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RH: Turning A Frown Upside Down

Takeaway: Sensing the Chinese water torture of S1s could hurt, RH upped guidance a lot closer to what we think it will earn (but still not enough).

RH got some good advice on this one and averted what could have been a multiple-killer.


When the company announced yet another follow-on offering on July 5, the story immediately lost some momentum. The underlying fundamentals were still solid, but anyone with a shred of analytical integrity had to step back and wonder if it was going to be like a 'Chinese water torture' of additional stock sales.


That was particularly the case with the size of the deal growing to 12mm shares from 10mm after the close tonight, and with officers and Directors participating instead of just Home Holdings (the three firms that took it private -- whose ownership will be down to 15.9% post offering ).


But alas, RH came out and issued new long-term growth targets that are nothing short of parabolic. It made the following changes…

    1. revised revenue growth to low 20s vs prior goal of mid-high teens. 
    2. EBITDA growth from twenties to high 20s
    3. EPS growth of mid-high twenties from prior growth of 'about 20%'


Note that the revenue growth guidance is a bit closer to our model, but our much more aggressive top-line forecast of 30%+ is the base of our roadmap for RH to achieve triple-digit status (see our research below). We should also note that we think that the company is being conservative with the leverage to the EPS line of a company in this business that is growing its top line in excess of 20%.  In three years' time we get to $3.36 in EPS vs the Street at $2.22. Ultimately, in 5-years we're over $5.


RH: Turning A Frown Upside Down - 1





Takeaway: RH is expensive and it's built to stay that way. It continues to meet or beat our lofty expectations. The consensus is low by 60%.

Conclusion: Still one of our favorites. The company overdelivered on a heck of a lot more than the EPS line. It took up sales and EPS guidance well ahead of what the 1Q beat would imply. It accelerated square footage, announced yet another two businesses, two new catalogs for Fall, and made a  major hire in luring away the President of the Williams-Sonoma brand to be CMO for its RH Kitchens and Tableware business (where current share is near zero). RH continues to meet or beat our expectations in almost every area. The biggest question for us here revolves around how much higher the stock can go. After all, the stock is up 82% in six months, and is flat out expensive. But it was also expensive 82% ago. In addition, if our model is right, we're looking at an earnings CAGR of about 50% for each of the next three years. Then it eases to something in the mid/high 20s. So what's a fair multiple for that? 30x? 40x? It's tough to say. But what we can say is that we're 60% ahead of the Consensus in the outer years, and until the Street realizes that there's $5.00+ in EPS over 5-years, then we're comfortable owning it even if it's expensive. 



RH was one of our favorites headed into the quarter, and it remains so after the quarter. But aside from a solid beat, we did not expect much in the line of new disclose or thesis-changing information with this print given that the company just executed on its secondary on May 15th (which in itself was just weeks after a delayed 4Q earnings print and subsequent positive preannouncement).  We were wrong -- they gave the thesis some more positive go-juice.


Here's what changed on the margin:

      1. First off, RH beat the quarter by $0.03, but took up full year guidance by $0.10-$0.12. Not many companies are doing that these days. RH took up annual revenue guidance by 4%, and 2Q revenue by 7%. None of these things are thesis-changers for us, and in fact, we're still well above these numbers. But they're confidence-builders nonetheless.
      2. RH is fresh off the ICSC conference in Vegas and the company had better than expected success in pairing up with potential landlords for new Design Galleries. Not only does it take up the number of Galleries we're likely to see over time (over 50), but we think it also takes up the average size per store. These two factors are a critical on a combined basis as it relates to our margin of safety on the RH growth algorithm (see below). With more favorable availability of sites comes more favorable rents and cap rates -- it's economics 101.
      3. RH is launching two new businesses -- again.  Does this sound familiar? In RH's first quarter out of the IPO gate it announced the launch of RH Tableware, RH Objects of Curiosity, and RH Fine Art. Now we've got RH Kitchen and RH Antiquities. Both of these are massively fragmented businesses and present huge opportunities for RH. These are in addition to RH Leather and RH Rugs, two new catalogue drops this fall. #growthaccellerating
      4. RH managed to snag Richard Harvey from Williams-Sonoma to be CMO for RH Kitchens and Tableware. The simple fact that RH's share of this category is close to zero today, and they went ahead and hired the person with the best track record in the world in brand-building, sourcing and merchandising in the kitchen space….that's just huge.
      5. There's only one new risk that we can point towards…and that's execution. We're looking at a company that should double square footage, triple revenue, and take up its EBIT ten-fold over the next 5-years (seriously…let us know if you want to see our model). In doing so, RH will need to introduce and scale new categories in some of the most fragmented categories in all of retail. Fragmentation is good from a competition standpoint, but it is also usually characteristic of a category is difficult to scale. From a modeling perspective, we can quantify the cost of a new store. We know square footage. We can make pretty good estimates on the new store productivity curve. We can also make assumptions about rents and leverage hurdles for occupancy expense. But what we find very difficult to do is modeling SG&A. We think that we're safe in modeling a 15-20% SG&A growth rate in each of the next 5-years. SG&A might not be very sexy, but we think that this is the biggest and most unknown lever in the model.




We think that RH is to home furnishings what Ralph Lauren is to Apparel and what Nike is to Athletic Shoes. It's the preeminent brand in the space, and sets/leads consumer style trends/wants/needs but with very little fashion risk. From a maturity perspective, we think that RH is 8-10 years behind RL, and 15-20 years behind NKE. Its got the runway. And even though it has such minimal market share across its categories, the competitive set is actually not very strong.


One thing that makes the RH model stand out is the growth algorithm over the next 5-years. Specifically…

      1. Square footage is not growing today. The company has perhaps one more quarter where it shrinks and then it starts its' climb. 
      2. But our point is that today it is the comp that's driving the model. We can clearly see where that's coming from, we can map out additional sales as new businesses come on line, and we can draw out the comp curves for new higher productivity stores entering the comp base and hitting more mature productivity levels. We're modeling sales per square foot going from $846 last year to just shy of $1,500 in year 5.
      3. Ultimately, comps will slow. It's a mathematical certainty. But at the time comps slow we're likely to see square footage growth accelerating to peak rates of growth. Square footage is shrinking slightly today, and should be up at a rate near 20% by year 3.
      4. So you see…we can safely model the comp today due to reasons discussed above. Then as that starts to level off, we have square footage ramping up. We can safely model that too. As the second chart shows, that gets us to just over 20% annual revenue growth with comp and square footage flip-flopping their importance to the model as time passes.


RH: Turning A Frown Upside Down - 2a 

RH: Turning A Frown Upside Down - 3a




Circus Bears of Consensus

There is nothing worse for the 2013 Perma-USA stock market bears than a no-volume ripper day like today.


Circus Bears of Consensus - cirbe


It’s now four up days in a row for US Stocks. The S&P 500 is just a hair away from its all-time closing high of 1,669.16. The Nasdaq posted its best close since October 2000. And to top it all off, the Russell 2000 just notched a third consecutive all-time high.


In case you missed it this morning, here's a #timestamped look at how off-the-mark the #OldWall consensus bear has been. 


Circus Bears of Consensus - Chart of the Day

GIS – Investor Day Take-Aways

Today GIS presented at its Investor Day in NYC; there were, however, few updates today versus its commentary on the Q4 2013 earnings call on 6/26/13. We will be looking to the next quarters to evaluate returns from its yogurt and cereal businesses, in particular, and its margin management results in the face of COGS headwinds in a year in which the company expects to raise the dividend 15% and buyback 2% of shares outstanding. Our fundamentally bearish view of the company remains, as expressed in the note titled “GIS – Not Much To Like”, however our quantitative model signals a bullish formation in the stock across its immediate term TRADE and intermediate term TREND levels.


GIS – Investor Day Take-Aways - vvv.gis


Here are the points of the business we are focused on:

  • Gross margins remain under threat for cereal, yogurt, and convenience meals
  • Cereal, its largest category, remains under pressure from demographic headwinds, particularly in America, despite increased advertisement spending; GIS is bullish on gradual improvement in the category following strong merchandizing from competitors in the beginning of year
  • Yogurt has more room to show improvement, following the Yoplait acquisition; we like the innovation and marketing push behind its new Greek style yogurt and the runway in the U.S. given the lower share penetration versus other geographies (like Canada or France)
  • Convenience meals remain off track and the company acknowledge the importance of returning to Helpers (core) versus its previous push towards a more artisanal offering
  • Input cost pressures of 3% will remain a headwind in 2014, which the company hopes to overcome through cost savings initiatives via Holistic Margin Management (HMM); expect some pressure on promotions
  • We like the expanding international footprint (34% outside of U.S. today vs 25% 5 years ago) and opportunity to increase cereal consumption in emerging markets. [Currently one half of GIS cereal volume is in the UK, Australia, Canada, and the U.S., which collectively only account for 6% of the world’s population]
  • Company’s consumer outlook is one of improvement in which shopper seeks best value, which GIS can capture with its reach across retailers: Grocery (50%); Supercenter (30%); and Other Channels (20%) = Costco, Walgreens, Dollar General, and Whole Foods

Matthew Hedrick

Senior Analyst

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#RatesRising - Sector Study

We’ll introduce our detailed view on #RatesRising and the cross-asset class implications of the reversal in the 30Y bull cycle in bonds on our 3Q13 macro Themes call next Tuesday (July 15th, 11am). 


As a visual preview and for some historical context, the sector study below shows the average, relative Q/Q sector performance during periods in which the factor combination of:  Rising 10Y Yields, Expanding Yield Spread, and $USD appreciation all prevailed.  At n=7, the sample population isn’t overly large but we’d still view the output as instructive. 


General underperformance in defensives and outperformance in cyclicals isn’t particularly surprising.  Additionally, we’d note that given the policy catalyzed, positive relative performance in yield chase assets, the downside for sectors such as Utilities and Staples is likely larger than historical precedent would suggest.  


Further, in the context of our #StrongDollar and Bearish China/Emerging Markets view, the relative performance risk for Materials and select Energy & Industrials is likely to the downside vs the historical mean.  


In short, alongside continued TREND improvement in domestic Labor Market, Housing, Confidence and Credit metrics, we’re viewing the back-up in Treasury rates and expansion in the yield spread as a pro-growth signals.  


In terms of positioning, the 1H13 playbook remains largely in-tact with Consumer Discretionary and Financials the best way to find positive $USD and domestic consumption leverage at the sector level.  While equities are immediate-term overbought here (see today’s note: Overbought: SP500 Levels, Refreshed) we continue to like the absolute and relative growth setup for the U.S. and pro-growth oriented asset exposures.


#RatesRising - Sector Study - Sector Performance Rising Yields   Expanding Yield Spread    USD Appreciation


#RatesRising - Sector Study - 2013 MACRO FLOW



Christian B. Drake

Senior Analyst 


Growth Is Getting Paid

Takeaway: Beware the Antichrists of Growth.

The Antichrists of Growth (Gold, Treasuries, Utilities, etc) are still underperforming.


Just to give you an idea: Utilities (XLU) are down 0.5% on the month, whereas pro-growth Consumer Discretionary (XLY) is up 3.4%. A not-so-subtle 400-basis point divergence there.


Growth Is Getting Paid - Growths Dichotomy


Pro-growth Financials (XLF) are up 2.67% July-to-date. Gold? Hell on earth, scorched over 25% YTD.


As for Bill Gross, his 10-Year Treasury is down about 6% in the last three months; the S&P 500 is up over 5%.


Last but not least. The Russell 2000 is breaking out to new all-time highs, notching its second consecutive record high in as many days. It’s up 19% YTD. Many would acknowledge that the Russell 2000 breaking out is probably a pro-growth signal.


Here's another way of looking at it.


Growth Is Getting Paid - Risk Managing the Growth Trade


In other words, growth is getting paid. 


(This is an excerpt from Hedgeye Risk Management CEO Keith McCullough's morning call. If you would like more information on our services and how Hedgeye can help you please click here.)

FDX: If Ackman Isn’t Buying FDX, He Should (Market Speaks)

Takeaway: If Ackman is not buying FDX, he should take a look. The move in FDX today indicates that FDX matches his criteria well.



We do not know if Pershing Square is planning to invest in FDX, but many of the characteristics described appear to be a solid fit.  FDX trades at a meaningful discount to UPS, despite having a more impressive franchise in many ways.   In concept, FDX offers a simple service and competes in an industry with very high barriers to entry.  The company’s topline is fairly predictable and FDX could generate substantial free cash flow if it ramped down capital spending (perhaps an issue for activism). The market cap is right, too.   If Ackman is not buying FDX, he should take a look.  The move in FDX shares today may be indicating just that – FDX matches his investment criteria well.


To review the opportunity at FDX, see our black book call here and write-up here.  We have also had expert calls on independent contracting at FedEx Ground and on FedEx’s relationship with an evolving USPS.  After all, if DHL can match competitor margins, FDX certainly can.  In short, we think FDX is one of the best long-term opportunities in the sector.



Timing Matters 


10-K Filing:  FDX is scheduled to release its 10-K around July 15th.  That matches the commitment timing for the Pershing investor commitments  of July 17th.  Reviewing the data released in the 10-K would be important before taking a concentrated, long-term position.


FY 4Q Express Margin:  As we expected and noted, FedEx delivered on its goal to improve the Express division margin in its FY4Q 2013 earnings release.  Gains should continue into FY2014 and FY2015 as the restructuring continues.  It is less risky to commit after the company has already made headway on a critical restructuring.



Upside in Restructuring


Revaluation Potential:  FDX matches peer margins in its Express division, we estimate that there is >50% upside in the shares (best case valuation of ~180, base case of 120-150, and a favorable  sum of the parts approach).  FDX has already started to generate improvements as of FY4Q 2013 results.  There is no point in activism without the potential to unlock value and even following today’s move, FDX has that potential in abundance.


Expectations Low:  FDX seems broadly misunderstood, with some analysts holding funny ideas about networks, leverage and contracts.   Investors have trouble trusting FDX and an activist might help with that.  Intentionally (in our view) weak guidance in the FY4Q earnings release has kept FY14 expectations for FDX very low relative to recent results.  If Ackman could just get management to guide less conservatively, there could be significant upside.



Activism at FDX?


Unwelcome, but Likely Useful:  We are not sure that activism at FDX will be especially welcome, but outside scrutiny of the Express segment restructuring is positive for shareholders.  FedEx can be a bit insular and may not pay enough attention to the wishes of shareholders (e.g. FY3Q earnings were a tough comp because of a previously undisclosed insurance reserve reversal at FedEx Ground in the prior period – that is not helpful). 



If He Isn’t, He Should


Ackman should buy a stake in FDX.  The move in the shares today should make that clear. 




P.S. BGG Could Use Some Activism, Too


In the event Mr. Ackman receives this, Briggs and Stratton should sell its Products segment.  Even declaring it a discontinued operation could make the shares pop, we think.