RH: An Update On Restoration Hardware

Editor's Note: In light of the recent blow to RH shareholders, please see the following research report written by Hedgeye Retail Sector Head Brian McGough. According to McGough, "My timeframe has always been on the company's 2018 numbers. The fundamental thesis still holds and should start to play out before then. But that's no excuse for getting caught in this collapse."


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As the mega bulls on Restoration Hardware, this preannouncement is a clear kick in the gut. But there are a few things at work...a) more than half of the shortfall was because RH couldn’t fill orders in its new Modern product line. We’d rather that than have no orders and too much product. b) Energy markets still a drag. c) the smallest part of rev miss (18%) is a miss in Jan as business slowed due to market volatility. Biz came back in Feb, we think, that qtr was not disclosed. d) incremental margin on lost sales is too high (41%) for this business model.


We think RH knew it had to preannounce, so it put the highest octane it could find in the preannounce-o-meter. All in, this stock is trading at 14x what we think is a trough earnings level. An all-out recession gets us $2.50 x 12, or $30. An acceleration in 2H with all its growth drivers (that no one cares about today) gets back above $100 in a year. We could talk about the 2-3 year earnings/multiple upside – but admittedly that does not matter now.  How we see it, there’s $60 up and $10 down. We can search all year for better odds, and still never find it in US retail.




This flat-out stinks. We knew an 8k was coming from RH, but certainly wasn’t expecting a 35% guide down for the quarter, with no forward guidance whatsoever. Furthermore the company’s press release is riddled with ambiguity and lacks important context that we’re certain will hurt the stock more than it deserves. And to be clear, it definitely deserves to be down from a traders duration.


Our implied earnings for 2016 is $3.10, suggesting that the stock is trading at about 14x earnings. We can argue til we’re blue in the face how ridiculously low that multiple is for a company that grew 13% in a transition year (’15), should grow another 15% in a pseudo-recession year, and then 30%+ long term (starting in ’17). But in the end, we’re going to need to see this business stabilize and reaccelerate for the stock to work. That should be within two quarters.  


As a frame of reference, we outlined two recession cases in our January Black Book (see link below), which implied $2.63 in EPS in a ‘normal recession’ (whatever that is), and $2.30 in EPS if we revisit the downside we saw in the Great Recession.  Our $3.10 for this year is likely to come out ahead of consensus, and we’re relatively confident in our number.


But from where we sit, the magnitude of the revenue shortfall in no way is indicative of solid demand, and the earnings shortfall is even further overstated. By our math, we’re looking at $66mm. Consider the following.


Top Line: Reported a 9% comp versus prior expectations of 22% -- that’s about $66mm. There are several reasons for this.

  1. Modern Revenue Shortfall. The simple fact is that RH bit off more than it could chew with this new product line. Bookings were up 21%, though it could only fulfill 11%. Definitely a big execution problem with vendor management, but certainly not a demand problem for the brand. Those orders – at least the ones that are not cancelled due to miffed customers – will ultimately be delivered.  Of the $66 revenue miss, we think the execution issue in delivering Modern accounted for about $35, or 53%.
  2. Energy/FX Market Drag. This is nothing new, but the weak performance we saw in 3Q continued at -400bps to the comp. Keep one thing in mind…this company – at least how it exists today – has never really managed through a major Energy or FX cycle before. That’s no excuse – it’s shareholders expect it to do so, and they should. Overall Energy/FX cost about $19mm in the quarter, that’s 29%.
  3. “Weakness in the High End Consumer”. This is classic. Not because it isn’t happening, but because out of the entire $66 revenue miss, this only accounted for about $12mm (18%). On its own, it’s not even worth preannouncing over, and yet we all know it will capture the headlines tomorrow “RH Guides Down Due to Weakness at the High End”.  In reality, our sense as to what happened is that the company saw a slowdown for about three weeks in January as the equity markets were in a freefall. Then markets stabilized, and sales rebounded in February. But February is 1Q, which RH won’t comment on until March 23rd. Overall this cost about $12mm in the quarter due to fewer orders, and an increase in cancellations.


Funky Incremental Margin Math


Can someone explain to us how revenue missed expectations by $66mm, but EBIT missed by $27mm. Yes, that’s an incremental margin of 41%. That is simply ridiculous from our vantage point. Keep in mind that a given retail operation like Nike, Ralph Lauren, Tiffany, Ulta…you name it…keeps virtually all product in a storeroom or on the floor. The consumer picks the merchandise, pays, and they walk out the door satisfied. Given the inventory carrying costs associated with this model, and almost all retail models, the incremental margin on a dollar won or lost can often be as high as $0.50-$0.60. 


But in a business model like RH, only 5% is ‘cash and carry’ (i.e. minimal storeroom usage) with the remaining 95% on order for delivery over the coming 1-2 months. That, by definition, means that the incremental margin on lost revenue will be dramatically closer to the company’s EBIT margin rate – usually 10-20%. So how or why did RH put up a 40% incremental margin?


Go Big or Go Home!


As noted, RH’s incremental margin of 40% is simply too high. We’re completely reading into this, and would never look for anyone to confirm or deny it, but we think this high rate of flow through is on purpose.


Think of it like this…RH has never missed a quarter – at least not in this iteration of being public. And now, largely because of execution gaffes around keeping up with demand for a new product line (Modern), it has to guide down. This is a competitive management team, and one that definitely cares about its stock. We like that, but sometimes it comes at a cost.


The entire team has been in business planning sessions over the past month, and when a preannouncement became necessary, we think someone probably said something like “If we’re going to miss for the first time ever, let’s miss big, and make 100% sure it does not happen again.”


As such, we think RH likely made investments in the quarter that would have otherwise taken place in 2016 – hence taking the incremental margin on the revenue loss meaningfully higher.


We also think that the lack of 2016 guidance was purposeful. First off, the company gave a mouthful and plenty to digest with this announcement. Second, the consensus numbers for 2016 are likely to come down 20% or better given the absence of any other information.  THEN, when RH issues guidance on March 23, it will have a very low hurdle – and it probably won’t guide much above that.


Then we’ll have a low earnings bar, likely upside to earnings, anniversarying weakness in Energy/FX markets, a meaningfull step-up in contribution from six opened design galleries as they enter the key part of the maturation curve, and an upgraded vendor base for Modern and Teen. THEN and only then will people care about the outsized square footage growth, new product flow, and astoundingly favorable rent structures on new properties.

FL | Eroding on the Margin

Takeaway: As good as 4Q was, most metrics look sequentially worse to us. This is a fat-tailed short call, and we think it’s starting to play out.

FL numbers looked fine, good actually. But our point on the stock all along is that there’s asymmetric risk to the downside in a) the rate of change in fundamentals, and even more so b) the stock. FL beat by $0.04 ($1.16 vs the Street at $1.12) and put up a very respectable 7.9% comp. But…

  1. FL has beat every single quarter this economic cycle save one, and by an average amount well above what we saw today. This company is EXPECTED to beat.
  2. The flow through in profitability is less than half of where it trended 3 and 4 quarters ago. Compares are starting to get tough.
  3. Comp trends are disappointing in Feb, at a low-single digit rate month-to-date EVEN THOUGH a) there was a sequential uptick in Nike/Jordan launches this month versus last, and b) Feb 2015 was disappointing – so it faced an easy comp. i.e. there’s an increasing bifurcation between Nike’s solid release schedule and FL results. That’s bad.
  4. The steady sequential decline in e-commerce is unsettling, to say the least.
  5. Management sounded very confident in 1Q and the year – but this team only knows how to be confident. They’re reign started in the middle of the biggest multi-year surge in Volume and ASP-boosting Nike product since the early 1980s. Now that ends.


On Wednesday we said a whole mouthful on FL when we presented out 65-page Black Book – here’s the link to our report (CLICK HERE). This quarter was in line with our thinking.


Additional Details:


Comp Trends: Solid 4Q number at 7.9% showing an acceleration on a 2 and 3 year basis.  That was mostly generated outside the US, as the FL banner domestically put up a MSD comp for the first time since 3Q13. Quarter to date trends at LSD for the month of February are not encouraging.

FL  |  Eroding on the Margin - 2 26 2016 FL chart1


Monthly Comps: Below are our estimates of the monthly comps based on management commentary. i.e. MSD = 5%, LDD=11%, etc. We’ve now seen two consecutive months of LSD comp growth. Commentary around the February trend doesn’t add up. Per Nike’s website the basketball launches accelerated sequentially into the All-Star game and it is the easiest comp of the year for the company. From here, everything gets more difficult for FL.

FL  |  Eroding on the Margin - 2 26 2016 FL chart2


e-Commerce Erosion: Another bad indicator on the margin for FL who now competes directly with Nike online for dollars. Yes, FL has the stores that Nike does not, and there is still a place in this space for that experience. But, with more of the growth headed online we think a disproportionate amount of those dollars go directly to the brands – Nike in particular.  Nike hosted its analyst day back in October of 2015, where it laid out its $7bil e-commerce plan by 2020. A number that we think is low by $4bn. No surprise that the sales trends have followed the traffic trends at FL we’ve called out over the past few months at the same time Nike took its intentions public. Banner growth was just 20%, a big deceleration from the 50% we saw early in the year.

FL  |  Eroding on the Margin - 2 26 2016 FL chart4


Profitability: Incremental margin is down to 36% from the mid-70s in 1H15.  Now working against tough compares as comps moderate and spending accelerates. The leverage in this model is all but tapped, as noted by management on the call when talking about the need for MSD comps to leverage fixed expenses vs. the prior LSD.

FL  |  Eroding on the Margin - 2 26 2016 FL chart3

Central Planners' Futile Fight Against Economic Gravity

Takeaway: What happens when the edifice of omnipotent central planning comes crashing down?

Central Planners' Futile Fight Against Economic Gravity - central banker cartoon 02.02.2016


As the reality of global #Deflation and #GrowthSlowing continues to sink in, investors across the world are slowly awakening to the stark conclusion that central planners cannot fight economic gravity.


The latest case in point? Germany's CPI numbers this morning. Here's an update from our Macro team in a note sent to subscribers:


"German February Preliminary CPI fell to -0.2% year-over-year vs Expectation of 0.0% and 0.4% Prior. This is yet another data point that is going to force the ECB’s hand to act at its next policy meeting (March 10th) as inflation is tanking."


Central Planners' Futile Fight Against Economic Gravity - mario draghi


Bearing this in mind, it's worth reflecting on the almost frantic capitulation among serially overoptimistic global policymakers:


  • The IMF is now calling for "bold multilateral actions to boost growth and contain risk," while warning that a global growth downgrade from its current 3.4% is "likely."
  • The BOJ has called for greater G7 cooperation to "soothe" market jitters.
  • The ECB "is ready to do its part."
  • Meanwhile, Fed officials hold conflicting views about whether March is a "live" meeting or not for rate hikes.


In a recent Early Look, Hedgeye CEO Keith McCullough put forth a new theory about what happens when macro markets no longer believe the whims of audacious central bankers:


"... My Big Bang Theory for the #CurrencyWar (one of the Top 3 Themes in our Macro deck right now) is as follows:

  1. Japan is no longer able to convince markets that it can burn its currency at the stake on command
  2. Japan’s Yen starts to rise, and Japanese stocks start to crash
  3. Europe then fails to convince consensus of the same
  4. Euro goes up (instead of down) on Draghi’s next central-market-planning day (March 10)
  5. European and US stocks resume their current crashes and go straight down"


It's a troubling scenario...


One thing we're crystal clear on ... when the edifice of omnipotent central planning comes crashing down, it won't be pretty. Don't say we didn't warn you.


Central Planners' Futile Fight Against Economic Gravity - Card house cartoon 12.03.2014

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REALITY CHECK: Inside Today's GDP Report

Takeaway: The modest upward revision to Q4 GDP was mostly due to a build in inventories.

REALITY CHECK: Inside Today's GDP Report - GDP cartoon 05.29.2015 large


Sorry. Today's updwardly revised Q4 GDP report from 0.7% to 1.0% is not the auspicious economic harbinger many are purporting it to be.


"Hold on a second," Hedgeye Senior Macro analyst Darius Dale wrote following this morning's revision. "Inventories rip because consumers bought less stuff than was initially estimated and this is POSITIVE for GDP?" 


Take a look at the table below from Hedgeye U.S. Macro analyst Christian Drake. As you will see, the modest upward revision to 4th quarter GDP was mostly due to a build in inventories. Also note that consumer spending was revised down.


Not good.


Click image to enlarge. 

REALITY CHECK: Inside Today's GDP Report - gdp today



We're sticking with our U.S. #GrowthSlowing call.

REALITY CHECK: Inside Today's GDP Report - GDP cartoon 10.29.2015


Client Talking Points


German February Preliminary CPI fell to -0.2% year-over-year vs Expectation of 0.0% and 0.4% Prior. This is yet another data point that is going to force the ECB’s hand to act at its next policy meeting (March 10th) as inflation is tanking.


Part of our bearish thesis on housing centers on our expectation for home price growth to slow. Home prices follow the slope of housing demand on a 9-12 month lag and we are in month 8 of deceleration in Pending Home Sales in the existing market. The Case-Shiller 20-City HPI index released Monday was flat after 5-months of acceleration and yesterday’s HPI series from FHFA reflected a 2nd straight month of deceleration. We weren’t expecting the negative inflection in price growth quite this soon but the fledgling slowdown is worth noting. Recall, from a sequencing perspective: Demand leads price and the equities tend to follow the 2nd derivative trend in price.  


The multi-month trending increase in implied volatility on the Chinese yuan appears to have petered out, and the nascent series of lower-highs throughout the YTD is in line with our views on the currency: there won’t be a material, one-off devaluation over the intermediate-term. Rather, policymakers will look to continue to guide the currency lower, at the margins, in line with the recent trend of minor reference rate revisions. Today’s -3bps devaluation in in line with the recent slow-bleed we’ve been seeing since the large -51bps revision in early January. PBoC Governor Xhou Xiaochuan’s early comments at the Shanghai G20 Summit reiterated his previous guidance that “there is no basis for continuous yuan devaluation”. We disagree with that statement in that there is certainly a basis for the yuan to fall much further from here, but there’s also a myriad of reasons why they don’t want to pursue such a strategy, which we’ve discussed in recent notes.

Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

Long-Term Treasuries (TLT) and Utilities (XLU) remain our two best fixed income and equity vehicles to play #Lower-For-Longer on growth and interest rates as the market gets more and more skeptical about the central bank dogma.


With market turmoil, the Junk Bond ETF (JNK) is down -4.5% vs. the defensive, growth slowing equity sector Utilities (XLU) which is up 6.7%, outperforming the S&P 500 by 12.9% on a relative basis. That’s yet more confirmation of our dour economic outlook economy (spreads widen in tumultuous market environments and Utilities are a defensive sector that outperforms when growth is slowing).


General Mills (GIS) is a large player in the Yogurt category with their Yoplait brand. Their competitors, Dannon, Chobani and Fage have been aggressive on merchandising and consumer spending, making it difficult to compete while maintaining internal margin objectives. GIS is turning on innovation with the growth of Annie’s yogurt and that should help the trajectory of the business. Yogurt being a roughly $1.4 billion business, turning it around is a top priority for management.


On the broader GIS long thesis, it's unlikely that the stock is going to go up 20% in the next year, but we do believe it will fare better than most in the consumer staples sector, especially as we head into an economic slowdown.


With the market losing faith in the central planning policy backstop, investors continue to yield to top-down market signals and the direction of the data. To be clear, the data continues to deteriorate and volatility continues to break-out.


The yield spread (10-year Treasury yield minus 2-year Treasury yield) has compressed 24 basis points this year, and TLT is up 8.6% vs. the S&P 500 which is down -5.2%. The December Federal Funds Futures contract has declined in a straight line since December’s rate hike.  

Three for the Road


The key takeaways on #Wayfair:

VIDEO | Under 60 Sec: Wayfair's Earnings Report | $W



There is no royal road to anything. One thing at a time, all things in succession. That which grows fast, withers as rapidly. That which grows slowly, endures.

Josiah Gilbert Holland


According to its annual report, FIFA with just 474 employees spent $115 million on personnel expenses in 2014.

CHART OF THE DAY: China's Economy Continues To Slow

Editor's Note: Below is a brief excerpt and chart from today's Early Look written by Director of Research Daryl Jones. Click here to learn more.


"... In the world of global macro data points, one to note this morning is that a survey of Chinese economists indicated that the Purchasing Managers Index is expected to decline in March. As emphasized by the Chart of the Day, this would be the seventh straight monthly decline in Chinese PMI and just another in the litany slowing economic data points globally. But don’t worry, PBOC Governor Xiaochuan was speaking at the G-20 yesterday conference and indicated the Chinese central bank still has room to ease..."


CHART OF THE DAY: China's Economy Continues To Slow - 02.26.16 Chart

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