RH Form 10-K Summary
Reporting period: The supplied filing is RH’s Annual Report on Form 10-K for the fiscal year ended February 3, 2018, comprising 53 weeks. The request metadata references “2016 Q4,” but the filing itself reports fiscal 2017 and compares it primarily with the fiscal year ended January 28, 2017.
Business Context
RH is a luxury home furnishings retailer operating through Galleries, outlet stores, Source Books, websites, phone orders, Trade and Contract channels, and integrated hospitality offerings. The company also operates Waterworks, acquired in May 2016. At year-end, RH operated 83 retail Galleries, 32 outlet stores, and 15 Waterworks Showrooms in the United States, Canada and the U.K.
- Fiscal 2017 channel mix was 56% store-originated sales and 44% direct sales.
- Approximately 405,000 RH Members generated 95% of core RH sales at year-end.
- RH sourced approximately 86% of merchandise outside the United States, including approximately 77% from Asia.
Financial Performance
| Metric | Fiscal 2017 | Fiscal 2016 | Change |
|---|---|---|---|
| Net revenues | $2.440 billion | $2.135 billion | +14.3% |
| Gross profit | $849.1 million | $679.8 million | +24.9% |
| Gross margin | 34.8% | 31.8% | +3.0 percentage points |
| Income from operations | $131.3 million | $53.0 million | +147.6% |
| Operating margin | 5.4% | 2.5% | +2.9 percentage points |
| Income before taxes | $30.2 million | $8.6 million | +252.5% |
| Net income | $2.2 million | $5.4 million | Down $3.2 million |
| Diluted EPS | $0.07 | $0.13 | Down $0.06 |
| Adjusted net income | $89.2 million | $51.8 million | +72.2% |
| Comparable brand revenue growth | 6% | (7%) | Improved 13 points |
Revenue growth included a 53rd week, approximately $61.1 million of additional outlet and warehouse sales, $21.4 million of additional recognized membership revenue, and a larger contribution from Waterworks. Outlet and warehouse sales represented 2.9 percentage points of consolidated revenue growth and negatively affected margins because of increased discounts and inventory liquidation.
Gross-margin improvement reflected distribution-center savings, reverse-logistics efficiencies, lower RH Modern-related costs, reduced inventory-rationalization impact, and operating leverage. Reported results also included product recall costs, distribution-center closure costs, and other unusual items.
Cash Flow, Liquidity and Capital Structure
- Operating cash flow was $555.1 million, compared with $78.8 million in fiscal 2016.
- Management reported approximately $433 million of free cash flow for fiscal 2017.
- Capital expenditures were $112.5 million, with an additional $14.4 million deposited for future Gallery construction.
- Cash and cash equivalents declined to $17.9 million from $87.0 million, primarily because of share repurchases and debt-related financing activity.
- Total debt, including current portions and net debt discounts, was $923.9 million, compared with $581.3 million at the prior year-end.
- Debt included $350 million of 0.00% convertible notes due June 2019, $300 million of 0.00% convertible notes due July 2020, $200.0 million outstanding under the asset-based credit facility, and $80.0 million under the LILO term loan.
- Revolving-credit availability was $186.4 million net of letters of credit, but estimated incremental borrowing capacity was approximately $136.4 million after the fixed-charge coverage restriction.
- RH completed approximately $1.0 billion of share repurchases, or approximately 20.2 million shares, during fiscal 2017. Outstanding shares declined substantially, and stockholders’ equity ended with a deficit of $7.3 million.
- Management stated that expected operating cash flow and available financing were sufficient for near-term needs, while noting the need to fund or refinance the $650 million of convertible notes at maturity.
Material Changes Versus the Prior Comparable Period
- Revenue growth accelerated from 1.2% in fiscal 2016 to 14.3% in fiscal 2017, while comparable brand revenue moved from a 7% decline to 6% growth.
- RH consolidated two furniture distribution centers, eliminated approximately 1.75 million square feet of distribution capacity, and expects annual savings exceeding $20 million.
- RH opened Design Galleries in Toronto and West Palm with integrated hospitality offerings and closed or consolidated several legacy locations.
- Waterworks revenue increased to $120.8 million from $74.8 million, although Waterworks remained loss-making at the operating-income level.
- RH recorded a $33.7 million goodwill impairment for Waterworks, reducing remaining Waterworks goodwill to $17.4 million.
- RH recorded $4.9 million of debt-extinguishment loss after repaying a $100 million second-lien term loan.
- Inventory declined by approximately $220.8 million, reflecting SKU rationalization, outlet liquidation and the distribution-center redesign.
- Reported net income remained low because of higher interest expense, the Waterworks impairment, non-cash compensation, tax reform effects and other unusual items.
Guidance, Outlook and Management Commentary
- Management expected approximately four new Galleries in fiscal 2018, including locations in Portland, Nashville, New York and Yountville.
- Beginning in 2019, management expected to increase the Gallery-opening cadence from three to five locations annually to approximately five to seven locations annually, supported by a smaller and more capital-efficient prototype.
- Fiscal 2018 gross capital expenditures were expected to be approximately $100 million to $110 million, partially offset by approximately $25 million of anticipated asset-sale proceeds.
- Management expected continued free-cash-flow generation, margin expansion from supply-chain and inventory initiatives, and a return to broader product and business expansion in 2019.
- Management described the membership model, distribution redesign, reverse logistics, home delivery improvements, hospitality offerings and real-estate transformation as key long-term growth and margin initiatives.
Risks, Contingencies and Unusual Items
- Luxury consumer spending and high-end housing activity are sensitive to economic conditions, stock-market volatility, interest rates, tax policy and regional conditions such as energy prices.
- Tariffs, trade restrictions, foreign sourcing, shipping disruptions, vendor capacity and currency movements could increase product costs or reduce availability.
- Waterworks underperformed its plans and may require additional impairment charges if operating results do not improve.
- Product recalls affected fiscal 2017 results by $7.7 million before tax, including a $3.2 million revenue reduction and $4.3 million of incremental costs and inventory charges.
- RH faces substantial lease and contractual commitments. Total minimum lease commitments were approximately $1.473 billion, and merchandise purchase commitments were approximately $339.6 million.
- A securities class action related to RH Modern was allowed to proceed to discovery after the court denied RH’s motion to dismiss in February 2018. The filing states that the company believes the claims lack merit.
- The Tax Cuts and Jobs Act resulted in approximately $7.0 million of fiscal 2017 tax expense, including a provisional $6.0 million deferred-tax remeasurement and a $1.0 million transition-tax charge. The accounting was subject to further guidance and finalization.
- Future adoption of lease accounting standards was expected to significantly affect the balance sheet because of RH’s substantial lease portfolio.
- RH reported effective disclosure controls and internal control over financial reporting as of February 3, 2018, and received an unqualified audit opinion from PricewaterhouseCoopers LLP.
Important Facts for Investors to Verify
- Confirm the intended reporting period, because the supplied filing is fiscal 2017 rather than 2016 Q4.
- Reconcile reported net income of $2.2 million with adjusted net income of $89.2 million and review every adjustment excluded from the non-GAAP measure.
- Assess whether operating cash flow remains strong after the benefit from the $220.8 million inventory reduction is normalized.
- Review the liquidity plan for the $350 million 2019 convertible notes and $300 million 2020 convertible notes, including potential cash settlement and dilution.
- Evaluate Waterworks’ operating performance, goodwill impairment assumptions and remaining goodwill balance.
- Test whether projected Gallery openings, hospitality offerings and the proposed five-to-seven-location annual cadence are achievable within the stated capital budget.
- Monitor inventory liquidation, outlet discounting, product recalls, tariffs and supply-chain changes for effects on gross margin.
- Review the RH Modern securities litigation, other legal contingencies and the company’s required lease and purchase commitments.