Despite the stock action after hours, this was not a good quarter for RH. Let’s be clear about that. Comp was -3%, organic revenue growth was 3% YY, and that translated into an EPS decline of 49%. But relative to expectations, almost every single line of the P&L and balance sheet and cash flow statement came in ahead. We also think that management was artful as it relates to controlling the Consensus estimates (i.e. keeping them low) even though it is probably confident it can do better in 2H and 2017. They have their public guidance, and we have ours. Ours is higher.
But the best thing, in our opinion, is management’s poise and demeanor on the video, conference, and our follow up call with the entire executive team. Anyone who saw the video/was on the call knows what we’re talking about. Both Gary, Karen, and even DeMonty Price (Co-President) were very synched on messaging, and really did not deviate one bit. No rants about the economy and very little mention of oil prices and a weak high end consumer. They talked about what they can control, and how they are well on their way to recovering from the self-inflicted wounds from earlier this year. But most importantly, they outlined initiatives in product (which looked very refreshed), people (new logistics Head from Amazon), and process with a high degree of confidence, but with a massive dose of humility. We don’t like seeing either of those two things exist in management teams without the other. The reason why this is so critical here is that easily 9 out of 10 investor concerns we get on this focus around 1) management credibility, and similarly 2) lack of operational control and subsequently, the risk of another blow up. This will take time to instill and mend the wounds. But it was as plain as day on this event from where we sit.
Our point ahead of the quarter (see below) was that this name will see a remarkable improvement over a TREND duration, setting up much better visibility in the TAIL. This could be a very big stock in 2017.
Here Are some Added Points Of Interest
A) Management: This is a two part bullet under the same umbrella. Both we think are positives.
- The first point is around the general tone set on the call today. The team at RH has taken its share of licks from the pundits out there, and rightly so given the destruction in shareholder value over the past 9 months. But, what we heard today was the message of re-energized management team playing offense with a good dose of humility. The company is 4 months removed from its corporate shakeup, which saw the appointment of the three headed co-President hydra and an ensuing round of layoffs. But, now we think the right pieces are in place in the right capacities to set the company up for a meaningful rebound in 2017. That’s not to say there isn’t a lot of work to be done. There is. But today went a long way towards restoring some semblance of confidence with the Street.
- There were two new appointments announced today, one being Brendan Sodikoff who is continuing his work with RH after the successful Hospitality partnership in Chicago – that’s minor. The other being the hiring of Alex Kreuger coming on as SVP of Operations and Customer Experience from Amazon to handle the logistics component. The latter, we think, will add credence to the strategic changes the company is making in order to sure up its supply chain. We have a feeling it won’t be the last new face in the building as RH builds out its executive depth.
B) Working Capital: Hard to say that there was a whole lot of positive developments on the working capital side when the cash conversion cycle extended by 27 days in the quarter. But, in fact, there was a lot of progress on the inventory front despite the acquisition of Waterworks (which was only was around for 2 months), the sales to inventory spread went from -19% to -7%. With the opening of additional outlets in 2H on top of the four the company opened in 2Q and a margin cushion big enough to absorb additional SKU rationalization – we expect to see continued improvement on that line throughout the year. The negative was on the payables side where DPO came in by 30 days. Some of that may be attributable to the WaterWorks deal, but we think that’s pennies compared to RH helping it’s vendor network out as the company works to normalize product flow. That’s an obvious wrinkle to the near term visibility of positive FCF flow, but we think a necessary pseudo-investment in order that will pay dividends over the long term.
C) Back Half Loaded – With No Expectations: That’s very counter to the set-up RH experienced last year when expectations were heavy loaded into the back half of the year, dependent mostly on flawless execution of Modern. We all know what happened as a result. But this year we are seeing the inverse play out – that is plenty of top line catalysts with no real expectations. The catalysts include: a considerable re-set of the interiors product line (take a look at the video it looks like RH 2.0), heavy mailing of what once was Spring now is Fall Source Book, a fleet-wide floor reset for the first time in at least 3yrs that will include the RH Modern product, and a normalized product flow. That’s not to say the RH numbers will inflect in 4Q, but there are considerable building blocks in place to support the top-line into an improving margin picture.
We could opine on every facet of this quarter – but we won’t. We’re going to focus on the majors – on what matters with the stock trading where it is. From that vantage point, all systems are a Go.
Our Note From Earlier In The Week
09/07/16
RH | APATHY
Takeaway: RH sentiment is straddling ‘apathy’ and ‘dammed if they do, dammed if they don’t’. Not good near-term, but the up/down can’t be ignored.
Conclusion: The RH story is more complex than ever, but the call on the stock is arguably as simple as we’ve seen it in a while. Over the near term, the company is in the ‘dammed if they do, dammed if they don’t’ category. Sentiment is still so bad around the name, and both the stock and the team running the company are so hated, that we’re relatively sure that people will drill down hard on any misteps in the quarter – and there will be missteps – there always are with such a dynamic story. Conversely, whatever goes right, either by design or even by accident, is not likely to lend much to RH’s Street cred, at least not until the company can exhibit that things have stabilized and it can drive the business consistently in the right direction. Let’s face it…right now this company was just handed a Red Card and was ejected from the game. And to be clear, so are we for making the call. But so much of that is in the stock, and arguably was there before the company owned up on the last print when the stock fell from $103 to sub $30. Being ejected (TRADE) from the game does not wipe out the season (TREND), and very rarely/(thankfully) does it end a career (TAIL). We make mistakes and we learn. But in the end, we definitely think that RH will play again this season, and that should be apparent in 4Q of this year.
As we’ve stated numerous times since the blow up earlier this year, we’ve stepped back and re-examined this one ad nauseum. We have absolutely no problem walking away from a mistake. But any way we look at it (most ways, at least) we come out on the long side at $33 and a mere $1.6bn in market cap relative to $3bn in identifible and profitable revenue growth ahead of RH. No one cares about $6, $7, or $8 in earnings power anymore (even if it’s still there). If they did, it would not be trading at 6x those earnings and 3x EBITDA. But with the stock so beaten down, there are two real questions to ask…
1) Is the long-term opportunity still there? And,
2) Does management have the vision, the plan, and the raw process/talent to execute on the plan?
If the answer is Yes to both (and we think it is) – and if you have the luxury of looking at a TREND and TAIL duration (ie. into 2017 and through 2018/19), then we suck it up on the red card and look to the rest of the season. In spite of all the hate mail on the call, and the downright apathy as it relates to the story, we think that the upside/downside over 6-12 months is 4 to 1 on this name.
It all comes down to earnings and growth, right? In the end, earnings estimates for next year and beyond are too low. Yes RH messed up on the Modern roll out, managing new product flow, and a significant slow-down in the space early this year. It did not help that it all happened at once – mostly self-inflicted. But when we look at the costs associated with this mess (which we credit RH as not stripping out of results as other companies might do), we’re looking at underlying earnings of $2.50 this year versus the $1.65 it is likely to report. When we look at the base, grow it by maybe 10% – which it should at least do given square footage growth, a newer, less stale and more relevant product assortment, and better gross margin flow through from lower lease minimums associates with larger-format stores – then we can build to EPS of $2.80-$3.00 in 2017. The Street is currently at $2.30. Perhaps $3.00 is rich given the lack of management credibility and the potential for something to go wrong – again.
But building up to $4.50-$5.00 over 2-3 years is completely realistic. This earnings stream is absolutely not permanently impaired. Those numbers are 50-60% ahead of consensus. At the current multiple, we think the stock will work if earnings are only 10% above consensus.
Here’s a few points on both the call and what we want to see from the print.
- Inventory, Inventory, Inventory: This is obviously a bigger issue for the company than cleaning up its balance sheet. The company made a strategic decision to a) put a hold on the opening of new distribution facilities for at least another 2-3 years, and b) reduce its SKU count as it works to reassort the back end across category lines instead of regional lines. The company has the latitude to do the heavy lifting over the near-term with gross margins guided down 600-700bps in 2Q16. But in order to get more comfort in a rebased earning stream in 2017, we’ll need to see meaningful progress on this line.
- Efficacy of Grey Card RH Membership Program: Changing the way consumers shop is a tall enough task on its own. But this has been anything but an ordinary operating environment for RH. That, we think, makes it tough to gauge the efficacy of the Membership Program (as it is now being dubbed). Here is what we mean…i) the company decided to push all new product introductions (with the exception of RH Outdoor) into 2H16, skewing the math on what had been a typical late spring/early summer supply and demand curve, ii) vendor and supply chain snafus have limited the flow of product to the extent that order behavior has been altered by out of stocks, and iii) the promotional behavior from the company hasn’t changed significantly as it has worked to clean up inventory levels. On the last point, the company sent 115 promotional emails in 2Q16 – of those, 41% mentioned a sale in the title of the email blast above and beyond the 25% discount associated with the Membership Program (55% RH, 32% RH Teen, and 0% RH Modern). That looks a lot like the old status quo. There’s a good chance that RH meaningfully backs away from the Membership program – and already kinda did when it changed up the name. This might be the right business decision, and the right consumer decision, but not a Wall-Street confidence booster until people see that its accretive to the financial model. We’ll see…
- Management: The company is about 3 months removed from its corporate re-shuffle which saw the company eliminate $20mm in corporate related employee costs. Along with that, there has been considerable movement in the C-Suite with the COO Ken Dunaj, Chief Development Officer Doug Diemoz, and all 3 Chief Merchants exiting stage left in the past 18 months. Tack on the creation of the three Co-Presidents and it = a lot of moving pieces on a management team that has seen its credibility take a hit along with its market cap. That being said, we think that Gary Friedman has the strategic vision and pieces in place in order to execute on the plan. But – and this is a big but – we think that there needs to be plenty of talk about the additional pieces added to the RH management equation to give the street some confidence in the management team, as well as its ability to execute on the plan to restore sustainable growth to this story.
