Restoration Hardware: Their numbers don’t make a lot of sense

Restoration Hardware is a retailer with a shrinking store count, going from 95 stores in YE2010 to 70 stores in YE2014.  Despite this drop in store count, capital expenditures have grown from $2.024M to $93.868M in that timeframe.  One explanation is that Restoration Hardware is improperly capitalizing expenses to inflate its earnings.  Of course, it is also possible that there is no accounting fraud here.  Perhaps Restoration Hardware is legitimately making a huge investment in software and store renovations.  As always, you should do your own due diligence and come to your own conclusions.

Market cap:  $2.6B
Borrow:  <1%
Shares short / shares outstanding: 10.3% (Shares short as a % of float would be higher)

The fraud thesis

Disclaimer:  Fraud is one of many possible explanations.  There may very well be legitimate explanations as to why Restoration has some very unusual numbers.  What I write below is simply my theory as to what’s happening.  There will likely be parts of my theory that are wrong.  It is entirely possible that all parts of my theory are wrong.

Inflating earnings via capitalization of expenses

This Worldcom-style form of fraud is simple.  Capitalizing expenses removes expenses from the income statement.  Lower expenses mean higher earnings.

Over time, the capitalized assets (whatever they are) will throw off depreciation and/or amortization expenses.  The net effect is that capitalizing expenses inflates earnings in the short term with offsetting losses in the long term.

Sometimes it is hard to tell if expenses are being improperly capitalized.  If they are, then capital expenditures will greatly exceed DD&A (depreciation, depletion, and amortization).  This is the case for Restoration Hardware.  However, quickly-growing companies will also exhibit this in their balance sheets.  Because growth companies typically spend large amounts of capex on growth initiatives, their capex often exceeds DD&A.  Restoration Hardware’s revenue growth suggests that it is growing.  Its store count (and selling square footage) suggest that it is shrinking.

Intentionally deflating earnings

It’s possible that RH has deflated its earnings prior to its IPO.  By doing so, it (A) increases future earnings and (B) contributes to an illusion of high growth.

Capital expenditures

A closer examination of the capital expenditures suggests that the trends in capex spending are very odd.  The YE2014 10-K states:

  • For fiscal 2013, net cash used in investing activities was $93.9 million primarily as a result of investments in new stores, investment in supply chain and systems infrastructure, renovations to our corporate headquarters and investment in information technology. [2 stores opened]

From the YE2013 10-K:

  • For fiscal 2012, net cash used in investing activities was $49.4 million primarily as a result of investments in new stores of $27.8 million and investment in supply chain and systems infrastructure of $21.3 million and the purchase of a new domain name for $0.3 million. [5 stores opened]

The IPO prospectus states:

  • For fiscal 2011, capital expenditures were $25.6 million as a result of investments in new stores of $15.7 million and investment in supply chain and systems infrastructure of $9.9 million. [ 5 stores opened ]
  • For fiscal 2010, capital expenditures were $39.9 million as a result of investments in approximately 80 Gallery store conversions of $21.2 million, new stores of $11.0 million and investment in supply chain and systems infrastructure of $7.7 million. [4 stores opened this fiscal year.  While 80 stores were converted, the next fiscal year would end with the company having 74 stores.]
  • For fiscal 2009, capital expenditures were $2.0 million as a result of investments in new stores of $0.7 million and investment in supply chain and systems infrastructure of $1.3 million.  [ No new stores opened.]

Investments in supply chain and systems infrastructure have grown from $1.3M in FY2009 to $27.8M $21.3M in FY2012.  It is weird that this capex has skyrocketed.

Capex per store opened has grown from $2.75M/store in FY2010 to $5.56M/store in FY2012.  (No stores were opened in FY2009.)  While this metric is not entirely correct, it is weird that capex spending has gone up so much on a per-store basis.

Unfortunately the FY2013 numbers don’t break out the expenditures into the “new stores” and “supply chain and systems infrastructure” categories. It is a little odd that the financials have less transparency compared to previous years.

Comparing FY2013 to FY2012, the number of new stores opened has gone down from 5 to 2.  Yet overall capex is 90% higher.  It does not seem to add up.

Same store sales

From YE2011 to YE2014, RH posted incredible comparable store sales figures:  +19%, +25%, +28%, +27%.  Very few retailers post such incredible numbers.  These numbers would put RH in the same ranks as Lululemon.

Normally with hot retailers, it would make sense to see the store count go up.  Lululemon’s store count has been growing; RH’s has not.

It would also make sense for a hot retailer to see its search queries trend higher in Google Trends.  This has not been the case with RH.  To be fair, Google Trends data may not correlate well to actual store sales.  If you compare RH to peers such as Pier 1, Pottery Barn, Williams Sonoma, etc. the pattern is that RH’s search queries are catching up to its competitors on a relative basis.  RH’s search queries have largely stayed flat while its competitors have seen declines in search queries (and increases in their revenues).

Management has indicated on a conference call (transcript) that it will no longer report comparable store sales going forward.

Phantom revenue and expenses?

RH could use fake revenues and offsetting fake expenses to create fake revenue growth.  To some degree, this helps to market the stock as Wall Street likes to see strong comparable store sales numbers (as well as growth).

Again, this goes back to the store count.  If the company has seen its operations become much stronger and its profitability skyrocket, why has it been shrinking its store count?

History

Restoration Hardware initially IPOed around June 1998 (424B1 filing).  Earnings grew astronomically from YE1997 to YE1999, going from $0.796M to $4.866M.  (*Note: the company’s fiscal year ends sometime around January or February, so fiscal year 1998 would correspond to a year ending in jan/feb 1999.)

In the years after the IPO, the company lost money consistently with earnings bottoming out with a $33.867M loss in YE2002.  I don’t believe that it was a coincidence that earnings peaked around the time that the company was selling shares in its initial IPO.  To be fair, sometimes companies really do run into rough patches.  Some honest companies will inevitably see their earnings decline after they IPO.  However, the capex spending before and after the 1998 IPO look suspicious to me.  In the IPO year (YE1999), capex was $38.546M.  The next year, capex grew to $46.620M.  Afterwards, it shrunk to $23.506M in YE2001 and a measly $3.798M in YE2002.  Most retailers do not exhibit such wild swings in their capex spending.  This is difficult to prove but I think that RH capitalized expenses to inflate earnings around its 1998 IPO.

I have a feeling that history may repeat itself.

Poor track record

GAAP retained earnings are negative.  This suggests that the company hasn’t been profitable since inception, assuming that distortions caused by GAAP accounting are not meaningful after several years have passed.  (Note that earnings inflation via fraud would make the retained earnings figure higher than it should be.)

On a tax basis, the company has significant net operating losses.

It is rare in the retail industry for a management team to run a retailer with mediocre results and suddenly start posting double digit comparable store sales figures.  CEOs don’t suddenly go from being benchwarmers to superstars.  It just doesn’t happen.

Historic store count

The store count peaked in YE2001 at 106 stores.  (Note: In this blog post, I ignore YE2009 because I did not find data for it on EDGAR.)  Store count may correlate with the company’s overall profitability.  If the company is losing money, then usually it would make rational business sense to close down underperforming stores.  If this assumption holds true, then it would mean that RH’s profitability peaked somewhere around YE2001 and has been in decline ever since.

To be fair, there may be an alternative explanation for the downward trend in store count since YE2001.

US import export data

If Restoration Hardware truly has increased its sales, one would expect that it is importing more goods/tonnage into the US.  This should show up in government port data.  I have not done this analysis.

Source Book

The company publishes a mega-catalogue that is several hundred pages (!).  The catalog has been criticized for being environmentally unfriendly due to its unusual length.  Recently, RH has lowered the mailing frequency on its catalogue by eliminating the fall catalog.  Instead, it will mail a larger 3200 page (!) catalog once a year.

On the balance sheet, “capitalized catalog costs” were $49.274M in YE2014 versus $43.828M in YE2013.  This may be a “cookie jar” area where management can reach in and inflate/deflate earnings.  The amortization period of each catalog seems to vary.  I find it a little weird that the capitalized costs went up in YE2014 even though catalogs circulated dropped 62.3% and catalog pages circulated dropped 58.9% year over year.

Inventory and receivables

Days sales outstanding and inventory turns seem reasonable relative to Restoration Hardware’s stated revenues.

If revenues have been inflated through fictitious revenue and expenses, then it would also make sense for some of the inventory and receivables to also be fictitious.  If there is fraud, then it would be likely that a portion of the inventory and PP&E are fake.  The same could apply for prepaid expenses.

Perhaps RH is not a fraud

I could be wrong.  I do not have evidence that the company is committing accounting fraud.

Other notes

Insider trading

Insiders and the various PE firms who invested in RH have been selling their shares.  Around $963M of insider shares were sold in the 2013 IPO and in the two subsequent secondary offerings.

Excessive spending?

In July 2012, the Company purchased the domain rights to the web address “www.rh.com” for $0.3 million.  This strikes me as wasteful.

Gary Friedman’s inappropriate relationship with a female employee

In YE2013, the company spent $4.778M on its special committee investigation and remediation.  The CEO (Gary Friedman) improperly engaged in a relationship with a 26 year old female employee.  The whistleblower was  her ex-boyfriend (who apparently has a criminal record).  According to comments posted at the website Pissed Consumer, Mr. Friedman may (or may not) have given Eva Vaughan a well-paying job at RH and a raise while they were in a relationship.  (There are actually some pretty ugly rumours on that webpage if you read all of the comments.  I obviously wouldn’t know if they are true.)  A LinkedIn page for an Vaughan implies that she has left RH to work for another company in New York.

I’m not sure why the investigation and “remediation” cost millions of dollars.  If the remediation was actually ‘hush money’, then it would suggest that the CEO has done something unethical (perhaps some of the ugly rumours are true).  Or… the company is simply wasteful.

Valuation

If there is fraud, then I think that the company should trade at a discount to its stated book value of $545M as of the latest quarter (PP&E and inventory would be inflated).  If the business is declining as suggested by its store count, then it is not a wonderful growth business and deserves to trade at a discount to what its assets are worth.  The current market cap is $2.6B.  If I’m right, the company should (in theory) trade at less than a fifth of its current market cap.

*Disclosure:  No position.  I may short this in the future.

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4 thoughts on “Restoration Hardware: Their numbers don’t make a lot of sense

  1. You just got me interested in shorting. I think i will give it a try in may/june this year with 10-20% of my portfolio. I found a lot of overvalued stuff with a basic screener that sceams technically for a decline and has already started the first leg down and is now in a upward correction. I will place a stop on the last high with these short positions. Perhaps its the right move this year, it looks like there are a lot more overvalued stocks than undervalued stocks in the US at the moment.
    Thx for this idea.

  2. Pingback: Restoration Hardware versus West Elm | Glenn Chan's Random Notes on Investing

  3. Dude, I’m all for accounting analysis and shorting high multiple stocks, but RH’s business model is to shrink the store count, focus on much larger stores to showcase the merchandise and direct traffic towards online. So they are opening stores that are 50% to 300% bigger than their previous stores. It’s their explicit strategy to reduce store count (for now) and focus on larger store formats. It’s also a truly “omnichannel” retailer, with 46% of sales coming from online/catalog (“direct sales”). Their capex/store is relatively unimportant as 1) their opening different types of stores and 2) half the biz is online, so they need to invest in that much more than they did 5 years ago.

    Regardless, this is a company that is growing sales at a 25-30% and until that breaks stock isn’t going down. Saying that it “could be” phantom revenue and then not having evidence of that is a bit weak.

    Just my two cents. Thanks.

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