RH Form 10-Q Summary
Reporting period: Three months ended May 5, 2018, compared with April 29, 2017. The request metadata identifies “2017 Q1,” but the filing is for the first quarter of fiscal 2018. RH is a luxury home furnishings retailer operating Galleries, outlet stores, catalogs, websites, Waterworks showrooms and related sourcing operations. At period-end, RH operated 84 retail Galleries, 32 outlet stores and 15 Waterworks showrooms.
Financial Performance and Position
| Metric | Q1 FY2018 | Q1 FY2017 | Change |
|---|---|---|---|
| Net revenue | $557.4 million | $562.1 million | Down 0.8% |
| Gross profit | $212.0 million | $170.3 million | Up 24.5% |
| Gross margin | 38.0% | 30.3% | Up 7.7 percentage points |
| Operating income | $53.6 million | $6.9 million | Up $46.7 million |
| Operating margin | 9.6% | 1.2% | Up 8.4 percentage points |
| Net income (loss) | $28.1 million | $(3.4) million | Improved by $31.4 million |
| Diluted EPS | $1.11 | $(0.09) | Improved |
| Adjusted EBITDA | $78.4 million | $29.6 million | Up 165% |
| Net cash from operating activities | $7.8 million | $123.9 million | Down $116.2 million |
| Capital expenditures | $27.1 million | $21.2 million | Up $5.9 million |
Revenue was approximately evenly split between stores and direct channels: stores generated $314.5 million and direct channels generated $242.9 million. Comparable brand revenue growth was 1%. Waterworks revenue increased 10.0% to $31.4 million, while RH Segment revenue declined 1.4% to $526.0 million.
Gross-margin expansion reflected improved product margins, reduced effects of SKU rationalization and inventory optimization, distribution-center occupancy leverage, and lower shipping costs. SG&A declined 3.0% to $158.4 million, although results included a $2.0 million lease-loss liability reversal and $1.9 million of post-acquisition legal costs.
Cash and cash equivalents were $20.8 million at May 5, 2018, with restricted cash equivalents of $1.9 million. Total cash, cash equivalents and restricted cash equivalents were $22.7 million, compared with $99.4 million at the prior-year quarter-end. Merchandise inventories were $530.7 million.
Debt and Liquidity
- Credit facilities totaled $299.0 million, consisting of $219.0 million drawn under the asset-based revolving facility and an $80.0 million LILO term loan.
- The revolving facility had $138.8 million of stated availability net of $27.8 million of letters of credit; fixed-charge coverage restrictions reduced actual incremental borrowing availability to approximately $92.2 million.
- Convertible senior notes had aggregate principal of $650 million: $350 million due June 2019 and $300 million due July 2020. Neither series was convertible as of May 5, 2018.
- Management reported approximately $928.7 million of net debt, excluding build-to-suit lease obligations, and stated that it expects to repay the convertible notes in cash at maturity to minimize dilution.
- Management expects operating cash flow, credit availability and other financing arrangements to fund working capital, planned capital expenditures and other needs for the next 12 months.
Material Changes and Unusual Items
- RH adopted ASC Topic 606 using the modified retrospective method on February 4, 2018, reducing opening retained earnings by $21.0 million after tax. The adoption changed the timing and classification of advertising, membership revenue, gift-card breakage, shipment revenue and sales-return accounting.
- Reported Q1 FY2018 net revenue and net income were $7.6 million and $6.5 million higher, respectively, than amounts estimated under the prior revenue standard. Investors should exercise caution when comparing the periods because the prior-year quarter was not recast.
- Operating income included a $2.1 million benefit from distribution-center closure adjustments, a $0.3 million recall-related benefit, $1.9 million of post-acquisition legal costs and $0.2 million of Waterworks inventory-step-up amortization.
- Operating cash flow fell sharply because of working-capital uses, including a $57.2 million reduction in accounts payable and accrued expenses, $26.2 million of increases in prepaid assets and other assets, and $7.2 million of higher accounts receivable.
- RH completed no repurchases under a public program during the quarter. Fiscal 2017 repurchase programs had already repurchased approximately $1.0 billion of stock.
Guidance, Outlook and Risks
- Management expects fiscal 2018 capital expenditures of approximately $125 million to $135 million, partially offset by approximately $50 million of asset-sale proceeds.
- RH expects two additional Design Galleries and one smaller Gallery to open in fiscal 2018, and targets five to seven new Galleries annually beginning in fiscal 2019.
- Management expects improved operating margins from SKU rationalization, inventory reduction, lower Waterworks drag, operating-platform savings, real-estate transformation and the membership model.
- Key risks include execution of the real-estate transformation, construction delays and costs, inventory and supply-chain execution, customer demand, transportation costs, leverage and refinancing risk, variable-rate debt, potential dilution or cash requirements from convertible notes, and litigation.
- The company is defending a securities class action concerning statements about RH Modern and inventory levels, as well as a related shareholder derivative action. Management believes the claims lack merit, but litigation outcomes are inherently uncertain.
- On June 12, 2018, after quarter-end, RH amended its credit agreement to clarify eligibility requirements for in-transit inventory and confirm that prior noncompliance did not constitute a default or event of default.
- Management reported effective disclosure controls and no material changes to internal control over financial reporting. It reported no material off-balance-sheet arrangements.
Investor Verification Points
- Verify the effect of ASC 606 on revenue, advertising expense, deferred revenue, retained earnings and period-over-period comparability.
- Assess whether the significant gross-margin improvement is sustainable after excluding unusual items and accounting-timing effects.
- Monitor operating cash conversion, inventory levels, vendor deposits and accounts-payable timing given the substantial decline in operating cash flow.
- Evaluate liquidity available to meet the $350 million 2019 convertible-note maturity and the $300 million 2020 maturity while funding Gallery expansion.
- Review borrowing-base availability, fixed-charge coverage restrictions, variable-rate exposure and compliance with credit-facility covenants.
- Track progress and capital requirements for Design Galleries, hospitality initiatives, distribution-network changes and the planned return to broader product expansion.
- Review the securities class action and derivative lawsuit for potential financial, governance or reputational consequences.