Looking Past the Shine on Restoration Hardware

Restoration Hardware (RSTO) has crawled out of one hole, but some people wonder if its stock isn't heading down another.

Certainly the yuppie furniture and accessories chain has its fans. The stock has rallied into the $11 range this spring after trading for just pennies early last year. Same-store sales rose strongly last month, as the company continued to benefit from cocooning consumers' renewed interest in home furnishings.

But there are those who characterize Restoration's rebound as a classic case of smoke and mirrors. A former executive points to the strong competition in home furnishings and questions whether the company, which lost $34 million last year, can ever make a profit. A short-seller notes that insiders have filed to sell millions of shares, potentially flooding the market. Despite repeated promises, the company has failed to share financial guidance with Wall Street, prompting the one analyst who was covering the stock to give up.

"I think the fundamentals are bad," says Mike Swanson, who runs the Web site timingwallstreet.com and is short the stock. He notes that the company has been willing to make vague, optimistic-sounding promises but hasn't offered details of its expectations. "It seems the company can give a prediction about next year, but can't give any guidance about the next quarter," he says.

Promises

To that end, Restoration has said only that it expects to return to profitability in 2003 and that it eventually hopes to have at least $1 billion in sales -- slightly less than triple last year's figure. Still, considering that the company lost $1.57 a share for 2002, the ambitious projections paint a picture of a company making steady progress toward reachable goals.

That said, the company's recent past has been anything but smooth sailing. In March, the company announced it would have to restate earnings for 2000 and 2001 because of an accounting change. Meanwhile, short interest -- bets that the share price will fall -- is more than double the level of a year ago, according to figures provided by Nasdaq. Those figures point to a growing skepticism in some quarters.

Talking Turnaround Tracking sales, profits at Restoration ($millions)

Source: Company news releases

"I doubt that they will ever make money," says Rob Wilson, the company's former treasurer who resigned in March 2001, just before Gary Friedman, former head of rival Pottery Barn, took the reins of Restoration Hardware. Wilson, who runs Retail Stock Investor, which researches retail stocks for hedge fund clients, warns investors that the turnaround is a lot less certain than the runup in the stock price would suggest.

For one, he questions the company's strategy of focusing on upscale linens, noting competition from the likes of Pottery Barn and Williams-Sonoma (WSM). But something perhaps more important for the company's finances, he says, is less well-known: Because of how the company's leases are structured, Restoration could have difficulty closing underperforming stores.

When Restoration expanded in 1998, it failed to secure clauses in the leases that would have allowed Restoration to back out if stores didn't perform, explains Wilson, adding that such clauses are common in retail. Restoration closed three stores last year because it was able to sell the leases, and has plans to close six to eight by 2004. But Wilson estimates Restoration would like to close 20 to 25 stores and can't because of the lease structures.

Kevin Shahan, Restoration's chief financial officer, disputes that contention. "I think that's a high number," he says. He acknowledges the problems with the leases but won't provide an alternative figure. "I think kick-out clauses are more normal to have at shopping centers, rather than the single-owner mom-and-pop spaces" where many of Restoration's stores are, he says.

What's 'Realistic'

Restoration, based in Corte Madera, Calif., was a hot stock following its 1998 IPO before fizzling under poor inventory management two years later. By the time the holidays rolled around in 2000, the company was out of cash and on the verge of filing for Chapter 11 bankruptcy protection, Wilson says. Restoration was able to secure financing in a preferred share deal, on the condition that it hire a CEO with extensive retail experience. In stepped Pottery Barn's Friedman, with a plan to eliminate clutter in the stores and slash the number of items sold.

The company rolled out the new linens, and completed its store remodeling plan, in April, Shahan says. The early indication is positive: Same-store sales grew 10.5% from a year ago in April. Shahan says Restoration will finally give some financial guidance when it reports quarterly earnings on May 22. After that, he predicts Wall Street will again take notice.

"It's not realistic to expect an analyst following without being in the routine of giving guidance," he says.

Stocking

Others say the stock could be due for a fall because some of the investors who rescued the company in 2001 are preparing to bail out. In a February filing with the Securities and Exchange Commission, the company said that some 6.8 million shares owned by a variety of investment partnerships, some controlled by Glenn Krevlin, a director, may be sold. This would amount to roughly 30% of the total number of shares outstanding. Some worry that all that selling would send the stock cratering.

"It certainly raises the red flags," says Swanson, the trader who is short Restoration.

Another potential red flag, investors say, is that according to a recent SEC filing, two investment partnerships associated with Krevlin have been selling the stock short, betting on its decline. The partnerships don't list Krevlin as a principal, though they share a common address with Krevlin's investment vehicles. Krevlin didn't respond to a request for comment.

To be sure, it isn't illegal for a director or his affiliates to short his company's stock, and Restoration disclosed in earlier filings that the partnerships could engage in short-selling to hedge against losses. However, such an arrangement is virtually unheard of, say experts.

"It looks horrible," says Tom Twedt, a partner at the law firm Dow Lohnes & Albertson and an expert in securities law. "The perception is you're making a bet against the company."

It's a bet other investors might consider making.

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