RH Form 10-K Summary
Business context and reporting period
This filing is RH’s annual report for the 52-week fiscal year ended January 28, 2017, referred to as fiscal 2016. The request metadata identifies “2015 Q4,” but the filing is not a 2015 quarterly report; it covers fiscal 2016 and compares primarily with the 52-week fiscal year ended January 30, 2016.
RH is a luxury home furnishings retailer operating Galleries, outlet stores, Source Books, websites, phone orders, and Trade and Contract channels. As of January 28, 2017, RH operated 85 retail Galleries, including 15 Waterworks showrooms, and 28 outlet stores. RH acquired a controlling interest in Waterworks on May 27, 2016 for approximately $119.9 million and owned more than 90% of the business after the transaction.
Financial performance and key metrics
| Metric | Fiscal 2016 | Fiscal 2015 | Change |
|---|---|---|---|
| Net revenue | $2,134.9 million | $2,109.0 million | Up 1.2% |
| Gross profit | $679.8 million | $752.7 million | Down 9.7% |
| Gross margin | 31.8% | 35.7% | Down 390 basis points |
| SG&A expense | $626.8 million | $567.1 million | Up 10.5% |
| Operating income | $53.0 million | $185.6 million | Down 71.4% |
| Operating margin | 2.5% | 8.8% | Down 630 basis points |
| Net income | $5.4 million | $91.1 million | Down 94.1% |
| Diluted EPS | $0.13 | $2.16 | Down $2.03 |
| Adjusted net income | $51.8 million | $114.8 million | Down 54.9% |
| Net cash from operations | $78.8 million | $126.7 million | Down 37.8% |
| Capital expenditures | $157.6 million | $133.5 million | Up 18.1% |
Stores generated $1,178.9 million of revenue, up 8.8%, while direct revenue declined 6.8% to $956.0 million. Comparable brand revenue declined 7%. Waterworks contributed $74.8 million of revenue and reported a $12.9 million operating loss for the post-acquisition period.
At year-end, cash and cash equivalents were $87.0 million, short-term and long-term investments totaled $175.9 million, and working capital was $722.4 million. Total debt, including current portions and other debt obligations, was $581.3 million. This included $350 million principal amount of 0.00% convertible notes due 2019 and $300 million principal amount of 0.00% convertible notes due 2020. No amounts were outstanding under the revolving credit facility, which had $535.2 million of undrawn availability and $14.4 million of outstanding letters of credit.
Material changes versus the prior comparable period
- Revenue growth slowed sharply from 13% in fiscal 2015 to 1% in fiscal 2016, while comparable brand revenue shifted from 11% growth to a 7% decline.
- Direct revenue declined following the decision to move the annual Source Book mailing from spring to fall; the fall mailing was not completed until mid-December.
- Margins declined because of higher membership-program discounts, inventory markdowns and SKU rationalization, RH Modern customer accommodations and expedited shipping, higher shipping costs, and occupancy deleverage.
- RH launched the RH Members Program, replacing much of the prior event-driven promotional model. Membership fees are recognized ratably over one year, creating a short-term timing effect on revenue and margins.
- RH acquired Waterworks, adding 15 showrooms and approximately $74.8 million of revenue, but the segment produced an operating loss and included acquisition-related non-cash charges.
- SG&A increased due to Waterworks, employment costs, technology infrastructure depreciation, professional fees, reorganization costs, impairments, and other unusual items. Advertising expense declined to $79.8 million from $107.7 million because of the Source Book timing change.
- Cash declined by $244.4 million, principally because of capital expenditures, the Waterworks acquisition, investment purchases, and construction-related deposits.
- RH expanded its retail footprint from 69 to 85 retail locations, but retail sales per leased selling square foot declined to $1,271 from $1,463, reflecting the larger and newer store base.
Guidance, outlook, commentary, risks, and unusual items
Management stated that it expects fiscal 2017 to benefit from anniversarying RH Modern launch costs, additional membership revenue and renewals, the Source Book strategy, incremental revenue from new Design Galleries, and hospitality initiatives. RH lowered its planned new-Gallery opening cadence to three to five locations per year to improve capital discipline and reduce execution risk.
Management expects fiscal 2017 gross capital expenditures of approximately $140 million to $160 million, partially offset by approximately $15 million to $25 million of expected asset-sale proceeds. RH also intends to invest in a new integrated back-end operating platform covering supply chain, home delivery, quality systems, and company-wide data.
- Fiscal 2016 unusual items included $12.7 million of product-line impairments, $8.7 million related to the legal claim involving collection of customer ZIP codes, $6.8 million of Waterworks inventory step-up amortization, $5.7 million of reorganization costs, $4.8 million of aircraft impairment, $4.6 million related to product recalls, $3.7 million of Waterworks-related non-cash compensation, and $2.8 million of acquisition costs.
- The product recall reduced revenue by $3.4 million and reduced pretax income by $4.6 million. A recall reserve of $4.3 million remained at year-end.
- RH Contemporary Art was integrated into the broader RH platform, resulting in restructuring costs and a $3.2 million lease-loss liability.
- Two securities class actions were filed in February and March 2017 concerning alleged misstatements about the RH Modern rollout. The cases were at an early stage, and management stated that it believed the claims lacked merit.
- RH relies heavily on foreign sourcing: approximately 88% of fiscal 2016 purchase volume was sourced outside the United States, including approximately 78% from Asia. Potential tariffs, trade restrictions, transportation disruptions, vendor capacity constraints, and product-quality issues could affect margins and availability.
- Other principal risks include luxury-consumer and housing-market weakness, inventory markdowns, supply-chain and delivery execution, long-term lease commitments, cybersecurity and data privacy, product liability and recalls, litigation, acquisition integration, and the ability to fund or refinance convertible notes due in 2019 and 2020.
- On February 21, 2017, the board authorized a $300 million share repurchase program. By March 24, 2017, RH had purchased approximately 4.9 million shares for $171.5 million.
Important facts for investors to verify
- Confirm that comparisons use fiscal 2016 ended January 28, 2017, rather than the “2015 Q4” period in the request metadata.
- Reconcile the decline in comparable brand revenue, gross margin, operating income, adjusted net income, and operating cash flow with management’s stated temporary factors and ongoing initiatives.
- Assess Waterworks’ post-acquisition revenue, operating losses, integration costs, goodwill, and potential contribution to future profitability.
- Review liquidity after the fiscal 2016 cash decline, planned fiscal 2017 capital expenditures, the $278.2 million of merchandise purchase commitments, and substantial lease obligations.
- Evaluate refinancing or cash-settlement risk for the $650 million principal amount of convertible notes due in 2019 and 2020.
- Monitor the product recall reserve, ZIP-code legal claim, securities litigation, and other potential litigation exposures.
- Review the effect of Source Book timing, the RH Members Program, inventory rationalization, markdowns, and the slower Gallery opening cadence on future revenue and margins.
- Consider potential dilution from approximately 8.5 million outstanding stock options, convertible notes, and related warrant transactions.