RH Reports Record Second Quarter Fiscal 2019 Results

RH (NYSE: RH) today announced second quarter fiscal 2019 results. 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 2019 HIGHLIGHTS

Q2 GAAP NET REVENUES INCREASED +10.3% TO $706.5M
Q2 ADJUSTED NET REVENUES INCREASED +9.9% TO $706.5M

Q2 GAAP OPERATING INCOME INCREASED +27% TO $104.0M VS. $81.8M LY
Q2 ADJUSTED OPERATING INCOME INCREASED +39% TO $105.0M VS. $75.5M LY

Q2 GAAP OPERATING MARGIN INCREASED 190 BASIS POINTS TO 14.7% VS. 12.8% LY
Q2 ADJUSTED OPERATING MARGIN INCREASED 320 BASIS POINTS TO 14.9% VS. 11.7% LY

Q2 GAAP NET INCOME INCREASED +1% TO $63.8M VS. $62.9M LY
Q2 ADJUSTED NET INCOME INCREASED +31% TO $71.4M* VS. $54.5M* LY

Q2 GAAP EPS INCREASED +25% TO $2.86 VS. $2.29 LY
Q2 ADJUSTED DILUTED EPS INCREASED +59% TO $3.20* VS. $2.01* LY

Q2 FREE CASH FLOW INCREASED TO $109.2M VS. $25.2M LY
YTD Q2 FREE CASH FLOW INCREASED TO $137.9M VS. $2.5M LY

*The Company’s adjusted net income and adjusted diluted EPS benefited by $4.5M and $0.20, respectively, in the second quarter due to a change of the normalized tax rate to 21% versus the previous estimate of 26%, and the Company now expects the effective tax rate for fiscal 2019 to be 21%. The Company has normalized all periods presented using a tax rate of 21% to support comparability of growth for purposes of presenting non-GAAP adjusted earnings in order to facilitate year over year comparison of operating results on a comparable basis with historical results at a consistent tax rate across time periods. The Company has also provided reconciliation tables that update historical results to reflect these changes.

As of February 3, 2019, the Company adopted Accounting Standards Update 2016-02, Accounting Standards Update 2018-10 and Accounting Standards Update 2018-11 (together, “ASC 842”), which pertain to accounting for leases. The Company’s previous and current guidance conforms to the new policy. Under the Company’s adoption method, the Company’s financial results for prior comparative periods are presented with adjustments to reflect the impact of ASC 842. The Company has provided reconciliation tables that update historical results to reflect these changes in lease accounting standards.

Please see the tables below for reconciliations of all GAAP to non-GAAP measures referenced in this press release.

To Our People, Partners, and Shareholders,

We are pleased to report another quarter of record results, and are raising our fiscal 2019 guidance for the third time this year. We generated record GAAP revenues of $706.5 million, an increase of 10.3%, record GAAP operating margin of 14.7%, record adjusted operating margin of 14.9%, record GAAP earnings per share of $2.86, and record adjusted diluted earnings per share of $3.20, a 59% increase versus $2.01 a year ago applying a 21% normalized tax rate in both years.

We are raising our fiscal 2019 guidance for the year as follows:

* The prior guidance for this financial measure is implied by the Company’s July 29, 2019 upward revision to adjusted earnings guidance. The last actual guidance issued for this financial measure was on June 12, 2019 in connection with the Company’s first quarter earnings release, when the Company provided fiscal 2019 adjusted operating income guidance of $332.5 million to $350.5 million, adjusted operating margin guidance of 12.6% to 13.2%, and adjusted net income guidance of $206.2 million to $218.2 million.

Our focus on elevating the brand, architecting an integrated operating platform, and pivoting the Company back to growth has resulted in RH standing out as one of the few brands that is growing revenues, expanding operating margins, and driving significantly higher returns on invested capital and free cash flow. Despite achieving industry leading operating margins, we continue to demonstrate our ability to grow earnings significantly faster than revenues, illustrating the desirability of our differentiated product offering, and the emergence of RH as a luxury brand generating luxury margins.

Second quarter adjusted net revenues increased 9.9% over last year reflecting the strength of our core RH business, the performance of our new galleries, particularly RH New York, the continued expansion of RH Hospitality and planned accelerated outlet sales due to the previously mentioned closure of a 500,000 square foot distribution facility in the fourth quarter of fiscal 2018. Additionally, we experienced better than expected delivered sales in the last few weeks of the quarter as a result of shipping efficiencies and lower returns due to the recent redesign of our home delivery network.

As a reminder, embedded in our 2019 guidance there is an approximate 3 point revenue reduction as a result of editing unprofitable and non-strategic businesses, namely the elimination of the remaining holiday business (1 point), the elimination of fringe promotions (1 point), and the transition of our rug business from a single source importer to a direct sourcing model (1 point). As planned, the drag was approximately 2 points in the first quarter, 4 points in the second quarter and we expect approximately 2 points in the third quarter and 4 points in the fourth quarter. Taking into account the approximate 4 point negative drag, adjusted net revenues would have increased 13.9% in the second quarter. We expect our new rug collection to contribute to both revenue and earnings growth in fiscal 2020.

Despite the increase in tariffs and some negative macro trends, we remain optimistic that our business momentum will continue, supported by a number of positive factors including by the recent mailing of the Fall Interiors and soon to be in-home Modern Source Books, the increasing contribution from RH Beach House, the launch of RH Ski House and new Galleries opening this fall.

Our largest and most important new Gallery, RH New York, continues to trend comfortably in excess of $100 million in annualized revenue for fiscal 2019 and will generate more than $30 million of cash contribution in its first full fiscal year. We are on track to open RH Minneapolis, the Gallery in Edina, RH Columbus, the Gallery at Easton Town Center, and RH Marin, the Gallery at the Village of Corte Madera, in the second half. These new prototype Galleries average 45,000 square feet of indoor and outdoor selling space spanning three levels with rooftop parks, restaurants, barista bars and consumer facing RH Interior Design offices, and will enable us to place our disruptive product assortment and immersive retail experience into the market at a fraction of our former investment. Looking forward, we expect to accelerate our real estate transformation to a rate of 5 to 7 new Galleries in Fiscal 2020 and 7 or more new Galleries in Fiscal 2021.

Regarding trade with China, we do not expect the current tariffs to impair our ability to achieve stated financial goals and the impact from the increased tariffs is embedded in our guidance for the year. We continue to receive pricing accommodations from vendors and have implemented price increases where necessary with little to no impact to our business.

As it relates to our balance sheet, we ended the second quarter with inventory of $481 million versus $551 million last year, down $70 million, or 13% versus a 10% revenue increase. Due to the efficiency of our supply chain network redesign and the simplification of our reverse logistics and outlet model we expect to end the year with inventories down $80 to $90 million versus 2018. We are now projecting to generate free cash flow in the range of $325 to $350 million and expect total net debt to trailing twelve month adjusted EBITDA of approximately 1.8x to 1.9x at year end.

While we remain comfortable with our balance sheet, the current market conditions for convertible debt are attractive. As previously communicated, we will continue to be opportunistic as it relates to the capital markets. If there is an opportunity to issue convertible debt at acceptable terms, it could enable us to lower interest expense and increase adjusted diluted EPS by as much as $0.20 to $0.25 this year, and $0.65 to $0.70 next year, creating shareholder value and providing increased optionality for RH.

We believe our Company remains undervalued and will continue to evaluate share repurchases. Thus far in 2019, we have acquired 2.2 million shares at an average price of $115.36. Inclusive of our share repurchases in 2017 and 2018, we have repurchased 24.4 million shares at an average price of $61.40 per share, or approximately 60% of the total shares previously outstanding. We believe the repurchase of our shares will prove to be an outstanding allocation of capital for the benefit of our long term shareholders.

Looking forward, we continue to see a clear path to $4 to $5 billion in North America revenues, with mid-to-high teens operating margins and ROIC in excess of 50%. Additionally, we now believe there is an opportunity to more than double those revenues as we begin to expand globally, and move the brand beyond creating and selling products to conceptualizing and selling spaces.

Our long term targets remain:

Net revenue growth of 8% to 12%
Adjusted operating margins in the mid to high teens
Adjusted net income growth of 15% to 20% annually
Return on invested capital (ROIC) in excess of 50%

We do understand 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.

Ironically, I was reading an article in Forbes this morning with the headline “RH, (A.K.A. Restoration Hardware) Fails When It Comes To Digital.” The writer, Pamela Danziger, points to the Digital IQ Index published by Gartner L2, a consulting group who ranks the digital IQ of 103 specialty retailers with only Charlotte Russe keeping RH off the bottom of the ranking. She pointed out that Gartner L2’s principal specialty retail research analyst Supriya Jain mentioned, “For at least the last three years, RH has ranked in our (feeble) class in specialty retail”, and goes on to point out that every other directly competitive brand ranks higher, with Pier 1 ranking in the highest (gifted) class. I like to advise our team that it is dangerous to run your business or live your life based on other people’s thinking, especially ones who tend to be sideline critics and have no experience building a business like ours. I’m sure if Pamela, Supriya, and Gartner L2 did a Retail IQ Index that looked at earnings growth and shareholder value creation over the past three years across all channels, they would find RH’s placement in the hierarchy quite different. Or better yet, since 85% of retail sales are still done in stores, maybe a Retail Store IQ Index, ranking retailers on store performance or the metrics important to customers would be interesting, and most likely find us somewhere near the very top. Nonetheless, somehow “feebly” we generate over a billion dollars in our digital channel, which also ranks above all the competitive brands mentioned in the article. We like to say on Team RH that “Leaders have to be comfortable making others uncomfortable.” It’s what leaders do, and when you know you’re on the right path, even when it makes others uncomfortable, or when they call you feeble.

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.

We would like to thank all of our people and partners whose passion and persistence bring our vision and values to life each and every day, as we pursue our quest to become one of the most admired brands in the world.

Carpe Diem,

Gary

Note: We define return on invested capital (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 24, 2019 by dialing (855) 859-2056 or (404) 537-3406 and entering passcode 6784388, as well as on the Company’s investor relations website.

ABOUT RH

RH (NYSE: RH) is a curator of design, taste and style in the luxury lifestyle market. The Company offers its collections through its retail galleries across North America, the Company’s multiple Source Books, and online at RH.com, RHModern.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 operating income, adjusted net income or adjusted net earnings, adjusted net income margin, adjusted diluted earnings per share, normalized adjusted net income, normalized adjusted diluted net income per share, ROIC or 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.

FORWARD-LOOKING STATEMENTS

This release contains forward-looking statements within the meaning of the federal securities laws, including without limitation, statements regarding: Our fiscal 2019 guidance including our expectations for adjusted net revenue, adjusted operating income, adjusted operating margin, adjusted net income, adjusted diluted EPS, the impact from the increased tariffs, the impact of revenue reduction as a result of editing unprofitable and non-strategic businesses; our future opportunity, growth plans and strategies, including our focus on elevating the brand and architecting an integrated operating platform, and RH becoming one of the few retailers that is growing revenues, expanding margins, and driving significantly higher returns on invested capital; our optimism that our business momentum will continue despite negative macro trends and increased tariffs; our expectations regarding our tax rate for fiscal 2019 including assumptions regarding our applicable tax rate and factors that would affect our tax rate; our expectation that our RH New York gallery will continue to trend comfortably in excess of $100 million in annualized revenue for fiscal 2019 and will generate more than $30 million of cash contribution in its first full fiscal year; our plan to open new stores in the remainder of 2019; our belief that the current tariffs will not impair our ability to achieve our stated financial goals and that our response to tariffs will not have an adverse impact on our business; the impact on our business trends from macro factors; the expected acceleration of our real estate transformation including the opening of 5 to 7 new Galleries in fiscal 2020 and a minimum of 7 new Galleries in fiscal 2021; our belief that our Company remains undervalued and that the repurchase of our shares will prove to be an outstanding allocation of capital for the benefit of our long term shareholders; our expectations regarding the convertible notes market and our ability to complete a convertible notes financing on favorable terms; our expectations regarding sources and uses of capital; our expectations with respect to year-end inventory levels; planned accelerated outlet sales; our projections regarding free cash flow and net debt to trailing twelve month adjusted EBITDA at year end; our path to $4 to $5 billion in North America revenues, with mid-to-high teens operating margins and ROIC in excess of 50%; our belief that there is an opportunity to more than double revenues as we begin to expand globally; our long term targets, including net revenue growth of 8% to 12%, adjusted operating margins in the mid to high teens, adjusted net income growth of 15% to 20% annually and ROIC in excess of 50%; our intention to be opportunistic as it relates to the capital markets and the potential benefits to our Company of completing a notes offering on acceptable terms; our positioning on store performance and metrics important to customers relative to other retailers; and any statements or assumptions underlying any of the foregoing. You can identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. These statements may include words such as “anticipate,” “estimate,” “expect,” “project,” “plan,” “intend,” “believe,” “may,” “will,” “should,” “likely” and other words and terms of similar meaning in connection with any discussion of the timing or nature of future events. We cannot assure you that future developments affecting us will be those that we have anticipated. Important risks and uncertainties that could cause actual results to differ materially from our expectations include, among others, risks related to our dependence on key personnel and any changes in our ability to retain key personnel; successful implementation of our growth strategy; risks related to the number of new business initiatives we are undertaking; successful implementation of our growth strategy including our real estate transformation and the number of new gallery locations that we seek to open and the timing of openings; uncertainties in the current performance of our business including a range of risks related to our operations as well as external economic factors; general economic conditions and the housing market as well as the impact of economic conditions on consumer confidence and spending; changes in customer demand for our products; our ability to anticipate consumer preferences and buying trends, and maintaining our brand promise to customers; decisions concerning the allocation of capital; factors affecting our outstanding convertible senior notes or other forms of our indebtedness; our ability to anticipate consumer preferences and buying trends, and maintain our brand promise to customers; changes in consumer spending based on weather and other conditions beyond our control; risks related to the number of new business initiatives we are undertaking; strikes and work stoppages affecting port workers and other industries involved in the transportation of our products; our ability to obtain our products in a timely fashion or in the quantities required; our ability to employ reasonable and appropriate security measures to protect personal information that we collect; our ability to support our growth with appropriate information technology systems; risks related to our sourcing and supply chain including our dependence on imported products produced by foreign manufacturers and risks related to importation of such products including risks related to tariffs, the countermeasures and mitigation steps that we adopt in response to tariffs and other similar issues, as well as those risks and uncertainties disclosed under the sections entitled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in RH’s most recent Form 10-K and Form 10-Q filed with the Securities and Exchange Commission, and similar disclosures in subsequent reports filed with the SEC, which are available on our investor relations website at ir.rh.com and on the SEC website at www.sec.gov. Any forward-looking statement made by us in this press release speaks only as of the date on which we make it. We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by any applicable securities laws.

The following table presents RH Gallery and Waterworks showroom metrics and excludes outlets:

See the Company’s most recent Form 10‑K and Form 10‑Q filings for square footage definitions.

Total leased square footage as of August 3, 2019 and August 4, 2018 was 1,451,000 and 1,414,000, respectively.

Weighted-average leased square footage for the three months ended August 3, 2019 and August 4, 2018 was 1,451,000 and 1,392,000, respectively.

REVISED RECONCILIATION OF FIRST QUARTER FISCAL 2019

GAAP NET INCOME TO ADJUSTED NET INCOME

(In thousands)

(Unaudited)

As a result of the fluctuations in our quarterly income tax rate, driven primarily by the variability of tax benefits associated with equity awards including exercise of employee stock options and vesting of employee restricted stock units, beginning in the second quarter of fiscal 2019 RH will use a normalized tax rate of 21% when reporting adjusted net income and adjusted diluted net income per share in order to facilitate year over year comparison of operating results on a comparable basis with historical results at a consistent tax rate across time periods. The normalized tax rate of 21% approximates our expected effective tax rate for fiscal 2019. The table below presents the revised adjusted net income and adjusted diluted net income per share for the first quarter of fiscal 2019 to reflect the normalized 21% tax rate.

ASC 842 IMPACT OF ADOPTION

(In thousands)

(Unaudited)

We adopted Accounting Standards Update (“ASU”) 2016‑02, ASU 2018-10 and ASU 2018-11 (together, “ASC 842”), which pertain to accounting for leases, on February 3, 2019, the first day of our first fiscal quarter of 2019, using a modified retrospective approach. Under this adoption method, the results of prior comparative periods are revised with an adjustment to opening retained earnings of fiscal 2017.

Condensed Consolidated Statements of Income

The following tables summarize the impact of adopting ASC 842 on our fiscal 2018 annual and quarterly condensed consolidated statements of income: