Wall Street Ignores Margin Collapse Warning

Value investors, those concerned about inflation, and bears passed around the Restoration Hardware (RH) conference call, but even among those groups, I don't think it received nearly as much coverage as it deserved. Long story short: inflation kills stock valuations in many ways. Margin compression is one. As discussed by the RH CEO, companies have three main choices when dealing with inflation: cut quality to hold the line on price, raise prices and accept risk of lower sales, eat the costs via shrinking margins. All of these choices have negative impact either immediately (weaker sales or falling profitability) or later (brand destruction via lower quality).

RH fell nearly 20 percent last week as a result of its earnings and conference call warning of the struggle ahead:

He made an important point in the call, one that I think you could try beating into the heads of bulls with a 2x4, but would only end up with a pile of mush. He said he's very excited about the future, maybe the most excited he has been. There are many opportunities for the business. And yet, he also thinks this economic situation is similar to the scene in The Big Short when Bear Stearns stock suddenly implodes: This makes perfect sense to a bear such as myself. RH could have a great business and a great future, and it can also be the case that the market is valuing RH 50 percent higher than it should. The example I always go back to, because it so perfectly encapsulates the situation, is Amazon. The stock fell more than 90 percent during the dotcom bust. The economy and corporate success do not matter when valuations and sentiment change.

Here are profit margins with a regression line. Notice the surge following the pandemic. Inflation always looks like a boom at first. Corporations appear more profitable because inflation hits them first, in a good way. The first impact is rising demand. Every producer benefits because supply is constrained in the short-term.

Here is profit margin versus the S&P 500 Index:

The RH CEO tells us the benefit for the end stages of production is gone. Inflation is turning into a destroyer of value:

There's already evidence the recession may already be underway in the distribution stage.

ZH: Looming Freight Recession Sparks Plunge In Trucker Stocks, First Post-COVID Job-Losses

Here is a link to the Q4 2021 RH conference call. I do not know if that link will remain viable in the future. Below is the account that brought it to my attention. There are time stamped points worth giving a listen.

Retail is doomed if the RH CEO is alerting us to a sector trend. Investors seem to understand the risk for retail. XRT looks ready to plunge and IBUY, the online retail ETF, has already erased all of its gains since 2020.

The rest of the stock market is still oblivious. Also, consider the big Apple news last week in context of the RH CEO's comments: Apple Pay push is scarier for fintechs than banks

Apple (AAPL.O) is taking a bite out of the financial-technology sector. Digital upstarts like Affirm (AFRM.O) and Jack Dorsey’s Block (SQ.N) should be on high alert. Lenders like Goldman Sachs (GS.N), however, have less to fear.

The $2.9 trillion iPhone maker led by Tim Cook is beefing up its in-house financial-services infrastructure and expanding further in consumer credit, Bloomberg reported on Wednesday.

A move into consumer credit is the antithesis of growth and technology, but it does strike me as a-not-terrible decision in the face of collapsing margins.

$RH $Stonks @doombergt
Part 1.
I just listened to the earnings call. Quite entertaining...
Restoration Hardware CEO Gary Friedman said during Q&A:
- Inflation much higher than led to believe
- demand getting destroyed with rising prices
- costs going up everywhere

— nyugrad (@nyugrad1) March 30, 2022

Restoration Hardware earnings call CEO Gary Friedman said during Q&A:

- Inflation much higher than ppl think

- demand getting destroyed with rising prices

- costs going up everywhere

- consumer acting like they have no savings

- said it’s like the moment in the Big Short where ppl were in the room watching Bear Stearns fall

- believes consumers will get run over

- believes RH is a platform for curating wealthy tastes

Timestamps of note

17:20 inflation

34:00 supply chain

40:30 are record housing prices sustainable?

41:05 i dont think everyone understand how inflation will overrun the consumer. Has the fed called any businesses at all to ask them about inflation?

43:00 freight rates more than doubled

44:00 this is like the scene in the big short

Give it a listen.

P.S. NYU Grad has a Substack here.