Takeaway: The best TAIL story in retail just showed why it’s the worst quarterly model. Bears will focus on mgmt cred. I’ll buy the sell-off all day.

Last quarter I wrote a note called ‘Unleash the Kraken’ after RH upped long term targets yet again capping off one of the biggest upward earnings revision cycles I have ever seen from a company in my career. 2019 earnings expectations bottomed out at $2.93ps 2-years ago (Feb ’17) with the stock at $26, and went all the way up to $10.11ps (preliminary guidance) alongside the Dec report with the stock clocking in at $160. #astounding. My gut concern at that point in time was that the company had just pulled forward every piece of good news it had pent-up in the model. Conspiracy theorists will look at the timing of that mega-release and juxtapose the fact that RH was looking to do a simultaneous convert and needed to put its best foot forward – and make stretch assumptions about 2019 before the model was baked and ready for prime time.

I don’t buy that. Seriously…I don’t. I think the company was simply calling it like it is – and as of that point in time the business was absolutely killing it. For many people watching the red on their screen today, this is gonna come down to a ’what the heck is Gary doing to us’ call. Let’s face it, when the stock is blowing up people think he’s nuts, and when the stock triples and he pulls off the financial engineering move of the century they think he’s a genius. I’ve told him those opinions to his face, and he gets it (I actually think he welcomes it). You might like Gary, and you might hate him…but the guy is not a liar. He’s painfully and brutally honest – real time --  sometimes to his detriment. But I’d rather that than be lied to – which there’s no shortage of in retail management teams these days.

So…Kraken unleashed. And while the company crushed earnings expectations this quarter (right in line with our $3.00 estimate and 5% comp vs the Street at $2.86) unfortunately, it turns out that The Kraken is deathly afraid of the equity market wealth effect. While RH was on the road a day after the last print with the stock at $160 the market began a 16% melt down that lasted through Dec 24th. Needless to say a deal didn’t get done – and December went down as the first month that no company borrowed through the US Hi-Yield corporate bond market since November of 2008. Ironically, one of the last deals that got done was Wayfair’s $500mm 1.125% convert at a 32.5% premium and priced at $116.40. (W purchased capped calls with a premium of 150% or $219.63. Net proceeds of $562mm.) Wayfair rarely beats RH at anything (except for selling product at a loss) – this is a rare instance in which it won. #lucky.

The weeks after the deal was pulled, the 16% decline in equity markets and dried up credit markets took RH’s business down 10%. I know this business is cyclical – but such a massive magnitude of change so quickly scares the bejeezus out of me. Has it gotten MORE cyclical? Fair question, bc this never happened before. But the answer is ‘No’. In years past, RH would have run promotions and barraged millions of customers with emails to sell product on the cheap. But it didn’t do that…instead managing the business for margin. As such, January and February were both terrible – before recovering (importantly) in March. But as it relates to 1Q revenue it cost the company three points of consolidated revenue growth.

So what I learned here is that there is a new normal with RH – it’s not going to flex on profitability, but we need take up our discount rate in the quarterly model materially higher in order to account for the outsized revenue moves that will happen based on RH’s reluctance to chase revenue to hit quarterly targets. The company does not care about quarterly revenue – it cares about earnings, cash flow and creating a business with no competition. But the challenge is that 80%-90% of PM’s out there add up the quarters to get to years, which makes RH uninvestable for the majority of Wall Street. Fortunately for the 10-20% of people that can stomach the vol and invest over a TAIL duration, they can capitalize on the upside that comes along with a retail story unlike any we’re likely to see in a generation.

On top of all this, we have a (sort of) brand new CFO. Jack Preston has been part of RH in a strategic financial capacity for the better part of 10-years – and I gotta say, I was kinda expecting him to be quiet on this – his first – conference call. But he got right in there – even interrupting Friedman once or twice (props!) and sounded a lot to me like Karen Boone, who was a massively positive influence inside that company. If I were Preston, I’d want to clear the deck with targets and be as transparent and realistic as possible as the year progresses. That’s what we got today.

So if the new theme is increased cyclicality based on the direction of high end housing, we need to scrutinize the balance sheet, and the company’s ability to fund its growth – even despite the ‘capital light’ nature of Stanchak’s new real estate deals. The good news when you’re focused on profitability and cash flow is that you can more predictably manage the flow of borrowings and plan how to either convert or settle maturities in cash. Because of RH’s improved inventory turns and cash position, it's in the pole position to settle the $350mm 2019 convert in cash – though will limit capacity for stock repo. And for the record, I wouldn’t be surprised to see Friedman step up and buy more stock personally on this sell-off. If you ask him where his stock is headed, he won’t say $200, he’ll say $500. Whether you agree or not, that’s what he’s managing, building and planning for. Get used to it.

So what’s the earnings power here and what’s it worth…?

I have no reason to doubt the 1Q guide – barring another melt down in equity markets over the next four weeks. The company was transparent with the impact of the elimination of promotional programs by quarter, as well as with the impact of lease accounting on reported earnings. Longer term, I think the company’s growth goals are completely realistic. It can add 5-6 new galleries per year for a decade – and that’s without considering Int’l growth. We’ve done the market by market analysis to back it up – down to how much money people by demo spend on couches vs coffee tables and lighting fixtures in every MSA in the US. The white space is better than any other retailer/brand I can find today. Do I think there’s a lot of upside in Gross Margin? Maybe 1 or 2 points after the rip we saw over the past two years as it largely optimized its promotional strategy and logistics network. But rather this should be a raw top line growth story with outsized unit/rent economics and corporate SG&A leverage. Will it grow 20%+ this year? No. Because of 1Q revenue hit, elimination of the unprofitable programs noted, and the start of lease accounting with the June report – it’s going to cost over 1,000bps. But the earnings CAGR here and $14.00 per share (with stock at $110) over a TAIL duration is something I’d challenge you to find anywhere else.

More modeling, timing, and valuation detail to come after the 10-K is filed tomorrow.