RH is trading at 203x EARNINGS!

🧠 The Takeaways

Today we’re shorting RH ($6.1B). A Brand w/ falling sales + collapsing earnings shouldn’t be trading at a P/E ratio of 203x.

1. They claim their consumers buy in line with stock market performance. But Sales don’t match up.

2. They bet the farm and then some on growing now. But is it the right time?

3. Eventually, everything always reverts to the mean.

+ Why all operators need to become Financial Engineers, and all financial Engineers need Operators.

LBAB Community -  Operators Become Financial Engineers

One of my big bets this year (and the foundation of everything I've been doing) is that over the next 5 years, all Operators will need to become financial engineers, and all financial engineers will need to become, or bring on, operators.

After looking through 200 deals over the last year (+ talking to 200 founders), my biggest insight is that 90% of the people who want investment/growth capital/exit just need more education and understanding of how financial engineering works.

The big misconception, especially around PE investments—really anything that isn’t straight VC—is that most of what PE does post transaction is financial engineering to unlock more cash in the biz.

But a great Operator can do all the financial engineering themselves to skip the round of investments because most bands <$50m don’t actually need investment. They need better cash flow management.

Financial engineering has become a kind of dirty word for cash flow management, but at it’s core it really is sophisticated cash management. How do we optimize the assets of the biz to get as much cash flowing through the biz and into our pockets as possible.

Let’s be honest. That’s the name of the game we’re all playing. With more cash flow the biz will grow faster, and put more cash in your pocket.

On the flip side. More financial engineers need more operating experience (or need other operators on their team). There’s only so much you can learn in theory. With ZIRP ending the margin for error has evaporated on most of the arbitrages.

Now knowing the underlying mechanics, and what move them matter more than ever.

The best case scenario is when they understand (and can do) both: they know their P&L at a granular level and they know how to pull cashflow levers to take the biz to the next level.

The real winners over the next 10 years will be the people who align themselves with both to play the game on both fields. In the trenches + in the skies.

Let’s Examine This Biz

RH put the pedal to the metal, and they’re accelerating into a financial hurricane—hoping the game-changing bet will accelerate them fast enough they don’t get sucked in. 

Trading at $348.10/share with a $6.4B market cap, RH is +92% L5. They’ve left themselves without a parachute if things don’t go well.

Financial Summary

TLDR Analysis: Literally Every Wrong Trend

• COGS are falling half as fast as Rev YoY. 😰

• OPEX reduction is only 1/3 as much as Rev’s YoY decline. 😓

• Net Income got destroyed (-76% YoY).🤢

How on God’s green earth is this biz trading at 203x its earnings!?!?!?!

Just for comparison, a “reasonable” 40x P/E Ratio (where AMZ + WMT trade) would put RH’s market cap at $1.2B. But that’s still a terrible comp since AMZ & Walmart are actually growing top + bottom line and are 2 of the largest + strongest bizs on the planet.

By every actual metric, RH is heading for bankruptcy court. They beat their recent Q2 2024 earnings, but barely. I honestly have no idea why this biz is trading so well other than “rich people like this stock”. This thing should have imploded months ago.

Let’s Fix This Biz!

Here are the 3 reasons I’m short on RH, and where a great biz can blow it all up. 

1) This biz doesn’t trade against the stock market

Their 10-K is littered with the claim that macroeconomic forces (stock prices/volatility and interest rates) have a great impact on their sales, because their customers think of buying RH furniture like an investment.

So the price of their other assets impacts their buying decision. The “Dog at my homework” excuse for a brand of this scale.

I’m calling horse hockey on the stock market point. If you look at the S&P 500 over the last 5 years, RH Sales don’t follow the same trend line.

The dip in 2022 vs. 2021 explains RH’s -4% YoY sales decline, but the stock market went up by 24% over 2023. How much did RH’s sales increase?

They decreased another 16% YoY.

And when the market been RIPPING in 2024: they’re experiencing flat to little growth.

I can see RH’s logical fallacy. Their wealthy customers: 

• Look to their products like investments for their multiple homes, which are also seen as investments. 

• Mark their wealth to the current price of the S&P 500.

But they are deluding themselves if they think they aren’t just another home goods brand that trades along the same macro trends as everyone else in the space.

I can see the interest rates as a viable reason just like every other homes goods brand. The housing market has slowed because of high interest rates + home prices.

I can see it especially hitting wealthy people who would us more debt than the average person to buy their 2nd/3rd/4th home. 

Bigger % points on bigger numbers are more costly. 

RH’s experiencing the same consumer pullback that Wayfair and Home Depot are. Their consumers might look different than the Wayfair/Home Depot consumer, but it’s the same buying behavior trend.

Interest rate cuts will help more wealthy people buy more Real Estate, and they will probably be one of the first segments to start buying from RH as they can afford record high home prices so they’ll re-enter the market first.

But does RH have the time to see the effects of those cuts?

Takeaway: RH doesn’t actually know why their customers buy.

2) RH has bet the farm on the current market

In 2023, RH reduced their cash position by -92% from $1.5B in 2022 -> $123m in 2023. Mostly paying off debt + a stock buyback stock to the tune of $1.25B.

Considering they have $2.5B in outstanding debt, they have no reserves left if anything happens.

Also for everything doing the math home, by not having that cash reserve on their books, moving forward, their Net Debt is +135% YoY. That’s moved from $1B in 2022 -> $2.4B in 2023.

Their debt to earning ratio is 19x, which is scarily high.

I’m actually bullish on RH’s core thesis:

• Create mega-experiential Stores (Like in-store Champagne/Caviar bars)

• Moving into Lux experiences (RH Yachts/Private hotels/etc)

• International expansion into major European markets (London, Paris, Milan)

All to be powered by the RH Members Program, which gives “insiders” access to designers, exclusive discounts, and more benefits. The program accounted for 93% of their 2023 Rev on core products.

But was 2023-2024 the year to completely empty the strategic reserves to accomplish it?

Interest rate cuts just started in September to move down from historic highs. The housing market won’t actually start moving again until a reduction of 1-2% total off of 40 year historic highs. Will that happen before 2026? (We’re currently at 0.5%. Probably not.)

International luxury is struggling across the board given the war in Europe + slowing sales in China. RH has plenty of room to grow in Europe before they need to worry about China, but it’s not like France, Italy, and the UK are spending like drunken sailors. And Germany is having an energy crisis.

Then comes China. Most luxury retailers saw 20-30% of their sales come from China before its current economic slowdown. RH’s timeline to Asia is too far away to give an accurate forecast here, but bottom line: it’s not such a rosy market anymore.

The brass tax: RH is basically a luxury real estate market biz that layers on expensive, long-cycle furniture purchases. 2 incredibly cash-intensive, long-cycle bizs where bad market conditions can sink the boat.

If the housing + stock market don’t rip the way they expect it to, RH can be stuck paying massive Real estate, Debt, and inventory bills using borrowed $$$.

A recipe for bankruptcy.

Takeaway: All in bold bets work. But when you have so much to lose it needs to be a guaranteed win.

3) Mean Reversion

I probably didn’t need to write the rest of this newsletter and could have just written mean reversion on why I’d short this stock, but I think it’s important to properly cover when someone throws a good thing into the fire.

At the end of the day everything, especially multiples and investment , reverts to the mean.

There’s no way RH will continue to trade at 203x earnings for a meaningful amount of time, and as we covered 👆, it’s HIGHLY unlikely they grow into their current valuation any time soon.

They’ve exhausted their financial emergency fund + tapped out their debt. So, there are no more silver bullets to boost the stock price when they don’t hit their targets.

Even if they do hit their targets, Investors who are half-sober or paying attention will realize that there are hundreds of better places to put their capital and will also realize they need to get out while the getting is good.

This insane valuation is also preventing them from taking the right course-correcting actions to get themselves back on the right track.

From their Q2 2024, earnings their sales are stabilizing, but their Net Income % is decreasing! And NI % has already fallen off a cliff. 

• In FY 2021 NI % was 18%. 

• In FY 2023 it was 4%.

• In Q2 2024 it was 3.5%

All markets are cyclical. 

Everyone eventually figures out the jig, and when they do, the game is up. RH might be able to keep this game going for a few more quarters. Maybe even a year.

But the quality of their fundamentals are decaying exponentially. Eventually, investors will realize and reallocate.

Takeaway:  Eventually everything at scale reverts to the mean.

Final Thought

RH is the epitome of how the stock market doesn’t reflect biz fundamentals or reality anymore.

They’re propped up by financial engineering and news cycle momentum, but this is a biz that really should be down in the dumps with all the other massive lockdown winners.

But through leveraging debt up to their eyeballs, buying back stock, and associating their brand to the success of the stock market, they’ve convinced investors that this is a good stock to own.

And apparently worth 203x their earnings! 

I’m sorry, I still can’t get over that. It’s so ludicrous.

I can understand why this happens. At a certain point, everyone who has a seat at the table has so much of their comp tied up in the stock price that it’s more valuable for them to boost the stock price then run the biz properly.

But it really does feel like William Butcher on V.

They’re continuing to pump themselves full of short-term power while killing the core. (If you don’t watch The Boys, sorry that’s going to be a tough reference).

The other thing is, and I could be completely wrong here, their bet-the-farm strategy might pay off.

They might become the next LVMH acquisition. But do they need to take this risk to get there?

RH should really be at a ~$1.5-2B cap after getting hammered in 2022-2024 because their demand pulled forward and left them with falling Rev + plummeting Earnings (-81% from 2021).

Like every other Lockdown mega winner.

But through a good narrative, false signals, and doing the “right financial things,” they’ve been able to Weekend at Bernie’s this stock.

We live in a perverted loop where all the incentive structures have completely inverted. 

Tying most of Exec comp to equity is supposed to align leadership with the longer term goals of the biz. I’m picking on RH, but I’ve noticed this trend across so many other bizs.

Bizs reporting performance on quarterly cycles is now incentivizing behavior that is more short-term than if you gave Execs annual bonuses. We’ve moved their focus from building the biz for the long term to wrangling their stock price on a 90-day cadence.

It’s the equivalent of having a president who needs to constantly run for re-election. These teams aren’t heads-down building important products. Just optimizing for the next quarterly report.

RH really needs to get back to the basics. Get their costs in control to reduce their debt and find the right long-term strategic bets to make on the back of early wins (which they have a good amount of) and progressively continue to invest.

It’s trying to map ludicrous speed growth plans on bizs that take decades to build.

RH was founded in 1979, and has all the makings of a future LVMH hall of fame inductee, yet is falling victim to the same fate as other brands. Growth Growth Growth and more Growth tomorrow.

They should have maintained their long-term vision.

The average LVMH House (along with most staple consumer brands) is 50–75+ years old. Everyone needs to stop deluding themselves that they’ll build a multi-billion dollar brand in under a decade.