Earnings Call: Q3 2017

Dec 8, 2016

American poet Robert Frost wrote, 2 roads diverged in a wood and I, I took the one less traveled by and that has made all the difference. In a world defined by duplication with little incentive for innovation, we find ourselves surrounded by sameness, the same products on similar websites, in the same stores with similar signs, providing the same service, sending the same emails, with the same promotions, driving lower and lower prices. I wasn't quite sure how to react to a headline from an analyst report published the Monday after Thanksgiving that read, Amazon beats the competition in Black Friday pricing study. It went on to report that online prices declined an average of 3.5 percent for Black Friday for the exact same items across 4 companies they compared. Make no mistake, many retailers find themselves in a race to the bottom, a race we at RH have chosen not to join and we believe that choice will make all the difference. I'm sure our short term results will be misinterpreted by many as choosing the wrong road as we continue to invest in differentiating and redefining the RH brand. While we've expected to endure some short term pain in exchange for long term gain, we are nearly through the most uncertain stages of our transformation and are becoming more certain with each passing quarter as to what lies ahead. Looking forward to 2017, we will anniversary the costs related to the launch of RH Modern, which we've estimated at approximately $20,000,000 We will move beyond the timing issues related to the launch of RH membership and we expect membership revenues and earnings to increase approximately $20,000,000 in 2017. We begin to cycle our efforts to reduce inventories and rationalize our SKU count. We expect product margins to rebound meaningfully year over year beginning in the Q1 of next year. We expect revenues will increase in 2017 as the fall 2016 interiors book builds and we benefit from the 2nd mailing of RH Modern in home next spring. Additionally, our business will continue to be driven in 2017 by growth in new stores and new businesses. Let me take a moment on each. As it relates to new stores, despite the delay mailing our source book in 2016 and the macro factors affecting our business, we are pleased with the performance of our new galleries. Our real estate transformation should enable us to more than double our store volumes, while also driving a lift in our direct business in every market. Regarding new businesses, you should anticipate that we will invest into the development and expansion of our brand and platform. Our plan is to aggressively capitalize on the development and expansion of RH Modern, as it is proving to be incremental, opening up our brand to an entirely new market. This spring, we will unveil new collections from several renowned designers from around the world such as We announced that Brendan Sotokoff has joined us as President of RH Hospitality. Brendan has assembled an exceptional team to build on our success at this historic 3 Arch Club in Chicago. We believe we've created a unique and differentiated hospitality concept, beautifully integrated into the retail experience unlike anything seen before in our industry. The cafe continues to drive traffic into our gallery and expose our brand to new and aspiring customers. Here is a video clip sent to us by our chef, John Asbati from Sunday morning, November 6. It's been over a year since opening and as you can see, we still have a line that forms around the block every weekend to get a table for brunch in our courtyard. We plan to integrate cafes, wine vaults and coffee bars into 5 of the 6 new galleries opening in 2017. As you know, the prestigious bath and kitchen brand, Waterworks, joined the RH family this year and positions RH as the only fully integrated luxury brand servicing every room of the home. We expect Waterworks to be additive to our growth in 2017 and we look forward to sharing the longer term view of the opportunity with you in the future. Let me shift your attention to our customer experience and supply chain. Under the leadership of Co President, Chief Operating Service and Values Officer, De Monte Price, we continue to make investments to enhance the customer experience and optimize our operational infrastructure. Damonte has added several new key leaders to the team, including Alex Krueger, Chief Supply Chain and Customer Experience Officer, who joins us from Amazon Tom Kurtz, Senior Vice President, Customer Experience, who joins us from Nike and previously worked with Alex at Amazon Dave Newman, Senior Vice President, Supply Chain Operations and Technology, who is in leadership positions at Target and Apple. The team is currently working to redefine the customer experience, redesign the supply chain and build a culture of quality that is consistent with the RH brand. Lastly, while we are clearly disappointed with our short term results, we have demonstrated an ability to navigate through challenging periods before and emerge an even stronger business and brand. I believe what's important to take note of is a series of choices we made over the past decade and how together they form an integrated branded business that has no fear. In 2,008, when many in our industry lowered quality to reduce prices, we went the opposite direction, raising the level of quality and design. While others have reacted to the threat of the Internet by closing stores and shrinking their retail footprint, we are building some of the most inspiring and productive retail experiences in our industry. During a period that is being defined by stream of endless promotions, we have once again chosen our own path, building our brand around membership, design, quality and value. We began this journey as a nearly bankrupt business, selling nostalgic discovery items with a $20,000,000 market cap and have transformed into a multi $1,000,000,000 luxury home brand that is redefining its marketplace. We are confident that our choices, while non conforming, will prove to be the right ones, driving long term sustainable growth and shareholder value. Many times over the past decade, 2 roads diverged in the wood and we took the one less traveled by and that has and will continue to make all the difference. While our results in fiscal 2016 are well below our expectations with many temporal factors affecting our business, we continue to believe the key decisions we made this past year were the right ones in order to position our brand and a platform for long term sustainable growth. We see a clear road to profitable growth and cash flow generation in fiscal 2017 and firmly believe that we will drive top line reacceleration, operating margin expansion and significant earnings growth in every single quarter of fiscal 2017. Let me start with our revised outlook. As we discussed previously, there are a combination of factors that are impacting our business in fiscal 2016, including moving the annual source book mailing and newness introductions from spring to fall, timing issues related to the launch of the RH members program, our efforts to rationalize and optimize our inventory, the costs related to the launch of RH Modern and luxury consumer headwinds. While we began mailing our spring 2000 source books in September, the vast majority of the circulation is just getting in homes in the last few weeks, which is approximately a month later than planned. This is resulting in a shift of sales that would have been booked in Q4 into the Q1. Given the slower in home of our fall holiday sales than expected, total revenue is expected to be in the range of $562,000,000 to $592,000,000 in the 4th quarter. There are several factors impacting adjusted gross margin in the 4th quarter. First, due to the weaker holiday sales, we are taking a much more aggressive approach to clearing the seasonal merchandise as this is not a business we plan to be in the long term. 2nd, we are taking a more aggressive approach to rationalizing our SKUs and there is and there is expected to be a higher penetration of these sales. 3rd, the lower sales outlook and higher proportion of promotional volume is driving deleverage of our fixed occupancy and shipping costs. These factors are expected to result in gross margin deleverage of approximately 150 basis points versus the prior year, fixed occupancy and shipping costs. These factors are expected to result in gross margin deleverage of approximately 150 basis points versus the prior year. We've also made investments that further position the company for a reacceleration in growth as we exit 2016 and for the long term, which include our supply chain and delivery initiatives and the expansion of our hospitality business. 4th quarter adjusted EPS is now expected to be in the range of $0.60 to $0.70 including approximately $0.19 from the temporal issues impacting gross margin. We are lowering our fiscal 2016 revenue growth outlook to flat to 1% or 2.1 $1,000,000,000 to $2,140,000,000 We now anticipate adjusted diluted EPS in the range of $1.19 to $1.29 Let me recap the previously discussed temporal costs and margin related issues that are impacting our fiscal year 2016 earnings. 1st, our more aggressive approach to rationalizing our SKU count and optimizing inventory and higher penetration of these sales is now expected to result in an approximate 0 point $4.0 to 0 point 4 $5 reduction to fiscal 2016 earnings. 2nd, accommodations largely due to RH Modern production delays during the first half resulted in an approximate 0 point 3 $0.25 negative impact related to deferred membership revenue, which will not be recognized in the period collected. This is lower than our prior outlook given the lower 4th quarter sales outlook. As we look ahead to next year, we expect to cycle many of these one time costs and investments and expect sales to reaccelerate, operating margins to expand and to be free cash flow positive. We believe we are making the necessary investments in 2016 to position our business for the long term and for higher growth and cash flows beginning next year. Let me now turn to our results and Q3 performance. Total revenues during the Q3 increased 3% on top of 10% last year. Approximately 5 points of growth during the Q3 resulted from the addition of Waterworks. While written orders were lower than anticipated during the quarter, our conversion of orders into sales was better than anticipated given our strong in stock levels and supply chain improvements and related consumer preferences, which drove higher than expected net revenue growth during the period. In addition, our non comp next generation design galleries and standalone RH Modern store contributed to our growth in the Q3. Comparable brand revenue declined 6% during the quarter, largely driven the 3% decline we experienced in our direct channel. The decreases in our direct channel and comp store sales were largely driven by the lack of a spring source book mailing this year, as well as the fact that we have not introduced any meaningful newness in our core business or made any significant changes to our legacy store floor sets in over 16 months. During the quarter, we added 5 outlet locations in conjunction with our SKU rationalization and inventory optimization efforts. Outlet sales did not contribute to our growth during the quarter as we were up against last year's annual warehouse sale volume. Adjusted gross margin decreased 4 40 basis points to 32.3 percent, consistent with our expectations. As we have discussed in the past few quarters, our gross margin is being impacted by several temporal factors that are a drag on margins this year that we do not anticipate occurring next year. Most significantly, gross margin in Q3 was impacted by the higher discount rate offered through the RH members program versus our prior promotional cadence in the Q3 of last year. In addition, SKU rationalization resulted in an approximate 120 basis point negative impact to gross margin in the 3rd quarter and the membership deferral impacted margin by approximately 30 basis points during the quarter. Transportation costs in the quarter were also higher due to the the incremental and one time shipping and transportation costs associated with the reset and remodel of our retail stores during the quarter. Adjusted SG and A delevered 170 basis points during the quarter, driven by Waterworks related employment and other corporate costs of 70 basis points. One time costs associated with the retail floor resets and addition of design affiliates in our galleries and other corporate costs, offset by advertising leverage as we moved our spring source book mailing to the fall. Our adjusted earnings per share of $0.20 includes approximately $0.14 related to the temporal costs and investments impacting gross margin. Turning to the balance sheet. Inventory at the end of the 3rd quarter was up 2% versus last year. Excluding the addition of Waterworks, RH inventory was down 2% compared to last year, reflecting the significant progress we have made in our inventory optimization efforts. Our diligence in this process has allowed us to remove inefficient SKUs from our assortment, eliminate the need for additional DC occupancy and improve our working capital. Our inventory growth is expected to end the year roughly in line with sales growth as we are benefiting from our SKU rationalization efforts. As a result of continued capital discipline, we are lowering our fiscal 2016 CapEx outlook to a range of $180,000,000 to $190,000,000 from our prior range of $180,000,000 to $210,000,000 We opened 4 next generation design galleries in fiscal 2016 and remain on track to open 5 in fiscal 2017, including galleries in West Palm Beach, Toronto, New York, Portland and Nashville, in addition to a billboard location in the Napa Valley. Accordingly, new store month, excluding Water Works, are expected to accelerate from 42 in fiscal 2016 to more than 60 new store months in fiscal 2017. We are pleased with the progress we are making as it relates to our real estate transformation and the performance of our next generation design galleries opened thus far, all of which are tracking at or above expectations despite the later source book and macro factors impacting our business in 2016. In addition, we are extremely pleased with the performance of the RH members program. We now have approximately 260,000 customers who have become RH members and over 90% of sales in our core business have come through memberships since the launch of this program. While we've experienced short term margin pressure associated with the 25% discount without the full benefit of the membership fee, we believe the program is the right thing for our business and our brand in the long term. As we enter 2017 and anniversary the program, we expect margins to expand as we benefit from both the deferred membership revenue and the renewal of current members. Based on the nature of our business and home buying cycles, we also expect to continue to attract new members to this program year after year. In closing, while there are temporary factors impacting our business in the short term, our long term growth strategies remain firmly intact. We continue to believe that we have an opportunity to reach $4,000,000,000 to $5,000,000,000 in North American sales, mid teens operating margin, improved returns on invested capital and drive significant value for our shareholders over the long term. We wish you, our team and all of our partners a very happy holiday season.