RH Form 10-Q Summary
Reporting period: Quarterly period ended July 30, 2016, with comparisons to August 1, 2015. The request metadata identifies “2015 Q2,” but the supplied filing is RH’s fiscal 2016 second-quarter Form 10-Q, filed September 8, 2016.
Business Context
Restoration Hardware Holdings, Inc. is a luxury home furnishings retailer selling through galleries, outlets, catalogs, websites and commercial channels. As of July 30, 2016, RH operated 84 retail stores, 23 outlet stores and sourcing operations in Shanghai and Hong Kong. On May 27, 2016, RH acquired more than 90% of Waterworks, a luxury bath and kitchen business, for approximately $119.9 million.
Financial Metrics
| Metric | Three Months Ended July 30, 2016 | Three Months Ended August 1, 2015 | Six Months Ended July 30, 2016 | Six Months Ended August 1, 2015 |
|---|---|---|---|---|
| Net revenues | $543.4 million | $506.9 million | $998.8 million | $929.4 million |
| Gross profit | $179.8 million | $194.3 million | $307.3 million | $337.7 million |
| Gross margin | 33.1% | 38.3% | 30.8% | 36.3% |
| Income from operations | $22.0 million | $56.4 million | $10.5 million | $73.5 million |
| Net income (loss) | $6.9 million | $29.9 million | $(6.6) million | $37.1 million |
| Diluted EPS | $0.17 | $0.71 | $(0.16) | $0.88 |
- Second-quarter revenue increased 7.2%; six-month revenue increased 7.5%.
- Stores revenue increased 15.4% in the quarter and 17.1% year to date, while direct revenue declined 2.1% and 3.0%, respectively.
- Comparable brand revenue declined 3% in the quarter; the filing reports no comparable brand growth for the six-month period.
- Waterworks contributed $20.8 million of revenue after the acquisition date.
- SG&A increased 14.5% in the quarter and 12.3% year to date. Reported SG&A included acquisition-related costs, reorganization costs and a one-time $3.7 million Waterworks option grant.
- Interest expense increased to $10.9 million in the quarter and $21.4 million year to date, primarily due to convertible-note discount amortization and build-to-suit lease interest.
Cash Flow, Liquidity and Debt
- Six-month operating cash flow was negative $91.6 million, compared with positive $13.6 million in the prior-year period. Working-capital uses included a $48.7 million inventory increase and an $81.4 million reduction in accounts payable and accrued liabilities.
- Investing cash flow was negative $218.5 million, including $116.1 million for the Waterworks acquisition, $71.0 million of capital expenditures and net purchases of investments.
- Cash and cash equivalents declined to $37.7 million from $349.9 million at January 30, 2016. Short-term and long-term investments totaled $180.0 million, producing approximately $217.7 million of cash and investments.
- Capital expenditures were $71.0 million for the first six months. Management expects fiscal 2016 gross capital expenditures of approximately $180 million to $210 million.
- Convertible senior notes had principal amounts of $350 million due 2019 and $300 million due 2020. Balance-sheet carrying values were $305.0 million and $227.9 million, respectively.
- The revolving credit facility had no borrowings, $586.2 million of undrawn availability and $13.8 million of outstanding letters of credit. RH was in compliance with its covenants.
- Management believes expected operating cash flow, financing availability and the revolving facility will satisfy working-capital and capital-expenditure needs for the next 12 to 24 months.
Material Changes and Management Commentary
- Profitability deteriorated despite revenue growth. Six-month operating margin fell to 1.1% from 7.9%, and the company recorded a six-month net loss.
- Margins were pressured by markdowns and outlet-channel inventory reductions, the higher discount rate under the RH Members Program, higher shipping and occupancy costs, and customer accommodations related to RH Modern production delays.
- Management estimated that customer accommodations and related investments associated with RH Modern production delays reduced six-month revenue by approximately $16 million.
- The RH Members Program, introduced in March 2016 for a $100 annual fee, is intended to replace reliance on promotional events. Membership revenue is recognized over the membership period, and management noted longer selling cycles and near-term margin pressure.
- Management expects to open four next-generation Design Galleries in fiscal 2016, including locations in Austin, Las Vegas and Seattle; the Leawood, Kansas location opened in August 2016.
- A June 2016 reorganization reduced personnel. Total expected reorganization charges were approximately $6.1 million, with completion expected during the third fiscal quarter.
Risks, Contingencies and Unusual Items
- Management cited weakness in luxury consumer spending, underperformance in energy- and oil-related markets and currency-affected markets as ongoing headwinds.
- The Waterworks acquisition creates integration, execution, cost and management-attention risks, and expected benefits may not be realized promptly.
- The acquisition generated $3.4 million of inventory fair-value step-up amortization in the quarter and $3.7 million of non-cash compensation from fully vested options.
- The filing discusses litigation related to alleged collection of customer ZIP codes. The judgment remains enforceable while an appeal is pending; the company has recorded a liability but states that additional losses could exceed accrued amounts.
- RH states that no material off-balance-sheet arrangements existed at July 30, 2016 and that no material changes occurred to previously disclosed risk factors.
- The company is evaluating several new accounting standards, including revenue recognition, leases and financial instruments. The new lease standard is expected to significantly affect the financial statements because of RH’s substantial lease portfolio.
Facts Investors Should Verify
- Whether revenue and comparable sales improve after the RH Members Program transition and the Fall Source Book mailing.
- Whether gross-margin compression from markdowns, discounts, shipping, customer accommodations and occupancy costs reverses.
- Waterworks integration progress, contribution to revenue and profitability, and any additional acquisition-related costs.
- Cash-generation trends, inventory levels, accounts payable timing and funding of the planned $180 million to $210 million fiscal 2016 capital program.
- Liquidity relative to the 2019 and 2020 convertible-note maturities and potential conversion or dilution from related warrants.
- Final costs and operational effects of the reorganization, RH Modern production issues and the pending ZIP-code litigation.