RH (RH) reported quarterly earnings last week and it went extremely well. The company beat on revenue by nearly $9 million and beat on earnings by $0.18. The stock spiked over 40% on the news. Part of the rise was due to the solid earnings reports, and partly due to short covering. RH had over 30% of its shares sold short into earnings:
I understood why investors would have been short. The retail space is in a period of upheaval. More product is being purchased online; home furnishings is being bombarded by the likes of Amazon (AMZN), Wayfair (W) and Walmart (WMT), which does not bode well long-term for RH. Lastly, RH is in the process of revamping its business strategy while all this upheaval takes place. RH is changing to a membership model where members get first access to clearance items an special sales, and amenities like concierge services and free interior decorating advice. The concierge and interior decorating services sounds like nice touches that could appeal to the upscale market. However, making a new strategy pay off while the retail space is being disrupted sounds like an improbable task.
There is risk in life and the short bet did not pay off into earnings. Below is my take on the quarter.
Strong Revenue Growth
Revenue of $615 million was up 13%. This is a strong indication that the company’s new membership-based strategy could be working. Double-digit revenue growth in the retail space has been difficult to come by. Secondly, solid top-line growth could potentially lead to other positives for the company such as expanding margins. Comparable store revenue was up 14%, while direct-to-consumer revenue rose 13%. Direct revenue was a sharp departure from the 2% decline experienced in the year earlier period. Comparable brand revenue was up 7%; this includes the Waterworks operations which the company acquired last year and membership revenue.
Management was rather quiet on details of its membership revenue, as it should be. It might take a few quarters before management can put together a coherent narrative on membership, and begin to forecast it. For now, investors will have to focus on total revenue growth.
EBITDA Margins Are In Free Fall
The other narrative is that the company reduce its SKUs, rationalized the number of items in stock and monetized its inventory balance. Inventory ended the quarter at $608 million, down from $808 million in the year earlier period. This represents a 25% reduction and an excellent source of cash. Now management can start to focus on those items it expects to sell well and fit with its developing customer base.
The inventory reduction and sales growth did not come without a cost. RH had to put some items on clearance in order for them to move. Gross margin was 33%, similar to that of the year earlier period. However, SG&A expense grew 23% Y/Y, outstripping revenue growth. As direct sales continue to grow RH’s SG&A costs could be a drag on earnings. EBITDA margin fell to 5% from 7% in the year earlier period. On a dollar basis EBITDA was down 20% Y/Y.
Usually a double-digit decline in EBITDA amid double-digit growth in revenue would send a stock lower. It also connotes that there might not be much leverage in the business. When clearance sales dissipate I would expect margins to expand. Otherwise, it could be a bad omen of RH.
Share Buybacks Help Punish Shorts
During the quarter the company repurchased about $700 million in shares, and about $1 billion through the first six months of the year. Herbalife (HLF) waged a similar war with short sellers a few years ago. This one appears just as cantankerous. Through the first half of the year RH generated $316 million in cash flow from operations, yet cash decreased by $65 million during that period. Cash on hand is now $87 million. I would rather have seen the company squirrel away capital for a rainy day.
Its $1.2 billion debt load is over 10x run-rate EBITDA. If the business turns down there might not be much of a safety net. RH won the battle with shorts this quarter but the war is far from over.
Conclusion
At over 30x run-rate EBITDA RH is overvalued. As short covering subsides the stock might begin to trade lower. RH is a long-term sell.
