Restoration Hardware shorts had it too good for too long.
After reporting abysmal numbers in Q3 2016, Q1 2016, Q4 2015 - when the company went so far to blame its own crashing stock price for poor earnings - RH stock more than doubled after its better than expected Q4 2016 numbers as long-suffering investors (not to mentioned squeezed shorts) assumed that that was finally it: that the company has finally turned the corner. It all came crashing again last quarter, when as we reported "Restoration Hardware Imploded After Terrible Guidance, Bizarre Disclosures."
Sadly for the shorts, who doubled down on their efforts to slam the stock, it all ended last night with a bank, not a whimper, when the company reported better than expected Q3 ESP and revenue and lifted its sales and profit forecasts for the year. On the subsequent analyst call, CEO Gary Friedman said he expects that RH, which has faced concerns about its high debt level, would generate about $400 million in free cash flow in 2017, once again reverting to the company's infamous optimistic posture. That “should address any concerns about our balance sheet and debt ratios,” he said.
More importantly, the company also unveiled a full blown war with shorts, when in its press release it announced that since the beginning of the year, the company had repurchased an unprecedented 49.5% of its shares outstanding, spending a record $1 billlion on buybacks in the 6 months ended July 2017. To wit:
We have reinvested the $282 million of free cash flow generated in the first half, and the $263 million of cash and investments on our balance sheet at the beginning of the year towards the repurchase of our stock, which we believe is an excellent allocation of capital for the long-term benefit of our shareholders. We have repurchased 20.2 million shares to date in 2017, or 49.5% of the shares outstanding at the beginning of the year. Outside of the convertible notes that are due in June 2019 and June 2020, we had aggregate debt of approximately $504 million at the end of the second quarter, including a $100 million second lien bridge loan that we expect to repay in full by year end.
And here is what may be the most amazing cash flow statement we have ever seen: the company borrowed $460 million in 2017, and used virtually all of its available cash and working capital to repurchase stock.
The company also said that "we believe that our shares remain undervalued, and we will continue to evaluate further share repurchases based upon market conditions and our capital allocation priorities"even if it means conducting half a management buyout of the company just to punish the shorts.
That is all the panicked shorts needed to hear, and as of this morning, a historic short covering squeeze has ensued, with RH stock exploding higher by over 40%, on pace for its best day since the company went public nearly five years ago.
And speaking of short pain, there is plenty of it to go around: there was roughly $528 million in RH short interest at last check, and following today's mauling, shorts are poised to take $231 million in paper losses if the share price closes at these levels, according to S3 Partners, quoted by the WSJ. That’s likely to encourage some shorts to get out of the trade, according to Ihor Dusaniwsky, head of research at the financial analytics firm.
Until today, RH was the second most heavily shorted stock among home furnishings brands, behind only Williams-Sonoma, although perhaps sensing the turn, the value of the short interest had declined rapidly since July, when short interest was at roughly $1 billion.
That's eased up the cost of borrowing, which had been as high as 71% of the share price on an annualized basis but has since dropped to about 12%, according to S3 Partners. Still, that fee for most stocks is below 1%.
While the chart below shows now-dated information, management's plan was clear: buyback as much stock as possible, and crush as many shorts as possible before reporting modestly good numbers and a sterling outlook. For now, it appears to have achieved its mission.
Still, the war between longs and shorts is far from over: between the end of last year and July 19, when the stock hit its highest closing level of 2017, shares climbed more than 150% as the company executed a share repurchase program. That was right around the time that short interest peaked, and the stock subsequently dropped 36% through Wednesday.
Naturally, chasing price, the WSJ reports that some analysts said they’re finding a lot to like in the stock after the earnings report. Bradley Thomas and Sameet Desai, analysts at KeyBanc Capital Markets, said in a note to clients that, “while our July downgrade to Sector Weight was predicated on valuation and leverage, we find ourselves increasingly positive on RH.”
And so, here come the sellside upgrades, dutifully following the surge in the price, just in time for the company to massively disappoint again in three months when it once again misses its wildly optimistic forecast, sending the stock crashing yet again and resetting this rather entertaining (if not for the shorts today) cycle.
Meanwhile, one question that has emerged: with RH repurchasing half of its outstanding stock, will there be naked shorts who are physically unable to cover their bearish bets, in the process prompting speculation of yet another Volkswagen-type event, as a scramble begins to cover at any price?