1 Toxic Stock I'm Avoiding at All Costs

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There's a subtle but very important difference between investing and gambling.

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Investing requires evaluating a company's mission, moat, and future outlook, then deciding for yourself that you want to own a piece of that business. Gambling is making a speculative bet on where a stock may end up over a relatively short period of time.

If you're considering putting your money into shares of RH (NYSE: RH), I'd argue that what you're doing is far more akin to gambling than investing. I actually wrote my first draft of this piece before the company popped over 40% following its most recent earnings report. You might think that means I was wrong -- but I don't think so. Gambling doesn't mean you'll lose every time, it just means you'll lose if you keep playing.

Do with that what you will, but here's why investors should proceed with great caution.

A little background

RH -- earlier known as Restoration Hardware -- sells upscale furniture and interior design units. The company flew under the radar, biding its time in California before going public in 1998 and getting a new CEO from William Sonoma in Gary Friedman in 2001.

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The newly minted company didn't last long on the public market as Friedman and a host of private equity firms took it private in 2008. But after four years, it was determined that RH would once again trade openly. Friedman actually had to step away as CEO after an "inappropriate" relationship with a co-worker was revealed, but it was only a matter of time before he was back at the helm as CEO and chairman of the company.

All along, he was one of the largest shareholders of the company, so he had considerable sway no matter what his official title was.

A difficult field to begin with

Given that the biggest threats to RH are posed by the move away from malls thanks to online competitors like Amazon and Wayfair, why spend so much time on Friedman?

The answer is that what makes this stock a gamble more than an investment is the intersection of industry dynamics and Friedman's behavior.

In response to the e-commerce pressure, RH decided to double-down on its Design Galleries -- huge brick-and-mortar operations that offer a rich in-person experience, including a focus on food (RH Hospitality). The company also debuted a membership program for $100 per customer per year.

But the results haven't been pretty. Last year was awful for shareholders, with the stock losing 60% of its value as Friedman blamed just about everything under the sun -- shipping delays, ineffective promotional activity, low oil prices, currency fluctuations, the presidential election -- except, of course, himself.

In fact, an internal email leaked to the press shows whom he really thinks the blame lies with: employees.

But the bottom line is this: RH is taking a very risky walk by doubling down on its brick-and-mortar, membership-based business model. All the while, Friedman has been rewarded with an average compensation package of over $15 million per year -- including massive payouts of $36 million in 2013, $28 million in 2012, and a $24 million payment just this past quarter.

But there's more ... much more

That is just the backdrop. What's happened over the past six months is what's really got me confused. First, the company decided to spend $300 million buying back shares, largely with cash on hand.

Then, on May 2, the board decided to rework Friedman's compensation plan. He would now be getting bonuses based on the company's ability to see its stock hit $100, $125, and $150 in a given year.

Just three days later, the company announced it would be commencing a $700 million buyback, financed entirely through debt and convertible notes. Even more amazingly, the company completed the buyback in just over two months.

Over the course of this year alone, the number of shares outstanding has almost been cut in half and now sits at just 20.2 million. Friedman's stake in the company went from 16.7% to somewhere near 29%. And between the date when Friedman's new compensation package was announced and mid-June, shares advanced 60% to $77 per share.

What has all of this done to the company's balance sheet? While an updated one hasn't been released yet, here's what the big picture looks like, with the most recent reading being my own estimation.

Management claims that it will first be able to pay off a $100 million loan -- which has an interest rate of 9.48% -- by the end of the year. That had better be true, because without that, the company will be looking at almost $10 million in interest payments per year on this one small part of the buyback alone!

The biggest surprise: free cash flow

By far the biggest surprise coming out of RH's most recent report is the company's strong free cash flow. Over the past three fiscal years, it has not once been free cash flow positive. All of a sudden, it has produced $278 million in free cash flow in the first half of 2017 alone, and it expects to churn out $400 million by year end. To put that in perspective, even after the 40% jump, shares are currently trading for just six times expected 2017 free cash flow. That's cheap.

It's not, however, quite as simple as that. The company is benefiting mightily from its inventory reduction and holding off on its accounts payable. All told, those two line items account for 61% of the company's positive free cash flow thus far.

Let's put that in perspective: Over the last 12 months, RH has generated $361 million in free cash flow. If we back out the contributions from reduced inventory alone -- and give them a pass on accounts payable -- free cash flow gets more than cut in half, down to $177 million.

Why is that important? Because this reduction in inventory is a one-time deal, and investors shouldn't be counting on it to help bolster the balance sheet indefinitely. Don't get me wrong, what Friedman has done over the last six months has been savvy: dramatically cutting the share count while boosting free cash flow via inventory reduction and creating a short squeeze. However, it will only benefit investors if the company can continue seeing healthy free cash flow. 

But that's a big if -- if that doesn't happen and if the fundamentals deteriorate, or the debt levels start to make RH's fragility all the more apparent, there's still a long way the stock could fall. We usually see such bifurcation of return possibilities in small biopharma stocks -- not interior design brick-and-mortar retail.

That's why I think investing in RH is more akin to gambling, and why I won't be going anywhere near the stock.

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Brian Stoffel owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon and Wayfair. The Motley Fool recommends RH and Williams-Sonoma. The Motley Fool has a disclosure policy.