Earnings Call: Q4 2017

Mar 28, 2017

Helen Keller once said, the only thing that's worse than being blind is having sight but no vision. At RH, we concur and believe vision is everything. Vision leads the leader. It ignites the human spirit, generating hope and inspiration that can turn a company into a cause. We also believe that vision has to come from within. It doesn't come from listening to focus groups or outside consultants. It requires thinking until it hurts, until we can see what others can't see and do what others can't do. Vision requires having the courage to destroy today's reality so we can create tomorrow's future. At RH, we've had the vision to create the most compelling and comprehensive product offering in our market, curate a brand aesthetic that is recognized nationally and desired globally, build a product platform that attracts and amplifies the best design and manufacturing talent in our industry produce product of quality and quantity, enabling us to offer a disruptive value proposition create some of the most inspiring and immersive physical retail experiences in the world, introduce an integrated hospitality experience that activates all of the senses and drive significant traffic to our galleries, Launch one of the most exciting new concepts in retail, RH Modern, that we believe will quickly become a $1,000,000,000 brand. Build an interior design business that moves a brand beyond creating and selling products to conceptualizing and selling spaces. Develop a spaces develop a fully integrated multichannel platform that enables us to scale new products and businesses quickly and profitably Add the prestigious Waterworks brand to our platform, positioning RH as the only luxury brand addressing every room of the home. And lastly, make the brave move from a promotional to a membership model that will elevate our brand, streamline our business and drive higher profit margins for years to come. In many ways, we have built a brand with no peer that is disrupting the marketplace and cannot be replicated online. Yet, with all that we've done, we have 3 important goals to accomplish in our quest to become one of the most admired brands in the world. 1, develop a back end operating platform and customer experience that matches the front end quality of our brand. 2, drive mid teens operating margins and return on invested capital. And 3, generate significant free cash flow and internally fund our growth. Let me take a moment to put our 2016 performance into perspective, articulate our priorities for 2017 and frame our outlook for 2018 and beyond. 2016 was a year of transformation and transition. We transformed our business from a promotional to a membership model that will enhance our brand, streamline our operations and vastly improve the customer experience. We also began the transformation of our supply chain network design. As you know, we aggressively rationalized our product offer last year so we could forego building a planned distribution center scheduled to open in 2017. We are in the process of transitioning our inventory into fewer facilities, which will simplify our business and significantly reduce working capital. 2016 was also the 1st full year of many new business initiatives such as RH Modern, RH Teen, RH Hospitality, the redesign of our RH interior source book, the rollout of design ateliers and the addition of Waterworks to our platform. All of these new initiatives are expected to contribute to growth in 2017 and beyond. 2017 will be the year of execution, architecture and cash. First, our efforts will be focused on the execution of our core RH business, our new membership model and the new businesses introduced in 2016. We just completed the mailing of our 2017 Outdoor Sourcebook with over 3 40 pages of inspired design featuring 7 new collections. Let's take a look. We also plan to unveil the 2nd edition of RH Modern this spring, featuring 38 new furniture and lighting collections across more than 400 pages. Here's a quick peek at what to expect. As you know, we mailed our completely redesigned RH interior source book this past fall. The book, designed by esteemed art director Fabian Baron, has a clean and contemporary design that gives more prominence to the talented designers, artisans and manufacturers we work with around the world. Additionally, we are beginning to see the investment we made in RH Design Services begin to bear fruit. As you might recall, we installed design ateliers across our fleet and significantly expanded the number of interior designers in our galleries. In 2017, there will be no new business investments outside of RH Hospitality, where we will have significant start up costs to support the rollout of an integrated food and beverage experience similar to our successful gallery at the 3 Arch Club in Chicago. We expect to open 5 new galleries in 2017, including RH Toronto, the gallery in Yorkdale RH Palm Beach, the gallery at City Place RH New York, the gallery in the historic meatpacking district RH Nashville, the gallery in Green Hills, RH Portland, the gallery in the Northwest Historic District. For the new galleries, Toronto, Palm Beach, New York and Nashville will include cafes, wine vaults and coffee bars. 2nd, we plan to invest significant time in 2017 designing a new back end operating platform inclusive of the supply chain network, the home delivery experience, a metric driven quality system and company wide decision data. Our goal is to break down the silos that exist in most businesses of scale and cross functionally architect a fully integrated operating platform that simplifies our business, enhances the customer experience and amplifies decision quality and speed. And third, we will have a relentless focus on maximizing cash flow and internally funding our growth. While our investment strategy will always maintain a long term view, we believe we can improve working capital and ROIC by having a more disciplined approach to capital allocation. To that point, we now plan to open 3 to 5 new galleries per year. We believe this will result in improved deal economics, lower build out costs and higher returns. Additionally, the slower growth will put less pressure on the infrastructure, enabling greater capital discipline throughout the organization. As we look to 2018 and beyond, our focus will be on building the new platform, continuing to invest in long term growth and maximizing cash flow. Our expectation is that by the end of 2019, our new operating platform will be substantially in place, and we will have one of the most dynamic new models in all of retail. We remain firmly on our path towards reaching $4,000,000,000 to $5,000,000,000 in North American revenues with mid teens operating margins. Our new galleries continue to perform above our expectations and we believe the addition of hospitality will only enhance the model. Additionally, we believe the brand has enormous potential globally and plan to explore those opportunities once we've perfected our platform in North America. While 2016 can be characterized as a disappointing year from a short term financial perspective, we believe it will be remembered as a year of brave and bold decisions that will further elevate the RH brand, streamline our business and position the company for accelerated long term growth. When you step back and consider that we are 1, building a brand with no peer 2, creating a customer experience that cannot be replicated online and 3, have total control of our content from product to presentation, you realize what we are building is extremely rare and valuable in contrast to today's retail landscape. Yet I would tell you, our most valuable asset is not what we have done. It's who we've become. We've become a team of people who don't know what can't be done, a team that is driven to innovate versus duplicate, A team that is passionate about leadership and allergic to fellowship. A team that is willing to destroy today's reality to create tomorrow's future. A team that has the courage to march into hell as we did last year for a heavenly cause and a team that has a bold vision for the future and an organization that has demonstrated it can bring that vision to life. We believe that we have made the right investments in fiscal 2016 to position our brand and business for long term growth and positive cash flow beginning in fiscal 2017. As we've articulated the past four quarters, there were 4 temporal issues that impacted our business in fiscal 2016. We estimate these issues depressed margins by approximately 2 60 basis points and adjusted earnings per share by approximately $1 Let me recap these temporal factors. 1st, the costs related to the launch of RH Modern. During the first half of fiscal twenty sixteen, we invested approximately $20,000,000 in customer accommodations as a result of RH Modern production delays and our efforts to elevate the customer experience. This consisted of approximately $16,000,000 of customer accommodations that were a direct offset to revenue, as well as $4,000,000 of expedited shipping charges and other product costs. The impact was an approximate 60 basis point negative impact to gross margin or a $0.30 negative impact to fiscal 2016 earnings. 2nd, the timing of recognizing membership revenues related to the transition from a promotional to a membership model. The $100 RH members program fee is amortized on a monthly basis over the annual membership period. And accordingly, at the time of launching the program, these fees are a drag to margin in the short term. We collected approximately $30,000,000 of membership revenue in fiscal 2016, of which approximately $15,500,000 was deferred at year end and will be recognized in fiscal 2017. During 2016, this resulted in margin deleverage of approximately 50 basis points and a $0.23 negative impact to earnings. 3rd, efforts to reduce inventories and rationalize our SKU count. Beginning in the Q2, we took a more aggressive approach to optimizing inventory through markdowns in an effort to forego adding a planned furniture DC to the network. This resulted in an approximate 150 basis point drag on our gross margin in fiscal 2016 or a $0.46 negative impact to earnings. As we have discussed, we do anticipate some continued efforts to reduce inventories and rationalize SKUs into the first half of twenty seventeen. And 4th, our decision to push our 2016 RH Interior Sourcebook mailing from the spring to the fall and the second mailing of RH Modern from fall 2016 to spring 2017 depressed revenues last year. Let me turn to our fiscal 2016 financial highlights, starting with the balance sheet and cash flow. Our balance sheet is strong, and we are well positioned to execute on our long term value driving strategies. We ended fiscal 2016 with cash and investments of approximately $263,000,000 and no outstanding borrowings on our $600,000,000 line of credit. Inventory at the end of fiscal 2016 was $752,000,000 up 4% versus last year. Excluding the addition of Waterworks, RH inventory was flat, reflecting the progress we have made in our inventory optimization efforts. Fiscal 2016 capital expenditures were $181,000,000 compared to our guidance of $180,000,000 to $190,000,000 Last month, we announced that our Board authorized a $300,000,000 stock repurchase program. We believe our shares have been undervalued in the market. And based on the strength of our balance sheet, the expectation for positive free cash flow in fiscal 2017 and our long term outlook, there is an opportunity to create value for our shareholders while continuing to invest in our key value driving strategies. As of March 24, we had purchased approximately 4,900,000 shares of our common stock under the program. Turning now to the P and L. We reported net revenues in fiscal 2016 of $2,140,000,000 up 1%. Growth was driven substantially by the acquisition of Waterworks, which contributed 4 points of growth and the addition of new stores. Growth was offset by a 7% decline in comparable brand revenues, primarily driven by the timing shift related to our source books. Outlet sales were essentially flat year over year. We ended fiscal 2016 with approximately 300,000 RH members and are pleased with the early trends and renewal rates as we enter year 2 of the RH members program. Fiscal 2016 adjusted gross margin decreased 370 basis points. Most significantly, gross margin was impacted by the approximate 260 basis points of deleverage resulting from the temporal factors quantified earlier. In addition, we experienced product margin deleverage related to the higher discount rate offered through the RH members program versus our promotional cadence in the prior year. We also experienced higher shipping costs and deleverage in our occupancy costs based on the lower sales volumes. Fiscal 2016 adjusted SG and A as a percent of sales increased 120 basis points due to costs associated with our retail floor resets, the addition of design ateliers in our galleries and the impact of consolidating the Waterworks P and L into the parent company. Fiscal 2016 adjusted earnings per share was $1.27 compared to $2.72 last year. Let me now turn to our outlook. As Gary stated, while 2016 was a year of transformation and transition, 2017 will be the year of execution, architecture and cash. Gary spoke to our focus on execution and architecture. Let me provide more detail on our efforts to drive meaningful free cash flow in fiscal 2017. First, we expect growth in cash from operations as a result of higher earnings. 2nd, inventory is planned to be a source rather than a use of cash in 2017, as our efforts to optimize inventory and simplify our supply chain network design is expected to drive lower inventory year on year. And third, we expect to reduce capital spending to a range of $140,000,000 to $160,000,000 versus $181,000,000 last year. In addition, we expect to generate between $15,000,000 $25,000,000 of cash related to planned asset sales. Given our focus on high quality, sustainable growth and cash flow, we plan to reduce our new gallery opening cadence to a range of $3,000,000 to $5,000,000 per year, which is expected to lower our capital requirements and risk over the course of our real estate transformation. Fiscal 2017 net revenues are expected to be in the range of $2,300,000,000 to $2,400,000,000 representing growth of 8% to 12%. While our outlook is based on a cautiously optimistic view of the macro environment, we anticipate revenue to build from the mailing of our fall 2016 source books and the second mailing of the RH Modern source book this spring. In addition, we expect incremental revenues from the 4 new design galleries we opened in 2016 and the 5 galleries opening in fiscal 2017. As a reminder, fiscal 2017 is a 53 week year for RH, which is expected to contribute approximately 2 points of growth on the year. While we expect to cycle the majority of the 2016 temporal issues, we are making key investments in 2017 in the following areas. 1st, based on the success of our Chicago gallery, we are building a hospitality division to support the rollout of cafes, wine vaults and coffee bars in virtually all of our new galleries planned to open over the next 3 years. 2nd, the continuation of our efforts to rationalize our SKU count, which should be substantially complete by the end of the second quarter. 3rd, investments related to the design and architecture of a new back end operating platform, inclusive of our DC network design, home delivery experience and a metric driven quality system. In addition, we expect higher advertising costs year over year based on the mailing cadence of our source books. Accordingly, we expect fiscal 2017 adjusted net income in the range of $65,000,000 to $80,000,000 and adjusted earnings per share in the range of $1.78 to $2.19 using weighted average diluted shares outstanding of 36,600,000 as of March 24. Comparable to current fiscal 2017 analyst estimates and using a diluted share count of 41,100,000 shares, our adjusted diluted EPS guidance would be in the range of 1.58 dollars to $1.95 Turning to the Q1. We expect Q1 fiscal 2017 net revenues in the range of $530,000,000 to $545,000,000 representing growth in the range of 16% to 20%. Approximately 5 points of growth is due to the acquisition of Waterworks, and 5 points of growth is related to higher outlet and warehouse sales stemming from accelerated inventory optimization efforts during Excluding these factors, we are expecting growth in the range of 6% to 10% as we experienced the build from our fall 2016 source book and benefit from the anniversary of the launch of the RH members program. While our higher outlet revenues and inventory optimization efforts are having a positive impact on sales, they will have a negative impact on margins and earnings. Accordingly, we expect 1st quarter adjusted net income in the range of $800,000 to $2,400,000 and adjusted diluted earnings per share in the range of $0.02 to $0.06 based on using weighted average diluted shares outstanding of 38,100,000 as of March 24. Comparable to current Q1 analyst estimates and using a diluted share count of 40,800,000 shares, our adjusted diluted EPS guidance would also be in the range of $0.02 to $0.06 In closing, as we have communicated throughout 2016, we made several strategic investments and changes to our business model that temporarily depressed financial results in the short term that we believe will strengthen our brand and position the business for accelerated growth in 2017 and beyond. As we cycle these investments and changes, we expect sales to reaccelerate, operating margins to expand and to generate significant free cash flow. We are confident that our choices will prove to be the right ones, driving long term sustainable growth, improved returns on invested capital and significant shareholder value.