Restoration Hardware Q2 2014 notes

I think that investors should pay attention to all of the costs being capitalized in the latest 10-Q.

Capex

From the 10-Q:

For the six months ended August 2, 2014, net cash used in investing activities was $39.1 million primarily as a result of investments in new and existing stores, investment in information technology, investment in supply chain and systems infrastructure, and renovations to our corporate headquarters.

For the six months ended August 3, 2013, net cash used in investing activities was $30.6 million primarily as a result of investment in supply chain and systems infrastructure and investments in new stores.

In the past, RH would break out how much was spent on new stores and how much as spent on supply chain infrastructure.  It has stopped that practice.  However, if the spending on new stores is somewhere around $2.5M-$5M per store (the historical range for YE2011-YE2013), then it is likely that the majority of capex spending is on supply chain infrastructure.  It is unusual that RH has been spending significantly more money on its supply chain than new stores.  Every year this spending increases.  On the conference call, Gary Friedman uses the metaphor of a railroad (transcript):

So in many cases we’re building a new railroad and that requires not only us to step up, build new infrastructure on both the frontend and the backend of the business both from a human point of view, organizational point of view and from a systems and physical facilities point of view.

So yeah, they’re uh… building a metaphorical railroad.

The renovations to corporate headquarters are a new area of capital spending that did not previously exist in the last 10-K (but did appear in the last 10-Q).

Capitalized catalog costs

Capitalized catalog costs have gone from:

  • $49.274M at February 1, 2014.
  • $73.718M at May 3, 2014.
  • $80.777M at August 2, 2014.

Capitalized costs have gone up despite the company lowering the number of mailings a year to one massive packge (lowering overall mailing costs) and reducing the number of pages mailed.

The Source Book has widely been criticized by customers for being wasteful and environmentally unfriendly.  Technically, the new approach is better for the environment due to fewer pages and lower mailing costs.  Nonetheless, the optics of the situation are poor.  The new approach makes it more obvious that the Source Books are a unnecessary waste of paper.

Interestingly enough, even Gary Friedman admits that the catalog is overwhelming (transcript):

Listen, I run the company and my big set of books came and I was telling the team last night. I said, look, it’s sitting in my counter, in my kitchen and I haven’t even sat down and look through all the books yet because it’s a lot. So you have to kind of have a committed time that you’re going to go through it.

In my opinion, the rise in capitalized catalog costs is an earnings distortion.

Free cash flow

In the 6 months ended August 2, 2014:

Net cash provided by operating activities: -$29.725M
Capex: -$38.800M
Total:  -$68.525M

Historically, the business is seasonal so free cash flow will pick up during the Christmas selling season.  Free cash flow for the trailing twelve months is roughly -$76M.  This -$76M happens to be an all-time low for RH (ignoring the time RH was owned by private equity).  Gurufocus.com has a good presentation of RH’s historical financial data.

*Disclosure: I am short RH (via common shares and puts) and added slightly to my position today.  I may lose money on my puts if I am wrong about the timing of my short position.

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