Restoration Hardware Holdings, Inc (NYSE:RH) has become one of the biggest battleground stocks in the market. Heading into the company’s fiscal fourth-quarter earnings report on Tuesday afternoon, some 41% of the float of RH stock was sold short.
That short interest, combined with aggressive share repurchases by RH, has created a huge amount of volatility. In less than three years, the price of RH stock has moved from over $100 to under $25 and back over $100, before dropping about 28% in two months heading into the Q4 release.
RH stock looks set to recapture some of those losses, with the stock currently up more than 21% after a Q4 beat. Plus, with the financial engineering aspect of the story now having played out, RH looks like an intriguing investment.
EPS guidance for fiscal 2018 (ending January 2019) looks solid. RH stock looks reasonably cheap, and an innovative business model and early success with in-store cafes suggests both growth and margin expansion over the next few years.
There are risks here, though, even after a strong report. RH very well may stay a traders’ plaything for the next few quarters. But, the story at RH is getting interesting. And, in the least, Q4 earnings show why investors should have no interest in continuing to short RH stock.
While investor focus has been on the trading gyrations of RH stock, the company actually is posting strong results, which continued in Q4. Adjusted net revenue (which backs out changes in a recall accrual) rose 13% year over year, including a 2-point bump in comparable-store sales.
Gross margin expanded an impressive 400 bps, mostly through higher product margins, according to the Q4 conference call. In an increasingly and intensely promotional environment in retail, RH isn’t chasing “low quality sales,” as CEO Gary Friedman put it on the call. Adjusted operating margin rose 260 bps to 11.2%, a rate that appears to be highest in the industry at the moment. (Ethan Allen Interiors Inc. (NYSE:ETH) used to be in the double-digit range, but its December quarter margins dropped below 9%.)
As a result, adjusted net income increased 55% year-over-year. And thanks to the aggressive buybacks of RH stock – RH repurchased $1 billion in shares during the year – adjusted EPS jumped 149%. The $1.69 print was $0.14 ahead of Street estimates.
FY18 guidance is a little light on the top line, with RH projecting sales of $2.53 to $2.57 billion against consensus of $2.59 billion. The figure, excluding the impact of a 53rd week in FY17, represents 5-7% year-over-year growth. Adjusted EPS is guided to $5.45-$6.20, mostly ahead of Street projections of $5.50. Operating margin expansion should continue, with RH raising its guidance to 9.2-10.2%, up from 7.0% in FY17 and 4.8% the year before.
All told, Q4 looks like a strong quarter. And it may be enough for investors to start looking at RH stock as an investment, not just a trade.
The Case For RH Stock
Coming out of the quarter, RH looks like an even more dangerous short. The squeeze potential here is enormous. A simple screen suggests that out of over 7,000 stocks, RH has the 25th highest short float. Only well-known targets like Overstock.com Inc (NASDAQ:OSTK) and recent IPO Roku Inc (NASDAQ:ROKU) are more heavily shorted.
But, the case is getting thinner. Operating margins are on track to potentially double in two years. RH now is targeting $4-5 billion in revenue — as much as double FY17 levels — at low double-digit margins. Free cash flow figures are huge: $433 million in FY17, and a guided ~$250 million in FY18. That should allow RH to repay its large convertible debt balance in cash, cleaning up the balance sheet.
If the plan works, the upside is potentially enormous. Even the low end of FY21 targets suggests at least $400 million in operating income. $339 million in debt beyond the convertibles requires $15-$20 million in interest expense. At FY18’s 26% tax rate, that would lead to EPS over $13 per share. Put a 15x multiple on that and RH stock trades at $200.
Risks Remain – But Mostly to Shorts
That type of upside isn’t guaranteed by any means. There is macro risk here, although one could argue that RH’s high-end clientele might be less affected by a weaker economy than a middle-class retailer like Bassett Furniture Industries Inc (NASDAQ:BSET), who posted a disappointing fiscal Q1 report on Wednesday morning, or La-Z-Boy Incorporated (NYSE:LZB).
Margins still are relatively thin as well; any missteps could reverse the recent gains. Even 100-200 bps in margin pressure from increased clearance or higher freight costs can send earnings tumbling 10-20%. And Friedman’s audacious strategy to build huge, high-end showrooms is, by the CEO’s own admission in the Q4 release, “in direct conflict with conventional wisdom.”
Coming out of Q4, however, it’s hard to argue that strategy isn’t working. If it continues to do so, RH will be a huge gainer. The potential upside here makes RH stock a potential high-risk play from the long side. At the least, it makes a short of RH almost suicidal.
As of this writing, Vince Martin has no positions in any securities mentioned.