Earnings Call: Q2 2016

Sep 10, 2015

We are often asked by investors and analysts, how do you think about the threat of online retailers? What do you believe your strategy of opening larger stores will succeed? What about the risk of complexity? You're expanding into new categories and businesses at an unprecedented pace. I thought we would take a moment and share our thinking on these topics and while doing so, put our less than conventional strategy into the proper perspective. We believe the right question to ask is this one. How many online only retailers have reached $1,000,000,000 in revenues and have positive net income? For the 2014 fiscal year, the answer would be 2 and just barely. Many investors and analysts are seduced by the notion of a capital light retail strategy and completely overlook the fact that the ongoing advertising expense to market an invisible online store is an unproven and we believe unsustainable model. Also interesting is when investors or companies tout their online growth rates, believing it to be the more profitable channel. First, it's obvious that growth rates in a new undeveloped channel will grow faster than a mature one. It's also somewhat irrelevant. A big percentage of a small number is still a small number. Shifting transactions from one channel to another does not change the economics. We know of no store based retailer that significantly increased their operating margins by growing online faster than retail. The important question is, why would anyone conclude that online is more profitable than retail? As we've said before, it's not about physical versus digital. As A. T. Kearney eloquently put it, it's about physical with digital. Where the transaction takes place is a lot less important than where the decision to purchase is derived, unless you're positioning yourself to be the low price leader or you're selling replenishable commodity products like laundry detergent, paper towels, groceries and the thousands of things that we don't sell. That's why we believe when the dust settles, our strategy of undertaking what is arguably the most significant retail store transformation in history will prove to be the right one. That the physical manifestation of an aspirational brand in an inspiring three-dimensional environment will prove to be more important than an invisible one dimensional online store. Retailers who demonstrate true product leadership with an inspiring physical presence and a fully integrated channel agnostic strategy will win. We believe our performance proves that point. We have demonstrated, 1st in Houston and in Los Angeles in 2011, then with Scottsdale and Boston in 2012 'thirteen and now with Greenwich, Melrose and Atlanta that our real estate strategy has more than doubled our retail sales and earnings versus our legacy stores, while also lifting our direct business in each market. And we believe our next generation design galleries scheduled to open this year in Chicago, Denver, Austin and Tampa will increase retail sales and earnings by 3 times on average versus our legacy stores in those markets. While our model might be capital heavy, it is also earnings heavy, which we believe will prove to be significantly more valuable than a capital light, earnings light model. Let me address the risk of complexity. We would have you focus on our execution during this time of unprecedented growth. Our operating margins in the almost 3 years since our public offering have grown from 5.8% to our guidance of at least 10.5% this year, roughly the same as our largest peer on half the revenue. That's in spite of the significant investments we are making to develop the many new businesses we have in the pipeline and the infrastructure we are putting in place to scale them. As Ken Denae, our Chief Operating Officer, likes to point out during our leadership team meetings, while the left hand side of the equal sign is important, it's the right hand side that counts. We believe the right hand side of the equal sign would say we are very good at executing what some might see on the left hand side as a complex strategy. Since we are on the topic of unprecedented growth, let me turn your attention to what will be the most revolutionary period of innovation ever witnessed in our industry. During the span of 3 months, September through November, we have 2 significant new businesses launching with their own source books, websites and a significant retail presence, RH Modern and RH Teen. We have 4 revolutionary next generation galleries opening in Chicago, Denver, Tampa and Austin. These never seen before retail experiences blur the lines between residential and retail, indoors and outdoors, physical and digital, experience that feel more like a home than a store where customers say, I want to live here. In Chicago, we will again break new ground as we attempt to blur the lines between home and hospitality, integrating a restaurant and a wine bar in a seamless fashion. Unlike other stores with a cafe or restaurant where there's a clear demarcation between the 2, ours will be an integrated experience designed to render the whole more valuable. In Denver, we will be the 1st specialty retailer in history to ever anchor a regional shopping center. We've replaced a former Saks Fifth Avenue with the developer rebuilding and remerchandising an entire wing of the mall. Our new galleries will have a full floor, up to 15,000 square feet dedicated to RH Modern, and RH teen will share a full floor with RH baby and child. We will be unveiling a revolutionary new design atelier in these galleries, a dedicated space for interior designers and architects to work with their clients to design their homes. There will also be newly designed apartments for window treatments, rugs, bed and bath linens and bath hardware. The new galleries will have up to 16,000 square feet designated for RH Outdoor with a rooftop conservatory and park plus terraces and gardens on the ground floor. No one has ever built a retail experience like this. We just finished photography for RH Modern and it looks better than we could have ever imagined. The book designed by Fabian Baron, who Vanity Fair calls the most in demand art director in the world is revolutionary in both substance and style. Weighing in at approximately 500 pages, it is the most comprehensive launch of a new business and brand in the history of our industry. Let's take a quick peek. Our first standalone RH Modern store in Los Angeles will itself be a revolutionary concept. The entire building and outdoor space have been completely reimagined into a contemporary structure reflecting the design vernacular of this new business. The space will include a modern sculpture garden for outdoor collections with soaring palm trees, stretched canvas and an 18 foot wide and 16 foot tall wall of water inspired by the famous fountain in New York City's Paley Park. The interiors reflect the new brand's point of view with a 2 story lobby and monolithic staircase that leads you to the 2nd floor. The entire space will be finished with polished plaster by Olivier Garnier and will serve as a canvas for artistic installations of home furnishings in a gallery setting. The space will also include an integrated RH Contemporary Art Gallery as we expand our plan to make original artwork more accessible. This new store concept will be as innovative in its own right as our new Melrose Gallery, which opened in October of last year. You may have noticed the e mail teaser for our H team we sent out recently. To remind you, we are launching a 200 page source book, a dedicated website and a significant retail presence. Here is a short video that will give you a sense of the style and spirit of this new brand. The sheer scope of what we're about to show the world in such a short period of time illustrates our execution capabilities, our unmatched level of innovation and the power of our multichannel platform. It also puts us on a path to accelerate our growth in Q4 and into fiscal 2016. In closing, I'll return to the question I opened with. How do you think about the threat of online retailers? We believe the better question is, how do they think about the threat of RH? We remain on track to reach $4,000,000,000 to $5,000,000,000 in revenue with the mid teens operating margin once our North American real estate transformation is complete. We have a proven ability to execute during a period of unprecedented innovation in one of the most significant store transformations in retail history. And we remain confident that we will continue to gain significant market share and deliver profitable growth for our shareholders over the long term. Let me remind you how we get there. In addition to the continued expansion of our product offer, the key to unlocking the value of our company is the transformation of our real estate. Our next generation galleries will present 6 to 8 times the square footage of our legacy stores, and we expect retail sales to increase 2 to 4 times in each market. The incremental square footage will allow us to fully monetize the dominant assortments we have built and also capitalize on future category expansions and new businesses. In addition to sales growth in each market, we believe there are opportunities for significant operating margin expansion as we experience leverage of our occupancy, advertising and fixed corporate expenses as well as improvement in our product and shipping margins. By the end of our real estate transformation, we see a clear path to achieving mid teens operating margins above our Home Furnishings industry peers. We also see a clear near term path to becoming free cash flow positive and continue to expect to reach this important goal within 15 months. We continue to generate strong returns on our invested capital and believe that trajectory will only continue to improve. We have taken important steps to strengthen our balance sheet. As you know, we executed our 2nd 0 coupon convertible debt offering earlier this year and now have the capital to execute our strategy in any economic environment. It's also important to know that we also executed a hedge transaction that prevents dilution from the convertible bonds until our market cap reaches nearly $8,000,000,000 The hedge is also tax deductible further reducing the cost of this extra capital. Let me now talk about our recent results and outlook. We are pleased to again report industry leading results that exceeded our guidance during the 2nd quarter. Revenues during the quarter increased 17% on top of 14% last year as we continued to gain market share. Comparable brand revenue growth was 16% in the 2nd quarter on top of 13% last year. As we've stated in the past, the delta between comparable brand revenue growth and net revenue growth remain close until we see more meaningful square footage acceleration as we roll out our next generation design galleries. We also delivered solid earnings growth and operating margin expansion. Operating margins expanded 90 basis points to 12.2% and adjusted net income increased 30% to $36,000,000 during the quarter. Inventory at the end of the 2nd quarter was up 29% and we expect to end the year with inventory growth that is higher than our sales growth given the inventory investments necessary for the launches of RH Modern and RH Teen. In addition to our continued product innovation and the launch of our 2 new businesses, as well as the acceleration of our retail store transformation, we continue to execute on several key operational initiatives. The investments we have made in our supply chain and systems infrastructure enable us to improve the customer service experience and support our long term growth. In August, we opened a new state of the art 1,500,000 square foot furniture distribution center in Northern California to support our growth. We recently completed the pilot of our Final Mile customer delivery system as well as the successful implementation of a new scalable financial system and continue to make progress with our new CRM platform rollout. Turning to our outlook, we continue to expect fiscal 2015 weighted average lease selling square footage growth to be in the mid teens. We would expect to have approximately 22 new next generation Design Gallery store months in fiscal 2015, accelerating next year to approximately 50 to 60 new store months as we benefit from the stores that we are opening late this year, plus the addition of the next generation Design Galleries opening in fiscal 2016. Based on the continued momentum and strong business trends of our core business, in addition to the launch of RH Modern and RH Teen and the new stores opening later this year, we are increasing our fiscal 2015 revenue guidance to $2,158,000,000 to $2,178,000,000 representing growth in the range of 16% to 17%. We have also raised our adjusted operating margin outlook to a range of 10.5% to 10.7%. Our adjusted diluted EPS guidance has increased to a range of $3.06 to $3.16 representing growth in the range of 30% 34%, above our long term target of earnings growth in the mid to high 20s. As discussed with you last quarter, in 2015, more than half of our newness is being introduced later in the year via the launch of RH Modern and RH Teen. While our spring 2015 source book mailing was in home several weeks earlier than last year, the amount of newness that we introduced this spring was significantly lower than last year. Our 4 new next generation galleries plus our new freestanding RH Modern store in Los Angeles are opening in October November and will not begin to add meaningful growth until the Q4. The timing of the openings combined with the introductions of RHT and RH Modern now coming in the latter part of Q3 means our revenues will somewhat decelerate in the Q3 as we anniversary the build of the spring books from last year and then reaccelerate in the Q4 and into 2016 as we begin shipping orders from these new businesses. For the Q3, we anticipate revenue growth to be in the range of 10% to 12%, accelerating to 20% to 21% in the 4th quarter. We expect adjusted diluted EPS growth for the 3rd quarter in the range of 22% to 33% and 34% to 39% in the 4th quarter. We are excited about the future and the opportunity that lies ahead and are focused on delivering on our long term goals, including $4,000,000,000 to $5,000,000,000 in revenues in North America, mid teens operating margin and significant free cash flow generation and ROIC growth. We have a proven ability to execute and deliver. This, combined with our unmatched level of innovation and the power of our multi channel platform, positions us to continue to deliver industry leading results and tremendous value for our shareholders over the long term.