Earnings Call: Q1 2016

Jun 11, 2015

Who is the home brand for the luxury customer? The Neiman's, Nordstrom's, Barneys, Bergdorf, LVMH customer? RH has built the most comprehensive collection of luxury home furnishings in the world. Over 2,700 pages presented across multiple source books, websites and the most inspiring spaces in the retail industry. Furniture of this quality has never been made in these quantities and our ability to develop a network of the finest artisan partners in the world has proven to be a meaningful competitive advantage. We are the largest retailer of Italian bedding, Belgian linen, ties silk, crystal lighting, and high quality solid wood, indoor and outdoor furniture in the country and possibly the world. We also believe it's important to point out that this level of design was only available behind the iron curtain of the 2, the trade design centers and only accessible to interior designers or those with a resale license. It's a market that has many layers of opacity and very little synergies. Opacity as it relates to customer accessibility, availability and pricing and an absence of synergies due to the fragmentation of distribution points, buying power and scale. We like to say there are those with taste and no scale and those with scale and no taste and believe the idea of scaling taste is large and far reaching. It's what Steve Jobs referred to as the most important difference between Apple and every other technology company when he said, ultimately, it all comes down to taste. It's what has enabled us to become the highest performing home furnishings retailer in the world, outperforming our peers by a wide margin. With average comparable brand growth of 25% over the past 5 years, we've gained significant market share and believe we have created a new and larger market, inspiring customers to invest in their homes. While our past performance has had historical standards, we believe it's our future plans that will make history. We are excited to unveil today what we believe is the most innovative and new concept in the world of home design and represents our finest work today. Introducing RH Modern. RH Modern launches this fall with a 300 page source book, a dedicated website, and a significant retail presence, including a freestanding RH Modern store at our former gallery on Beverly Boulevard in Los Angeles, the entire ground floor of our Flatiron Gallery in New York City, plus entire floors of our next generation design galleries in Atlanta and opening later this year in Chicago, Denver, Tampa and Austin. In each of these locations, we plan to integrate RH Contemporary Art, featuring exhibitions of the many artists we represent from around the world. Later this year, 20 of our largest legacy stores will be designed to include 2,000 to 3000 square feet dedicated to RH Modern. In total, RH Modern will have over 120,000 square feet of selling space in its 1st year of operation. Looking forward, with RH Modern occupying up to 15,000 square feet in our future next generation design galleries and the possibility for additional freestanding locations, RH Modern will have a retail footprint that grows by up to 100,000 square feet per year and will be a disrupted force in the highly fragmented modern market. We will also support the launch of RH Modern with a national advertising campaign in the top design and luxury publications such as Architectural Digest, Elle Decor, Town and Country, and Wallpaper, as well as key online marketing and opening events in Los Angeles and New York. As you may know, the home furnishings market for modern design has historically been small and some would say insignificant. What you may not know is who or what drives the trends in our industry. We believe the trends that are driving a shift towards modernism and support our thesis that we can create a significant and new market much larger than at any time in history. The largest trends in home design are driven by the dead. That's right. Generations pass away and their possessions go into estate sales, which feed the antique markets, which feed the high end design trade, which feed the reproduction market and trickle down from there. The second trend is being driven by architecture, which has been predominantly modern over the past 2 decades, with projects ranging from the Guggenheim in Spain to the largest private development project in the grow who have grown up with technology and modern workspaces are beginning to enter their home purchasing years and are driving this new trend. Additionally, my generation, the baby boomers, who have the greatest amount of disposable income want anything but to grow old. They're driving the pursuit of youth, anti aging and health and wellness trends. Even those who want to retire don't want to grow old to get there. We believe in the baby boomers quest to remain youthful and relevant. They will invest in upgrading their homes and surroundings to reflect what is current and of the moment, and they can certainly afford to do so. And lastly, the return to urban living and revitalization of cities is predicted to create a shift in where people live as our major cities densify and go vertical, emulating New York, Miami and Hong Kong. Hence, we believe modern living will become more meaningful than at any point in history conceptualizing, creating and capturing this new and important market. As we've articulated, our 2 largest value driving strategies are the expansion of our product offer and the transformation of our real estate. Beyond RH Modern, we have multiple new concepts in our product development pipeline that we believe will continue to demonstrate the innovative and disruptive nature of our brand and drive industry leading performance for years to come. But with less than 10% of our current assortment displayed at retail, the key to unlocking the value of our company is to transform our real estate platform and open next generation design galleries in every major market in North America. While many have allocated their resources to build an online business and are downsizing their retail presence in an effort to shrink to greatness, we have moved in exactly the opposite direction. When debating the general softness in US retail sales to the emergence of online shopping, 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 anchor stores are archaic windowless boxes lacking any sense of humanity. Without natural light or fresh air, plants die in typical retail stores. This is the building of an unnamed former retail anchor that has been torn down to build RH Denver, the gallery at Cherry Creek, opening this fall with 4 levels and 112 sets of French doors filled with natural light and fresh air with a conservatory and rooftop park, garden courtyards with trickling fountains and interior installations designed to inspire and enlighten spaces that reflect human design, balance, symmetry and the golden mean. Spaces that blur the between residential and retail, indoors and outdoors, physical and digital. Spaces that render its contents more valuable. Spaces that inspire customers to say, I want to live here. Spaces that on average will have 6 to 8 times the selling space and 2 to 4 times the revenue of our existing legacy stores and spaces that we believe will drive increased profitability and higher returns on invested capital. Our first next generation design gallery, RH Atlanta, the gallery at the estate in Buckhead, continues to accelerate and gain momentum and we are even more pleased with this evolution. With the 2015 source books just now reaching the Atlanta market, this gallery is on track to exceed our original expectations. Later this year, we are opening 4 new next generation galleries. RH Denver, the gallery in Cherry Creek, RH Tampa, the gallery at International Plaza, RH Austin, the gallery at the Domain, and RH Chicago, the gallery at the historic 3 Arts Club. As you might now come to expect, we will continue to innovate and evolve and believe we are creating spaces that will inspire our guests to invest in their most valuable asset, their homes. Throughout our organization exists a culture of disruptive innovation, a culture that is willing to destroy today's reality to create tomorrow's future. A culture that is obsessed with leadership and allergic to followership. While the world is always searching for a predictive model, the future is unpredictable. What is predictable is what you can expect from us. You can expect us to continue to innovate rather than duplicate, to deliver industry leading results, to invest our capital as if we owned 100% of the company, and it's the last place we will ever work. And you can expect us to never stop learning, questioning, challenging, testing and striving to become not only the home brand for the luxury customer, but to be one of the most admired and highest performing brands in the world. We 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 our North American real estate transformation is complete. Let me remind you how we get there. We believe we have the world's largest collection of luxury home furnishings under one brand, trapped in undersized 7,000 square foot legacy stores. And the key to unlocking the value of our company is to transform our real estate. Our next generation galleries will present 6 to 8 times the product assortment of our legacy galleries, and we expect retail sales to increase 2 to 4 times in each market as we continue to expand our product offering into new categories and businesses. 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 we have in the pipeline, such as RH Modern and multiple others that will be introduced over the next several years. Simply put, our retail presence in each market will go from 7,000 square feet of selling space generating approximately $10,000,000 in revenue to 45,000 square feet generating approximately $30,000,000 per year. The simple math will tell you that the implied productivity will therefore be lower. To be clear, our real estate story is not about growth and productivity and higher sales per square foot. It is about significant growth in sales and earnings and will result in occupancy leverage, margin expansion, increased cash flow and higher returns on our invested capital. And this is just at the retail store level. We have also experienced a lift in our direct business in every market to date. We are extremely pleased with the early performance of our recently opened galleries in Los Angeles and Atlanta. Both are tracking ahead of our original plans and provide even further validation of our long term strategy. We will be adding a full floor of RH Modern in the new Atlanta gallery later this year and believe the incremental revenues from this new business will drive sales further above our projections. Not only do we see a clear path to our long term revenue target of $4,000,000,000 to 5,000,000,000 but we also see a clear path toward industry leading mid teens operating margins. We expect to see 600 to 700 basis points of improvement in our operating margin from the 9.3% we ended last year. We also see a clear near term path to becoming free cash flow positive and continue to expect to reach this important goal within the next 6 to 18 months. As Gary points out, we've been growing our business horizontally by expanding our product assortment and adding new businesses. It takes a year to properly optimize new investments. We expect that as we accelerate square footage growth and grow our business vertically as with most retail models you are used to, we will begin to increase inventory turns and significantly improve cash flow and working capital needs. We are also working with our vendors to extend our payment terms such that our payables increase as our businesses scale together. Let me now talk about our recent results and outlook. We are pleased to report results that exceeded our guidance during the Q1. Revenues during the quarter increased 15% on top of 22% last year, driven by strength across all channels and continued strong consumer response to our existing product assortments and newness introduced to date. We continue to gain market share and deliver industry leading sales growth. Comparable brand revenue growth was 15% in Q1 on top of 18% last year. As we have stated in the past, the delta between comparable brand revenue growth and net revenue growth will remain close until we see more meaningful square footage acceleration as we roll out our next generation design galleries. We delivered solid earnings growth and operating margin expansion. Adjusted net income increased 38 percent to $9,800,000 during the quarter. Inventory at the end of the Q1 was up 24% and we expect to end the year with inventory growth that is higher than our sales growth given the inventory investments in RH Modern and other newness that we will introduce this fall. Turning to our outlook, let me start with some context that is important for you to understand. First, our next generation design gallery rollout is in its infancy and will begin ramping later this year and into fiscal 2016 and beyond. While our least ending selling square footage is expected to increase by approximately 30% this year, on a weighted average basis that equates to approximately 16% growth. Also, when we first open a new store, is important to remember that there is a ramp period that exists for written orders to convert to shipped net revenue. That is why we have a 14 month period for new stores to reenter the comp. In very simplistic terms and not adjusting for this ramp, in the first half of fiscal twenty fifteen, our business will have the benefit of 6 new store months. That is 1 next generation gallery Atlanta will be open for 6 months. The number of new store months will accelerate later in the year as we open 4 next generation design galleries. In fiscal 2015, we would expect to have approximately 20 new store months. In fiscal 2016, that accelerates meaningfully to approximately 50 to 60 new store months as we benefit from the new stores that opened in the latter part of fiscal 2015 plus the greater number of next generation galleries we plan to open next year. The second point I would like to highlight regarding our near term outlook relates to our new product introductions. In 2015, more than half our newness will be introduced later in the year via the launch of RH Modern and another new category we will announce shortly, as opposed to all in the spring as has been the case in the last few years with our annual spring source books. Based on the continued momentum and strong business trends, along with our plans for the launch of our new categories, we are increasing our fiscal 2015 revenue guidance to $2,146,000,000 to $2,176,000,000 representing growth in the range of 15% to 17%. With RH Modern and another new yet to be announced incremental business both launching this fall, we expect business to accelerate in the back half of the year. We have also raised our adjusted operating margin outlook to a range of 10.4% to 10.7%. Our adjusted EPS guidance has increased to a range of $3.02 to $3.15 representing growth in the range of 28% to 33%, above our long term target of earnings growth in the mid to high 20s. For the Q2, we anticipate revenue growth in the range of 14% to 16% and adjusted EPS growth in the range of 19% to 25%, which reflects the shift of a significant portion of our newness to the fall. We are excited about the future and the tremendous 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. We believe we have an extremely compelling plan over the near term and one of the most dynamic and transformational stories in all of retail, enabling us to deliver significant shareholder value for years to come and putting us firmly on the path toward becoming one of the world's most admired and highest performing brands.