Recapitalization significantly increases operating risk, makes company less attractive takeover target. On 7/14/2017, RH completed share repurchases during FY17, totaling $1 billion, or 20.22 million shares YTD (49.6% of the FYE16 shares outstanding). The company maintained prior guidance of sales of $595 million to $610 million with adjusted net income of $13 million to $15 million, but raised EPS to $0.43 to $0.50 due to 13% fewer shares than originally guided. For 2H17, diluted shares are approximately 39% lower than prior expectations. RH's guidance for FY17 significant free cash flow is unchanged. More than doubling its debt post-repurchase and cutting shares outstanding in half, we believe RH has significantly increased execution risk, and in doing so, has also made itself far less attractive to would-be buyers. Post-repurchase leverage is ~7.4x. On a Net Debt/EBITDA basis, the recap adds 4.6x of leverage, while on an Adjusted Net Debt/EBITDAR Leverage Ratio, the recap adds 2.8x of leverage. With both leverage ratios well above the recommended 6.5x leverage, this certainly makes RH an unattractive LBO or strategic target. (Please see Exhibit 3 for more information).
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Wolfe Research's Senior Consumer Research analyst, Adrienne Yih, hosted a webcast on FASB ASC 842 and its potential impact. You can explore additional educational resources offered by FASB for investors on their website, www.fasb.org.
The Wolfe Retail Monthly Short Report is published using the end-of-month reported short interest positions. Our Retail Monthly Short Report helps to gauge sentiment on individual stocks. In this report, we show two metrics 1) short interest shares as a percent of float and 2) short interest share change month-over-month for the last twelve month period. Given the increasing volatility in the sector, particularly ahead of earnings reports, we believe tracking short interest in concert with recent stock price moves relative to valuation is another useful tool to gauge near-term investor sentiment.
Terminating coverage post COH acquisition. We are withdrawing our coverage of KATE following the completion of its acquisition by COH on July 11th, 2017. Following the merger, Kate Spade & Company will be a wholly owned subsidiary of Coach, Inc. (COH).
BMO on 7/10/17, ANF announced the termination of discussions regarding a transaction. This was the primary upside risk factor to our UP rating, and as such, we believe shares have little support over the next several quarters. We reiterate our UP rating based on: 1) inventory productivity degradation measured through Operating Margin Return on Inventory Investment (“OMROI”), 2) low visibility into comp turnaround given anemic traffic and deeper promos, 3) longer-term fixed cost deleverage with limited line-of-sight for a 2H margin rebound, 4) limited historical examples of successful brand repositioning in retail, & 5) risk to what we believe is an unsustainable ~9% dividend.
Week 9 was the week leading up to July Fourth; retailers drove traffic with promos. Promos QTD remain “Flattish” compared to last year’s very aggressive promotions, despite all efforts across the sector to keep inventory supply tight. This suggests the demand environment remains challenging and the appetite for apparel remains anemic. Consumers are only coming out to shop when there is a major holiday, such as July Fourth, but between traffic-driving events, we see ongoing weakening demand.
Apparel Sector grade: C+ in 1Q17 (from B+ in 4Q16). Only 41% of covered retailers posted a positive sales-to-inventory spread in 1Q17. Supply (inventory) management is no longer yielding gross margin expansion. Given that mall traffic (demand) remains in a multi-year decline, even with “clean” inventory at the beginning of a quarter, slack demand has been resulting in margin-eroding clearance. We note excess supply of 1) absolute number of retail stores/square footage & 2) number of retail concepts targeting the same consumer. A sales-to-inventory spread at parity is only supportive of margins insofar as future demand is, at worst, flat, but hopefully improving. When demand further erodes from the time at which a retailer placed inventory orders, we call this “chasing the ball downhill.”
Mounting evidence suggests a 2H17 turn is less likely. BMO on 7/6/17, LB reported a -9% June comp versus the Retail Metrics Consensus of -6.9%. LB reported a sizable miss at Victoria’s Secret with a -17% (vs. -12% Cons), offset by a beat at Bath and Body Works with a +8% (vs. +1.9% Cons). The weakness at VS was driven by a softer Semi-Annual sale during June, as well as the planned exit of swim and apparel which caused a 10 point headwind to VS comp. Total LB comp sales excluding the non-go-forward categories were -2% and came in at the low end of the guided range. We believe the new bra product has limited evidence of target market acceptance and believe odds of a 2H recovery are fleeting. LB shares were down ~14% in mid-session trading.
ZUMZ reported a June comp beat of +5.3% vs. the Retail Metrics Consensus of +1.1% and raised 2Q17 guidance. June comp accelerated nicely into the +MSD range and beat expectations as well as the two year stack. Comp growth continues to be driven by positive transaction growth and growth in average unit retail, offset slightly by lower average dollar sales and units per transaction YoY. Men’s and Junior’s continues to be a point of strength, while Hardgoods, Accessories, and Footwear saw negative comps in June. As a result of the comp strength, management raised 2Q17 comp guidance from 1%-3% to 3%-4% with LPS (loss per share) from ($0.11) to ($0.06) to ($0.08) to ($0.06) with Consensus at ($0.08). In reaction, ZUMZ traded up ~7% in the after-hours session.
Potential risk to 2H17 margins as Teen sector remains highly competitive. Due to the combination of negative mall traffic, potential markdown risk from inventory growth that is faster than sales, continued brick-and-mortar deleverage as sales shift to E-Commerce, and increased promotional activity, we add AEO to the 2H17 Wolverines list as an Underperformer.
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