RH Form 10-Q Summary
Reporting period: Quarterly and six-month periods ended July 29, 2017, compared with July 30, 2016. The supplied metadata identifies “2016 Q2,” but the filing is for fiscal 2017 second quarter. RH is a luxury home furnishings retailer operating Galleries, outlet stores, catalogs and websites, with Waterworks as a separate reportable segment. As of July 29, 2017, RH operated 85 Galleries, 28 outlet stores and 15 Waterworks showrooms.
Financial Performance and Position
| Metric | Q2 FY2017 | Q2 FY2016 | Six months FY2017 | Six months FY2016 |
|---|---|---|---|---|
| Net revenue | $615.3 million | $543.4 million | $1,177.4 million | $998.8 million |
| Revenue growth | 13.2% | — | 17.9% | — |
| Gross profit | $205.8 million | $179.8 million | $376.1 million | $307.3 million |
| Gross margin | 33.4% | 33.1% | 31.9% | 30.8% |
| Operating income | $12.1 million | $22.0 million | $19.0 million | $10.5 million |
| Operating margin | 2.0% | 4.1% | 1.6% | 1.1% |
| Net income (loss) | $(7.9) million | $6.9 million | $(11.2) million | $(6.6) million |
| Diluted EPS | $(0.28) | $0.17 | $(0.31) | $(0.16) |
- Comparable brand revenue growth was 7% in the quarter and 8% for the first six months.
- Stores revenue increased 13.0% in the quarter and 17.9% year to date; direct revenue increased 13.5% and 17.9%, respectively.
- Waterworks revenue was $31.5 million in the quarter and $60.1 million for the first six months. Comparisons benefit from only nine weeks of Waterworks results in the prior-year six-month period.
- SG&A increased 22.7% in the quarter and 20.3% year to date, reaching $193.7 million and $357.1 million, respectively. Q2 included a $23.9 million non-cash executive stock-compensation charge.
- Net interest expense increased to $14.4 million in Q2 and $26.6 million year to date, compared with $10.9 million and $21.4 million, respectively.
- Cash provided by operating activities was $316.4 million for the first six months, compared with cash used of $73.6 million in the prior-year period. The improvement primarily reflected a $140.3 million inventory reduction and other working-capital changes.
- Investing activities provided $146.2 million, including investment sales and maturities, asset-sale proceeds and $39.4 million of capital expenditures.
- Financing activities used $528.1 million, primarily reflecting $1.0 billion of share repurchases, partly funded by borrowings.
- Cash and cash equivalents declined from $87.0 million at January 28, 2017 to $21.6 million at July 29, 2017.
Debt, Liquidity and Capital Structure
- Outstanding debt included $283.0 million under the asset-based revolving facility, an $80.0 million LILO term loan, a $100.0 million second-lien term loan, $350.0 million principal amount of convertible notes due 2019 and $300.0 million of convertible notes due 2020.
- The revolving facility has total commitments of $600 million, plus a potential $200 million accordion, and matures June 28, 2022. Reported availability was $181.1 million net of letters of credit, but the filing states that practical incremental borrowing capacity was approximately $129.4 million because of fixed-charge coverage restrictions.
- The second-lien term loan bears interest generally at LIBOR plus 8.25%, matures January 7, 2023, and is secured by a junior lien on substantially similar collateral to the first-lien facility.
- RH was in compliance with applicable debt covenants at July 29, 2017. Management stated that operating cash flow, borrowing availability and other financing arrangements were expected to cover working capital, capital expenditures and other needs for the next 12 months.
- Total liabilities were $1.87 billion and stockholders’ equity was a deficit of $46.8 million at July 29, 2017, compared with equity of $919.9 million at January 28, 2017, primarily due to the $1.0 billion share repurchase programs.
Material Changes and Unusual Items
- RH completed a $300 million repurchase program in the first quarter and a $700 million program in the second quarter, repurchasing approximately 20.2 million shares in total during the first half.
- Q2 results included a $5.0 million product-recall charge, reducing revenue by approximately $3.8 million, reducing gross profit by $4.6 million and reducing pretax income by $4.7 million.
- RH recorded a $1.3 million Q2 gain related to the sale of a Gallery building and land; the remaining $0.7 million of the total gain is expected to be recognized in the following quarter.
- Inventory optimization, outlet promotions, markdowns and SKU rationalization supported revenue and working capital but pressured merchandise margins and earnings.
- The company adopted ASU 2016-09, recording excess tax benefits of approximately $2.5 million in Q2 and $2.4 million for the first six months. The tax rate was distorted by losses, non-deductible stock compensation and these discrete benefits.
- The prior-year six-month cash flow statement was revised for the presentation of negative cash balances and related accounts payable offsets; management concluded the prior-period misstatements were not material.
Outlook, Management Commentary and Risks
- Management expected fiscal 2017 capital expenditures of approximately $120 million to $140 million and anticipated additional free cash flow during the remainder of the year.
- RH expected to open three next-generation Design Galleries in fiscal 2017 and planned to consolidate its furniture distribution-center network from four locations to three by the fourth quarter. A subsequent event disclosed a plan to close one furniture distribution center before the end of fiscal 2017; the financial impact had not yet been determined.
- Management expected benefits from the RH Members program, additional membership revenue, the RH Interiors Source Book, new Design Galleries, RH Modern expansion and hospitality offerings.
- Management cautioned that inventory optimization, distribution changes, Gallery development, product recalls and multiple simultaneous initiatives could create near-term volatility in revenue, margins and profitability.
- The company must address $650 million of convertible notes maturing in 2019 and 2020 and stated that it may require additional liquidity or refinancing to repay them in cash.
- Risks include significant leverage, variable interest rates, restrictive debt covenants, limited cash balances, refinancing availability, retail and consumer demand, execution of Gallery and supply-chain initiatives, product liability and recalls, and litigation.
- A securities class action concerning statements about the RH Modern rollout was pending at an early stage. The company stated that potential loss could not be estimated and that it intended to defend the claims.
Investor Verification Points
- Reconcile reported revenue growth with the timing effect of Waterworks consolidation, Source Book mailings, outlet sales and membership revenue.
- Assess underlying margins excluding the executive stock award, product recall, inventory step-up amortization, asset-sale gain and other adjusted items.
- Monitor liquidity after the $1.0 billion repurchase program, including cash of $21.6 million, borrowing-base availability and planned second-lien repayment.
- Evaluate the company’s plan and funding sources for the $350 million 2019 notes and $300 million 2020 notes.
- Track inventory reductions, markdown activity, outlet dependence and resulting merchandise-margin trends.
- Review the financial impact and execution risk of the distribution-center closure and planned Gallery openings.
- Follow developments in product recalls, the RH Modern securities litigation and any changes to debt covenants or refinancing conditions.