RH Form 10-Q Summary
Reporting period: Three months ended April 29, 2017, compared with April 30, 2016. Although the request metadata identifies “2016 Q1,” the filing is RH’s fiscal 2017 first-quarter report, filed June 2, 2017.
Business Context
RH is a luxury home furnishings retailer selling through Galleries, outlet stores, catalogs, websites and commercial channels. As of April 29, 2017, the Company operated 85 retail Galleries, 28 outlet stores and 15 Waterworks showrooms. Waterworks was acquired on May 27, 2016 and contributed $28.6 million of first-quarter 2017 revenue.
Financial Results and Key Metrics
| Metric | Q1 2017 | Q1 2016 | Change |
|---|---|---|---|
| Net revenues | $562.1 million | $455.5 million | 23.4% increase |
| Gross profit | $170.3 million | $127.5 million | 33.6% increase |
| Gross margin | 30.3% | 28.0% | 230 basis-point increase |
| Income (loss) from operations | $6.9 million | $(11.5) million | Improved by $18.4 million |
| Net loss | $(3.4) million | $(13.5) million | Improved by $10.1 million |
| Basic and diluted loss per share | $(0.09) | $(0.33) | Improved |
| Adjusted net income (non-GAAP) | $1.8 million | $(2.1) million | Improved |
Stores revenue increased 23.7% to $316.7 million, while direct revenue increased 23.1% to $245.4 million. Comparable brand revenue growth was 9%. Furniture revenue was $353.0 million and non-furniture revenue was $209.1 million.
Operating margin improved to 1.2% from negative 2.5%; net margin improved to negative 0.6% from negative 3.0%. Interest expense increased to $12.2 million from $10.5 million, primarily because of higher build-to-suit lease costs and convertible debt discount amortization. The effective tax rate was 36.2%, compared with 38.8%.
Net cash provided by operating activities was $125.1 million, compared with $90.4 million of cash used in the prior-year quarter. The improvement was driven primarily by a $66.1 million reduction in inventory and a $22.2 million increase in deferred revenue and customer deposits. Investing activities provided $167.2 million, principally from sales and maturities of investments. Financing activities used $299.1 million, primarily for share repurchases. Cash and cash equivalents ended at $80.2 million.
Capital expenditures were $13.5 million, compared with $45.3 million in the prior-year quarter. The Company expects fiscal 2017 gross capital expenditures of approximately $120 million to $140 million, offset by anticipated asset-sale proceeds of approximately $15 million to $25 million.
Balance Sheet, Debt and Liquidity
- Total assets were $1.95 billion and stockholders’ equity was $622.8 million at April 29, 2017.
- Merchandise inventory was $684.0 million, down from $752.3 million at January 28, 2017.
- The Company had $650 million aggregate principal amount of 0.00% convertible senior notes: $350 million due in 2019 and $300 million due in 2020. The combined carrying value was approximately $561.9 million.
- The revolving credit facility had no outstanding borrowings and $478.0 million of availability, net of $14.4 million of letters of credit. Because of the fixed-charge coverage ratio restriction, actual incremental borrowing availability was approximately $430 million.
- The Company was in compliance with its credit agreement covenants; however, it would not satisfy the fixed-charge coverage ratio if availability fell below the specified threshold.
Material Changes Versus the Prior Comparable Period
- Revenue growth benefited from the Waterworks acquisition, the timing of Source Book mailings, higher membership revenue and increased outlet and warehouse sales.
- Outlet and warehouse revenue increased by $28.1 million and accounted for approximately 6.2 percentage points of RH Segment revenue growth. Management expects continued inventory markdowns and outlet activity to pressure margins and earnings.
- Gross margin benefited from lower customer accommodations and shipping costs, occupancy leverage and higher membership revenue, but was pressured by promotional activity, markdowns and inventory reserves.
- The prior-year quarter included approximately $14 million of customer accommodations and related expenses associated with RH Modern production delays, as well as $7.7 million of coupon redemptions related to a legal claim.
- RH repurchased approximately 7.8 million shares for $300 million at an average price of $38.24 per share, reducing outstanding shares and equity.
- The Company revised prior-year cash-flow presentation to correct the treatment of negative cash balances arising from outstanding checks. Management concluded the prior misstatements were not material and reported no income or equity impact.
Guidance, Outlook, Risks and Unusual Items
- Management lowered its new Gallery opening cadence to three to five Galleries annually to improve capital discipline, reduce execution risk and support higher returns.
- Management expects fiscal 2017 capital expenditures of approximately $120 million to $140 million and continued investment in Design Galleries, technology, supply chain and customer experience.
- A $700 million stock repurchase program was authorized in May 2017. The filing states that additional repurchases may require existing cash flow, asset sales or additional debt financing.
- The Company may need additional liquidity to repay the $650 million principal amount of convertible notes at maturity, particularly the $350 million due in June 2019. The filing does not provide a committed refinancing plan.
- On May 2, 2017, RH granted the CEO an option for 1.0 million shares at a $50 exercise price, expected to produce an approximately $24 million non-cash stock-compensation charge in the second quarter.
- RH is defending a consolidated securities class action alleging misstatements concerning the RH Modern rollout. The matter was at an early stage, and management stated that the claims lacked merit. Additional losses beyond accrued amounts are possible, although management did not expect current matters to have a material adverse effect.
- Management expects continued near-term uncertainty from inventory rationalization, markdowns, outlet growth, new Gallery openings and other operating initiatives.
- New lease accounting guidance is expected to significantly affect the financial statements because of the Company’s substantial lease portfolio; the impact was still being evaluated.
Investor Verification Checklist
- Verify whether the strong revenue growth is sustainable after separating Waterworks, outlet and warehouse sales, Source Book timing and membership revenue effects.
- Monitor gross margin and operating margin as inventory rationalization and markdown activity continue.
- Assess liquidity available for the $700 million repurchase authorization, capital expenditures and the 2019 and 2020 convertible note maturities.
- Review the fixed-charge coverage ratio trigger and borrowing-base limitations under the revolving credit facility.
- Track the financial impact of the CEO’s approximately $24 million stock-compensation charge and future equity awards.
- Follow developments in the RH Modern securities litigation and other legal contingencies.
- Evaluate the effect of future lease and revenue-recognition standards, including expected changes to gift-card breakage presentation.