Company Raises Fiscal 2019 Guidance for the Fourth Time this Year
CORTE MADERA, Calif.–(BUSINESS WIRE)–RH (NYSE: RH) today announced third 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.
THIRD QUARTER 2019 HIGHLIGHTS
Q3 GAAP NET REVENUES INCREASED +6.4% to $677.5M
Q3 ADJUSTED NET REVENUES INCREASED +6.0% TO $676.7M
Q3 GAAP OPERATING INCOME INCREASED +111% TO $89.2M VS. $42.2M LY
Q3 ADJUSTED OPERATING INCOME INCREASED +44% TO $87.8M VS. $61.1M LY
Q3 GAAP OPERATING MARGIN INCREASED 660 BASIS POINTS TO 13.2% VS. 6.6% LY
Q3 ADJUSTED OPERATING MARGIN INCREASED 340 BASIS POINTS TO 13.0% VS. 9.6% LY
Q3 GAAP NET INCOME INCREASED +161% TO $52.5M VS. $20.1M LY
Q3 ADJUSTED NET INCOME INCREASED +52% TO $65.4M* VS. $43.2M* LY
Q3 GAAP EPS INCREASED +197% TO $2.17 VS. $0.73 LY
Q3 ADJUSTED DILUTED EPS INCREASED +74% TO $2.79* VS. $1.60* LY
Q3 FREE CASH FLOW INCREASED TO $96M VS. $16M LY
YTD FREE CASH FLOW INCREASED TO $234M VS. $19M LY
*The Company’s adjusted net income and adjusted diluted EPS benefited by $5.5M and $0.24, respectively, in the third quarter due to a lower tax rate of 13.7% versus the previous estimate based on a normalized tax rate of 21%.
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 record third quarter results and are raising our fiscal 2019 guidance for the fourth time this year.
We generated record GAAP revenues of $678 million in the quarter, an increase of 6.4%, inclusive of a two point drag from eliminating unproductive product categories and fringe promotions. Taking into account the two point drag, revenues for the quarter would have increased 8.4%. We also generated record adjusted operating earnings of $88 million, up 44% versus last year; record adjusted operating margin of 13.0%, a 340 basis points increase versus 9.6% a year ago; record adjusted diluted earnings per share of $2.79, up 74% versus $1.60 last year; and $96 million of free cash flow in the quarter versus $16 million a year ago.
We believe real models will become wildly popular in the post WeWork era
We have spent decades building a business model that generates industry leading profitability and return on invested capital, and believe real models will become wildly popular in the post WeWork era.
We also believe this recent period has been reminiscent of previous times when growth without profitability has been unjustly rewarded, and valuations were based on the misplaced belief that an online retail business is more profitable than a physical store. This view has driven new concepts to launch as “digitally native brands” chasing internet valuations and cheap capital from private and public markets who have somehow confused an online retail startup, or in the case of WeWork, an office subleasing business, with a technology company. It’s becoming clear that retail brands birthed online desperately need a store lifeline to survive, as many are finding the variable cost of marketing an invisible store an unprofitable path to the future.
Traditional retailers hoping for the same favorable valuations, and in some cases driven by the fear of not being viewed as fashionable by millennials, have allocated the vast majority of their capital to unnaturally grow their digital business. This has resulted in shifting, not lifting, sales online at greater costs, driving down margins while physical stores have been left to rot.
We on the other hand have chosen to take the road less traveled, and believe, like Robert Frost, that it will make all the difference. Our focus on elevating the RH brand by building architecturally inspiring spaces that blur the lines between residential and retail, indoors and outdoors, home and hospitality with seamlessly integrated restaurants and services, have rendered our brand more valuable while creating a customer experience that cannot be replicated online.
Our dominant physical presence combined with our integrated multi-channel platform that generates over a billion dollars online will continue to enable the RH brand to disrupt the highly fragmented luxury home furnishings market and take share for years to come.
Add to the above the most efficient operating platform in our industry, a vertically integrated real estate development model that is dramatically lowering capital requirements and occupancy costs, and our discipline of driving high quality profitable growth and you begin to understand why RH is one of the only brands that is expanding operating margins while generating industry leading returns on invested capital and significant free cash flow.
The emergence of RH as a luxury brand generating luxury margins
We expect our operating margin to expand at least 200 basis points in fiscal 2020 and now see a clear path to a 20% operating margin over the next several years.
Factors contributing to 200 additional basis points in 2020 include:
- Cycling 1,000 basis points of margin erosion in 2019 in our Outlet business due to liquidating excess inventory from the closure of a distribution center in the fourth quarter of 2018.
- Cycling the margin drag from transitioning our rug business in 2019 from a single source importer to a direct sourcing model. We expect rug margins to increase approximately 2,000 basis points year over year as we cycle markdowns to clear old inventory and realize significantly higher margins by eliminating the additional markup from our previous single source importer.
- Cycling the margin drag from the investments to launch RH Beach House and RH Ski House in mid to late 2019 and the requirement to expense 100% of the advertising costs when the books were mailed while only realizing a fraction of the annual revenues. We expect to leverage that initial investment next year, while also expanding and optimizing the assortments and mailing strategy.
- As previously communicated, we also expect margin contribution from the redesign of our operating platform and home delivery network in 2020 as our teams continue to use first principles thinking to reconceptualize industry methodologies that have been widely duplicated but rarely innovated.
Our planned margin improvement next year takes into account negative impacts on margin from:
- The continued 50 basis point operating margin drag from our investments to build a hospitality platform and the associated pre-opening costs of bringing six restaurants and our first RH Guesthouse to life in 2020. We expect this margin drag to subside over the next few years as we begin to gain scale in hospitality and leverage our infrastructure.
- A 70 basis point operating margin drag from Waterworks which we expect to reduce over the next several years as we gain efficiencies by greater integration of the business on the RH platform.
We also continue to see long term margin opportunities as a result of our new vertically integrated real estate, design and development organization. We have in-sourced the majority of the real estate functions, developed the RH Architecture and Engineering group, and have formed RH Build, our own internal construction company, driving dramatically lower costs to source and build our new Galleries. This development model combined with the high productivity of our new Galleries and one of the most attractive hospitality concepts available to developers, continues to enhance our deal economics, resulting in lower capital requirements and higher returns on invested capital.
Additionally, we have begun to prove our capability as a property developer with our first two development projects in Yountville, California, and Edina, Minnesota. In Yountville we were able to acquire, develop, and execute a sale leaseback of the project at a cap rate of 4.26%, recouping the vast majority of our capital, and we expect to complete a sale leaseback of our Edina Gallery by the first half of next year at a cap rate in the range of 5.0% to 5.25%, again recouping most of our investment. We are also developing our Aspen Gallery and Guesthouse in a joint venture that requires no upfront capital, and where RH has a profit interest upon completion and sale of the properties. We expect to recoup 90% to 100% of the minimal finish and fixture capital investment in both projects.
We believe the combination of our new capital-light lease developments, joint venture developments, and RH developments will result in lower occupancy costs, lower capital requirements, higher cash flow, and significantly higher returns on invested capital.
Lastly, as we continue to transform our real estate in North America from legacy to new design Galleries, we expect our revenues to increase substantially, leveraging occupancy, advertising, and other SG&A costs across the platform.
Product elevation + Gallery transformation + Global expansion = $20 billion opportunity
In 2019 we began to elevate our product offer with the introduction of RH Beach House and RH Ski House, plus the test of Bespoke Collections in our RH Interiors Source Book. The revenue growth from those investments will begin to bear fruit in fiscal 2020 as we gain a full year of sales and continue to expand the assortments, optimize the Source Books, and present collections in our Galleries. We will also gain a partial year of revenues from the launch of RH Color next fall.
We plan to increase our Gallery openings to 5 to 7 per year despite unexpected delays in development timelines we’ve experienced in our recent projects. As an example, the mall construction related to the development of RH Marin, The Gallery at the Village of Corte Madera is not complete and we have decided to delay the opening until the first quarter of next year. We do not get a second chance to make a first impression, and opening our new Gallery facing unsightly construction is not an option. Our other new development, RH Columbus, The Gallery at Easton Town Center is opening next week, and we hope to see some of you at the party on Wednesday night. We are having success filling the development pipeline with more than enough projects to reach our goal of 5 to 7 new Galleries per year going forward, and have increased confidence in the predictability of openings as the majority are prototype Galleries, and we take greater control of the development process.
We expect to open five new Galleries and one Guesthouse in fiscal 2020 with RH Marin, RH Charlotte, and RH San Francisco opening in the first half, and RH Dallas, RH Jacksonville, and our first RH Guesthouse in New York opening in the second half of next year. Additionally, we will benefit in 2020 from the late 2019 openings of RH Minneapolis and RH Columbus. We also plan to open a minimum of 7 new Galleries in fiscal 2021.
RH New York, our largest and most important new Gallery, continues to trend comfortably in excess of $100 million in revenue for fiscal 2019 and will generate more than $30 million of cash contribution in its first full fiscal year.
We are building towards the launch of RH International in 2021 or 2022 and are close to completing real estate transactions for 5 to 7 initial locations across Europe. As discussed, we now believe RH International represents our largest growth opportunity, and based on the penetration of other luxury businesses, we believe it will position RH to become a $20 billion global brand.
A capital structure that creates flexibility and optionality
Focusing on our balance sheet, we ended the third quarter with inventory of $429 million versus $566 million last year, down $137 million or 24% versus a 6% revenue increase. Due to the efficiency of our supply chain network redesign and the simplification of our reverse logistics and outlet business we expect to end the year with inventories down $90 to $100 million versus 2018.
We are projecting to generate free cash flow in the range of $350 to $360 million for 2019 and expect a ratio of net debt to trailing twelve month adjusted EBITDA of approximately 1.7 times at year end.
While we remain comfortable with our balance sheet, the current market conditions for convertible debt remain attractive. As previously communicated, we will continue to be opportunistic as it relates to the capital markets and may issue additional convertible notes if the terms are favorable. Looking back, had we not been opportunistic in responding to market conditions through our prior convertible notes financings we would not have been in a position to repurchase 24.4 million shares, or approximately 60% of the total shares outstanding at an average price of $61.40, which has proven to be an excellent allocation of capital for the benefit of our shareholders. We believe our Company remains undervalued and we will continue to evaluate share repurchases.
China tariffs – the long and winding road
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.
Increasing our long-term outlook
Looking forward, we see a clear path to over $5 billion in North America revenues, with high teens to low twenties operating margins and ROIC in excess of 50%. Additionally, we now believe there is an opportunity to build a $20 billion global brand as we expand internationally and further develop the RH ecosystem that will move the brand beyond creating and selling products to conceptualizing and selling spaces.
We are increasing our long-term targets to:
Net revenue growth of 8% to 12%
Adjusted operating margins in the high teens to low twenties
Adjusted net income growth of 15% to 20%
Return on invested capital (ROIC) in excess of 50%
Building a brand with no peer
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.
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.
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 December 18, 2019 by dialing (855) 859-2056 or (404) 537-3406 and entering passcode 5322168, 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 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.
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; our statements regarding RH being a real model that generates industry leading profitability and return on invested capital, and our belief that real models will become wildly popular in the post WeWork era; our future opportunity, growth plans and strategies, including our focus on elevating the brand; 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 the RH brand will continue to disrupt the highly fragmented luxury home furnishings market and take share for years to come; our expectation that operating margins will expand over the next several years and the reasons therefor; our expectations concerning our ability to increase our operating margins in future periods such as the expectation that operating margins will expand by at least 200 basis points in fiscal 2020 and our path to 20% operating margin over the next several years including the basis for such expectations, such as expectations concerning cycling previous drags on margin and operating margin improvements from our current and future business initiatives such as our rug strategy, the introduction of RH Beach House, RH Ski House and other new product categories and assortments, the redesign of our operating platform and home delivery network in 2020 and other operational improvements, the benefits of our real estate strategy including capital efficiencies and lower capital requirements and higher ROIC as well as our expectation to alleviate the current drag on operating margins from various investments we are making such as investments in RH Hospitality and RH Guesthouse as well as expected benefits from greater integration of Waterworks on the RH platform; statements regarding elevating the RH brand by building architecturally inspiring spaces that blur the lines between residential and retail, indoors and outdoors, home and hospitality with seamlessly integrated restaurants and services which have rendered our brand more valuable while creating a customer experience that cannot be replicated online; our belief that RH is one of the only brands that is expanding operating margins while generating industry leading returns on invested capital and significant free cash flow; our statement that RH Build is driving dramatically lower costs to source and build our new Galleries; our statement that our development model combined with the high productivity of our new Galleries and one of the most attractive hospitality concepts available to developers continues to enhance our deal economics, resulting in lower capital requirements and higher returns on invested capital; our statement that our product elevation, Gallery transformation and global expansion presents a $20 billion opportunity; our statement that our capital structure creates flexibility and optionality; our statement that we are building a brand with no peer; our expectation that revenues will increase as we continue the transformation of our real estate in North America from legacy to new design Galleries; our expectation for revenue growth from RH Beach House, RH Ski House and Bespoke Collections in our RH Interiors Source Book; our expectations regarding year-end inventory levels; our expectation that we will complete a sale leaseback of our Edina Gallery in the first half of next year; our expectations regarding our investments in our Aspen Gallery and Guesthouse projects; our belief that the combination of our new capital light lease developments, joint venture developments, and RH developments will result in lower occupancy costs, lower capital requirements, higher cash flow, and significantly higher returns on invested capital; our statement that our RH New York Gallery continues to trend comfortably in excess of $100 million in revenue for fiscal 2019 and will generate more than $30 million of cash contribution in its first full fiscal year; our belief that the current tariffs will not impair our ability to achieve our stated financial goals; our expectation to increase our Gallery openings to 5 to 7 per year; our plan to open five new Galleries and one Guesthouse in fiscal 2020 with RH Marin, RH Charlotte, and RH San Francisco opening in the first half, and RH Dallas, RH Jacksonville, and our first RH Guesthouse in New York opening by the second half of next year; our plan to open a minimum of 7 new Galleries in fiscal 2021; our plan to launch RH Color next Fall; our belief that RH International represents our largest growth opportunity and our belief that it will position RH to become a $20 billion global brand; our plan to launch RH International in 2021 or 2022 and to complete real estate transactions for 5 to 7 initial locations across Europe; our belief that our Company remains undervalued and that the repurchase of our shares will prove to be an excellent allocation of capital for the benefit of our 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 projections regarding free cash flow and net debt to trailing twelve month adjusted EBITDA at year end; our path to over $5 billion in North America revenues, with high teens to low twenties operating margins and ROIC in excess of 50%; our long term targets, including net revenue growth of 8% to 12%, adjusted operating margins in the high teens to low twenties, 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; and any statements or assumptions underlying any of the foregoing.