Earnings Call: Q2 2017

Sep 8, 2016

Charles Darwin believed, it is not the strongest of the species that survives, nor the most intelligent, but the one most responsive to change. As we think about how quickly information circles the globe today, we believe trends are being halved and competitive advantages are becoming unsustainable. We believe the pace of change and innovation must become revolutionary versus evolutionary. We believe only brands that are willing to continually disrupt their own business models will thrive, while others struggle to survive. We also believe being bound by conventional wisdom or traditional business constructs that limit innovation and change will create the proverbial sitting ducks, ripe targets for well funded startups who are unconstrained by the short term thinking of public markets. We live in a world where an entire industry can be disrupted by a single app. The only sustainable competitive advantage is a culture of imagination and innovation. Organizations that are hardwired to imagine the future and have architected a culture of innovation to build it. That is why you can expect us to continually destroy our own reality to create tomorrow's future. We believe you have to think until it hurts, until you can see what others can't see and do what others can't do. Whether it's the complete transformation and reconceptualization of our retail stores to immersive design galleries that will more than double our business in every market, the continued expansion of our product offering, like the recent launch of RH Modern or the addition of Waterworks, both brands that we believe can be in excess of $1,000,000,000 the move from a promotional model to a revolutionary new membership model that will simplify and streamline our business, eliminating tens of 1,000,000 of dollars of cost and working capital, the delay of our spring source books to fall, allowing us to completely redesign and rephotograph our core RH interior source book we're moving beyond a traditional retail model that creates and sells products to a multidimensional ecosystem that conceptualizes and sells spaces. We will forever be focused on the important strategic moves that will define our brand and redefine our industry. Because we are continually innovating and iterating, we are often misunderstood. Let me take a minute and attempt to simplify the many initiatives we are pursuing for 2016 that are temporarily depressing short term results as we position the brand for long term growth. If you put the macro headwinds to the side, there are 4 temporal issues affecting our performance in 2016. 1, the costs related to the launch of RH Modern 2, timing issues related to the launch of membership 3, efforts to reduce our inventories and rationalize our SKU count and 4, our decision to push our source books from spring to fall. Let me add some color to each one of these. First, the costs related to the launch of RH Modern have been widely discussed and well documented. We invested approximately $20,000,000 to delight our customers due to the difficulties ramping up production on some of the new product lines. We are now well past those issues and are tracking at 90% in stock on non special order items. 2nd, the timing issues related to the launch of RH membership are twofold. 1, we increased the discount rate for members, but have to amortize the membership fee we receive over 12 months, thus depressing revenue and earnings this year and benefiting revenues and earnings next year. 2, we have learned that the buying cycle of a member is longer without the artificially imposed deadlines of promotional end dates. Therefore, pushing revenues from Q4 this year into Q1 next year. 3rd, our efforts to reduce inventories and rationalize our SKU count will enable us to forego building another distribution center this year and allow us to simplify our supply chain network design, optimizing inventory and reducing the long term working capital needs of the business. 4th, while the decision to move our spring source books to fall is having a negative impact on our revenue in the near term, it was an important decision for two reasons. 1, it gave our vendors time to recover from the launch of RH Modern. And 2, it allowed us time to completely redesign and rephotograph our entire collection of source books, presenting our brand in a fresh and dynamic new format. While these investments are having a temporal effect on our 2016 financial results, they are positioning the brand and business for accelerated revenue and earnings growth in 2017 and beyond. Additionally, there are several near term priorities that will create an inflection point beginning in Q4. First, the RH Interiors book has been completely redesigned by legendary director Fabian Baron, who designed the RH Modern book. Like RH Modern, the book highlights our relationship with some of the world's most renowned and respected designers and captures the unique design, quality and aesthetic details that differentiate the RH brand from others in the market. The architecture of the book creates a harmonious balance between key items, category and lifestyle presentations that amplify both the customer experience and business logic, while presenting the entire collection in a fresh new light. 2nd, based on our tests of RH Modern in several markets last year, we are introducing RH Modern in all of our galleries. 3rd, we are also installing Design Ateliers, a professional workspace where customers can conceptualize and design their homes and spaces. We are making a significant investment in our interior design program, doubling our team of designers versus a year ago, and training our entire team on our unique design ethos and philosophy. While many in our industry have been aggressively marketing design services, which frankly are nothing more than novice decorators or sales associates posing to something more than they are. We've been relatively quiet in regards to marketing our interior design program, as we've worked for the past several years developing our capabilities and culture. We believe we are now ready to exploit this unique capability, which also supports our evolution from creating and selling products to conceptualizing and selling spaces. This fall, we plan to launch an innovative multi channel marketing campaign, including print, digital and video across the leading lifestyle publications, websites and social platforms. The campaign demonstrates our ability to imagine and transform spaces, while communicating our unique and authentic design philosophy. The infinite potential of a blank canvas, the reinvention of your favorite room, the home you hope to create. We believe the most pleasing environments are a reflection of human design. They are a study of balance, symmetry, and perfect proportions. We respect the hierarchy and important relationships between architecture, furniture, and decor that create harmony. It's the discipline of addition through subtraction, where less becomes more and calm is created through continuity. The result is a holistic design that is strong, yet simple. We subscribe to da Vinci's philosophy that simplicity is the ultimate sophistication. Our designers place you at the center of the creative process, working to realize the potential of your home and bring your vision to life. All you have to do is imagine. And lastly, our Real Estate transformation will continue to create incremental revenue as we complete our openings for 2016, which include RH Kansas, the gallery in Leewitt, which opened last month RH Austin, the gallery at The Domain, which opens next week RH Las Vegas, The Gallery at Tivoli Village, opening in October. And RH Seattle, The Gallery at University Village, opening this November. Next year, we will continue to gain momentum from gallery transformations and new locations as we plan to open RH Toronto, The Gallery in Yorkdale RH Palm Beach, the gallery at City Place RH Nashville, the gallery in Greenhills RH Portland, the gallery in the Northwest Historic District RH Yountville, the gallery in Napa Valley and RH New York, the gallery in the historic Meatpacking District. In Palm Beach, Nashville, Yountville in New York, we have the added benefit of restaurants, wine vaults, and coffee bars, expanding upon the success of our first hospitality venture at the historic 3 Arts Club in Chicago. Famed restauranteur, Brenda Sotokoff, our partner in Chicago, has joined our team as the Founder and President of RH Hospitality. Brendan began his career in Paris, working with Alain Ducasse and honed his culinary skills with Thomas Keller at The French Laundry and Rich Meldman at Lettuce Entertain You, before creating his wildly successful Hog Salt Hospitality Group. Brendan is building a world class team of hospitality professionals, as we add this exciting new dimension to our immersive brand experience. Let me end with a few thoughts. While the degree and pace of innovation at RH might seem ambitious comparatively, It is the result of years building a culture engineered to be, as Darwin believed, the one most responsive to change. In a world moving exponentially faster, where evolution is being replaced by revolution, we believe we are building the only true sustainable competitive advantage, a culture of imagination and innovation, a culture that is proving itself capable of imagining the future and an organization that is demonstrating it can build it. While fiscal 2016 represents a year of strategic investments that are pressuring short term results, we believe these important decisions will strengthen our brand and position the business for sustainable long term revenue and earnings growth as we continue on our path toward $4,000,000,000 to $5,000,000,000 in North American revenues with mid teens operating margins. The continued expansion of our product offering, including the strong initial consumer response to RH Modern will be amplified later this year through a significant retail presence across our entire fleet. Our RH Modern gallery in Los Angeles continues to track toward over $25,000,000 in annual demand sales, and we believe that Modern has been largely incremental to our business and the markets where we've added it. As it relates to the transformation of our real estate, we are pleased with the progress we are making and the performance of our next generation design galleries opened thus far. Our Atlanta next generation design gallery has now been open for nearly 2 years, and our galleries in Chicago, Denver, and Tampa have all been open nearly a year and are all tracking at or above our expectations. New store months, excluding Water Works, are expected to accelerate from 42 in fiscal 2016 to a range of 60 to 70 in fiscal 2017. Our Co President and Chief Operating, Service and Values Officer, De Monte Price, is making significant changes and investments across our entire supply chain and customer experience platform, including new leadership for our supply chain, home delivery and customer care centers. Recently, Alex Kruger joined us as Chief Supply Chain and Customer Experience Officer. Alex spent the past 6 years at Amazon in fulfillment and customer service, most recently leading their North American customer operations. And prior to Amazon, Alex had supply chain leadership positions at Target and M&M Mars. Additionally, DeMonte and Alex are making revolutionary changes in investments to elevate our furniture home delivery experience, which we believe will reduce delivery failure rates, returns, damages and other costs by the second half of twenty seventeen. Let me now turn to our recent results and second quarter performance. Total revenues during the Q2 increased 7% on top of 17% last year. Approximately four points of growth resulted from the addition of Waterworks during the quarter. In addition, our next generation design galleries and our standalone RH Modern store that opened last fall contributed to our growth in the Q2. We also added 4 outlet locations in conjunction with our SKU rationalization efforts, which drove higher outlet sales during the quarter. Revenue growth in our core business was higher than anticipated during the Q2 as we were able to convert a higher percentage of orders into sales, particularly in our Outdoor business. This resulted in a significant pull forward of revenue into the Q2 that we had expected to book during the Q3. The percentage of revenues from our membership program continues to perform as expected, and we are pleased thus far with the early results. We do expect to see an increase in both membership and revenue growth in the Q4 and into next year as the mailing of our fall books represent the 1st significant marketing of the program outside of email, which is a much smaller database. Comparable brand revenue declined 3% during the Q2, largely driven by the 2% 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. Adjusted gross margin decreased 560 basis points to 33.7 percent consistent with our expectations. As discussed last quarter, gross margin is being impacted by several temporal factors. 1st, costs associated with accommodations due to RH Modern production delays and our efforts to elevate the customer experience resulted in a drag of approximately 20 basis points. 2nd quarter, this resulted in deleverage of approximately 80 basis points. 3rd, during the Q2, we began rationalizing our SKU count and reducing inventories through markdowns in our outlet channel. This resulted in an approximate 220 basis point negative impact to gross margin. We plan on continuing these efforts throughout the remainder of the year, however, anticipate the most significant gross margin deleverage occurring during the Q2. We also experienced deleverage in our gross margins related to the higher discount rate offered through the RH members program versus our prior promotional cadence in the Q2 of last year. Lastly, we have not yet anniversaried the higher supply chain occupancy related to our new DC in Northern California, which opened in the Q3 of last year. Adjusted SG and A deleveraged slightly during the Q2, driven substantially by Waterworks related employment and other corporate costs, offset by advertising leverage as we moved our spring source book mailing to the fall. We reported adjusted earnings per share of $0.44 This includes approximately $0.30 related to the temporal costs and investments impacting gross margin. Inventory at the end of the second quarter was up 14% versus last year. We continue to expect inventory growth to moderate substantially this year given our plans to optimize our current product assortment and improve inventory turns, as well as the fact that we are not introducing newness until later in the year. Turning to our outlook, as we discussed last quarter, there are a combination of factors that are impacting our business in fiscal 2016. Given the pull forward of sales into the Q2 from the Q3, given shipping and delivery efficiencies, revenue is expected to be in the range of $520,000,000 to $530,000,000 in the 3rd quarter. We expect the decline in gross margin to moderate in Q3 and we expect gross margins to begin to increase in Q4 as we lap the significant promotional activity from the prior year. We anticipate Q3 adjusted gross margin to decline approximately 400 to 4.50 basis points versus the prior year. The most significant drivers of the decline are related to our SKU rationalization efforts and the deferred membership revenue that we will not recognize in the period collected. In addition, we also expect to see an uptick in outlet occupancy and related opening expenses due to 7 new outlets opening during the quarter. 3rd quarter adjusted EPS is expected to be in the range of $0.13 to $0.18 including the temporal issues impacting gross margin and based on the Q2 earnings fee, which reflected a significant pull forward from the Q3. While we remain cautiously optimistic as it relates to the remainder of the year, we believe that several of the incremental investments we are making in the Q3 should begin to impact sales in the Q4 and into 2017. We are maintaining our fiscal 2016 revenue growth outlook of 1% to 3% inclusive of Water Works and adjusted diluted EPS in the range of $1.60 to $1.80 Let me recap the previously discussed temporal costs, investments and margin related issues that are impacting our fiscal year 2016 earnings. First, accommodations largely due to RH Modern production delays during the first half resulted in an approximate $0.30 negative impact to fiscal 2016 earnings. 2nd, an approximate $0.30 to 0 point 3 dollars to 0.35 dollars negative impact related to deferred membership revenue, which will not be recognized in the period collected. 3rd, our more aggressive approach to rationalizing our SKU count and optimizing inventory is expected to result in an approximate $0.30 to $0.35 reduction to fiscal 2016 earnings. Excluding these short term margin and cost items, fiscal 2016 adjusted EPS guidance would have been in the range of $2.50 to $2.80 As we look ahead to next year, we expect to cycle many of these temporal costs and investments and expect sales to reaccelerate and operating margins to expand. While there are temporal factors impacting our business in the short term, our long term strategies are intact and we have tremendous confidence in the long term opportunity to reach $4,000,000,000 to $5,000,000,000 in North American sales, mid teen operating margins, improved returns on invested capital and significant shareholder value over time.