RH | Zegna and Wal-Mart Don’t Mix

Takeaway: 4Q was a hot mess. But let’s not lose sight of the oppty for RH, the capital being deployed to get there, and the weakening competitive set.

This RH quarter was the equivalent of accessorizing a Zegna suit with a tie from Wal-Mart – it simply does not work.  The metrics up and down the P&L and balance sheet were simply bad. We won’t rehash them here. We all know the numbers, and if anybody does not, then rest assured that a 100-day stock price decline from $105 to $38 most certainly does. We think another thing is for certain…RH will look meaningfully different in 12-months than it does today. We also happen to believe that we’ll see tangible evidence – both quantitative and qualitative in each quarter as we go. We like that a lot with the stock trading at a new trough valuation on what we think is the equivalent of a recessionary earnings number (Contact sales@hedgeye.com for our Black Book) and when we’re being pinged more than ever incrementally by value investors instead of the typical growth/garp hedge fund crowd.  We can complain about the current valuation, or simply respect it for what it is and act accordingly. This is one of the few transformational growth stories we’ve ever seen in retail (in 20+ years). This is like an UnderArmour, an Ulta, or a Chipotle (sans the e. coli). But not a single one of these – or any transformational story in any industry, for that matter – is a linear progression. There’s usually several stages in any transformational business for reassessing the competitive landscape, identifying the best growth, putting the appropriate capital behind those initiatives (even if shareholders don’t understand it at the time), and…on occasion…screwing up. Well, RH just had such an occasion, and we flat-out reject the premise that the long-term growth vision RH has had along has been smoke and mirrors.

 

As it relates to the stock, we’ve laid out a path to $300 over the course of three years. Does the latest turn of events change our analysis? Actually, the answer is No – it does not. We still think that RH will realize over $10 in EPS power, and Yes, there will likely be many hiccups as we get there. Does the magnitude of this quarter’s disappointment mean that we should take down our multiple for RH? Over the near-term, yes. But longer-term, absolutely not. When the company achieves our targets – you can rest assured that the Street will forget all about these past three months – just as it has with RH on several occasions since the company went public.  Will we ignore the guideposts along the way? No. We’ll scrutinize the P&L and balance sheet six ways til Sunday every quarter as the story plays out. That’s our job, or part of it at least.

 

But the market does not offer up too many gifts to the investment community. RH with a $3 (4, or 5) handle, is definitely one of them.

RH | Zegna and Wal-Mart Don’t Mix - 3 30 2016 RH Earnings

 

SOME CALLOUTS FROM THE QUARTER

1) Inventory: A negative sales to inventory spread is nothing new to RH given its business model, but it’s definitely a red flag in the quarter -- especially given that the revenue miss was associated with a lack of vendor ability to meet demand. To us that means either a) the core product significantly underperformed expectations, or b) RH bought heavily in Modern/Teen categories that didn’t sell. Management all but confirmed choice ‘a)’ on the call, but we think that inexperience in buying Modern/Teen also played a part in the $65mm revenue miss in the quarter. Inventory growth was 30% at years end and DIH was up 24 days into a slowing top line growth equation. We’d be more concerned if expectations weren’t for flat to down earnings growth. But the way we see it, RH now has a low enough margin bar to clear out excess inventory in slow turning core SKUs, which will allow the company to find the right mix between ‘newness’ and core and free up a tremendous amount of working capital – up to $140mm by our math.  

RH | Zegna and Wal-Mart Don’t Mix - 3 30 2016 RH SIGMA

2) Incremental margin math: RH is guiding to a $0.22 hit from ‘elevating the customer experience’ in 2016 most of which is loaded into 1H. That is composed of a $15mm reduction in revenue to try to mitigate cancellations, but the $0.22 EPS hit implies a $24mm hit to the P&L. Put another way, that’s an incremental margin of -160%. That means that there are certain other costs loaded into the revenue hit, which we think are both recoverable as we anniversary this headwind next year and will help set RH for the next leg of growth.

 

3) Design Gallery Performance: Qualitative commentary on the performance of the next generation Full Line Design Galleries has been extremely positive, but we haven’t seen the hard numbers like we saw in the early days of Beverley Boulevard or Houston as proof of concept. Nor should we, as that type of disclosure sets a tough precedent as the number of Design Galleries compounds. But, based on our math the instore performance looks to be at or above the $650/sq.ft. plan the company has spoken to. A few additional details…

  1. In 3Q and 4Q the company comped 10.5%-11% in its full price retail doors, with DTC averaging the total down to a 7% and 9% brand comp in 3Q and 4Q, respectively.
  2. Non-comp Design Gallery square footage amounted to 24% of total square footage in each of the past two quarters, and should (according to management commentary) when fully mature operate at a productivity level of $650/sq.ft. (about 44% of what the company currently does in its existing fleet).
  3. Yet, the company reported sales/average sq. ft. growth of 2.4% in 3Q and -3.3% in 4Q15. Mathematically that doesn’t work unless the new square footage is tracking ahead of plan. Based on our math, sales/sq. ft. (not average sq. ft.) should have been in the $340-$350 range in each of the past two quarters assuming non-comp Design Gallery sq. ft. peaks out at $650 and comes in at a productivity rate of 70%. Instead we saw $363 in 3Q and $373 in 4Q.

RH | Zegna and Wal-Mart Don’t Mix - 3 30 2016 RH spsqft