MoxReports just published a LONG (bullish) report on $RH at moxreports.com
This industry is projected to double in size from $22 billion to an estimated $44 billion
Summary is as follows:
Earlier this month, value investor Mohnish Pabrai took part in a Q&A session with William & Mary College students. Q3 2021 hedge fund letters, conferences and more Throughout the discussion, the hedge fund manager covered a range of topics, talking about his thoughts on valuation models, the key lessons every investor should know, and how Read More
***Section 1: Summary investment thesis
Shares of RH are being driven sharply higher as a result of financial engineering being conducted by RH’s CEO Gary Friedman. Throughout this article, please understand that the described reductions in share count have nothing to do with any type of meaningless “reverse split”. Instead, with RH these are actual and permanent reductions in share count which are having a very predictable effect on the price of each remaining individual share.
Right now some shorts appear to be taking the view that “if RH was a good short at $30, then it must be an even better short at $90”. But in fact, the share count has been reduced so aggressively (via share buy backs) that the market cap of RH is only up by 30-40% since April. Moreover, this moderate rise in valuation is arguably not far out of line with the recent improvements in financial results (and outlook) as announced in September. The September announcement alone saw the share price spike 45% in single day. The shares repurchased by RH were bought at far lower levels and much of these purchases were conducted with cash (not just debt), such that even the comparable rise in enterprise value is also far much lower that this sharp rise in the share price. In other words, comparing the price of a single share between one period and the next is no longer a consistent picture of the valuation of RH as a whole.
So here is what is happening:
In May of 2017, RH’s CEO Gary Friedman was quietly awarded a staggering nine figure incentive package if he can somehow engineer the share price to $150 or higher. Precisely how he achieves this goal is entirely irrelevant.
If Friedman is successful, the value of the total awards to him will exceed $500 million. At least $25 million of this will come to him within just the next few months. All that is necessary for Friedman to receive this payout is the financial engineering and ongoing reduction of share count coupled with even just very slight improvements in RHs business (in fact, whether real or perceived).
Mr. Friedman did not waste any time in putting his plan into action.
Within just two days of that award (on May 4th, 2017) RH quickly announced a $700 million share buyback to sharply reduce the share float. Some were surprised at the buyback because RH’s stock price had already been rising towards the highest prices of the year (then closing in on $50).
Even more surprising (to some) was that within just 50 trading days, RH had announced that it had already completed the entire $700 million share repurchase, accounting for a significant portion of the daily volume during that time.
What I will describe below is how Friedman is now using a combination of positive cash flow and new debt to further reduce the share count. Freidman is effectively conducting a “stealth/quasi/creeping” going private in order to drastically reduce share count. Ultimately, for Freidman to take home his nine figure package, the equity float must go lower. And this is what is happening. The impact on the share price is entirely predictable.
Throughout 2017, RH has already repurchased half of its outstanding float at an average price of $49.45. The share price has already nearly doubled since those purchases.
But what about the all of that debt ?
Because of its increased leverage, the market has been very focused on RHs “capital structure”. But changes in leverage can now cut both ways. As a result, when RH suddenly announced three weeks ago that it was already paying down its $100 million second lien term loan (within just 3 months of it being issued), the stock quickly shot up 20 points from the $70s to the $90s, quickly hitting new 52 week highs. And yet clearly that was a just relatively small deleveraging.
Of RHs remaining debt, the majority ($650 million) is in the form of convertible debt with strike prices of $116 and $118. And now suddenly these conversion prices are quite squarely within range.
But….did you also know that in 2014 and 2015, RH had already purchased complete “bond hedges” from underwriter BofA-ML to fully neutralize dilution once those convertibles convert at prices over $116 and $118. There is therefore no dilution until the share price exceeds well over $170.
In 2014 and 2015, RH paid BofA-ML over $130 million for the long legs of these bond hedges to neutralize dilution.
(Terms, details and dilution tables for the bond hedges are included below).
Yet the market has missed the details of these convertibles and bond hedges because just a few months ago, the share price was still below $50, making conversion seem highly unlikely.
(And quite frankly, I am very skeptical that many investors ever even knew about these massive bond hedges in the first place.)
Even aside from earnings announcements, Friedman has made use of other ongoing announcements to propel the share price higher over the past 5 months. There was the announcement of the share repurchase, the announcement of Friedman’s own open market purchases of $2 million in RH stock in the $70s and then the announcement of the early repayment of RH’s second lien notes in October. Each time, these separate announcements have driven the share price sharply higher. This is how we have gotten from the $40s to the $90s in just 8 weeks.
The next catalyst for a sharp spike higher
And now in just 8 trading days from today, RH has suddenly decided to conduct its first “investor day” after more than two years. In the past, RH has made very visible use of such events to make announcements which then sent the stock sharply higher.
There are a variety of announcements that Freidman could be expected to make at (or in advance of) this “investor day”.
The most obvious announcement would be that RH would announce the simple approval of the next leg of its ongoing share buyback.
Or RH could announce a subsequent reduction of leverage.
Or Mr. Friedman could simply reiterate his recent very bullish views on RH’s near term prospects, both in the US and in Europe.
Given the 48% short interest in RH and the moderate trading volume, any of these announcements could easily fuel an immediate and very sharp spike in the share price.
In the event that RH announces yet another shift in the capital structure (i.e. the next leg of the stock buyback or the next debt pay down), such a spike would most likely be permanent rather than temporary.
In the near term, if the share price stays above $100 (up just 11% from current levels) in the next few months, Mr. Friedman will receive an extra $4 million under the recently awarded incentive package.
But if the share price goes North of $150 then just that first near term incentive award swells to $25 million to be doled out to Mr. Friedman in just the next few months.
So ask yourself this: in its first investor day in more than two years, and with $25 million looming in near term incentives, do you think Mr. Friedman will say something positive or something negative ?