RH Reports Record Second Quarter Fiscal 2018 Results
Sep. 04, 2018
CORTE MADERA, Calif.--(BUSINESS WIRE)--Sep 4, 2018--RH (NYSE: RH) today announced second quarter fiscal 2018 results and Chairman & Chief Executive Officer, Gary Friedman, provided an update on the Company’s continued evolution and outlook.
RH Leadership will host a Q&A conference call at 2:00 p.m. PT (5:00 p.m. ET) today.
SECOND QUARTER HIGHLIGHTS
Q2 GAAP DILUTED EPS $2.33 vs. ($0.28) LY Q2 ADJUSTED DILUTED EPS $2.49 vs. $0.65 LY
Q2 GAAP NET INCOME $64.0M vs. ($7.9M) LY Q2 ADJUSTED NET INCOME $67.4M vs. $19.7M LY
Q2 GAAP OPERATING MARGIN 13.3% vs. 2.0% LY Q2 ADJUSTED OPERATING MARGIN 12.3% vs. 6.4% LY
Q2 COMPARABLE BRAND REVENUE +5% vs. +7% LY
Q2 GAAP NET REVENUES +4% vs. +13% LY Q2 ADJUSTED NET REVENUES +4% vs. +14% LY
COMPANY RAISES Q3, Q4 and FY18 EARNINGS GUIDANCE
Note: Please see the tables below for a reconciliation of all GAAP to non-GAAP measures referenced in this press release.
To Our People, Partners, and Shareholders,
Our record second quarter results demonstrate our commitment to earnings growth, the emerging power of our new business model, and our continued success revolutionizing physical retailing. Based on our strong second quarter performance and current trends, we are raising our fiscal 2018 earnings guidance for a third time.
As articulated since the beginning of the year, we continue to manage the business with a bias for earnings versus revenue growth. We will restrain ourselves from chasing low quality sales at the expense of profitability, and instead focus on optimizing our new business model while building an operating platform that will enable us to compete and win over the long-term.
It is clear that prioritizing earnings versus revenues this past year made it possible for us to see opportunities throughout our business that would have otherwise gone unnoticed. We now believe that our target of achieving low to mid-teens adjusted operating margins, and return on invested capital (ROIC) in excess of 30% by 2021 will happen sooner rather than later, as the earnings power of our new model is proving to be greater than previously anticipated and will be further amplified when we pivot back to growth in fiscal 2019.
In my 40 plus years in the retail industry spanning three leading platforms, I can honestly say I’ve never seen an organization as clear and focused on optimizing a business as RH is today. I could not be more proud of our team for driving these industry leading results, and remain confident that our path towards building the most profitable and capital efficient model in our industry will prove to be the right one for our people, partners, and shareholders.
Turning to our second quarter results, we achieved record GAAP gross margins of 42.4% in the second quarter, increasing 900 basis points versus a year ago, while adjusted gross margins increased 800 basis points to 42.1% compared to 34.1% last year. Our results reflect strong full price selling, lower outlet revenues, and a more streamlined distribution and reverse logistics network.
Second quarter GAAP operating margins reached a record 13.3%, and adjusted operating margins reached a record 12.3% versus 6.4% a year ago despite approximately 150 basis points of higher advertising costs due to the new accounting rule that requires catalog costs to be expensed in the quarter the books are distributed, versus the previous standard of amortizing the costs over the life of the book. As a reminder, this accounting change will also negatively impact the third quarter adjusted operating margins by approximately 200 basis points, while benefiting the fourth quarter by approximately 300 basis points. For the year, we expect advertising expense to be slightly down as a percentage of revenues compared to fiscal 2017.
GAAP diluted earnings per share reached a record $2.33 in the second quarter compared to a loss of $0.28 per share last year, and adjusted diluted earnings per share also reached a record $2.49 in the second quarter versus $0.65 per share a year ago.
GAAP and adjusted diluted earnings per share includes a $0.44 per share net benefit comprised of a $0.51 tax benefit from associate option exercises following the sharp increase in our share price, offset by $0.02 per share of payroll taxes on the option exercises, and $0.05 per share from a higher diluted share count due to the higher average share price in the quarter. There was also a positive balance sheet cash benefit from the option exercises of $18 million in the quarter.
Excluding the $0.44 per share net benefit, adjusted diluted earnings per share reached $2.05 in the second quarter, widely exceeding our guidance of $1.70 to $1.77, and more than three times last year despite lower than expected revenues, highlighting the earnings power of our new operating platform.
We generated over $25 million of free cash flow in the quarter, and reduced our ratio of net debt to trailing twelve months adjusted EBITDA from over 5 times at the end the second quarter of fiscal 2017 to 2.4 times at the end of the second quarter of fiscal 2018. We expect to generate free cash flow in excess of $260 million for the year, further reducing our ratio of net debt to trailing twelve months adjusted EBITDA to approximately 1.5 times by year end.
Comparable brand revenues increased 5% in the second quarter, despite a 3 point drag from last year’s inventory reduction efforts and on top of a 7% increase last year. Adjusted for last year’s inventory reduction efforts, comparable brand revenues increased 8% in the second quarter of fiscal 2018.
GAAP and adjusted net revenues increased 4% in the second quarter, accelerating nearly 5 points from the first quarter, reaching $643 million versus $619 million last year. Net of the 3 point negative drag from higher outlet sales and 3 point drag from SKU rationalization last year, adjusted net revenues increased 10% in the second quarter fiscal 2018.
Looking forward, we expect the revenue drag from SKU rationalization to be 2.5% in the third quarter and 1.5% in the fourth quarter.
While I would like to see our revenue forecasting accuracy improve, and believe it will in the second half of the year, it’s hard to be precise given the inventory optimization efforts last year, and even harder to be disappointed when the organization has been focused on operational redesign and earnings growth resulting in adjusted gross margins up 800 basis points, adjusted operating margins up almost 600 basis points, inventories down 9%, and adjusted diluted earnings per share up more than 3 times versus a year ago.
Raising Fiscal 2018 Earnings Guidance and Increasing Long-Term Targets
As a result of our strong second quarter earnings, we are raising our fiscal 2018 adjusted diluted earnings per share guidance for a third time. We are now expecting adjusted diluted earnings per share for the year to be in the range of $7.35 to $7.75 up 15% from our previous guidance of $6.34 to $6.83, while slightly lowering revenue guidance by approximately 2% as we continue to prioritize earnings over revenue growth and focus on optimizing the profitability of our new operating model.
As part of raising our full year guidance, we are also raising our third and fourth quarter adjusted diluted earnings per share guidance. We are now expecting adjusted diluted earnings per share for the third quarter to be in the range of $1.15 to $1.33, up from $1.04 to $1.23, and adjusted diluted earnings per share for the fourth quarter to be in the range of $2.33 to $2.54, up from $2.16 to $2.39.
Due to the earnings power of our new operating model, we are also updating our previous long-term targets. We are moving forward our expectations for adjusted operating margins in the low-to-mid teens, and ROIC in excess of 30% by 2021, a full year to 2020.
We continue to see a clear path to $4 to $5 billion in North American revenues, as well as a significant international opportunity that could lead to RH becoming a $7 to $10 billion dollar global brand.
Our long-term targets remain revenue growth of 8% to 12% and earnings growth of 15% to 20% annually.
Our detailed updated guidance for fiscal 2018 and the third and fourth quarters are provided in a table with our financial results attached to this letter.
2018 - A Continued Focus on Execution, Architecture and Cash
As communicated, we will continue to focus on optimizing our new business model, architecting a new operating platform and driving significant cash flow by increasing revenues and earnings, while decreasing inventory and capital spending in 2018.
We expect revenue growth to accelerate in the second half as the drag from last year’s inventory reduction efforts begins to lessen, and we benefit from the second contact of the RH Interiors and RH Modern Source Books that arrive in homes early September through early November.
While most in our industry are closing or downsizing stores, we remain committed to our quest of revolutionizing physical retailing. Our progress in fiscal 2018 includes opening RH Portland and RH Nashville in the first half of the year, and the upcoming openings of two very unique and diverse retail experiences, RH New York, opening on September 7th, and RH Yountville, opening on September 23rd.
We continue to be pleased with the performance of our new Galleries, and RH Portland and Nashville are no exception. RH Nashville is the fourth new Gallery with our integrated hospitality experience and the early hospitality results are exceeding the first year performance of RH Chicago.
RH President of Hospitality Brendan Sodikoff and his team are demonstrating we can execute a profitable high quality food and beverage experience across multiple markets while driving traffic into our Galleries that result in incremental revenues in our core business. With three of our four restaurants trending to generate $5 million to $6 million annually, and our fourth at approximately $4 million, we believe RH Hospitality is now a proven scalable business, and we plan to increase the number of new Galleries with integrated restaurants, wine vaults, and barista bars going forward. Additionally, we continue to believe strongly in the prospects for our first RH Guesthouse, opening summer of 2019 in New York, just steps from our new Gallery.
With a contemporary steel and glass structure rising up five floors through the original historic brick facade, RH New York, the Gallery in the Historic Meatpacking District is an architectural masterpiece designed by Jim Gillam, of the award winning firm Backen, Gilliam, and Kroger. Located on what is becoming one of the most iconic corners in the city, the approximate 90,000 gross square feet of indoor and outdoor space is connected by a soaring central atrium with stacked cast iron columns, a grand staircase that features the art installation “New York Night” by Los Angeles-based artist and designer Alison Berger, and a glass elevator that transports customers up to a rooftop restaurant with retractable doors opening onto a beautiful landscaped park with all-day sunshine and incredible views of downtown and Freedom Tower. The Gallery also features a Barista Bar & Outdoor Wine Terrace, full floors of RH Interiors, Modern, Outdoor, Baby & Child and Teen, plus RH Interior Design Offices supporting our onsite team, and an expansive Design Atelier with private presentation rooms for our clients.
RH New York provides us the rare opportunity, to create what we believe will be the most innovative new retail experience in the world, in arguably the most important city in the world. I’m sure most of you noticed our wrap of the Sunday New York Times this past weekend announcing the public opening September 7th, and many of you received invitations to our opening party September 5th, or to our Investor Event and cocktail party September 6th post our 3:15 pm presentation at the Goldman Sachs Global Retailing Conference. I would encourage you to join us at one of the events or at our opening on Friday September 7th at 11am, to see why, as we articulated on the cover of the Sunday New York Times that, “The Death of Retail. Is Overrated.”
RH Yountville, opening September 23rd, will be an integrated compound of food, wine, art and design. Reflective of the local culture, and intended to engage the global luxury clientele who visit and vacation in the Napa Valley, RH Yountville includes the Historic Ma(i)sonry building, which has been transformed into a dramatic two story stone wine vault with outdoor trellis covered living rooms that can be reserved for wine tastings from some of the Valley’s rare and hard to acquire wines. We are finishing construction of three new pavilions on the property, including an indoor - outdoor restaurant with a glass roof and retractable steel and glass doors where you will dine under heritage olive trees while listening to the sound of trickling water from dramatic central fountains. The pavilions will be connected by lush garden courtyards with outdoor fireplaces and walking paths of crushed granite and bluestone pavers. RH Yountville will be a unique and immersive experience, one that will serve to position RH as a taste and style leader in our industry.
RH President, Chief Operating, Service and Values Officer DeMonty Price and his team continue to lead a movement within the Company to build an operating platform and customer culture that will leapfrog us far beyond the customer experience and operating results that currently define our industry. They are shifting the focus from orders to customers, and from deliveries to delight, infusing their teams with an energy and passion that is echoing throughout our Company and into the homes of our customers.
Their work in home delivery includes a complete redesign of the network which will significantly increase the time product remains in its original packaging, reducing returns and damages, and doubling the productivity of our delivery teams.
We have also redesigned our call center network, closing a call center in Dallas, and opening a new Customer Delight Center at our headquarters in Corte Madera, CA ensuring the voice of the customer rings through the corridors of our corporate campus daily.
We expect our work architecting a new operating platform, inclusive of our distribution center network redesign, the redesign of our reverse logistics and outlet business, and the reconceptualization of our home delivery and customer experience, will drive lower costs and inventory levels, and higher earnings and inventory turns throughout the balance of fiscal 2018. Looking forward, we expect this multi-year effort to result in a dramatically improved customer experience, continued margin enhancement and significant cost savings over the next several years.
Regarding our balance sheet and leverage ratios, we continue to expect future cash flows will be adequate to repay the outstanding principal of our $350 million June 2019 and $300 million June 2020 zero coupon convertible notes at maturity. As a reminder, we purchased a bond hedge that is designed to protect us against dilution on the 2019 notes up to $171.98 per share, and up to $189.00 per share for the 2020 notes.
The strength of our business and the reduction in leverage we have achieved during the past four quarters has put us in a strong position to take advantage of the positive conditions in the capital markets.
As such, we executed our third zero coupon convertible notes offering in the second quarter of this year, raising $335 million in notes convertible at $193.65 per share, a 25% premium to our stock price of $154.92, the stock price at the time of the pricing of the financing. We also purchased a corresponding bond hedge to protect against dilution up to $309.84 per share. We used the recent notes offering proceeds net of the bond hedge to pay down interest bearing debt on our balance sheet, reducing interest expense for the year.
We continue to have multiple financing alternatives available to us on favorable terms that could further fortify our balance sheet providing us with additional financial flexibility at a very low cost of capital.
Looking back, had we not been opportunistic in responding to the favorable market conditions through our convertible notes financings in 2014 and 2015, we would not have been in a position to repurchase $1 billion of our stock when it was undervalued last year, which has proven to be an excellent allocation of capital for the benefit of our shareholders. We are regularly evaluating various low interest rate financing alternatives and expect to follow the same opportunistic capital allocation approach in the future regarding both sources and uses of capital.
As we did in fiscal 2017, we will once again hold ourselves back from adding new businesses in fiscal 2018 outside of ongoing investments in RH Hospitality as we remain focused on optimizing the profitability of our new operating platform.
It remains clear to us as we witness the failures of high growth - no profit, online pure plays and the declining operating margins of traditional retailers who are driving an unnatural shift online, that the complexities and costs of scaling a furniture business will favor those who control their brand from concept to customer, offer an immersive and inspiring physical and digital experience, and have a superior logistics network that extends the brand into the customer’s home. The road of endless promotions, free shipping, and a shrinking store base is resulting in broken and unsustainable retail models. We prefer the road less traveled by, and like Robert Frost, believe it will make all the difference.
As in past economic cycles where growth without profitability has been rewarded, when consumer markets tighten, so do capital markets, resulting in a scramble to survive, and the corresponding opportunity for those with strong brands and superior business models to thrive. While none of us has an ability to predict exactly where we are in the current economic cycle, we do have an ability to build a brand and business that should enable us to disrupt and dominate regardless of cycle time, consumer markets, capital markets, trade wars, or tweets.
2019 - A Pivot to High Quality, Sustainable Growth
Our plan is to pivot back to high quality, sustainable growth in fiscal 2019 as we return to our product and brand expansion strategy, which has been on hold as we focused on our move to membership and the architecture of our new operating platform. We have several new brand extension plans in our development pipeline, such as RH Beach House, and RH Color, launching in 2019. Additionally, we plan to expand our assortments in key categories, and accelerate the introduction of new collections as we pivot back to growth next year.
We plan to increase our investment in RH Interior Design with a goal of building the leading Interior Design Firm in North America. We believe there is a significant revenue opportunity by offering world class design and installation services as we move the brand beyond creating and selling products to conceptualizing and selling spaces. You will notice the expanded presence of RH Interior Design in our RH Interiors and RH Modern Source Books, and our IMAGINE advertising campaign in many of the leading shelter magazines.
Regarding our ongoing quest to revolutionize physical retailing and the evolving nature of our real estate transformation, we have developed a new multi-tier market approach that we believe will optimize both market share and return on invested capital.
First, we have developed a new RH prototype Design Gallery that will enable us to more quickly place our disruptive product assortment and immersive retail experience into the market. The new prototype is based on key learnings from our recent Gallery openings and will range in size from 33,000 square feet inclusive of our integrated hospitality experience to 29,000 square feet without. These new Galleries will represent our assortments from RH Interiors, Modern, Baby & Child, Teen and Outdoor. Due to the reduced square footage and efficient design, these new prototypes will be more capital efficient with less time and cost risk, but yield similar productivity. We anticipate these new Galleries will represent approximately two thirds of our target markets and enable us to ramp our opening cadence from 3 to 5 new Galleries per year, to a pace of 5 to 7 new Galleries per year.
Second, we are developing a Gallery tailored to secondary markets. Targeted to be 10,000 to 18,000 square feet, we believe these smaller expressions of our brand will enable us to gain share in markets currently only served by smaller competitors. We expect these Galleries to drive $10 to $15 million of revenues at a net investment of $0 to $5 million, with a payback on our invested capital of 0 to 2 years. Our plan is to test a few of these Galleries over the next several years, and if proven successful, this could lead to an increase in our long-term Gallery targets.
Third, we will continue to develop and open larger Bespoke Design Galleries in the top metropolitan markets, as we are doing in New York this year, and San Francisco in 2019. These iconic locations are highly profitable statements for our brand, and we believe create a long-term competitive advantage that will be difficult to duplicate.
Fourth, we will continue to open indigenous Bespoke Galleries in the best second home markets where the wealthy and affluent visit and vacation. These Galleries will be tailored to reflect the local culture, and be sized to the potential of each market. Examples of current and future Bespoke Galleries include the Hamptons and Palm Beach, and the Bespoke Gallery opening this year in Yountville.
Like our evolving multi-tier Gallery strategy, we have developed a multi-tier real estate strategy that is designed to significantly increase our unit level profitability and return on invested capital. Our three primary deal constructs are outlined below:
First, in many of our current projects, we are migrating from a leasing to a development model. We currently have two Galleries, Yountville and Edina, under construction using this new model, and have an additional three development projects in the pipeline. In the case of Yountville and Edina, we expect to do a sale-leaseback that should allow us to recoup all of our capital, and possibly more. In some cases we believe we may be able to pre-sell the property and structure the transaction where the capital to build the project is advanced by the buyer during construction, which could require zero upfront capital from RH.
Second, we are working on joint venture projects, where we share the upside of a development with the developer/landlord. An example of this new model, would be our future Gallery and Guesthouse in Aspen, where we are contributing the value of our lease to the development in exchange for a profits interest in the project. The developer will deliver to RH a substantially turnkey Gallery and Guesthouse, while we continue to retain a 20% and 25% profits interest in the properties. We would expect to monetize the profits interest at the time of sale of the properties during the first five years. The net result should be a minimal capital investment to operationalize the business, with the expectation for a net positive capital benefit at time of monetization of the profits interest.
Third, due to the productivity and proof of concept of our recent new Galleries, and the addition of a powerful, traffic generating hospitality experience, we are able to negotiate “capital light” leasing deals, where as much as 65% to 100% of the capital requirement would be funded by the landlord, versus 35% to 50% previously. We currently have 12 capital light deals in the development pipeline that would be scheduled to open in fiscal 2019 and beyond.
All of the above mentioned deal structures should lead to lower capital requirements, higher unit profitability, and significantly higher returns on invested capital.
Lastly, we are currently exploring opportunities for Design Galleries in the UK and Europe, and believe there is tremendous opportunity for the RH brand to expand globally.
Building a Brand with No Peer and a Customer Experience That Cannot Be Replicated Online
We do understand that the strategies we are pursuing - opening the largest specialty retail experiences in our industry while most are shrinking the size of their retail footprint or closing stores; moving from a promotional to a membership model, while others are increasing promotions, positioning their brands around price versus product; continuing to mail inspiring Source Books, while many are eliminating catalogs; and refusing to follow the herd in self-promotion on social media, instead allowing our brand to be defined by the taste, design, and quality of the products and experiences we are creating - are all in direct conflict with conventional wisdom and the plans being pursued by many in our industry.
We believe when you step back and consider: one, we are building a brand with no peer; two, we are creating a customer experience that cannot be replicated online; and three, we have total control of our brand from concept to customer, you realize what we are building is extremely rare in today’s retail landscape, and we would argue, will also prove to be equally valuable.
In closing, we are deeply grateful for all of our people and partners whose passion and persistence bring our vision and values to life each day, as we pursue our quest to become one of the most admired brands in the world.
Gary Friedman Chairman & Chief Executive Officer
1 Return on invested capital (ROIC): We define ROIC as adjusted operating income after-tax for the most recent twelve-month period, divided by the average of beginning and ending debt and equity less cash and equivalents as well as short and long-term investments for the most recent twelve-month period. ROIC is not a measure of financial performance under GAAP, and should be considered in addition to, and not as a substitute for other financial measures prepared in accordance with GAAP. Our method of determining ROIC may differ from other companies’ methods and therefore may not be comparable.
Q&A CONFERENCE CALL INFORMATION
Accompanying this release, RH leadership will host a live question and answer conference call at 2:00 p.m. PT (5:00 p.m. ET). Interested parties may access the call by dialing (866) 394-6658 (United States/Canada) or (706) 679-9188 (International). A live broadcast of the question and answer session conference call will also be available online at the Company’s investor relations website, ir.rh.com. A replay of the question and answer session conference call will be available through September 18, 2018 by dialing (855) 859-2056 or (404) 537-3406 and entering passcode 2476376, as well as on the Company’s investor relations website.
RH (NYSE: RH) is a curator of design, taste and style in the luxury lifestyle market. The Company offers collections through its retail galleries, Source Books, and online at RH.com, RH Modern.com, RHBabyandChild.com, RHTeen.com, and Waterworks.com.
NON-GAAP FINANCIAL MEASURES
To supplement its condensed consolidated financial statements, which are prepared and presented in accordance with Generally Accepted Accounting Principles (“GAAP”), the Company uses the following non-GAAP financial measures: adjusted net revenue, adjusted net income, adjusted diluted earnings per share, return on invested capital, free cash flow, adjusted operating margin, adjusted gross margin, adjusted SG&A, EBITDA and adjusted EBITDA (collectively, “non-GAAP financial measures”). We compute these measures by adjusting the applicable GAAP measures to remove the impact of certain recurring and non-recurring charges and gains and the tax effect of these adjustments. The presentation of this financial information is not intended to be considered in isolation or as a substitute for, or superior to, the financial information prepared and presented in accordance with GAAP. The Company uses these non-GAAP financial measures for financial and operational decision making and as a means to evaluate period-to-period comparisons. The Company believes that they provide useful information about operating results, enhance the overall understanding of past financial performance and future prospects, and allow for greater transparency with respect to key metrics used by management in its financial and operational decision making. The non-GAAP financial measures used by the Company in this press release may be different from the non-GAAP financial measures, including similarly titled measures, used by other companies.
For more information on the non-GAAP financial measures, please see the Reconciliation of GAAP to non-GAAP Financial Measures tables in this press release. These accompanying tables include details on the GAAP financial measures that are most directly comparable to non-GAAP financial measures and the related reconciliations between these financial measures.
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