RH: This one might take a while…

Restoration Hardware recently announced the pricing of the convertible debentures that they are selling (here is the press release filed on EDGAR).  Unfortunately, this is a blow to my short thesis.

Suppose that Restoration Hardware really is a fraud.  (*DISCLAIMER:  It may or may not be a fraud.  Please do your own homework and come to your own conclusions.  I don’t know with absolute certainty if it’s a fraud or not.)

The convertible debentures are bad for the short sellers because the proceeds will likely be used to keep the fraud going.  The debentures will raise $300-$350M minus the cost of convertible note hedge transactions and other expenses.  This is a lot of money relative to Restoration Hardware’s book value of $542M.  If RH is a fraud, this money can keep the fraud going for at least a few years.

The notes will be due on June 15, 2019.  There is a (very) small chance that the maturity will be the catalyst for the stock dropping significantly if Restoration Hardware were to have difficulty meeting the debt maturity.  However, the debt can be repaid in shares if RH’s share price is above $116.09.  RH’s share price may stay high well beyond 2019.

An ideal short implodes quickly so that put options don’t expire worthless and to ensure that the rate of return is high.  In my opinion, RH will not implode anytime soon.

If Restoration Hardware is not a fraud

I would say that the debt deal is a pretty good idea.  There has been heavy insider selling through secondary offerings.  Insiders’ actions suggest that the stock is overvalued.  The debt deal can be seen as a continuation of that insider selling.

Secondly, RH gave itself an option to repay the debt in cash, shares, or a combination thereof.  This is a good idea because RH can pay cash if its shares are undervalued and pay with shares if they are overvalued.  That RH gave itself this option suggests that the CFO/CAO (Karen Boone) is sophisticated and knows what she is doing.

According to the press release, “the Company entered into convertible note hedge and warrant transactions in order to prevent dilution up to a 100% premium to today’s closing stock price”.  This is inconsistent with the fraud thesis.  One would expect a fraudulent company to avoid the hedge given that the shares would be overvalued.

*Disclosure:  I am shorting RH via put options and common shares.

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6 thoughts on “RH: This one might take a while…

  1. Perhaps its a good idea to avoid shorts where most of the float is shorted. When i remember correctly it was something like 300% of the public float. I am pretty happy that i ended my short basket before that squeeze. Reminds me how dangerous shorting can be.

  2. Pingback: Short selling update July 2014 | Glenn Chan's Random Notes on Investing

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