RH quarterly report, Q3 FY2018

RH Form 10-Q Summary

Reporting period: The supplied filing is RH’s quarterly report for the three and nine months ended November 3, 2018, compared with October 28, 2017. The request metadata identifies “2017 Q3,” but the filing itself reports fiscal 2018 third-quarter results. The statements are unaudited. RH operated 86 Galleries, 37 outlet stores and 15 Waterworks showrooms as of November 3, 2018.

Financial performance and position

Metric	Three months ended Nov. 3, 2018	Year-over-year change	Nine months ended Nov. 3, 2018	Year-over-year change
Net revenue	$636.6 million	+7.4%	$1.835 billion	+3.7%
Gross profit	$254.5 million	+18.8%	$738.1 million	+25.0%
Gross margin	40.0%	+380 bps	40.2%	+680 bps
Operating income	$47.0 million	+8.9%	$186.0 million	+199.1%
Operating margin	7.4%	+10 bps	10.1%	+660 bps
Net income	$22.4 million	+70.4%	$114.5 million	From $1.9 million
Diluted EPS	$0.81	From $0.56	$4.27	From $0.06
Adjusted EBITDA	$87.9 million	+19.9%	$269.3 million	+61.9%

Stores generated $370.4 million of third-quarter revenue and direct channels generated $266.1 million. Comparable brand revenue growth was 4% in the quarter and 3% for the nine-month period.
Furniture revenue increased to $418.9 million in the quarter, while non-furniture revenue was $217.7 million. Waterworks revenue increased 10.0% in the quarter and 8.3% year to date.
Third-quarter SG&A was $207.5 million, or 32.6% of revenue, compared with 28.9% in the prior-year quarter. The increase included higher advertising, preopening, reorganization and lease-related costs.
Cash flow from operations was $127.6 million for the nine months, compared with $390.1 million in the prior-year period. The decline primarily reflected inventory and prepaid-asset increases and the prior-year benefit from inventory reductions.
Capital expenditures were $104.4 million for the nine months. Investing cash flow was negative $104.4 million, and financing cash flow was negative $39.6 million.
Cash and cash equivalents were $7.8 million at November 3, 2018; cash plus restricted cash equivalents was $8.7 million. Inventory was $566.1 million, up from $527.0 million at fiscal year-end.
Total assets were $1.843 billion and stockholders’ equity was $32.0 million, compared with a $7.3 million deficit at February 3, 2018.

Debt, liquidity and capital allocation

RH had $985 million of convertible notes outstanding: $350 million due June 2019, $300 million due July 2020 and $335 million due June 2023. The notes carry a 0.00% stated interest rate, although non-cash debt-discount amortization contributed $29.7 million of interest expense in the first nine months.
The asset-based revolving facility had $107.5 million outstanding and $359.1 million of availability, net of $12.8 million of letters of credit. The facility matures June 28, 2022, and RH was in compliance with its covenants.
Management reported approximately $987 million of net debt, excluding build-to-suit lease obligations, and trailing-twelve-month net debt to adjusted EBITDA of 2.7x, down from 5.1x at the end of the second quarter of fiscal 2017.
RH issued $335 million of 2023 convertible notes in June 2018 and received $287.8 million of net cash proceeds after discounts, offering costs, convertible-note hedges and warrants.
RH repurchased approximately 1.2 million shares for $145.2 million during the quarter under a new $700 million authorization; $554.8 million remained available at quarter-end.

Material changes versus the prior comparable period

Revenue growth accelerated in the third quarter, while year-to-date growth remained modest because prior-year outlet promotions and inventory liquidation had elevated comparisons.
Gross margin expanded materially due to improved merchandise margins, reduced SKU-rationalization impacts, occupancy leverage and better outlet margins, partly offset by higher delivery costs.
Net income and adjusted EBITDA benefited from stronger operating performance, lower stock-based compensation expense than in the prior year and the absence of the prior-year $4.9 million debt-extinguishment loss.
Operating cash flow declined substantially because the prior-year period benefited from a $190.6 million inventory reduction, while 2018 absorbed $39.8 million of inventory investment and $52.3 million of prepaid and other asset increases.
RH adopted ASC Topic 606 on February 4, 2018 using the modified retrospective method, reducing opening retained earnings by $21.0 million. The adoption accelerated Source Book expense recognition and changed the timing of membership, gift-card and shipment-related revenue recognition.
Management revised prior balance-sheet presentations to correct a $19.5 million misclassification between treasury stock and additional paid-in capital. The filing states that income and cash flows were unaffected and that the error was not material to prior financial statements.

Guidance, outlook, risks and unusual items

Management expected fiscal 2018 gross capital expenditures of approximately $125 million to $135 million, partially offset by approximately $50 million of asset-sale proceeds. Nine-month capital expenditures were $104.4 million.
Management expects operating cash flow, convertible-note proceeds, revolving-credit availability and other financing sources to fund working capital, capital expenditures and other needs for the next 12 months. It also expects to repay the convertible notes in cash at maturity to minimize dilution, but acknowledged that additional liquidity or refinancing may be required.
Strategic priorities include converting legacy stores to Design Galleries, expanding product and interior-design offerings, developing RH Hospitality, redesigning the supply chain and delivery network, improving margins and pursuing capital-light real estate structures.
Third-quarter unusual charges included $7.6 million of reorganization costs, $3.4 million of RH Contemporary Art lease-loss remeasurement, $3.9 million of distribution-center closure costs and $4.0 million of product-recall-related costs. The nine-month period also included a $5.3 million favorable legal settlement and $0.9 million of debt-extinguishment losses.
Key risks include the June 2019 cash or conversion obligation, high lease and other contractual commitments, dependence on foreign sourcing, China tariffs and freight disruption, product recalls, litigation, execution of Gallery and supply-chain initiatives, high-end consumer and housing-market weakness, and future lease-accounting changes expected to significantly affect the financial statements.
A securities class action was certified in October 2018 and is in discovery; RH appealed the class-certification order. A related shareholder derivative action was consolidated, and RH filed motions to stay and dismiss.
On November 23, 2018, RH amended its credit agreement to clarify insurance-proceeds provisions and permit up to $3 million of annual restricted payments for specified ordinary-course obligations.

Investor verification points

Verify the company’s ability to fund or refinance the $350 million 2019 convertible-note maturity and subsequent $300 million 2020 maturity without materially increasing leverage or issuing equity.
Reconcile GAAP earnings with adjusted net income and adjusted EBITDA, particularly debt-discount amortization, reorganization costs, recalls, lease losses and other excluded items.
Monitor whether gross-margin expansion persists after excluding recall, distribution-center and other unusual items, and whether SG&A growth moderates.
Assess inventory growth, working-capital consumption and the sustainability of operating cash flow after the prior year’s inventory liquidation benefit.
Track China tariffs, sourcing shifts, freight congestion and their effects on product costs, pricing and demand.
Review developments in the securities and derivative litigation, product recalls and related reserves.
Evaluate execution, capital requirements and returns from Design Galleries, RH Hospitality, interior design, supply-chain redesign and capital-light real estate initiatives.