We weren’t expecting to get hit with a press release from RH this morning about another convert offering. But it makes all the sense in the world. As we’ve stated many times, this is kind of transformative and disruptive growth story that comes along maybe once every decade in retail. But growth does not come cheap. While the company is on the cusp of being cash flow positive, the market is presenting an opportunity – with the stock 5% from its all-time high – to lock up funding for new concepts should they test well. This deal also completely wipes out RH’s net debt position. Simply put, you don’t see great retail concepts with net debt. Now you don’t see it at RH either.
While it might seem extremely similar to the convert RH executed last summer, the intent is very different. A few considerations…
- Last year’s deal, which netted RH $350mm in cash and becomes dilutive after the stock hits $172, was rather defensive. Yes, RH did it when the stock was near all-time highs (like today), but there was an interesting dynamic at play.
- Specifically, RH was starting to sign leases beyond 3Q16, which was the exact time that its credit facility expired. The bear case therefore was that RH was building bigger stores, and signing leases past the point where it had guaranteed financing. If we were to go into a recession, then the company would be on the hook for the leases without financial backing. That’s the ‘doomsday scenario’ that RH’s last deal pretty much blew out of the water.
- This time around, RH is securing the capital it might need if it chooses to expand more rapidly on concepts like RH Modern, and what’s likely another half dozen that are in the works. This is pure offense.
- To be clear, this is not just so RH could have capital to build out stores. That’s the least of our worries, actually. Landlords are bending over backwards to get RH as a tenant. Specifically, this capital gives RH the capital to ensure an appropriate build out of its sourcing organization and vendor network – which we think is critical to the company achieving it’s long-term plan.
06/11/15 10:48 PM EDT
RH - The Story Never Looked Better
Conclusion: We have never felt better about this story, and about management’s ability to profitably create growth that skeptics think does not exist.
This quarter is exactly what we were looking for from RH. The company put up a 15% comp – right in line with our model – and well above the 11% consensus. That flowed through to the bottom line with $0.23 in EPS, in line with our estimate, and 15% better than the Street.
In addition to the beat, we saw new store productivity get better on the margin, and management noted that Atlanta (about 6% of total square footage) is running ahead of expectations. Note that this had been a point of concern over the past quarter for many on the Street, as it is the first of the mega-galleries RH will be rolling out over the next few months. If Atlanta’s productivity was not cutting it, then we could see the reason for broader concern about the future. That issue is officially put to bed.
We like what the company did with guidance. It beat by $0.03, but took up the lower end of full year guidance by $0.07, and the top end by $0.05. At the same time, the company noted that there would be a meaningful ramp in 2H, and as such took down 2Q. Naturally, almost all of the questions we’ve gotten since the print revolve around 2Q guidance.
Let’s be clear about something…companies up and down the S&P and Russell are ‘conservatively’ guiding to down revenue, down margins and down earnings. With RH, not only did it take up guidance for the year – when it otherwise did not need to – but the mid-point of guidance for its worst quarter of the year calls for 15% revenue growth, improving new store productivity, and 23% earnings growth. That’s a pretty impressive algorithm in itself, especially given the fact that we start to see the benefit of new square footage growth in 2H15 as well as the impact of its new RH Modern concept.
The point here is that if the biggest thing people are worrying about is 2Q guidance, then we’ll take that any day given the fundamental setup that will likely allow RH to best its guidance while simultaneously staring at a meaningful 2H acceleration square in the face.
RH Modern: We think that most reports out this morning are likely to miss the mark on Modern. This is a lot more than a new category or concept for RH. We think it’s more like a classification. Think about it…everything that RH currently sells – whether it be Sofas, Chairs, Tables, Lighting, Flooring, Kitchen – that all falls under the traditional RH aesthetic. RH Modern, however, allows the company the opportunity to take every single category it sells, layer them over a new classification, and sell to a completely different customer.
If we have any concerns about this it will be the availability of retail space to sell the product – and the potential that RH takes space away from existing items to make room for RH Modern while it ramps up (which will take some time). Our sense, however, is that the stores will be getting bigger because the company will have the need for even more space. We’re going to follow up with another RH Black Book where we dive into the company’s real estate strategy in great detail. Expect that in the coming weeks.
Here Are Some Of Our More Detailed Thoughts From Earlier this Week
06/09/15 05:16 PM EDT
RH – ROADMAP INTO THE PRINT
Takeaway: When a Consumer story is this explosive and disruptive, every quarter is an event. Fortunately, this story is very much on track.
Our team remains convinced that RH is one of the unique TAIL opportunities in Consumer/Retail as the company disrupts a large fragmented space of localized high-cost competitors, and changes the paradigm for how people shop for Home Furnishings. This is, at most, in the second inning and the types of changes we’ll see to product classification, consumer type, purchasing experience and ensuing financial characteristics are neither in Consumers’ sights, or Wall Street’s models.
When all is said and done, we still think that this company has $11 in earnings power 4-years out, which is nearly double the consensus. We remain convinced that the debate should not be ‘if or when’ the stock hits $115 (22% upside -- the highest sell-side price target out there), but rather when we all have to adjust estimates for last year’s convert, which becomes mildly dilutive at $172 (83% upside). At that point, we’ll be looking at an earnings CAGR of 40-50% over five years. What kind of multiple does that deserve? 20x? 25x? 30x? We’d argue the higher end, but regardless, we’re talking a stock between $225 and $325. We won’t bicker which one it is with the stock at $94 today.
So there’s our TAIL call. And despite our confidence in where it’s headed long-term, we have to respect the near-term volatility in the market, and in particular, such dynamic transformational stories like RH. With all of that said, here’s a look at our key modeling assumptions for the quarter and the year, and more importantly, what can go wrong on Thursday after the close that might be a negative surprise to the market (i.e. let’s flesh it out now).
What Could Go Wrong
1. Revenue Weakness. This is the obvious item for a high multiple controversial growth stock. RH guided to revenue growth of 13-15% for the quarter. We’re at 16%. Considerations…
- Furniture sales ticked down materially industry-wide in April, though actually accelerated to the upside on a 2-year basis throughout the quarter. WSM noted this as well – but its sales accelerated on a 2yr basis by 300bps in 1Q even with the slowdown. Adding back the $30mm from the port strike sales accelerated 560bps
2. Management reset the topline bar when it issued guidance in March for FY15, and expectations look very conservative for both 1Q15 and the full year. 20% DTC growth (an almost 10 percentage point deceleration on the 2yr trend line sequentially) alone would support an 11% brand comp in the quarter, just a couple basis points shy of the current consensus numbers. The revenue backlog looked extremely positive headed out of 4Q14 with deferred revenue up 37% YY. In prior quarters deferred revenue has been a tightly correlated indicator of future growth.
3. Atlanta Opening. There has been so much negative noise around the new Atlanta Design Gallery, which opened in November. The source? None other than negative YELP reviews – all 8 of them. We actually couldn’t believe how many times we were asked about this. Maybe YELP is reliable to find a good cheeseburger for $12, but not for a $20,000 bedroom set at RH. Yes, it would be extremely negative if the company came out and said that Atlanta is a bust. But that is so highly unlikely. Think of the timing. It opened in November, then built local awareness for a few months, and did not really book any material revenue until 8-10 weeks later (i.e. March). As of 3-months ago, it had the second best opening of any store in the fleet. Things are highly unlikely to have turned so fast. So…we flag this as a risk, but it’s not a big one.
4. Backlog. The West coast port slowdown and lower inventory position (sales growth was in excess of inventory growth in 4Q14) will mitigate the flow of the product back log in 1Q, but that’s already in consensus numbers. The $10mm - $12mm revenue push from 1Q15 to 2Q15 management guided to shaves 250-300bps off the top line in the quarter the company will report of Thursday. But, that is far less exaggerated than the 500-600bps revenue hit WSM experienced. That’s because a) 95% of RH’s business is cash and carry compared to WSM at less than ~50% and b) WSM relies much more on seasonal product which is much more dependent on inventory in-stock positions.
5. New Concepts – On the call, RH should give detail on the two new concepts that it has had in the hopper for the past year (two of many, we should add). If it does NOT, however, then the Street will be left wanting. It might also cost the company revenue in 2H, as these concepts have probably started to fuel expectations. While the company didn’t officially say that it would unveil its two new lines on the 1Q call, the timing of the 2Q15 print (the company’s next officially scheduled opportunity to communicate with the street) doesn’t fall until early September. By that point it’s possible that the two source books scheduled for a Fall release will already be in homes. Thursday seems like the most logical time for the company to announce the new product coming down the pike.
6. The Biggest Loser. The Sourcebook that was just delivered weighed in at 6.5lbs, compared to 17lbs last year. That’s a huge improvement, particularly given that the Sourcebook was somewhat of a bust in 2Q14. That said, it also had twice the amount of product that we see in this year’s book. Is this the right formula? The company thinks so otherwise it would not have made the change. But the fact of the matter is that the Sourcebook remains a crutch for the company until its’ real estate profile is rightsized. Eventually, it won’t need it anymore. Until then, there will be hits and misses. Fortunately, this year we’re comping against a miss.
The Set-Up on the Top Line Improves as RH Exits 1Q.
- 2Q15 – Benefit of at least $10 - $12mm (2.5 to 3 percentage points of growth) of demand push from 1Q to 2Q due to the West Coast port delays at the same time the company laps the change up in Source Book strategy which cost the company by our math $12mm - $18mm in sales last year. RH decoupled its Outdoor Source Book (the most seasonally important book from a timing perspective) from the big Source Book mailer (which arrived in our offices yesterday) to get the category refresh in front of the consumer a month earlier than last year.
- 3Q15 – We’re modeling 3 new store openings in the quarter, 2 Full Line Design Galleries in Chicago and Denver and the re-opening of the Beverly Boulevard store in a new category/Baby & Child format after going dark when the Melrose Ave Design Gallery opened in 3Q14. That’s paired with the launch of 2 new categories. Expectations for the new lines are low as the company gains mind share, but any outperformance with the product launch could provide meaningful upside.
- 4Q15 – 2 additional Full Line Design Gallery openings in Austin and Tampa with the benefit of the new square footage added in 3Q starting to be recognized on the P&L. The 8-12 week delivery window for new product means we will begin to see the real benefit of the square footage additions in 4Q. With additional upside opportunity from the 2 new category launches.
Margins – The company guided to 100-130bps of Operating Margin expansion for the year on 14-16% revenue growth mostly attributable to ad spend leverage with ‘modest’ Gross margin expansion. There are puts and takes on both line items by quarter, but the fact that the company feels so confident in its operating margin expansion for the year, the company actually walked consensus EBIT margin expectations by 40bps on 14-16% top line growth for the year when it released guidance in February, is a bullish set-up for the year assuming the company can deliver on the top line.
Additional details on 1Q15…
- Gross Margin – We’re modeling 40bps of expansion driven by the price increases the company introduced when it released its Source Book in 2Q14. With DC occupancy pressure from the new West Coast distribution center and dead-rent for new stores opening in 2H partially offsetting the benefit. The West Coast port delays could drive additional shipping expense if product flow issues cause the company to make multiple in-home deliveries for multi-item orders.
- SG&A – The ad savings benefit will not be realized until we get into 2Q15. Because catalog costs are capitalized and then amortized over a 12 month window, the commensurate costs associated with the 2Q14 Source book will land in 1Q15. Which means marketing spend will be elevated on a YY basis. We’re modeling SG&A growth slightly below sales growth after two quarters of deleverage in part because of the absence of pre-opening related marketing expenses for new Design Galleries.