Monday, 5 June 2017

RH, The Perfect Short: Busted Growth Model And Gap To Fill

On May 6th we initiated a strong buy call on Applied Optoelectronics (AAOI) with our article "AAOI: Eight Reasons To Expect This Tech Unicorn To Double By The End Of 2017". A month later and the stock has risen 29% from $55.96 to $72.44. Our follow up pieces on May 10th called "Fund Buying And Short Interest Will Lead To A Massive Squeeze on AAOI" and on May 30th called "AAOI Would be $200 If It Was Valued Like NVDA" provides more bullish catalysts on this great company. Another bullish pick of ours is Puma Biotechnology (PBYI). You'll notice that it had a nice bounce after it pulled back to fill the gap made from the morning's spike over $90. We believe that it should revisit those highs by the end of the week. If you like our picks make sure to follow our blog by clicking the follow button on the top of the left hand panel. We are up to 221 followers despite the relatively few articles that we publish. We think this good growth in followers is indicative of people liking our picks and research.

We generally go long as we like value trades with good fundamentals or a news story that implies the stock is undervalued. A bullish chart helps as well. But we are not afraid to go short on a stock that does not have good fundamentals nor a good story and a nasty looking chart. Restoration Hardware (RH) fits perfectly into this mold. RH is a company with a busted growth model and a gap to fill on its chart. After its tank on Friday on poor earnings outlook, the stock had a nice dead cat bounce and miniature short squeeze on Monday which provided an excellent entry point for a short position in the final hour of trading.

We think RH will drop to the $36-$38 level in the near-term, at a minimum, and could drop further longer term. The short thesis on RH can be summed up in three major bullet points:

  1. At $46, the company's forward-looking P/E is over 25. While an aggressive valuation for a furniture retailer may have been acceptable when there was evidence of a clear turnaround in the business, RH now has a busted growth and profitability model which makes it extremely overvalued at this level. RH compares very poorly to its peers. 
  2. Looking at the chart, RH has gaps to fill, with the most obvious one being at around the $38 level after a breakaway gap a couple of months ago. With the stock breaking its upward trend, watch for this gap to get filled quickly.
  3. The eccentric and unusual comments of the CEO really brings into question the company's direction and should signal a lack of confidence in his ability to lead RH down the right path. 

RH has busted growth and is highly overvalued

Seeking Alpha summed up why RH tanked last Thursday afternoon in this news piece:

The mid-point EPS guidance of $1.80 fell 16% short of analyst consensus. If you look at RH's financial and and stock price performance over the last 2-3 years, you'll know that the company has struggled mightily. RH's stock has risen from the mid-$20's to as high as $60 at the expectation that the company has turned it around. With an EPS expectation of $1.80, that does show improvement from fiscal 2017, but is still well short of EPS numbers seen in fiscal 2015 and 2016. The company's mid-point guidance of $2.425 billion in revenue is a 13.6% growth rate on top-line revenues from last year. That's an okay growth rate, but it doesn't justify more than a 20 P/E on a retail furniture business with declining margins.

Let's put it in this context. RH at $46 has a P/E of 25.6 based on the mid-point EPS of $1.80. AAOI, one of the strongest performers in an optoelectronics industry serving the lightning hot growth of data center builds is trading at a forward P/E of 14. RH, this retail stock with profitability problems is trading almost twice as expensive as AAOI!

Even if someone doesn't like the AAOI to RH comparison, RH is still rather overvalued to industry peers. Select Comfort Corporation (SCSS) trades at a forward P/E of 17.4. Home Depot (HD) is not exactly a perfect competitor but is still an excellent bellwether stock for spending in the home. It trades at a forward P/E of 18.9. Williams-Sonoma (WSM) trades at a forward P/E of 12.2. Bed Bath & Beyond (BBBY) trades at a forward P/E of 8. We think readers get the point. Retail outlets that focus on products for the home do not trade at aggressive earnings multiples. RH did because there was an expectation that it was a disruptor turning around its business. This latest quarter shows otherwise.

RH chart looks ready to fill a gap in the $37.50 range

RH's trend of inconsistent earnings has resulted in an unusual amount of gaps in its chart. Note the four red squares below signifying the four gaps found in the chart over the last several months.

With the uptrend having officially broken down under the 200-day moving average, the most obvious gap that needs to be filled is the one in late March between $38 and $42. This also would take the stock down to the 50-day moving average where support would be found, at least until the next earnings release. The stock has flirted with the $42 mark both on Friday and Monday. Once RH hits that mark again, expect a quick slide down to the $38 level.

We generally aren't chart readers, but this one should be obvious for anyone:

  • broken uptrend
  • stock has broken down below the 200-day MA
  • gap to fill at $38 to $42
  • 50-day MA support will be around the $37 level

RH is going to head to $38 based on the chart.

The unusual ramblings of RH's CEO should be of great concern for investors

In addition to the financials and the chart both pointing to at least a 20% decline in RH's stock price, RH shareholders have an additional bearish catalyst to deal with that is uniquely all their own. This article on Zerohedge breaks down some very unusual comments made by RH's eccentric CEO. Specifically:

Do you recall what happened to the Yellow Pages? It has gone the way of the do-do bird along with the stock prices of the companies that owned those dying businesses. Mailings and catalogs are being dropped by other retail brands for good reason. The dwindling amount of people who still rely on mailings as their prime source of market research for purchases are probably not even in RH's demographic. Time Magazine even put out a piece on the company's wasteful and anti-environmental ways with this ridiculously-sized catalog from a few years ago:

On top of the catalog, RH has admitted to not using social media as a way of getting out its brand name. It's true that social media marketing might be hit or miss, but think of who makes the spending decisions in the household, particularity those on furnishings - moms. The work-at-home mom demographic made up of women who thrive off of online businesses are a prime target of social media campaigns that can go viral. Yet the company prefers to go the wasteful dinosaur route of catalogs to try to appeal to rich Gen X-ers and Millennials who have a social conscience and care about the environment. RH leadership has absolutely no awareness of how to appeal to the company's demographic.

The Zerohedge article goes on to describe more of RH's disclosure which was accurately described as "an ISIS pitchbook":


You could make a very good argument that with this business plan in utter turmoil and a CEO that rambles on about complete nonsense that RH should trade at a significant discount to its peers. We are looking for RH to trade merely slightly superior to its peers of a P/E of around 20. With a mid-point EPS expectation of $1.80, $36 would be a fair price for RH. At a minimum, the stock will fill its gap at around $38. So that's why we think $36 to $38 is a fair short term target on RH. However, we would not buy RH at that level unless the profitability of the company was back on track.

Disclosure: We are long AAOI, PBYI and short RH. 

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