"We're as confident as we've ever been." These aren't empty words from RH (RH 2.28%) CEO Gary Friedman. The company is backing up its confidence with one of the boldest moves I've ever seen: In the three months leading up to July 29, it spent $1.2 billion repurchasing its own shares. For perspective, its market capitalization is less than $6 billion.
In this article, I'll explain why this bet is contrarian, what could go right, and how it could all go terribly wrong.
The headwinds are blowing against RH
In May, business conglomerate Berkshire Hathaway (BRK.A -0.76%) (BRK.B -0.69%) revealed that it had sold its entire investment in RH stock -- nearly 2.4 million shares valued at over $600 million at the time. Forbes took this and ran the headline, "Bad Omen For Home Furnishings As Berkshire Hathaway Dumps Its RH Stock," showing how this was perceived by the market.
Berkshire Hathaway is run by famous investor Warren Buffett. And Buffett is an investor who's made several rewarding investments in the furniture space in the past. Dumping this many shares all at once suggests that Buffett knew something was up -- something that would make business hard for RH.
Indeed, RH is climbing an uphill battle. In the first half of its fiscal 2023 (which ended in July), the company's revenue fell 21% from the same period of fiscal 2022.
The luxury furniture company is greatly impacted by trends in the housing market. Right now, people aren't moving because they don't want to get rid of their mortgages with low interest rates. And because they're not moving, people are buying less furniture.
This is particularly problematic for RH. The company is updating its inventory this year and has to get rid of the old stuff. Because demand is low, it's lowering prices. And lower prices lead to lower operating-profit margins. The trend is seen in the chart.
RH Revenue (TTM) data by YCharts
No wonder Buffett sold.
Friedman's bold bet on RH
Friedman expects two things to happen. As he explained in the conference call to discuss financial results for the second quarter of the company's fiscal 2023, he expects that the Federal Reserve will lower interest rates at a relatively aggressive rate within the next year, leading to greater movement in the housing market.
Friedman also believes that RH's new inventory is so good that it will drive strong consumer demand regardless of what the housing market does. Therefore, Friedman said, "That's why we bought back 17% of the shares."
RH repurchased 3.7 million shares right after Berkshire Hathaway sold 2.4 million shares. On the surface, it appears that Friedman is betting against Buffett -- something few dare to do. But this isn't the only reason that RH's $1.2 billion buyback is a bold bet.
What could go right and wrong
RH didn't repurchase shares with money it earned from business operations. In 2021, the company borrowed over $2 billion on term loans. This debt was used to repurchase shares, and most of it is on a loan with a 7.69% interest rate, as of Q2.
Because of this debt, RH's quarterly interest expense is soaring, as the chart shows.
RH Total Interest Expense (Quarterly) data by YCharts
In a best-case scenario, Friedman is totally right, and RH's business will start booming later this year and into next year. If that happens, revenue will go up, operating margins will recover, and the profits will roll in. The company will be able to quickly pay down debt and pat itself on the back for repurchasing 17% of outstanding shares while they were cheap.
In a bad scenario, Friedman didn't time things right. If rates don't come down within the next year and people aren't ready to buy up pricey furniture, RH won't be as profitable as anticipated, at least not for now. That would likely cause the stock to flatline or go down, invalidating the urgency with which it repurchased shares. And those pesky interest expenses will keep chipping away at shareholder value.
However, there is one encouraging final thought. This isn't the first time Friedman has boldly bet on RH's future. In 2017, the company repurchased about 30% of shares outstanding in a very short time period. Shortly thereafter, the stock skyrocketed as the business proved the doubters wrong.
The chart doesn't reflect RH's aggressive buyback in Q2. But the buyback in 2017 is clearly seen, along with the upward stock price thereafter.
To be clear, RH has certainly increased the riskiness of its stock with its $1.2 billion buyback in Q2. But the company's timing proved prescient in the past. Shareholders hope that history repeats itself now.
