Last January, RH (NYSE: RH) was a struggling upscale home furnishings retailer. Its hybrid approach -- brick-and-mortar combined with e-commerce -- seemed to be failing, and its stock was tanking. At the time, shares traded for $27 apiece.
Fast-forward to today: Even though trailing revenue has risen a scant 14%, shares are trading 450% higher at around $150. When a move like that occurs, short-sellers usually swarm, and RH is no exception. According to Yahoo! Finance, 32% of the company's shares are currently sold short: an enormously high percentage.
Are the bears right, or will RH bulls continue to benefit from all this pessimism?
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The perfect short squeeze
RH may have pulled off the most effectively engineered short squeeze I've ever seen. This is thanks to two major decisions made by the company's management:
The company largely abandoned its e-commerce strategy, and doubled-down on brick-and-mortar "Design Galleries" with $100 annual membership fees.
The company bought back roughly half of its shares over the course of a few months.
We'll deal with the share buyback first. In May 2017, RH's board of directors announced a new compensation package for CEO and founder Gary Friedman. In it, he had the possibility to earn $75 million worth of shares if the company's stock could reach certain milestones at $100, $125, and $150 per share.
The very next day, the company announced that it was taking on $700 million in debt to repurchase shares. To put this in perspective, the company was only worth $1.7 billion at the time. By July 14th, the entire repurchase program was complete. When combined with a previous buyback of $300 million earlier in the year, RH's total share count dropped by 48% compared to the start of the year.
Why this has worked for RH...so far
That meant three things, two of which were great for RH and its shareholders. First, the remaining shareholders are each entitled to roughly twice as much of the company's profit now. Second, short-sellers suddenly found themselves in the crosshairs. Because RH's buyback program created demand for the shares, the stock price rose 48% between May 1, 2017 and July 14, 2017.
Short-sellers were forced to make a tough choice: either bite the bullet and post more cash to prove they could eventually cover their positions, or close out their short positions by buying RH stock. The former was nerve-wracking, and the latter just created even more demand for the stock, sending it even higher. That's why it's called a "short squeeze" -- there's no great option available to short-sellers.
The third thing the move did, however, was not so positive: RH took on a mountain of debt for the buyback. I was one of the move's biggest detractors, believing that the company couldn't possibly handle nearly $1 billion in long-term debt, including a high-interest tranche of $100 million.
However, there were some key details I overlooked. Most importantly, because the company was transitioning to focus more on brick-and-mortar, it drastically reduced its inventory. Such inventory reductions can do wonders -- albeit one-off, non-recurring wonders -- for a cash flow statement. Lo and behold, RH was able to pay off the high interest note in very short order.
At the same time, the business has had solid -- though not eye-popping -- results. Membership revenue is coming in higher than many expected, though a little thought experiment shows why: If you have to choose between buying a loveseat for $1,200 or paying for a $100 annual membership and getting the same seat for $1,000, wouldn't you choose to go the membership route as well?
Since the end of 2016, sales are up 14%. What's really remarkable, however, is that gross profit has jumped 29% thanks to the higher margins at Design Galleries and the membership model.
Which leaves us with our initial question:
Is RH as doomed as the bears would have us believe?
RH is currently sporting a debt load of $931 million, versus just $21 million in cash. However, the bulk of that debt -- about 63% -- is in the form of convertible notes due in 2019 and 2020 that have passed their strike prices. In other words, that debt could quickly be converted into shares.
That would make the resolution of two-thirds of the debt pretty easy, which is great news for the company. But it's not great news for investors. If all the shares were converted, the company would have roughly 5.56 million new shares -- diluting current shareholders by over 20%.
Still, focusing on the company's financials, RH needs to continue churning out solid free cash flow to prove it can sustain any growth initiatives and continue paying down non-convertible debt. The first year after the company's inventory reduction, free cash flow boomed to $419 million. Of that, however, inventory reduction accounted for over half, at $220 million. During the most recent quarter, when inventory reductions were no longer boosting cash flow, free cash flow dipped to negative $20 million from over $100 million a year earlier.
But perhaps most importantly, RH needs the economy to continue humming along. If high-end shoppers get spooked by a falling stock market or recession, RH could find itself in trouble. Counting on those $100 annual membership fees is nice -- especially since it comes in the form of automatic credit card charges, which have proven very sticky for other companies -- but without recurring traffic to Design Galleries, RH could once again find itself struggling.
The takeaway for shareholders is this: There's a high likelihood you'll not only be diluted by convertible notes, but also by Friedman's compensation plan. For longtime shareholders, that's no big deal, as RH's buybacks helped juice returns by 450%. More recent buyers of the stock, however, need to have full faith that RH will continue winning over customers and benefiting from its more lean design.
If those things turn out not to be true, the bears might have the final word yet.
