RH has some weird loans

The latest Restoration Hardware 10-Q discloses 2 unusual loans.  The first loan is a $14M promissory note “secured by the Company’s aircraft”.

  1. The collateralization of the loan is unusual.  I could not find FAA registration records that would suggest that there are any airplanes currently backing this loan.
  2. Secondly, it’s unclear if the interest rate is attractive for the lender.  The statement of cash flows and contractual obligations in the Q2 2017 10-Q imply that the lender will receive $14.0M back ($0.117M plus $13.883M) by 2022 or later.  On the face of it, it seems that this loan has a term of over 4 years and a cash interest rate of 0% (!!).  Now perhaps I am wrong about the terms of this loan as the 10-Q does not disclose many details on the note (e.g. effective interest rate, non-cash components, etc.).
  3. Similarly, there is a $20M “equipment security” note that also seems to have a cash interest rate of 0%.

It is a little weird that RH was able to find a party willing to lend money in such an unusual manner.

Unfortunately, I actually don’t know what’s going on… perhaps my readers can figure this one out.

The collateral / RH’s aircraft

The YE2015 10-K states the purchase price of the company’s 2004 Gulfstream G400:

In February 2015, the Company purchased an aircraft for a total purchase price of $9.5 million in order to facilitate more efficient business travel by the Company’s management team in development of the Company’s business.

A little more than 2 years later in April 2017, the plane was sold at a loss for slightly more than half of its purchase price.  Page 10 of the latest 10-Q states:

Aircraft

During the fourth quarter of fiscal 2016, the Company committed to a plan to sell an aircraft, which resulted in a reclassification of such aircraft from property and equipment to asset held for sale on the condensed consolidated balance sheets as of January 28, 2017. The asset held for sale had a carrying value of $4.9 million as of January 28, 2017. In April 2017, the sale of the aircraft was completed for a purchase price of $5.2 million and the Company incurred costs of $0.3 million to dispose of the asset.

The sale of the airplane is not good from the lender’s perspective, as it reduces the amount of collateral backing the loan.  Normally, loans have provisions to protect the lender against situations like this.  But even before the sale, a $9.5M plane would not have overcollaterized the loan of $14M.  Normally, collateral-based loans are overcollateralized so that the lender doesn’t take on much risk.

Is there any collateral currently backing the loan?

Let’s take a look at the name used by RH in its FAA registration- “RH FKA RESTORATION HARDWARE HOLDINGS INC”.  The Gulfstream G400 that was sold is currently registered to “JEMB AVIATION LLC” (see the FAA registration for N455MB).  Looking at FAA registration records, the plane previously had the N-Number N477SA which was  changed to N171RH (sources: planelogger.com and this SEC filing).  N477SA is currently registered to “RH FKA RESTORATION HARDWARE HOLDINGS INC”.  Searching through the FAA registry, I was unable to find any other registrations with that name (or those of RH subsidiaries mentioned in this list filed with the SEC).  It is possible that Restoration Hardware currently does not own any aircraft.

The original and amended Aircraft Time Sharing Agreements provide some different clues.  The original agreement talks about a single aircraft:

Lessor is the operator of the Gulfstream Aerospace Corporation model GIV (G400) aircraft bearing manufacturer’s serial number 1529 and current United States Registration Number N477SA (to be changed to N171RH) (“Aircraft”);

The agreement was amended to allow ALL corporate aircraft that RH operates:

WHEREAS, Lessor and Lessee desire to amend and restate the Original Agreement in order to allow the Original Agreement to cover all corporate aircraft that Lessor operates from time to time as set forth on Exhibit A hereto (currently such aircraft, individually or collectively, as the context may require, the “Aircraft”).
[On this blog, assume that the emphasis is mine unless stated otherwise.]

I could not find Exhibit A so it is unclear to me as to whether or not RH owns other aircraft.  If RH does own other aircraft, I failed to find them while searching through FAA registrations.  As well, I could not find instances where RH disclosed the additional aircraft purchases after the Aircraft Time Sharing Agreement was amended to allow for additional aircraft.

In any case, I have doubts as to whether or not the loan is collateralized by at least $14M in assets.

Zero cash interest

In the Cash Flows From Financing Activities section on page 6 of the Q2 2017 10-Q, repayments under the promissory note were 117 thousand.
In the Contractual Obligations section on page 47, the total payments due under the promissory note totalled 13,883 thousand.  This adds up to $14M.

Based on the little information disclosed in the 10-Q, it seems that the note has a cash interest rate of 0% and a term of over 4 years.  While there may be additional terms and payments due under the note, the 10-Q does not seem to disclose them or state the note’s effective interest rate.

A similar analysis of the latest 10-Q would show that the “equipment security notes” also have a cash interest rate of 0%.

Here’s what I don’t get

I don’t understand the purpose of these loans.  Suppose the thesis is that creative accounting is occurring.  If that were the case, these loans would do nothing to boost GAAP EPS or (adjusted) free cash flow.  These loans might affect the adjusted EBITDA reported by RH if there is a non-cash interest expense associated with the loan.  If that non-cash expense is paired with some form of income, then EBITDA would be inflated.  However, this theory seems like quite a stretch to me.  There are easier and better ways to inflate adjusted EBITDA, e.g. find more ‘one-time’ adjustments.

Another possibility is that RH likes these loans because of complex financial engineering attached to the loans.  Whenever complex financial instruments are involved, it is possible to abuse the accounting to inflate (or deflate) earnings in the short-term.  But that seems like a stretch to me because there are easier ways to inflate earnings (e.g. capitalize expenses into catalog costs or capex, under-report liabilities, etc.).

A simpler explanation would be that RH wanted to change its debt profile (e.g. away from short-term debt)… but I find it hard to believe that there are lenders out there that are willing to make such exotic loans.

If you have any ideas, please feel free to post them in the comments.  I did not check UCC liens on Restoration Hardware or its subsidiaries so I haven’t dug as deeply into this as I would have liked.

 

*Disclosure: Short RH.

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3 thoughts on “RH has some weird loans

  1. Thanks Glenn. I don’t do much active investing these days but do enjoy reading about these puzzles. The first thing that came to mind for me is that a 0% loan secured by the vehicle sounds a bit like purchase incentive financing from a car dealership. But it would be odd to not say that they had entered an agreement to buy a new $14M aircraft, even if they hadn’t yet taken delivery.

    • That sounds like a lease?

      When the 10-K comes out, it might be clearer as to whether or not RH owned any aircraft at the end of the fiscal year… in previous 10-Ks, the phrase “Machinery, equipment and aircraft” was used.

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