Numbers, photos, humor and tangible evidence substantiate the short thesis on RH Restoration Hardware, a company riddled in retail operating leases, regulatory red flags, and a ridiculous Dickensian charlatan of a CEO, whose every move has been predictable. Pattern recognition feeds the qualitative argument, while numbers expose the truth. RH's retail mansions are going down in figurative flames with the signing of each new lease.

1. RESTORATION HARDWARE
The Evolution of a Short Thesis
Dennis J. Wurst
March 3, 2017
Yale School of Management

3. Costly Catalogs
Eco-Unfriendly, Not Modern Printing, Shipping & Bad Press

4. Idea Generation Process
• Identify an Inconsistency (Good or Bad)
– Public Opinion Differs from Your Own
– Market Perception Seems Out of Whack
– Utility of a Product (New & Exciting? or Obsolete?)
• Pattern Recognition from Elsewhere In …
– Your Own Personal Life (Trust Your Instincts at First)
– World History (People Never Change, Just Sanitation)
– Literature (Life’s Instruction Manual for Human Behavior)
• Substantiate or Refute Suspicion with Numbers
– Quantify Your Initial Instinct with Facts NOT Feelings
– Personal Visits or Sending Surrogates on Your Behalf
– Pictures Tell 1000 Words (And Everyone Loves Pictures)

5. A Culture of Character:
Pattern Recognition Matters

7. Gary Sells Himself, Not Furniture
• Surrogate Calls from LA
• 17’ x 10’ Poster of Gary
• Hanging in West Hollywood
• Poster is Gone in One Week
• Recruit Friends in Your Quest
– Get a Posse to Snoop for You
– I’d Never Know Otherwise
• Humor Often Motivates
• Always Say “Thank You!”

8. Build-To-Suit Lease Accounting
• Developer capital contribution gets parked temporarily
under Property Plant & Equipment until sale/leaseback
• Temporary “Build-To-Suit Liability” (not “Lease”) on right-
hand side of the balance sheet, for the same amount of
developer capital input into incomplete projects (mansions)
• “Build-To-Suit Liability” and PP&E both disappear upon
sale/leaseback of each property
• Guggenheim’s analyst thought that was the forward lease
obligation related to all B2S properties under construction
• BB&T analyst (from Harvard Business School) failed to
understand B2S lease accounting yet still wrote $100+ buy
recommendations, before and after learning how it works.

9. Red Flags for Short Sellers
• Stadium Naming Rights
– Level 3
– Chesapeake Energy
– Sound Advice (Tweeter)
– Enron Field (Houston)
– PSI Net (Baltimore Ravens)
– American Airlines (TX & FL)
• Art Museum Installations
• Urban Renewal Projects
– “Secured the SF Pier 70
lease” (as if it’s difficult?)
• Avoidance of the word
“EBITDA” on conf calls
• Glamour Shots
• Changing CPA or Lawyer

10. Issuance of 0% Converts Instead of Junk
• Rather than to have a hard cash coupon assigned
to RH bonds, a 0% non-coupon hides the lack of
credit quality for anyone not paying attention to
the high yield OID (original issue discount).
– OID requires bond prices to “accrete” up to par
gradually or quickly, until eventual bond maturity.
• Equity investors really are not known for credit
awareness, nor for their curiosity around debt.
• Two $300+m convert issues seem to be the only
RH debt on the balance sheet besides payables.
• In 2019, FASB rules require that operating leases
appear on every balance sheet, as in Europe.

11. Spread Disappears Upon Default

12. 2019 FASB Lease Accounting Changes
• By January 2019, FASB requires all operating
leases (capital equipment, warehouses, offices
and retail space) included on balance sheet
• Many accounting firms and lawyers will
accelerate that requirement for their clients
• Operating leases are hidden under
“Contractual Obligations” deep in the 10K
• Capitalized interest + Operating Debt = Total
• Many USA retailers seem debt-light until 2019

13. Temples, Not Stores
• Repurposed Historic
Buildings = Huge Capex
• No “Cover Bid” after RH
– Who Takes over Leases,
If RH Fails or Vacates?
– Turn them into hotels?
– Plumbing alone is $$$
• What Happens to Sales-
Per-Square Foot or SSS?
– Once Stores Anniversary
into “CBRG” or SSS, Will
Momentum Continue?

14. Initiate the Short Thesis: July 2015
• 27% of all leases were due for renewal (or rolling-off) soon
– 8 local leases could possibly be consolidated but probably won’t be
• 20.5m shares voted AGAINST CEO’s compensation package & 15.3m for it
– Dissent surrounding CEO performance puts him in the penalty box
• Mid 30% Gross Margins may be dwarfed by SG&A vs sales (in $ & % terms)
• Mid Single-Digit Operating Margin (still there, despite “transformation”)
• Hidden Debt ($1.5B+ Contractual Obligations) will suppress margin & CF
– $582m Oper Leases + $17m Cap Leases + $491m B2S Leases = $1.09B Total
• $350m convertible bonds due 2019 (another $300m in 2020 issued later)
• $273 Oper Profit/Selling Sq Foot & $193 Oper Profit/Leased Sq Foot
• “Comparable Brand Revenue Growth” leaves iffy definition of SSS in 10K
• $271m Increase in Working Capital < $284m New Bonds
– Therefore, all Working Capital improvement came from debt issuance
• Trade imbalance increase ($209m payables - $185m ARs) $24m = quiet debt
• Tangible Book Value $579m (Stated Book Value Shareholder Eq – Goodwill)
• FCF = $82.5m Oper CF - $110.4m Capex = - $28m may worsen with $$$ plans

15. $-Burning Side Business Distractions
(WWD Apparel Article, Music, & Hotel)
Ma(i)sonry Wine, Why? RH Contemporary Art

16. FYE 2015: $2B Debt Hidden in Plain View
• Wine & Contemporary Art Vanish Quietly, While NY Meatpacking Hotel is Built
• Restaurants might not draw customers to RH (credit card receipts would prove it)
• 9% increase in gross profit dollars eaten by 8% higher SG&A costs alone
• CFO sells 1/3 of hers at $100/sh before RH stock falls hard; COO sells ½ then quits
• Taxable income up only 1.15% year-over-year, while commitments skyrocket
• Promises of 15% Oper Profit & $5B Revenue drifting into the impossible distance
• Leases bring gross leverage to 8X & EV to 15X vs $235m LTM EBITDA
• $10m private jet and staff for only 68 stores (Can’t Gary take 1st class commercial?)
• San Francisco Pier 70 urban renewal project is magnanimously $$$ and flashy
• “Learning” appears 6X on the conference call; “Newness” even more often.
• Inventory up, EBITDA margin range-bound, new leases
• $70m anti-dilutive collar makes bond conversion premium ~ 80%
• $548m Oper Leases + $741m B2S Leases + $650m Converts now = ~ $2B
• I predicted price erosion to $35/sh (2X Tangible Book) during Mkt Cap of $2B
• Internal all-caps e-mail rant to employees gets famously leaked to the press
• SSS (“Comp Brand Rev Growth”) deterioration, despite fancy moniker & formula
• Selling square footage is up 19% but sales per square foot only up 3.5%
• Bond-issue sized growth in operating leases (outlets & stores) happen quietly
• Contractual obligations grow from $1.5B to $2.2B during 2H15 (+$365m leases)
• Capex dwarfs Oper CF, yet mgmt continues to claim that FCF is 1-2 years away

17. $119m Price Tag for $16m of Assets:
Redundant Acquisition Begs Regulatory Scrutiny
• $119m Deal Price Tag
– 43% pays for Goodwill
– 43% pays for the Brand
• $16m Assets & Cash
• RH already had fixtures!
• Board members leave
immediately after deal
• Shifting to Renovation &
Wholesale, not just Retail
– Now Supposedly a
Designer Showroom

18. Board Members Jump Ship Together
• Pop Chips founder
replaces Producer
Tommy Mottola
• Catterton Partners
Sells its P/E
Investment &
Quits the BoD
• Petulant CEO?
• Bears Repeating:
$119m for $16m
worth of assets

19. 1Q16: Better Call Saul
Board of Directors is Failing Investors
• Waterworks: $119m price tag, $16m assets
– How can Goodwill & Intangibles be equal values?
– Seems like unscientific crony pricing with OPM
• Sales/sq ft up 3.62%; selling sq feet up 20%
• SSS only 4%, Adj. Oper Margin now just 0.20%
• Gross Margin < hefty 30%/sales SG&A hurdle
• Operating CF - $106m for Q1 vs - $14m 1Q15
• New Book Value = New Price Target Range
– Stated Book Value $21.66/sh
– Tangible Book Value now $17.40/sh

20. Red Flag: Art Installations

21. And Civic Urban Renewal Projects

22. 2Q16: Renovations Not Retail
• 27% selling sq footage expansion fuels a
– 10% contraction in sales/sq foot but only a
– 7% increase in sales dollars (stock reacts only to this #)
– Physical SSS (“CBRG”) is now negative: + 16% becomes -3%
• Meanwhile, “Direct” (web & catalog) erodes: +13% becomes -2%
• Inventory goes from a steady 84% of working capital to 109%
• Outlets become packed & Gary trashes web biz on Q2 video-gram
• Focus upon wholesale & designers not retail
• Opens 4 outlets rather than clutter mansions (Newport Bch doubles)
• Still has $10m airplane lease, staff & expenses
• Seeking higher sales ticket at the register
– Fewer sales transactions are supposedly part of “the transformation”
– “It’s a Revolution, not an Evolution” of the RH brand.
• Q2 Oper Margin 6% (not 4%) but down from 12%
• 1H16 Oper Margins now 3% not 1% but used to be 8%
• Gary rambles on the conf call incoherently and nervously, all excuses
• Tangible Book Value is now only $16/sh not $17.40/sh, down from Q1

24. Gary Poses & Waxes Poetic

25. 2016 Enron with Sofas:
Mansion Metrics Crumble & Waterworks Springs a Q3 Leak
• David Cross Netflix stand-up quotes the RH catalog
– Reads a description of a plate and abuses Gary harshly
• Tangible Book Value $626m = $15.36/sh not $16/sh
• Over L9M, Working cap inverts: - $102m from + $113
– Lease count soars from 86 to 113
– Operating Margin just 2.8% for Q3 & 1.7%
– Selling sq footage up 30% Q-o-Q and 25%
– Sales/sq foot down 15% Q-o-Q and down 8%
• Catalog lateness took disproportionate conf call time
– Cost RH $100m in sales  only $1.67m - $2.8m oper profit
• “We just don’t have visibility in the builds.” Yikes!

26. How Much Product Sells to Diners?

27. Tiny-Margin FYE 2016  $300M Buyback?
• Cash $281m at year-end is already spoken-for
• Full-year Revenue (adj.) $2.14B not $5B
• $754m Inventory grows relentlessly
• Gross Margin ~ 32%
• FY16 Operating Margins 2.5% to (adj.) 4.8%
• Capex $181m
• EPS stated $0.12 but adj. $1.26
– RH Modern 30c; Grey Card 25c; SKU 45c & catalogs
– All metrics were “in-line,” if one ignores adjustments.