I realize nobody wants to hear a negative viewpoint when a company's stock is up 15%, but I just don't see the reason for being so excited about the second-quarter results from Restoration Hardware (NASDAQ:RSTO). My Foolish colleague Rick Munarriz also likes the shiny penny that the company reported for its second quarter, but if you're willing to humor me, dear investor, I'll explain why I'm on the other side of the fence, unimpressed with the company's results.
I'll grant that the earnings, net income, and overall income statement performance at Restoration Hardware were impressive this quarter. I'll even admit to admiring the 3.1% increase in gross margins and the performance of the company's direct channel. However, as I look at the balance sheet and how it has weakened since the beginning of the year -- especially in comparison to last year -- I think the company has sacrificed its working capital management for an improved income statement.
As many Fools may already know, poor working capital management often leads to poor operating cash flow and free cash flow. The first hint that something is amiss is in Restoration Hardware's inventory growth of 32.3% and accounts receivable growth of 37.2%, with only 23.9% growth in sales. Getting a truer picture requires using the income statement and the balance sheet, and working backwards to estimate operating cash flow (at least until the company files its 10-Q with a full cash flow statement).
Starting with net income, estimating depreciation of $10.3 million for the first six months (based on the company's average over the last year), and taking into account movements in current assets and current liabilities, I estimate that the company turned in operating cash flow of negative $15 million or more versus last year's negative $3.4 million. That's a fairly large decline for a small company. It's important to note that there are always timing issues with working capital, and the company could still report strong full-year results. But as a rule, I want to see a rock-solid earnings report before buying into the feel-good story that comes with an earnings surprise and a 15% jump in the stock price.
Given that Restoration Hardware's operating cash flow has been negative in two of the last five years, and that the total operating cash flow over those five years is also negative, I'm even less inclined to buy into this one day of happiness. In fact, I think investors in this segment are better off considering Williams Sonoma (NYSE:WSM) or, for those willing to stray to a different section of home furnishings, Bed Bath & Beyond (NASDAQ:BBBY). Both of these companies have stronger balance sheets and consistent cash flow performance, and both have seen their share prices decrease more than 30% from their highs in the last year. Considering that consumer spending has shown signs of softening, the companies with the strong balance sheets have become even more important -- and much more attractive -- to my eyes.
Be sure to check out Rick Munarriz's take on Restoration's second-quarter results.
At the time of publication Nathan Parmelee had no interest in any of the companies mentioned. Bed Bath & Beyond is a Motley Fool Stock Advisor selection. The Motley Fool has an ironclad disclosure policy .
