that about 40% of shares are being shorted.
But I'll say this: if RH hits any bumps in the road, or if the stock market dives -- causing RH's customers to tighten their purse strings -- the company will be in trouble. If business continues as usual, shareholders could be rewarded. But with such large debt obligations -- or, in the case of convertible notes, share dilution -- the cash flow needs to continue rolling in.
If you have the stomach for the type of volatility that could send the stock down over 30% in one day, have a long-term time horizon, and trust that Freidman knows what he's doing, it's worth looking into buying shares. Otherwise, I think you should join me in not buying -- or shorting -- the stock.