Victor Luis, Coach’s CEO, has told investors about his brand transformation plans. In practice however, many aspects of his brand transformation plan have not panned out. Coach has succeeded in discouraging its fans from shopping at retail/mainline stores without actually reducing the discounting of the brand.
Key points in CONN’s latest 10-K
- Omitted the static loss table found in previous 10-Ks and 10-Qs.
- Removed the following sentence: “Under our current policy, the maximum number of months an account can be re-aged over the life of the account is limited to 12 months.”
I guess I will continue to hold my short position in CONN. While I don’t entirely know what’s going on, this does not smell right. (*The borrow is expensive.)
I’ve been thinking a lot about how somebody could commit fraud in retail. In my opinion, accounting fraud in retail is a bad idea. Fraudsters cannot both (A) avoid jail and (B) inflate earnings by a meaningful amount or otherwise significantly mislead investors. Smart fraudsters gravitate towards mining, oil & gas, pharma, etc.
While fraud is a bad idea in retail, some fraudsters are crazy enough to commit fraud even if there is significant risk of jail time. I think some people are biologically wired to steal and cheat even if it doesn’t make sense.
For investors, detecting accounting fraud in a retailer may be extremely difficult. I have not figured out reliable methods of independently verifying a retailer’s numbers.
My theory is that RH’s capex guidance telegraphs what future earnings will be. The latest guidance is for 27-45% higher capex than last fiscal year ($140-160M versus $110M).
- If RH is the real deal, then the growth investments should generate high returns on invested capital. If so, RH should rapidly grow earnings. (Of course, anything can happen and RH may see poor or negative returns on its new investments.)
- Suppose you believe that RH has been aggressively capitalizing costs that should more appropriately be expensed. Such accounting practices would inflate earnings. The high capex guidance may telegraph high reported earnings.
In either scenario, earnings will increase in the short term. My theory (and it’s just a theory) is that short sellers may wish to wait until the company guides capex lower.
*Disclosure: Short RH via common shares and put options.
I did a quick look at a few other retailers that post their actual sales returns in their SEC filings (WSM, AEO, and NILE). The pattern among those three is that sales returns as a percentage of revenue fluctuates very little. The rapidly-growing online retailer NILE shows the most variation of the three, ranging from 9.11% to 10.60%. RH’s range is from 4.43% to 7.47%. Without the error disclosed in RH’s latest 10-K, the range is from 10.22% to 11.14%.
On LinkedIn, a Restoration Hardware employee states that their department (ocean freight operations) has a consistent annual growth of 12%. This is much lower than the company’s reported
revenue COGS growth (20%+). I would note that RH has been increasingly sourcing more and more of its product from overseas:
- (EDIT: 4/2/2015) The 2011 S-1 states: Based on total dollar volume of purchases for fiscal 2010, approximately 73% of our products were sourced in Asia, the majority of which originated from China, 16% from the United States, 8% from Europe and the remainder from other regions.
- The FY2013 10-K states: Based on total dollar volume of purchases for fiscal 2013, approximately 69% of our products were sourced in Asia, the majority of which originated from China, 26% from the United States and the remainder from other regions.
- The FY2014 10-K states: Based on total dollar volume of purchases for fiscal 2014, approximately 84% of our products were sourced in Asia, the majority of which originated from China, 10% from the United States and the remainder from other regions.
Adjusting for the lower domestic sourcing would suggest that RH’s total overall buying may have grown at less than 12% annualized.
Restoration Hardware’s financial statements paint a picture of very high growth. In the past, the financials were more or less internally consistent. Numbers with a relationship to revenues (taxes paid, contingent rent, actual sales returns, employee count) largely tracked the growth in revenue growth. What’s curious in the latest 10-K is that actual sales returns no longer track reported revenues due to an error identified for FY2013 and FY2012.