Restoration Hardware – Taking The Road Less Traveled


Restoration Hardware Holdings, Inc. is a retailer in the home furnishings marketplace offering furniture, lighting textiles, bath ware, decor, outdoor and garden, as well as baby and child products. It operates an integrated business with multiple channels of distribution, including galleries, source books and websites. The company was founded by Stephen J. Gordon in 1980 and is headquartered in Corte Madera, CA.

RH Modern

This is an entirely new business that was unveiled at the end of last year. RH Modern has multi-distribution channels and has its own 540-page Source Book. The line will target the growing number of people who are drawn to modernist design, whether their aesthetic is rustic, classic, or contemporary modern. The depth of business spans to nearly every part of the home – from living rooms to dining rooms, bedrooms to bathrooms, and pools and patios. This assortment is the first brand to offer this groundbreaking breadth of furnishings. Most of the RH Modern is developed with some of the world’s most talented designers- including furniture collections from Barlas Bayar, Anthony Cox, and Thomas Bina; lighting from Jonathan Browning and Fortuny; modern rugs by Ben Soleimani; outdoor offerings from Leo Marmol and Ron Radzine. Gary Friedman said “From antiques to architecture, from the environments we work in to the devices we work with, there is a modern sensibility that is influencing what we see and how we live in the world. While the market for modern furnishings has always been somewhat small, the convergence of these trends creates an opportunity to develop a much larger market.”

To date, RH Modern has been more of a headwind than a tailwind due to a barrage of supply issues. The production delays have been big trouble throughout 2016 but seem to be worked out heading into Q4. The design of the new line is differentiated from current furniture offerings. Statement pieces include inviting platform and canopy beds; oversized ottomans; low, sophisticated sofas and sectionals with integrated accent tables; tactile carpets; dramatic sculptural lighting; floating lounge chairs and vanities; and stunning window and bath hardware.

The new brand has its own unique website and a significant physical presence, including a standalone RH Modern Gallery at the site of RH’s former gallery on Beverly Boulevard in Los Angeles, the entire ground floor of the Flatiron Gallery in New York, plus entire floors in the Company’s next generation Design Galleries in Chicago, Denver, Tampa and Austin. The freestanding RH Modern Gallery in Los Angeles is completely redone into a contemporary structure – indoors and out – featuring a modern sculpture garden with soaring palm trees. RH Contemporary Art – which has been integrated into RH Modern – will be showcased in each location with original works from a global roster of artists, creating the feeling of both a home and a gallery. RH has invested in integrating this brand into its existing portfolio. As most of the issues are behind the company this brand may provide a boost going forward.

Transition from Promotional to Membership

In Q1, RH announced the introduction of the RH gray card. This is their new membership program. For a $100 annual fee, the RH Grey Card provides 25% savings on everything. This includes all brands – RH, RH Modern, RH Baby & Child, RH TEEN, and RH Contemporary Art. RH Chairman and CEO Gary Friedman said “We want to shop for what we want, when we want and receive the greatest value. So rather than navigating countless promotions, we’re changing things…because time is the ultimate luxury.” In addition to the 25% off all regular merchandise, Card Members will also receive 10% savings on all sale merchandise, complimentary interior design services, eligibility for preferred financing plans for the RH Credit Card, dedicated concierge services to manage orders, and early access to clearance orders. This Card is expected to make shopping with RH more simple. Gary Friedman added that “Our lives are filled with complexity – and we long to break through the clutter to find simplicity.”

I really like this approach by RH. Not only does it simplify the shopping experience, but also, it encourages repeat business. The Company is taking a page out of the Costco playbook. I believe this membership model will be a long-term success. However it has caused near team margin pressure. In Q2’16 the Membership deferral resulted in a 80 BPS margin deleveraging. This deleveraging showed up again in Q3’16 as the company will not recognize the revenue up front.

The Membership Card will encourage customers to spend a minimum of $400 in the store. This is where customers break-even. $400*(-25%) = $300 + (Membership fee $100) = $400. Pretty simple, although it becomes harder to understand the read on how this stacks up to the old promotional model. Obviously, there won’t be many product offerings that are on sale with the new model. If a Card Member spends $2,000, they will save $400 net, so this will equate to a 20% promotion in the old model. The discount that any customer can achieve on regular priced merchandise is capped at 24%.

SKU Rationalization

In the Q2’16 earnings press release, Gary Friedman mentioned the current headwind of SKU rationalizing. Over the next couple quarters, this will continue to result in margin deleveraging. However, in the long-run these expenses will result in a smoother shopping experience. Once the SKU count has been optimized, this investment will be a tailwind for operating margin.

Source Books

This year, RH decided to delay the roll-out of their Source Books from spring to fall. This decision has created a drag on the stock. This decision will likely continue to put pressure on sales in Q3 and early Q4. Last year the Source Books shipped in Q2 and this year they won’t ship them until late Q3 or early Q4. The last major marketing initiative from the Company was in Q2’15 when they shipped the 2015 Source Books. The new Source Books have been completely redesigned and rephotographed. The redesign was done by art director Fabien Baron, who also designed the RH Modern book. The new books present the brands in a completely new format.

RH Austin, The Gallery at The Domain

I visited RH’s Austin Gallery to better understand the customer experience. From the moment that you walk in, the experience is unique. The ascetics of the Gallery are completely different than any other store. The store was very fresh and bright. I was told that RH management has painted the walls in every store white (from grey) in order to make the furniture standout against the background and brighten up the store. It worked, it gives the furniture a good look.

One of the biggest takeaways from my visit was the fact that the Company is in the middle of a massive product refresh cycle. I was told that they are about half way there. In total, about 80-90% of the product will be refreshed. The rollout of Modern into Gallery’s is well underway. About one-third of the store will be made up of the Modern product. The Modern brand is differentiated from the legacy/core brand. The two-thirds of the store that will have the core brand furniture are also being refreshed. The new product has new looks and finishes that have not previously been in stores. The refresh should improve store productivity. The design team member that helped me said Modern has been very popular among customers.

This Gallery had its grand opening on September 16, 2016 and traffic has been steady. The product refresh is beginning to peak interest from customers and it is driving repeat business. Slowly rolling out the Modern and the core brand is resulting in customers coming in more frequently to see the new furniture. Once the Source Books are sent out at the end of Q3, RH expects traffic to improve.

Gary Friedman’s Vision

Restoration Hardware shows off its innovation every step through the shopping experience. The first step for RH management was to blur the lines between retail and home. When you are in an RH Gallery, you certainly do not feel as though you are in a retail store. It feels like you are in a home and you are more relaxed. The second step for management is to add an element of hospitality into the mix. RH Chicago has a courtyard cafe where customers can eat while they shop. The cafe sits in an atrium that is filled with natural light. The store also has a pantry and coffee bar where customers can get hand crafted coffee drinks.

Gary Friedman wants to activate all five senses (sight, sound, smell, taste, and touch) during the shopping experience. Traditional retail experiences are boring and offer no natural lighting. RH Gallery’s provide a unique experience that can not be replicated online or at any other retailer today. While RH is not the first retailer to have a cafe or restaurant, they are the first to integrate the restaurant into the shopping experience. This strategy has worked tremendously well and the Company will begin to integrate it into new Galleries. In 2017 RH will add it to RH San Franciso The Gallery at The Historic Bethlehem Steel Buliding, RH Nashville The Gallery In Greenhills, RH Palm Beach The Gallery At City Center, and RH New York The Gallery At The Historic Meatpacking District. This will make five locations with the next generation shopping experience. Gary Friedman calls it “The most significant retail transformation in the history of our industry.”

Below is a picture of the Saks Fifth Avenue at Cherry Creek prior to it closing. This is the location of RH Denver, The Gallery at Cherry Creek.


RH purchased the land, tore down the Saks store and built RH Denver, The Gallery at Cherry Creek. A picture is shown below. Which store would you rather shop at? Easy decision.

RH Denver

Traditional mall and anchor stores are windowless boxes that have no fresh air. RH believes that customers will shop at brick and motor stores but you must provide them with a differentiated experience. Current mall and anchor stores lack imagination and have not innovated.


On April 12th, RH announced that it had acquired Waterworks for approximately $117 million in cash. Waterworks is a luxury bath and kitchen brand with fittings, fixtures, furniture, furnishings, accessories, lighting, hardware and surfaces. It is comprised of the Waterworks, Waterworks Kitchen and Waterworks Studio. Products are sold through 15 showrooms in the U.S. and U.K., boutique luxury retailers and online. The premier luxury bath and kitchen brand was founded in 1978 by Barbara and Robert Sallick, and has been led by Chief Executive Officer Peter Sallick since 1993. This acquisition “creates the first fully integrated luxury home platform in the world – offering a complete collection for every room of the home, in every channel, to both design professionals and consumers” according to the April 12th press release. Peter Sallick and Ralph Bennett, President, will continue to lead the Waterworks brand along with the rest of the leadership team from their headquarters in Danbury, Connecticut.

Waterworks is the only complete bath and kitchen business offering fittings, fixtures, furniture, furnishings, accessories, lighting, hardware and surfaces under one brand in the market. Ralph Bennett, Waterworks President stated, “We believe RH is the most significant brand being built in the home market today, creating extraordinary opportunities for us to collaborate and benefit from their unique and growing platform. As a combined organization, we look forward to extending and expanding our passion, product offer and commitment to outstanding service to our incredibly valuable clients.” Gary Friedman shared the enthusiasm by saying “There are certain brands that define their categories, like Hermès, Tiffany, Apple, Range Rover and Ralph Lauren, and we believe that Waterworks is one such brand. We have long held great admiration and respect for the esteemed brand and business the Sallicks have built, and feel honored and privileged to be partnering with the entire Waterworks team, as we combine forces to further redefine the industry.”

RH’s Executive Compensation Plan

RH’s executive compensation plan is built around three pillars.

  • It’s closely aligned with the performance of the Company, on both a short-term and long-term basis;
  • linked to specific, measurable results intended to create value for stockholders
  • tailored to achieve the key goals of our compensation program and philosophy.

RH’s executive compensation programs are aligned with stockholders’ interests. Performance-based compensation is tied primarily to annual earnings before taxes and long-term stock price performance.

Compensation Committee

The Board of Directors has established a compensation committee that is generally responsible for the oversight, implementation and administration of the executive compensation plans and programs. The compensation committee annually reviews and approves RH’s corporate goals and objectives. The core function of the committee is to review annual salary levels along with short-term and long-term incentives. The committee ensures that appropriate overall corporate performance measures and goals are set and determine the extent to which the established goals have been achieved and any related compensation earned. The executive compensation plan is aligned well with both short-term and long-term incentives. However, it doesn’t look like the compensation committee is doing the heavy lifting in setting up this plan as they have hired Willis Towers Watson as a compensation consultant. Charlie Munger has said “I’d rather throw a viper down my shirt front than hire a compensation consultant.” In short, the compensation committee could probably do without a compensation consultant.

Leadership Incentive Program

The Leadership Incentive Program, or “LIP,” is a cash-based incentive compensation program designed to motivate and reward annual performance for eligible employees, including named executive officers. The compensation committee considers annually whether LIP bonus targets should be established for the year and, if so, approves the group of employees eligible to participate in the LIP for that year. The LIP includes various incentive levels based on the participant’s position with the Company. Cash bonuses under the LIP link a significant portion of the named executive officers’ total cash compensation to overall performance. The LIP bonus for named executive officers is based on achievement of financial objectives, rather than individual performance. Each named executive officer is provided a target bonus amount equal to a percentage of the eligible portion of such officer’s base salary. The target bonus amount is based on the Company meeting the target achievement level for the relevant financial objectives. The compensation committee and/or the board of directors establishes the target achievement level at which 100% of such participant’s target bonus will be paid (the “100% Achievement Level”), the minimum threshold achievement level at which 20% of the participant’s target bonus will be paid (the “20% Achievement Level”) and the achievement level at which 200% of the participant’s target bonus will be paid (the “200% Achievement Level”).

The compensation committee, either as a committee or with the board of directors as a whole, sets the financial objectives each year under the LIP, and the payment and amount of any bonus depends upon whether RH achieves at least a certain percentage of the financial objectives under the LIP (at least 20% for fiscal 2015). The compensation committee generally establishes such objectives for the Company at levels that it believes can be reasonably achieved with strong performance over the fiscal year. For fiscal 2015, the performance metric for the LIP was based on adjusted net income (“Adjusted Income”), which is defined as consolidated income before taxes, adjusted for the impact of certain non-recurring and other items that are not considered representative of ongoing operating performance. For fiscal 2015, the compensation committee approved the following targets under the LIP (based on approximately 30% earnings growth):RH A

The following table sets forth the bonus targets as a percentage of the eligible portion of the executive’s base salary under the LIP in fiscal 2015. For 2015, the compensation committee determined based on discussions with Mr. Friedman, to provide him increased bonus targets in lieu of increases in base salary in order to better align his compensation with our overall financial performance. Consequently, the compensation committee approved an increase to Mr. Friedman’s bonus target as a percentage of base salary from 100% to 125% at the 100% Achievement Level, and from 200% to 250% at the 200% Achievement Level. No changes were made to the bonus targets for the other named executive officers.


Adjusted Income for fiscal 2015 for purposes of the LIP was approximately $184 million, which reflected the compensation committee’s determination that certain other extraordinary or non-recurring items should also be excluded from determining Adjusted Income for purposes of the LIP. Accordingly, the compensation committee approved payment of the bonuses earned under the LIP for our named executive officers, other than Mr. Dunaj, as follows:


Equity Compensation

In 2015, the compensation committee approved grants of stock options and restricted stock units to the named executive officers, as follows:


The stock options were granted at an exercise price of $87.31 per share which was the price of the common stock on May 6, 2015, the date of grant. The options vest at a rate of 20% per year over five years on each anniversary of the date of grant, expire in 10 years. Management is really going to have to get this thing in gear for them to be able to exercise these options. The stock will need to nearly triple.

Gary Friedman’s Stake

Mr. Friedman, has consistently maintained a significant equity ownership interest in the Company and beneficially owns approximately 15.1% of the Company’s common stock. Today his stock is worth about $200 million. However, just one year ago his stake was worth more than $540 million. Tell me he isn’t motivated to turn this thing around.

Q3 Earnings Commentary

RH reported Q3 earnings on December 8th and beat on the top and bottom line. However, they guided down Q4 which caused the stock to sell off 18% on Friday. So is this an opportunity? I say yes. The reasoning for the guide down was a bit of a surprise. There was a mix of issues that contributed including bad holiday inventory, membership model transition, delay in source books, and SKU rationalization. As the Company moves into 2017 they will lap the issues related to the launch of RH Modern and move past the timing issues related to RH Membership. The SKU rationalization is causing a $0.40 hit to EPS, RH Modern production delays are causing a $0.30 drag, and the membership timing issue has caused a $0.25 headwind. However, I think the Q4 guidance is awfully conservative and Gary Friedman said so on the conference call. Friedman said “I think I’d characterize it, I think we’re being conservative in Q4 today. So, because we just don’t have visibility in the builds, right? It could be a little better, but today, based on where we sit, we thought it was right to take a conservative view based on how we saw the rest of December and January.” This didn’t stop analysts from slashing Q4 estimates and even 2017 numbers.

Bear Case

The bear case assumes a normalized growth rate in the low single digits, only slightly ahead of GDP growth. This case assumes management will have to continue to invest in their supply chain and will never get back to prior peak operating margin of 9.8%. This scenario suggests that RH would pull back on opening larger-format galleries and the rate of high-end income growth slows which would impact the amount of new customers entering its TAM. In this scenario, RH would have to lower price points due to a sluggish demand environment.


As mentioned, the stock tumbled 18% on Friday and analysts have cut estimates. I also cut Q4 numbers but I didn’t move my 2017 estimates down as much as other analysts. As the source books have now been shipped, I think we will see some of Q4 sales show up in Q1.

IS Estimates

The DCF analysis I performed, suggests a stock price in the range of $35-$50. The scenario used implies a more normalized growth trajectory for the business relative to management’s current long-term plan to double revenue and reach a mid-teens operating margin over time. I assume a 5-year CAGR of 5.3% and a 9.0% operating margin in FY21 which assumes that RH will double EBITDA over that time period to $330M from $165M expected in FY16.


Per Share

Using a terminal EBITDA multiple of 7.5x, we are looking at a stock price in the range of $35-$50 and a $42 price target at the midpoint, implying 31% upside from current levels. I believe a 7.5x multiple is appropriate given its most direct home good peer, WSM, which is viewed as a bellwether in the space, has a five year historical EV/EBITDA average of 7.5x. I note that WSM is currently trading at a discount to its five-year average at a 6.5x EV/EBITDA due to a number of uncertainties regarding competitive threats to its long-term growth.

Bottom Line

RH is taking the road less traveled. In a time when retailers are shrinking their store counts, RH is looking on providing a differentiated shopping experience that can’t be replicated online. I believe it makes sense to shop online for many products. However, I don’t think home furnishings are in that category. RH’s stock is hated by pretty much everyone which makes it interesting to me. If you exclude the hedged shares, the stock has a 24.2% short interest. I believe RH will achieve its conservative Q4 guidance even if it’s from low quality liquidation sales. In my opinion, this might be enough to force shorts to cover and that could rally shares higher in 2017. In the next few weeks, I wouldn’t be surprised if the stock moves lower. I will add to my position below $30/share.


Long RH



Tribune Media Continues To Trade At Massive Discount

TRCO HeadlineOverview: I like Tribune Media Company at $36. I’ve owned it for almost a year and I continue to believe that it is trading at a substantial discount. Tribune is asset rich and is beginning to monetize its real estate assets. The company continues to build WGN as the total audience is up 51% y/y. WGN has three very promising original series’ which will drive audience growth. The potential monetization of spectrum could represent a cash flow boost, although there is much speculation about demand and price per market. The company operates in markets such as New York and Hartford where demand is likely to be strong. A sum of the parts valuation shows lots of value.

Market Overview

The United States broadcasting market has produced moderate growth in recent years and is expected to produce slightly lower rates of growth over the next decade. The United States is easily the largest global market for broadcasting and much of this is due to the investment in content and the popularity of this content abroad. Growth is driven by advertising and subscriptions growth, with advertising being very strong despite the trends which are moving advertising revenues into digital spheres. The broadcasting TV market has produced a 2.2% CAGR over the last five years. It is expected to slow to 1.2% over the next five years.

The value of Tribunes 42 owned or operated broadcast television stations is largely dictated by the quality of the content. Content quality is determined by total audience to make the product marketable to advertising businesses. WGN is thriving in this area with their Outsiders and Underground original series’. The rise in popularity of downloading programs, both legally and illegally, is having an impact on the market.

Cable networks are direct competitors of television broadcasters for viewership, advertising dollars and TV ratings. Cable television programming has historically been the largest rival to major broadcasters in terms of total viewership. Viewers who subscribe to the expanding range of alternative television content providers, which include basic and premium cable packages consisting of hundreds of unique programming options, are likely to reduce viewership of traditional broadcast programming. The number of cable TV subscriptions is expected to decrease in 2017. However, this negative trend will likely not have a large effect on broadcasters. Many people, myself included, have cut the cord and have purchased an HD antenna enabling us to watch traditional broadcast programming.

Economic Drivers

The major driver in broadcasting growth is disposable income which is affected by labor market growth, unemployment and interest rate changes. In addition, disposable income is a key determinant of retail sales and expenditures on other goods and services which can directly influence advertising expenditure on TV. Per capital disposable income is expected to increase in 2017.

Changes in the Market

In the last five years, operators in the television broadcasting industry have undergone structural changes to contend with stagnating revenues. Broadcast revenue is largely dependent on sales of advertising spots, which are determined by their advertisers’ corporate profit and the disposable incomes of their viewers. Although advertising expenditure has increased along with rising disposable income and corporate profit in the last five years, the media landscape has become increasingly competitive. Consumers are shifting towards online media for their news and entertainment, prompting advertisers to shift their spending away from traditional television broadcasting. In addition, platforms like Hulu and Netflix directly compete with industry broadcasters to provide new content.

Media Fragmentation

Advertising expenditure has recovered strongly since the financial crisis. However, advertisers now have a wider range of channels to reach their audiences. Historically, advertising and marketing has been spread across broadcast television, radio and cable, print media, and direct mail marketing. The advent of the internet and social media has dramatically boosted media access through social networks, streaming platforms, RSS feeds and podcasts. Advertisers have realized the power of online media, which allows for targeted ad campaigns that were impossible with previous forms of broad-based advertising. Social media networks can tailor ads to specific demographics, attracting a greater portion of advertising budgets. Over the same period, people have adopted digital video recorders (DVR) and on-demand programming. Together, they have decreased audiences attention to TV commercials which has lowered the price that advertisers are willing to pay broadcast networks for ad time. Services like Netflix, Hulu and cable-free subscription packages from HBO and Showtime enable more content variety and viewer control. The accelerating media competition will be a headwind to the broadcast industry’s growth prospects.

Broadcast TV Networks

Broadcast TV networks are composed of TV stations that release the same programming through several stations (i.e affiliates). This strategy saves time and cuts costs associated with programming for separate stations which allows broadcasters to negotiate better prices for advertising to a mass audience. The bulk of airtime is made up of programming developed for national broadcasting but certain time slots are designated for local or regional programming.

Next Ten Years

Broadcasters are now receiving monetary compensation from cable operators through retransmission fees. Demanding payments for the retransmission of content has forced cable operators to charge more for their packages. This revenue stream has reduced volatility for broadcasters because cable contracts are typically renewed annually.

Rising advertisement spending and disposable income will support the industry over the next decade. Total US advertising expense is expected to grow at an annualized 4.4% over the next decade. Competition from new media that allows advertisers to target specific audiences for less will make attracting TV broadcasting ad revenue more difficult.

The major development in the industry over the next decade will be interactive TV. This change will customize viewing experiences for audiences. By making TV interactive, broadcasters will be able to offer advertisers a more direct way of selling products and services to targeted audiences. Broadcasters will have features that allow a viewer to order a product in a commercial just with a click of the remote. Features like this may not be received well by online streaming audiences who prefer zero commercials. This opportunity has the potential to boost ad revenues and could possibly take market share away from social media platforms.

Tribune Media Segment Overview

Television and Entertainment

This is the larger of the two segments and includes Tribunes 42 broadcasting stations. This segment accounts for 85% of Tribunes revenues. A breakdown of this segment is shown below.


The primary drivers of the business are advertising and retransmission fees. As Tribune operates in some of the best quality broadcasting markets, it supports advertising revenue to grow modestly going forward. TRCO owns or operate local television stations in each of the nation’s top five markets and seven of the top ten markets by population. Tribunes stations and local news reach is approximately 50 million U.S. households in the aggregate, representing approximately 44% of all U.S. households.

The business owns a national general entertainment cable network, WGN America, which is distributed to more than 80 million households nationally. In 2013 the company created Tribune Studios to source and produce original and exclusive content for WGN America and local television stations. Tribune Studios provides alternatives to acquired programming across a variety of segments. WGN has three hit series’, Underground, Outsiders, and Salem. These three are helping drive retransmission fees and audience growth. The table below presents WGN’s lineup of series. This table does not include Salem as it is their newest series.WGN

Digital and Data Segment

The Digital and Data segment is comprised of a company named Gracenote. The company provides music, video, sports, and auto metadata to users who are often brands.

Gracenote Music

Gracenote Music is one of the largest sources of music data in the world, featuring music data for more than 235 million tracks, which helps power over a billion mobile devices including smart phones, tablets and laptops and many of the world’s most popular streaming. Music data includes a variety of content such as artist name, album name, track name, music genre, origin, era, tempo, mood, as well as album cover art and artist imagery. Gracenote Music derives the majority of its revenue from licensing its music data, software and services in the B2B segment to music services and to Tier 1 suppliers to the world’s leading automakers.

Gracenote Video

The video segment provides data around TV shows and movies, such as descriptions, genres, cast and crew details, actor long- and short-form biographies, imagery, TV schedules and listings, TV episode and season information and unique program IDs. Gracenote Video derives the majority of its revenue from cable, satellite, online, consumer electronics and other business-to-business (“B2B”) channels.

Gracenote Sports

The sports segment provides live data and statistics from over 4,500 leagues and competitions, such as the National Football League, Major League Baseball, National Basketball Association, National Hockey League, Premier League, F1, Bundesliga, Tour de France, Wimbledon and the Olympics, among others.

Gracenote Automotive

Gracenote Auto provides Automatic Content Recognition (ACR) technology into any car’s audio system to identify music playing from various sources including AM/FM and satellite radio, CDs or streaming services and deliver relevant metadata and cover art. In December 2015, Gracenote launched its first audio technology, Gracenote Dynamic EQ, designed to help automakers and OEMs automatically tune connected car audio systems to the optimal equalizer settings for individual songs based on genre, mood and release date.

Today, data powers the algorithms that make movie and music recommendations possible for popular on-demand video and streaming music services. Demand for data has grown from consumers, and therefore distributors. Gracenote has a large variety of distributors including companies that deliver music, video and sports content to consumers through devices, platforms and applications. Gracenote is uniquely positioned to take advantage of this increased demand for entertainment data as it provides data on a large scale in the four largest entertainment categories – TV, movies, music, and sports.

Real Estate

Tribune owns the majority of the real estate and facilities used in the operations of the business. The real estate portfolio comprises 74 properties after its recent sales. In April, TRCO entered into an agreement to sell a property in Pennsylvania. On May 5th, TRCO entered into agreement for the sale of the north block of the LA Times Square property and the Olympic Printing Plant facility in LA. (A previously agreement for the sale of the LA Times Square property was terminated in Q1’16). It is estimated that the entire real estate portfolio is worth between $1 billion and $1.1 billion. Management has estimated it at $1 billion and said on August 30th that the recent sales are in line with this valuation.


Tribune holds a variety of investments in broadcasting and digital assets. The two large investments that produce the most cash flows are in the TV Food Network and CareerBuilder. Tribune owns 31% of the TV Food Network and 32% of CareerBuilder.

TV Food Network

The TV Food Network has two television networks, The Food Network and the Cooking Channel. TRCO’s partner in TV Food Network is Scripps Networks Interactive, Inc. (“Scripps”), which owns a 69% interest in TV Food Network and operates the networks on behalf of the partnership. Food Network programming is divided into a daytime block known as “Food Network in the Kitchen” and a primetime lineup branded as “Food Network Nighttime”. “In the Kitchen” is dedicated to instructional cooking programs, while “Nighttime” features food-related entertainment programs, such as cooking competitions and reality TV shows. As of February 2016, Food Network is available to approximately 97,652,000 pay television households (83.9% of households with television) in the United States. The Cooking Channel focuses on providing content around food information and instructional cooking. As of February 2016, Cooking Channel is available to approximately 63,772,000 pay television households (54.8% of households with television) in the United States.

CareerBuilder, is the largest job website in North America on the basis of traffic and revenue. CareerBuilder offers a variety of services including talent management software, recruiting platforms, and employee retention solutions. CareerBuilder operates in over 65 markets and operates websites in the United States, Europe, Canada, Asia and South America. Tribune’s partners in CareerBuilder are TEGNA Inc. and The McClatchy Company, which together own a 68% interest in CareerBuilder.

Financial Overview

On February 24, 2016 Tribune announced a massive $400 million buyback. As of August 5, 2016 they had purchased $96 million. Once completed, this buyback program will allow management to repurchase over 13% of the company. Repurchase programs of this size cannot go unnoticed by investors due to the sheer size. Actions speak louder than words and management is taking advantage of an undervalued stock. Additionally, shareholders are getting paid to wait for the market to understand the story. The stock yields about 2.8% which is very generous.

Tribune’s broadcasting business will be supported by the strong markets they operate in. Owning or operating affiliates in seven of the top ten markets will help generate continued advertising growth.

TRCO Estimates

The broadcasting business provides a stable operating environment. However, political spending drives advertising revenues which is reflected in the 2016 and 2018 estimates. The amount of political spending as been a bit disappointing during the presidential campaigns. Neither candidate is spending as much as anticipated. The distribution between traditional media and social media is as expected.

Tribune Media is a sum of the parts story. The company has two primary segments in broadcasting and digital but also holds many valuable assets. These assets are being undervalued by the market. As the company begins to monetize some and grow others, I believe the market will notice the massive discount the company currently trades at.


A sum of the parts valuation indicates the stock is worth $64. This represents 80% upside. There is an ongoing FCC spectrum auction that should be over in the next 6 weeks. The spectrum market has support from cord-cutters purchasing HD antennas to watch broadcasting stations. There continues to be a lack of spectrum in the market and I expect this to continue. The outcome of this auction could be a near term catalyst for the stock.

I have owned the stock for almost a year and as of today, it is a loss (Average price about $37). I continue to believe the stock is trading at a massive discount. I am comfortable with the valuations of their investments and the real estate portfolio. It doesn’t appear that they have many level 3 investments which gives me confidence in the $1 billion valuation they have placed on the real estate portfolio. I continue to like the 2.8% dividend yield and the large repurchase program in place. I believe the market will begin to see the value in this company in the next 12 months.






Gap is Quietly Evolving


Most retailers had a difficult time in 2015. Between foreign currency headwinds, the West Coast port closure, and unusually warm winter weather it was a difficult environment to operate in. This has left investors wondering who will make adjustments and come back stronger in 2016. The Gap Inc. (NYSE:GPS) is the owner of several brands including Gap, Banana Republic, Old Navy, Athleta, and INTERMIX. It is led by Art Peck who transitioned to CEO February 1st of last year. Art joined Gap in 2005 and prior to being CEO, he was President of the company’s growth, innovation, and digital division. This might explain why so many of the company’s strategies and investments today are around their omni-channel platform and digital shopping experience.

The company is investing in areas of the business that could move the needle in 2016 and beyond. On Art Peck’s first conference call in February, he discussed the company’s initiative of getting its women’s product back on track. There were several issues that were causing women to leave Gap. However, management is adamant that they have identified the issues and they will be resolved. The company made strides in 2015 on adjusting the aesthetic direction of its women’s products. Art and his team have made it clear that they value the opinions of their customers. Fashion trends are changing faster than ever and it’s crucial that they identify them early. Art Peck mentioned that he reads hundreds of customer reviews that help him understand what customers want. Consequently, the company is making product changes especially in the Gap and Banana Republic brands. They are adding more color and will be more disciplined in the fit and quality of products which will drive customer loyalty.

Gap has been investing in its supply chain since 2013 and it is beginning to pay dividends. Gap is now using seamless inventory. This allows the company to use the same inventory for stores and online sales. CEO Art Peck explained that it will result in a higher average unit retail (AUR) because this system allows the company to get the product to the “highest bidder” whether they are online or in a specific store. The company is making itself more flexible and responding faster to customer needs. This inventory management system gives the company the ability to order less inventory initially, test it out with customers, and then respond with what is selling. Not only will this make customers happy but it will also boost sales. In addition, the company is using this model to leverage its omni-channel platform by reducing shipping costs and offering two day shipping to compete with Amazon (NASDAQ:AMZN). Prior to using seamless inventory, there was a ten month lead time before merchandise could actually get on the shelf’s. In 2016, this lead time will be reduced to six to seven months and they will also have flexibility in adjusting merchandise to current trends.

The company has been weighed down over the last year or so by the West Coast port closure as well as foreign currency headwinds. Together these two issues impacted margins by an average of 100 basis points per quarter from Q3 2013 to Q2 2014. This is worth noting because many analysts believe that margins have been in a downtrend and they think it might continue. However, the West Coast port closure is now behind the company and foreign currency headwinds will be eased due to the lag in currency hedging. In my opinion, margins will begin to increase in 2016 and will have plenty of room to expand due to the multi year initiative of investing in the supply chain. Today, gross margins are around 37.5% and I expect them to be closer to 40% five years from now. Operating margins could also move from 10.6% today to around 13% which would be well above the industry average of 11.76%.

Prior to the company’s investor day in June, they announced they would be closing 175 specialty stores in North America and a few stores in Europe. This is an effort to “right size” its store fleet and have an appropriate mix between specialty stores and the more profitable outlet stores. By 2018, the company will have reduced its specialty store count from 685 to 500 and will have opened about 20 more outlet stores in North America. This will bring the outlet store count to 300 in North America. The company believes this is the optimal mix of specialty stores and outlet stores. The net cost of the plan is approximately $150 million and will have annualized savings of $25 million. Closing these stores was a difficult decision for the company but it will create value for investors in the long run.

Although Gap, Banana Republic, and Old Navy get most of the spotlight, I would like to take a second to mention Athleta. This brand is known for its women’s active apparel and it has shown strong growth since being acquired by Gap in 2008. Art Peck was responsible for Athleta when he was President of growth, innovation, and digital. It is important to note that Athleta already uses the seamless inventory system that is being interwoven into the other brands. The brand is also much further along in the digital shopping experience. Athleta grows quickly in both of its sales channels. The digital channel is the optimal channel for growth because Gap doesn’t have to build a store to get the growth. Currently, Athleta only has about 120 stores in North America but I would expect many more in the future. This is an exciting brand that could grow into something special.

Gap Inc’s stock is down about 48% from its 52 week high set back in March 2015. The valuation is very reasonable. Analysts expect the company to make $2.45 a share next year which I deem to be conservative especially given the company’s history of buybacks. The company is on pace to buyback about $1 billion worth of stock in 2015 which equates to them buying back about 10% of the company. I expect them to approve another large buyback program for 2016 since the company generates over $1 billion of free cash flow each year. The stock also pays a nice 4% dividend. Sabrina Simmons CFO has made it clear that they would like to maintain about $1 billion worth of cash. The company made a very savvy move last October by borrowing $400 million in short term debt. I say it was savvy because the interest rate terms are LIBOR plus .75%, which means they are only paying about .50% of interest since LIBOR is currently negative. Having this extra cash gives the company the ability to continue to invest in its self, buyback stock, and keep its large dividend.

On an intrinsic valuation basis, my cash flow model suggests the stock could be worth $30 representing almost 30% upside. My model assumes that after tax operating income will decrease in 2016 and then turn positive in 2017. The stock also appears to be cheap compared to the rest of the apparel industry. Please see the chart below.Gap

Gap trades at a discount on all three metrics. It is particularly cheap using the EV/EBITDA metric at only 4.18 versus the industry average of 9.02. This is incredibly cheap for a company that continues to be very profitable even while its restructuring.

Bottom Line

Art Peck and his team are incredibly bullish on the future of the company. Investors should be excited about the investments and changes that have been made. As we get into 2016, both Banana Republic and Gap have much easier comps. In addition, expectations for the company are incredibility low. With the amount of stock the company has been buying back, sales could remain flat in 2016 and earnings would increase 8-10%. The benefits from the investments in the supply chain are beginning to show up which allows the company to be flexible and respond quickly to new fashion trends. I think investors are overlooking the benefits of having a responsive supply chain. 2016 may be the year that Art Peck’s optimism begins to show up in the company’s financial performance.

As always, thanks for reading!


Under Armour’s Going Global

UA store

Under Armour (NYSE:UA) is a very interesting company that continues to mature. The stock is down about 35% from its high back in September. Under Armour is run by CEO Kevin Plank who has done an incredible job. The company just celebrated its 10 year anniversary and it has come a long way. The big question for investors is where is this company going? Ten years ago, they started out by making compression t-shirts but they have transformed over the last couple of years and gotten involved in technology.

The company has been investing heavily in its future the last couple years. In 2015, they made a big push to make Under Armour a global brand. The company opened about 100 stores internationally. They particularly targeted China by opening about 75 stores. Prior to 2015, they only had 9 stores open in China. Investing in China right now is tough. We know that their economy has slowed down but no one knows how much economic growth there is today, if any. In addition, future economic growth is hard to predict. On one hand, you could say that this is a good time to be investing because in three to five years their economy might be steadily growing again. On the other hand, things could continue to slow which could impact Under Armour’s growth expectations.

Another growth driver for the company is in footwear. Many analysts have their eye on this segment. The segment has shown solid growth over the last five quarters. Please see the chart below indicating the footwear comps.


Footwear now accounts for 20% of the company’s revenues. CEO Kevin Plank has said that he wants to be the number one seller of athletic footwear which takes direct aim at Nike (NYSE:NKE). Under Armour has signed endorsement contracts with some amazing athletes that have tremendously helped drive growth in footwear. Stephen Curry in basketball, Jordan Spieth in golf, along with Tom Brady and Cam Newton in Football. Basketball shoes have demonstrated the strongest growth driven by the Curry 2’s that were launched in China last September. Obviously the company can not continue to grow this segment at an average of 50% per year. In fact, during the Q3 earnings call, the company mentioned that they had to discount some shoes to clear them out going into Q4. This had an impact on gross margins and the company’s average selling price (ASP) per unit metric. ASP’s have increased over the last few years due to the price point of their shoes. It will be important for the company to have strong footwear sales in Q4 or investors may worry.

In 2015, the company took a more definitive stance in fitness technology. They acquired Endomondo and MyFitnessPal in 2015 to go along with the UA Record and MapMyFitness apps it already owned. In Q3 Kevin Plank stated that with all four apps, they have had 150 million downloads. The hard part for investors is we have no idea how to think about this part of the business. It currently doesn’t make much money and there is no way to know if it ever will. Last week at CES, the company announced that the apps have a combined 60 million monthly active users (MAU), over 1.5 billion workouts logged, and over 6.5 billion foods logged. Currently, the company is collecting tons of data from the users and trying to figure out how to best leverage it. Under Armour’s fitness community of 150 million users is larger than Fitbit’s (NYSE:FIT). This part of the business is nearly impossible to value. This is uncharted territory and its hard to know if these apps will drive consumers to buy more apparel and footwear. That seems like what the company is hoping will happen.

Under Armour’s valuation has always been rich. However, investors have been willing to buy the stock because of the growth. Some people justify buying the expensive stock because “The valuation has always been high.” This is a horrible justification. The company has shown incredible and consistent growth by posting 20%+ growth for 22 straight quarters but this won’t happen forever. When I looked into this company, it was clear that they understand how Wall Street works. They always give conservative guidance in Q4 for the upcoming year and then they raise guidance each quarter. It happens year in and year out and Kevin Plank comes up with great excuses for the conservative guidance issued in Q4. In my opinion, companies that use this strategy have a  higher probability of the stock selling off after reporting Q4 than in the other quarters. This could create an opportunity.

When I look at the valuation, it is definitely tricky. It is tough to value it   on a relative basis because it is difficult to find a company with similar risk, growth, and cash flows. An intrinsic valuation is difficult too due       to the explosive growth and uncertainties around China, footwear, and the technology aspect. When I looked at the financials, the SG&A expense financial statement line item is something to note. When I looked at the ratio of SG&A expense to revenues it reminds me of Amazon (NASDAQ:AMZN). The reason it reminds me of Amazon is due to the fact that there is a large disconnect between revenue growth and earnings growth. In Q4 2014, the company gave guidance for operating income of $405 million in 2015. Fast forward to Q3 2015, the company has increased revenue projections by $150 million but operating income projections are still at $405 million. Where is the $150 million going? SG&A expense. The reason I bring this up is because I do not consider all of SG&A expense to be a “true expense.” The company is investing in the future of the company and the brand. They are using this money to invest in fitness apps and opening new stores. In theory, they are creating assets and a better brand with this SG&A expense. For Under Armour, I assumed that 50% of SG&A would be a “true expense” and I amortize the other 50% over twenty years. I deem this to be pretty conservative and it helps me get a better understanding of what the company would be like in a stable growth environment. Using this assumption I reached an intrinsic valuation of $74 representing about 10% upside. Please see the chart below that reflects how my assumption impacts valuation metrics.

Using this assumption, the P/E ratios for Under Armour are still relatively expensive. In my opinion, Under Armour is a terrific company that has a bright future but I am not willing to pay for excessive valuations.

Bottom Line

I think that Under Armour is a great company. The company is young and continues to grow. There are just a few issues. Investors have high expectations for the company and the return on the investments of the company is hard to predict. The company reports Q4 earnings on 1/28/15 and will give 2016 guidance. I would like them to give overly conservative guidance once again and have the stock fall. This is a company that I would like to own at a fair price. I plan on staying patient and hopefully the valuation will continue to come down.

As always, thanks for reading!


Is Macy’s Cheap For Good Reason?


Among the retailers that have been beaten down in the last 6 months is Macy’s (NYSE:M). The stock made all time highs in July and has since fallen about 45%. The company has come out with a long list of excuses. Among them is warm winter weather and poor sales to tourists traveling to the U.S. The company is now making some investments that could damage the brand in the long run.

One of the company’s largest investments is in a new store roll out called Backstage. Essentially this will be a discount store where Macy’s can discount the merchandise that they can’t sell in their flagship stores. First of all, I don’t think you would come up with this strategy unless you have had a lot of inventory that hasn’t sold or you foresee that to be a problem. There are many high-end retailers that have gone down this path and today they all have more discount stores than traditional stores. Competition in this space includes Nordstrom (NYSE:JWN), Saks Fifth Avenue, and Neiman Marcus among others. All of these companies have more discount stores than flagship stores. Opening discount stores has proven to damage brand value. Just look at the brand destruction that happen at Coach (NYSE:COH) and Micheal Kors (NYSE:KORS). Both of these companies are down over 50% from their highs and continue to struggle. Although brand value is not quantified on the balance sheet, it is there. Macy’s said on their Q3 earnings call that they have seen a trend of customers leaving Macy’s and shopping at high-end discount retailers instead. It seems like the company is now willing to sacrifice its brand value in an effort to get back to positive comps which brings me to the next issue. Macy’s plans on opening an undetermined amount of Backstage stores within existing Macy’s stores but assumes that there will be little cannibalized sales. The strategy is to bring in an entirely new set of customers that will shop at Backstage. I think this will be an extremely challenging task.

Last July, Jeffery Smith of Starboard Value made a presentation on Macy’s at The Delivering Alpha Conference. He contended that Macy’s could be worth $125 a share because its real estate might worth as much as $20 billion. Macy’s does have some impressive real estate and it is valuable. $20 billion might be a stretch, but even if it is worth that much, there is one big problem. Macy’s would have to pay rent on all these properties which would be violently expensive. Rent for a high quality retail building runs on average between 7% and 8% of the real estate value of the property. Valuing the real estate portfolio at $20 billion would equate into about $1.6 billion of rent payments each year. Macy’s net income last year was about $1.5 billion so the company would struggle to turn a profit. Macy’s has stated that they do not think it would create shareholder value to monetize its real estate.

To be fair, the company is also making some moves that could be great for shareholders. They continue to invest in Omnichannel that has been showing strong growth. In addition, they purchased Bluemercury last February for $212 million and they will begin rolling those stores out in 2016. Last week they also announced that they will be closing 36 Macy’s stores that will save $400 million in SG&A expense and they will continue to restructure throughout 2016. The real estate portfolio continues to be a hot topic with investors. The company is doing a good job by evaluating the locations that are least beneficial or have unused space and they are selling them. These strategies may help but the current vision for the company is rolling out Backstage which could be disastrous.

With the stock being down 45% since July, the valuation looks to be cheap. The stock currently trades at a price to sales ratio of just 0.45. Macy’s is expected to make $3.75 per share in FY 2017. Using this estimate, the stock trades at a reasonable 10.3x forward earnings (That is if earnings estimates are right). When I perform a 5 year intrinsic valuation on the company I come to a $40 price which is only about 3% higher than it is today. However, this factors in the estimated reduction in after tax operating income for FY 2016 and assumes that it will continue to decline, just at a slower pace through FY 2020. All valuations are biased, but considering the direction of the company, I have doubts that customers will return. I think the writing’s on the wall that margins may never be as high as they have been the last few years and sales may continue to disappoint.

I want to own wonderful companies at fair prices just like Warren Buffett’s quote says. I want to find companies that have strong demand for their products and a sustainable competitive advantage. Macy’s doesn’t seem to meet that criteria. It is having trouble selling merchandise. They are currently being forced to discount their merchandise to sell it and they are closing stores. They have now decided that the next chapter of the company will be discount stores. This strategy might help in the short-term but I think long-term brand erosion is certainly possible which will keep me from owning the company.