Earnings Call: Q1 2017

Jun 8, 2016

The Greek philosopher Epictetus said, it's not what happens to you, but how you react to it that matters. Our misfortunes of late are well known and widely documented. The launch of RH Modern, while the success on many levels, has suffered from difficulties ramping production. We continue to face headwinds in markets impacted by energy and currency. And there is a clear slowdown across the luxury market where we compete. Additionally, our decision to push out the mailing of our spring source books to fall, the move from a promotion source books to fall, the move from a promotion to a membership model and efforts to rationalize our SKU count are all weighing on our current performance. While the combination of these factors have made our business difficult to forecast in the short term, we are making strategic investments to position the brand accelerated long term growth. We plan to aggressively step up our investment in RH Modern as we correctly predicted the opportunity to create a new and incremental market. RH Modern has enjoyed strong demand since its inception and continues to gain momentum with in stocks now reaching 80%. Our first freestanding modern gallery in Los Angeles is on track to generate $25,000,000 annually. And the full floor presentations in our design galleries are performing exceedingly well. We believe the most important data point is the conversion of the 1st floor of our New York gallery, where we've experienced a sales increase of 35%. Based on these results, this fall, we will launch RH Modern across the entire retail fleet and believe we can create a meaningful positive arbitrage. This will be the most significant new product launch at retail in our history and will be supported by an expanded mailing of our Archimonde source book. Here's a preview of the new collection. Not all of the excitement this fall is modern. We will also be unveiling a dramatic refresh of our RH Interiors collection as the brand evolves to reflect a more contemporary point of view. The interior source book is being completely redesigned by famed Art Director, Fabienne Barron, who designed the RH Modern book and will feature a bold new logo, new layouts, new photography and several new furniture and lighting collections. Here's a sneak peek at what you'll see this fall. Additionally, the test of our first design atelier in Chicago, a fully integrated workspace for architects, designers and customers has been a huge success. We plan to begin rolling out design ateliers to all of our retail galleries beginning this fall, supporting our efforts to expand design services and position RH as a leading interior design firm. These strategic investments move the brand from beyond creating and selling product to conceptualizing and selling spaces. That same thinking led us to our partnership with Water Works. Water Works has long been the definition of the well appointed bath. It is the only complete bath and kitchen business, offering fittings, fixtures, lighting and surfaces under one brand in the market. We are thrilled to add this prestigious brand to our platform and welcome the dynamic Waterworks team to our family. It not only positions RH as an authority in the 2 most important rooms of the home, the bath and the kitchen, but also creates the 1st fully integrated luxury home platform in the world. Our recent move from a promotional to a membership model with the introduction of the RH Graycard further supports the evolution of our business from selling products to facilitating projects. While we are learning the selling cycle with members is longer as transactions are not closed with the urgency of artificially imposed sale deadlines, we are pleased with the early adoption rate and growth in average order size. At this point, we have every reason to believe membership will prove to be a success, elevating our brand, improving the customer experience and streamlining our business. Last month, we announced a new leadership structure, promoting Arie Chhaya, Damanti Price and Karen Boone to Co Presidents of RH. This new leadership structure is designed to increase collaboration and improve execution across the company. These leaders have already begun working together to break down silos, remove inefficiencies and engineered a leaner organization that will result in cost savings of approximately $20,000,000 annually. We also plan to simplify the network design of our supply chain. By holding product in fewer locations, we will reduce inventories and improve in stocks, while simplifying execution for our teams and our vendor partners. We continue to invest in the customer experience and have several initiatives we are working against. We are making significant investments to expand and elevate our design services, including adding additional designers and providing enhanced education, training and support. All of these efforts will be amplified by the installation of design ateliers in all of our galleries this fall. We recently rolled out the Salesforce CRM system across all of our galleries and continue to add capabilities that enable us to better serve our clients. We're in the early stages of rolling out our final mile home delivery system, designed to improve the customer experience and give us visibility of orders throughout our entire network. We are also testing taking more control of the customer experience by in sourcing delivery with our own trucks and drivers. And we are investing in a next generation digital experience and have hired a new Chief Digital Officer to lead that effort. Despite our recent difficulties, we remain the leading luxury home brand in the world with a clear path to $4,000,000,000 to $5,000,000,000 in North American revenues with mid teens operating margins. The 2 fundamental strategies that get us there, the expansion of our product offer and the transformation of our real estate, remain on track. If you look back historically at what we've accomplished, it paints a clear picture of what lies ahead. We began as a retailer of nostalgic discovery items with a $20,000,000 market cap and an 84 page catalog and transformed into a $2,000,000,000 plus luxury home platform with 2,500 pages of Inspire Design. As it relates to our product strategy, there are 3 key points to remember. 1, product of this quality has never been made in these quantities. 2, we built a product platform that amplifies the work of the best designers, artisans and manufacturers in the world, create a powerful competitive advantage. And 3, design of this quality was only available behind the iron curtain of the 2 to 3 design centers, a highly fragmented market with a lack of accessibility, transparency and scale. As it relates to our real estate transformation, it's important to understand we spent the last decade sizing our assortments to the potential of the market versus limiting them to the size of our stores. The vast majority of our legacy stores display less than 10% of our current assortment, and the key to unlocking the value of our company is to transform our real estate. We like to say, it's not about the Internet. Only 10% of retail sales are done online. It's about the lack of imagination at retail. Mall and Acre stores are archaic windowless boxes that lack any sense of humanity. There's no fresh air or natural light, and most like this one look like bomb shelters. This happens to be a picture of a former Saks Fifth Avenue that was torn down to build RH Denver, the gallery at Cherry Creek. We're building inspiring spaces that blur the lines between residential and retail, indoors and outdoors, physical and digital, spaces that are more home than store. The next logical step was to blur the lines between home and hospitality. That's what we've done at RH Chicago, the gallery at the historic 3 Arts Club. We've integrated a Courtyard Cafe under a soaring atrium filled with natural light, where you sit under olive trees and listen to the sound of trickling fountains while enjoying brunch, lunch or dinner. There's a dramatic wine vault with gold leaf groin vaults and sparkling chandeliers, where guests can choose from a curated selection of wines from around the world. The gallery also has a pantry and coffee bar, where customers enjoy handcrafted coffee drinks, fresh baked pastries and award winning donuts from Chicago's famous Donut Bowl. The gallery at the 3 Arts Club to seamlessly integrate the experience where the whole becomes more valuable than the parts. Based on the success of Chicago, we plan to integrate hospitality into several of our new galleries beginning in 2017, including RH San Francisco, the including RH San Francisco, the gallery at the historic Bethlehem Steel Building RH Nashville, the gallery in Green Hills RH Palm Beach, the gallery at City Center and RH New York, the gallery in the historic Link Packing District. With only 5 markets of next generation design galleries today and all a exceeding plan. We are at the very beginning of what we believe is the most significant retail transformation in the history of our industry. While our missteps and investments to transform our brand and business have depressed results in the short term, In the context of our long term vision and strategy, I believe they'll be recalled as brave bumps along the road less traveled, one that will be paved with innovation and leadership and long term value creation for our shareholders. While we are experiencing headwinds and missteps as it relates to our near term performance, we believe that our long term growth prospects are very strong and continue to see a clear path to generating $4,000,000,000 to $5,000,000,000 in revenue with the mid teen operating margin once our North American real estate transformation is complete. Let me start with our recent results and Q1 performance. Comparable brand revenue growth was 4% in Q1 on top of 15% last year. Total revenues during the Q1 increased 8% on top of 15% last year. We continue to experience weakness in markets impacted by currency and energy related consumer spend as well as overall softness in spending by the luxury consumer. We invested approximately $18,000,000 during the Q1 in customer accommodations and related expenses, largely as a result of RH Modern production delays as well as our overall initiative to elevate the customer experience. Approximately $14,000,000 resulted in a direct offset to revenue. This was higher than our original expectation of 8 to 10,000,000 as improvements in our modern in stock levels allowed us to fulfill more modern demand than anticipated, but drove higher accommodations during the period. We've also seen our cancel rates improve as a result of these efforts. Excluding the impact of the incremental customer accommodations, revenues increased 11% during the Q1. Adjusted gross margin decreased 4.60 basis points to 29.7%. Gross margin is being impacted by several one time factors that are important to understand. First, costs associated with accommodations due to RH Modern production delays and our efforts to elevate the customer experience are causing a drag of 300 basis points to gross margins. This consisted of approximately $14,000,000 of customer accommodations that were a direct offset to revenue as well as $4,000,000 of expedited shipping charges and other product costs. These investments had a negative impact to gross profit of 18,000,000 in the Q1. 2nd, while over the course of the annual membership period, the gray card will be margin neutral, the membership fee is amortized on a monthly basis over the membership period and therefore a drag to margin in the short term. During the Q1, this resulted in deleverage of approximately 80 basis points as we collected approximately 6,000,000 of membership revenue, of which approximately 5,000,000 was deferred and will be recognized over the next 12 months. In addition, we have not yet wrapped the higher supply chain occupancy related to our new DC in Northern California, which was opened in the Q3 last year. Partially offsetting this was modest leverage of our fixed retail occupancy costs. SG and A leveraged slightly during the Q1, largely driven by advertising leverage and offset by higher employment costs and other general and administrative expenses. We reported an adjusted net loss per share of $0.05 This includes approximately $0.34 related to the one time cost and investments impacting gross margin. Excluding these costs, EPS would have been $0.29 per share. Inventory at the end of the Q1 was up 27%. We continue to expect inventory growth to moderate substantially this year as we do not plan to introduce any new businesses. Our newness will be introduced during the second half consistent with 2015 and based on our plans to optimize our to optimize our current product assortment and improve our inventory turns. We are pleased to announce that we recently closed the acquisition of Waterworks. This transaction was valued at $118,000,000 and was funded from our existing cash balances. Following this transaction, we have approximately $230,000,000 in cash on hand. Waterworks has a double digit EBITDA margin and will be accretive to earnings this year. Turning to our outlook, as Gary discussed, there are a combination of factors that are impacting our business in the term, including the launch of the RH Graycard, headwinds in energy and currency impacted markets, moving the annual source book mailing and newness introductions to the fall, and our efforts to rationalize and optimize our inventory. Modern in stocks at the end of the Q1 were higher than anticipated, and we were able to ship more modern demand during the Q1 than in our original plans. This resulted in a slight pull forward of revenue from the Q2 into the Q1. We now expect to invest 2,000,000 to 3,000,000 during the Q2 due to customer accommodations related to RH Modern and our overall efforts to elevate the customer experience, below our original estimate of $5,000,000 to $7,000,000 Including this investment, as well as the integration of Waterworks, revenue is expected to be in the range of $505,000,000 to $520,000,000 As we look to the Q2, we do expect gross margins to delever at a more significant rate than the Q1. We estimate a decline of 6 to 700 basis points due to several factors. First, we are now planning a much more significant rationalization of our SKU count and reduction of inventory during the Q2, which will result in an approximate 250 basis point impact to gross margins. 2nd, we expect deleverage of approximately 100 basis points related to deferred membership revenue, which will not be recognized in the period collected. To deferred membership revenue, which will not be recognized in the period collected. 3rd, we expect an approximate 40 basis point drag from accommodations due to RH Modern production delays and our efforts to elevate the customer experience. These investments are not expected to continue into the back half of the year as RH Mod will be substantially in stock and our back orders return to normalized levels. We expect to continue to experience deleverage in our DC occupancy costs given the wrap of our Northern California DC, which opened last year in Q3 and outlet occupancy due to 4 new outlets opening during the Q2. We expect the decline in gross margin to moderate in Q3 and begin to expand in Q4 as we lap the significant promotional activity from the prior year. 2nd quarter adjusted EPS is expected to be in the range of $0.28 to $0.33 including the one time factors impacting gross margin. As a result of the continued weakness in energy and currency related markets as well as the slowdown in luxury consumer spend, in addition to the investments we are making in our customer experience and accommodations, our efforts to rationalize our inventory this year at a more accelerated pace and the ramping of the gray card, we are lowering our fiscal 2016 outlook. We now expect revenue growth in the range of 1% to 3% inclusive of Waterworks. We are lowering our fiscal 2016 earnings growth outlook and now anticipate diluted EPS in the range of $1.60 to $1.80 Let me recap the previously discussed one time costs, investments and margin related factors that are impacting our fiscal 2016 earnings. 1st, accommodations largely due to RH Modern production delays during the first half are resulting in an approximate $0.30 negative impact to fiscal 2016 earnings. 2nd, an approximate $0.30 to $0.35 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 a $0.30 to $0.35 reduction to fiscal 2016 earnings. Excluding these short term margin and cost items, fiscal 20 16 EPS guidance would be in the range of 2.50 dollars to $2.80 We've begun to see some of the improvements in our operating model that were expected from the transition to a membership model. These have allowed us to redesign and architect many areas of our business to be more efficient. We believe there is a broader opportunity to streamline many processes and have aligned our headcount accordingly. These actions are expected to result in over $20,000,000 of savings annually and will result in one time severance charges in the first half. We have also taken some aggressive actions to reduce discretionary spending and manage expenses in light of the current headwinds. As we look ahead to next year, we expect to cycle many of these one time costs and investments and expect sales to reaccelerate and operating margins to expand. Additionally, new store months are expected to accelerate from 40 in fiscal 2016 to a range of 60 to 70 in fiscal 2017. While we have experienced near term headwinds and missed debt, our long term strategies are intact and we have tremendous confidence in the long term opportunity to reach 4 to 5,000,000,000 in North American sales, mid teens operating margins, improved returns on invested capital and significant shareholder value creation over time.