Bulls and Bears Are Battling Over RH

 | Sep 06, 2017 | 12:00 PM EDT
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Home furnishings retailer RH (RH) reports its second-quarter fiscal 2018 earnings on Wednesday after the close. With nearly 42% of the float held short (June 30) there is more tension between the bulls and bears than between North Korea and the United States.

Year to date, shares of RH, formerly known as Restoration Hardware, are up 62%.

After RH missed the first quarter on June 1, management attempted to break the back of the short sellers by executing the most-aggressive stock buyback that I can recall.

On July 14, RH announced it had finished a $700 million share repurchase program, purchasing 12.37 million shares during the second quarter. Combined with the $300 million repurchase of 7.85 million shares completed at the beginning of the first quarter, the company has repurchased 20.22 million shares, or one half (49.6%) of its outstanding shares. The company spent $1 billion in less than 100 trading days trying to prop up its stock. (Holy share price manipulation, Batman!)

The buyback worked for a while. The repurchase drove the stock from about $40 to nearly $80 per share. After the buyback was finished in mid July, the stock sank 38% (from $80 to $49). The company borrowed virtually all of the buyback money.

The RH bulls are taking the buyback as a sign of confidence from the management team in their long-term approach, while the bears view the buyback as a speed bump on the way to the company's ultimate demise.

Now, all the company needs to report a strong second quarter to prove the bears wrong.

Right now, the consensus is looking for $606 million in revenue on $0.47 per share. Of the 20 analysts who cover the stock, 17 rate the shares hold.

RH doesn't have the most consistent record. The company has experienced a number of setbacks since fiscal 2015, as management has been restructuring the company around a gallery model.

RH took the unusual step of closing three-to-five retail stores per year and began building larger gallery destination stores in major cities. The galleries, such as the one in Boston, boast more than 40,000 square feet on multiple floors and are extravagantly designed. For example, the store in Boston was once the home of the Boston Museum of Natural History. The store has a music room dedicated to Motown, a library featuring magazines and newspapers from around the world and more than 150 chandeliers. The New York gallery is expected to be a budget busting 60,000 square feet. Currently the company has 50 galleries. Some of the galleries have full-service restaurants.

In addition, RH has moved away from a furniture discount model to a membership model, where lower prices are available to members only. For a $100 annual fee, members receive a 25% discount and free interior design service. In the past, most of the products were sold at 25% anyway, so moving to a membership model brings in incremental revenue.

In the past, RH has missed earnings because of shipping delays, production delays due to the roll out of RH Modern, SKU rationalization, consolidation of distribution centers, and luxury headwinds. The company has also struggled with too much or the wrong inventory. The company even blamed slow sales in the past on the price of oil.

For the quarter, RH should report EBITDA of $45 million and operating income of $28 million, which would be down 2% and 13%, respectively. Gross margin is expected to be 34%, up slightly from the 33.7% reported last year at this time.

The shift towards destination stores has helped comparable same-store sales. Same store sales are estimated to be 6%, which would be a big turnaround from the -3% posted last year.

The bulls think the company is headed in the right direction. By building gigantic destination stores, the company is attracting hordes of upscale buyers, insulating itself from Amazon (AMZN) and endless price competition in the furniture business. The larger stores allow the company to showcase its entire product line. Instead selling furniture by the piece, it is selling projects and rooms full of furniture. The larger stores are driving comps and ultimately margins.

The bears think the company's strategy is flawed. They argue that RH is drowning in debt, blew $1 billion of borrowed money on the stock, which went down anyway, and that it has no path to generating consistent free cash flow. In addition, most bears think the company's strategy has already been tried -- they used to call it a department store.

It's about to get interesting.

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