Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and the results of our operations should be read together with our condensed consolidated financial statements and the related notes included in Item 1 of Part I of this Quarterly Report on Form 10‑Q and with our audited consolidated financial statements and the related notes included in our 2018 Form 10‑K.
FORWARD-LOOKING STATEMENTS AND MARKET DATA
This quarterly report contains forward-looking statements that are subject to risks and uncertainties. Forward-looking statements give our current expectations and projections relating to our financial condition, results of operations, plans, objectives, future performance and business. You can identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. These statements may include words such as “anticipate,” “estimate,” “expect,” “project,” “plan,” “intend,” “believe,” “may,” “will,” “short-term,” “non-recurring,” “one-time,” “unusual,” “should,” “likely” and other words and terms of similar meaning in connection with any discussion of the timing or nature of future operating or financial performance or other events.
Forward-looking statements are subject to risk and uncertainties that may cause actual results to differ materially from those that we expected. We derive many of our forward-looking statements from our operating budgets and forecasts, which are based upon many detailed assumptions. While we believe that our assumptions are reasonable, we caution that it is very difficult to predict the impact of known factors and it is impossible for us to anticipate all factors that could affect our actual results and matters that we identify as “short term,” “non-recurring,” “unusual,” “one-time,” or other words and terms of similar meaning may in fact recur in one or more future financial reporting periods. Important factors that could cause actual results to differ materially from our expectations, or cautionary statements, include those factors disclosed under the sections entitled
Risk Factors
in Part II of this quarterly report and in our Annual Report on Form 10‑K for the fiscal year ended February 2, 2019 (“2018 Form 10‑K”), and
Management’s Discussion and Analysis of Financial Condition and Results of Operations
in Part I of this quarterly report and in our 2018 Form 10‑K. All forward-looking statements attributable to us, or persons acting on our behalf, are expressly qualified in their entirety by these cautionary statements, as well as other cautionary statements. You should evaluate all forward-looking statements made in this quarterly report in the context of these risks and uncertainties.
We cannot assure you that we will realize the results or developments we expect or anticipate or, even if substantially realized, that they will result in the consequences or affect us or our operations in the way we expect. The forward-looking statements included in this quarterly report are made only as of the date hereof. We undertake no obligation to publicly update or revise any forward-looking statement as a result of new information, future events or otherwise, except as otherwise required by law.
Overview
We are a leading luxury retailer in the home furnishings marketplace. Our curated and fully-integrated assortments are presented consistently across our sales channels in sophisticated and unique lifestyle settings that we believe are on par with world-class interior designers. We offer dominant merchandise assortments across a growing number of categories, including furniture, lighting, textiles, bathware, décor, outdoor and garden, and child and teen furnishings. We position our Galleries as showrooms for our brand, while our Source Books and websites act as virtual extensions of our stores. In 2015 we began to introduce an integrated hospitality experience, including cafés, wine vaults and barista bars, into a number of our new Gallery locations. We believe this has created a unique new retail experience that cannot be replicated online, and that the addition of hospitality is helping to drive incremental sales of home furnishings in these Galleries.
Our business is fully integrated across our multiple channels of distribution, consisting of our stores, Source Books and websites.
As of May 4, 2019, we operated the following number of retail Galleries, outlets and showrooms:
|
|
|
RH
|
|
|
Design Galleries
|
|
20
|
Legacy Galleries
|
|
43
|
Modern Galleries
|
|
2
|
Baby & Child Galleries
|
|
5
|
Total RH Galleries
|
|
70
|
Outlets
|
|
40
|
|
|
|
Waterworks Showrooms
|
|
15
|
As of May 4, 2019, six of our RH Design Galleries include an integrated RH Hospitality experience and we plan to incorporate hospitality, including cafés, wine vaults and barista bars in many of the new Galleries that we open in the future.
Key Value Driving Strategies
In order to drive growth across our business, we are focused on the following long-term key strategies:
|
·
|
|
Transform Our Real Estate Platform.
We believe we have an opportunity to significantly increase our sales by transforming our real estate platform from our existing legacy retail footprint to a portfolio of Design Galleries that are sized to the potential of each market and the size of our assortment.
|
New Design Gallery sites are identified based on a variety of factors, such as the availability of suitable new site locations based on several store specific aspects including geographic location, demographics, and proximity to affluent consumers, and the negotiation of favorable economic terms to us for the new location, as well as satisfactory and timely completion of real estate development including procurement of permits and completion of construction. Based on our analysis, we believe we have the opportunity to operate Design Galleries in 60 to 70 locations in the United States and Canada. The number of Design Galleries we open in any fiscal year is highly dependent upon these variables and individual new Design Galleries may be subject to delay or postponement depending on the circumstances of specific projects.
We opened our Portland Design Gallery in March 2018, our Nashville Design Gallery in June 2018, as well as our New York Design Gallery and our Design Gallery in Yountville, California in the Napa Valley, in September 2018. Our Galleries in Nashville, New York and Yountville include integrated cafés, wine vaults and barista bars.
We have identified key learnings from our real estate transformation that have supported the development of a new multi-tier market approach that we believe will optimize both market share and return on invested capital.
First, we have developed a new RH prototype Design Gallery that is an innovative and flexible blueprint which we believe will enable us to more quickly place our disruptive product assortment and immersive retail experience into the market. The new model is a standard we will utilize in the future that is based on key learnings from our recent Gallery openings and will range in size from 33,000 leased selling square feet inclusive of our integrated hospitality experience to 29,000 leased selling square feet without. These new Galleries will represent our assortments from RH Interiors, Modern, Baby & Child, Teen and Outdoor and contain interior design offices and presentation rooms where design professionals can work with clients on their projects. Due to the reduced square footage compared to our recent Design Gallery openings and efficient design, this new model will be more capital efficient with less time and cost risk, but yield similar productivity. We anticipate the new prototype Design Galleries will represent approximately two thirds of our target markets. Future prototype location examples include Edina, MN, Corte Madera, CA, Columbus, OH and Charlotte, NC.
Second, we will continue to develop and open larger Bespoke Design Galleries in the top metropolitan markets, similar to those we opened in New York and Chicago. These iconic locations are highly profitable statements for our brand, and we believe they create a long-term competitive advantage that will be difficult to duplicate.
Third, we will continue to open indigenous Bespoke Galleries in the best second home markets where the wealthy and affluent visit and vacation. These Galleries are tailored to reflect the local culture and are sized to the potential of each market. Examples of indigenous Bespoke Galleries include the Hamptons, Palm Beach, Yountville and Aspen.
Fourth, we are developing a new Gallery model tailored to secondary markets. Targeted to be 10,000 to 18,000 square feet, we believe these smaller expressions of our brand will enable us to gain share in markets currently only served by smaller competitors. Examples of target secondary markets include Hartford, CT, Oklahoma City, OK and Milwaukee, WI, among others. We expect these Galleries to require a substantially smaller net investment than our larger Design Galleries and to pay back our capital investment within two years in most instances. Our plan is to test a few of these Galleries over the next several years, and if proven successful, this format could lead to an increase in our long-term Gallery targets.
We believe our multi-tier market approach to transforming our real estate will enable us to ramp our opening cadence from 3 to 5 new Galleries per year, to a pace of 5 to 7 new Galleries per year commencing in fiscal 2020.
We continue to evaluate potential opportunities for standalone RH Baby & Child, RH Teen and RH Modern Galleries in select markets.
Like our evolving multi-tier Gallery strategy, we have developed a multi-tier real estate strategy that is designed to significantly increase our unit level profitability and return on invested capital. Our three primary deal constructs are outlined below:
|
·
|
|
First,
due to the productivity and proof of concept of our recent new Galleries, and the addition of a powerful, traffic-generating hospitality experience, we are able to negotiate “capital light” leasing deals, where as much as 65% to 100% of the capital requirement would be funded by the landlord, versus 35% to 50% previously.
|
|
·
|
|
Second,
in several of our current projects, we are migrating from a leasing to a development model. We currently have two Galleries, Yountville and Edina, using this new model, and have an additional projects in the pipeline. In the case of Yountville and Edina, we expect to complete a sale-leaseback that should allow us to recoup all or a large portion of our capital. In some cases we believe we may be able to pre-sell the property and structure the transaction where the capital to build the project is advanced by the buyer during construction, which could require zero upfront capital from us
.
|
|
·
|
|
Third,
we are working on joint venture projects, where we share the upside of a development with the developer/landlord. An example of this new model would be our future Gallery and Guesthouse in Aspen, where we are contributing the value of our lease to the development in exchange for a profits interest in the project. The developer will deliver to RH a substantially turnkey Gallery and Guesthouse, while we continue to retain a 20% and 25% profits interest in the properties, respectively. We would expect to monetize the profits interest at the time of sale of the properties during the first five years. The net result should be a minimal capital investment to operationalize the business, with the expectation for a net positive capital benefit at time of monetization of the profits interest
.
|
We anticipate that all of the above deal structures should lead to lower capital requirements, higher unit profitability, and significantly higher return on invested capital versus our prior Gallery development strategies.
|
·
|
|
Expand Our Offering and Increase Our Market Share.
We believe we have a significant opportunity to increase our market share by:
|
|
·
|
|
transforming our real estate platform;
|
|
·
|
|
growing our merchandise assortment and introducing new products and categories;
|
|
·
|
|
expanding our service offerings, including design services and cafes, wine vaults and coffee bars at our Design Galleries;
|
|
·
|
|
exploring and testing new business opportunities complementary to our core business; and
|
|
·
|
|
increasing our brand awareness and customer loyalty through our Source Book circulation strategy, membership program, our digital marketing initiatives, advertising, and public relations activities and events.
|
During fiscal 2017 and fiscal 2018 we deferred the introduction of major new product category expansions other than the ongoing development of RH Hospitality in conjunction with new Design Galleries. We plan a return to our product and business expansion strategy in fiscal 2019, which has been on hold as we focus on the architecture of a new operating platform.
We also plan to increase our investment in RH Interior Design in fiscal 2019 with a goal of building the leading interior design firm in North America. We believe there is a significant revenue opportunity by offering world class design and installation services as we move the brand beyond creating and selling products, to conceptualizing and selling spaces.
|
·
|
|
Architect New Operating Platform.
We have spent the last three years architecting a new operating platform, inclusive of transitioning from a promotional to membership model, our distribution center network redesign, the redesign of our reverse logistics and outlet business, and the reconceptualization of our home delivery and customer experience, enable us to drive lower costs and inventory levels, and higher earnings and inventory turns. Looking forward, we expect this multi-year effort to result in a dramatically improved customer experience, continued margin enhancement and significant cost savings over the next several years.
|
|
·
|
|
Grow Our Integrated Hospitality Experience.
In 2015 we began to introduce an integrated hospitality experience, including cafés, wine vaults and barista bars, into a number of our new Gallery locations. The success of our initial hospitality offering in Chicago led us to broaden this initiative by adding hospitality to a number of our other new Gallery locations. We believe this has created a unique new retail experience that cannot be replicated online, and that the addition of hospitality is helping to drive incremental sales of home furnishings in these Galleries
.
|
|
·
|
|
Pursue International Expansion.
We believe that our luxury brand positioning and unique aesthetic will have strong international appeal. As such, we believe there is tremendous opportunity for the RH brand to expand globally and are currently exploring opportunities for Design Galleries in several locations outside the United States, including the United Kingdom and Europe.
|
Business Initiatives
We are undertaking a large number of new business initiatives in support of our key value driving strategies. In particular, beginning in fiscal 2016 and continuing through fiscal 2019, we have pursued a range of strategic efforts to improve our business and operations including the following:
|
·
|
|
Introduction of Membership Model.
In March 2016, we introduced the RH Members Program, an exclusive membership model that reimagines and simplifies the shopping experience. For an annual fee, the RH Members Program provides a set discount every day across all RH brands in addition to other benefits including complimentary interior design services through the RH Interior Design program and eligibility for preferred financing plans on the RH Credit Card, among others. We believe that transitioning our business from a promotional to membership model has enhanced our brand, simplified and streamlined our business as well as allowed us to develop deeper connections with our customers.
|
|
·
|
|
We believe that the shift to a membership model has positively affected the financial results of our business. Specifically, we believe some of the benefits include:
|
Improved customer experience
. Our interior design professionals can now work with customers based on their timeline and project deadlines, as opposed to our prior promotional calendar. We believe this will lead to larger overall sales transactions for individual customer design projects.
Lower cancellations and returns
. As a result of the elimination of time-limited promotional events and the associated pressure of placing an order before a promotion expires, we believe the shift to a membership model has also resulted lower rates of cancelled orders and returns.
Improved operational costs
. The volume of sales, orders and shipments in our business under the prior promotional model was characterized by large spikes in customer orders based upon promotional events followed by lower orders and sales after the end of an event. This buying pattern also affected numerous other aspects of our business, including staffing and costs as we required elevated staffing levels to service the increased number of customers during peak sales events. Likewise, significant fluctuations in sales had downstream implications for our supply chain related to merchandise orders, manufacturing and production, shipment to our distribution centers and final delivery to our customers. All of these aspects of our operations are experiencing improved efficiencies as a result of the membership model whereby sales are more evenly distributed throughout the year as opposed to the peaks and valleys of orders and sales under the prior model.
|
·
|
|
Distribution Center Network Redesign.
As a result of our work to redesign our distribution network and optimize inventory, in fiscal 2017 we were able to forego building a fifth furniture distribution center planned to open and consolidate our current furniture distribution center network from four primary locations to two primary locations (Northern California and Baltimore, Maryland area). In fiscal 2017, we completed the closure of our furniture distribution centers in Los Angeles and Dallas, eliminating 1.75 million square feet of distribution center space, resulting in savings in excess of $20 million annually. In fiscal 2018, we completed the closure of a smaller furniture distribution center in Essex, Maryland, eliminating 500,000 square feet of distribution center space, resulting in savings in excess of $5 million annually. We believe managing our business in fewer facilities while decreasing our on-hand inventory will reduce fulfillment complexity, lower inventory transfer costs, increase inventory turns, improve working capital and should result in higher gross margins over time.
|
|
·
|
|
Reconceptualize Reverse Logistics Business.
In fiscal 2017, we implemented initiatives to re-conceptualize our Outlet and reverse logistics business. Previously, returns of furniture would be transferred via our home delivery hubs back to a furniture distribution center, then eventually to one of our Outlet locations. Now, returns of furniture are transferred directly from our home delivery hubs to Outlets, which has reduced transportation and handling costs, and improved selling margins across our Outlet network. We believe this initiative yielded substantial savings and margin enhancement of approximately $20 million annually.
|
|
·
|
|
Luxury In-Home Furniture Delivery Experience.
We believe there is an opportunity to improve the customer experience by enhancing our approach to services in connection with in-home delivery. We are in the
|
process of implementing a number of measures that are designed to increase our level of control and improve services levels over the delivery experience to the customer’s residence. We believe that we are well positioned to develop improved solutions for in-home delivery to the customer in the luxury market. We have already adopted a number of service improvements that are yielding improvements in the customer experience and reductions in product return and exchange rates. We expect to continue to optimize our service offering to customers in connection with the in-home delivery experience and are confident that our efforts in this regard will continue to achieve substantial results.
|
|
·
|
|
Elevate the Customer Experience
.
We are focused on improving the end-to-end customer experience. As we have elevated our brand, especially at retail, we are also working to enhance the brand experience in other aspects of our business. We are making changes in many aspects of our business processes that affect our customers, including the in-home delivery experience, improvements in product quality and enhancements in sourcing, product availability, and all aspects of customer care and service. We also believe that the introduction of experiential brand-enhancing products and services, such as expanded design ateliers, the RH Interior Design program and
the launch of
an integrated hospitality experience in a number of our new Galleries,
will
further
enhance
our customers’ in-store experience, allowing us to further disrupt the highly fragmented home furnishings landscape and achieve market share gains.
|
In fiscal 2017, fiscal 2018 and continuing into fiscal 2019, we have focused on the allocation of capital. We believe that our operations and current initiatives are providing a significant opportunity to optimize the allocation of capital in our business, including generating free cash flow and optimizing our balance sheet, as well as deploying capital to repay debt and repurchase shares of our common stock, which we believe creates a long term benefit to our shareholders.
We continue to pursue and test numerous initiatives to improve many aspects of our business including through efforts to optimize inventory, elevate the home delivery experience, simplify our distribution network and improve our organizational design including by streamlining and realigning our home office operations, as well as to expand our product offering and transform our real estate using a range of different models for specific real estate development projects. There can be no assurance as to the timing and extent of the operational benefits and financial contributions of these strategic efforts. In addition, our pursuit of multiple initiatives with respect to our business in any given period may result in period-to-period changes in, and increased fluctuation in, our results of operations. For example, our efforts to optimize our distribution network could cause us to incur costs and expenses in the short term with respect to changes in the way in which we operate our business. Delays in completion of our real estate development projects or costs overruns could also negatively affect our results of operation. Further, macroeconomic or political events outside of our control could impact our ability to pursue our initiatives or the success of such initiatives. For example, in recent periods the stock market has experienced significant volatility as well as periods of significant decline, which may negatively affect the financial health and demand levels of high-end consumers. The housing market is affected by a range of factors including home prices and interest rates and slowdowns in the housing market can have a negative impact on demand for our products. Factors that affect the higher end housing market in particular may have an outsized influence on our levels of consumer demand since our business is geared toward the higher end of the home furnishings market. The above factors and other current and future operational initiatives may create additional uncertainty with respect to our consolidated net revenues and profit in the near term.
Basis of Presentation and Results of Operations
The following table sets forth our condensed consolidated statements of income and other financial and operating data.
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
May 4,
|
|
May 5,
|
|
|
2019
|
|
2018
|
|
|
|
|
|
|
|
Condensed Consolidated Statements of Income:
|
|
|
|
|
|
|
Net revenues
|
|
$
|
598,421
|
|
$
|
557,406
|
Cost of goods sold
|
|
|
365,607
|
|
|
348,073
|
Gross profit
|
|
|
232,814
|
|
|
209,333
|
Selling, general and administrative expenses
|
|
|
164,181
|
|
|
161,186
|
Income from operations
|
|
|
68,633
|
|
|
48,147
|
Interest expense—net
|
|
|
21,118
|
|
|
15,098
|
Income before income taxes
|
|
|
47,515
|
|
|
33,049
|
Income tax expense
|
|
|
11,793
|
|
|
7,588
|
Net income
|
|
$
|
35,722
|
|
$
|
25,461
|
Other Financial and Operating Data:
|
|
|
|
|
|
|
Adjusted net income
(1)
|
|
$
|
45,188
|
|
$
|
30,586
|
Adjusted EBITDA
(2)
|
|
$
|
100,385
|
|
$
|
79,900
|
|
|
|
|
|
|
|
Capital expenditures
|
|
$
|
7,916
|
|
$
|
17,674
|
Landlord assets under construction—net of tenant allowances
|
|
|
4,542
|
|
|
18,648
|
Adjusted net capital expenditures
(3)
|
|
$
|
12,458
|
|
$
|
36,322
|
|
(1)
|
|
Adjusted net income is a supplemental measure of financial performance that is not required by, or presented in accordance with, generally accepted accounting principles (“GAAP”). We define adjusted net income as net income, adjusted for the impact of certain non-recurring and other items that we do not consider representative of our underlying operating performance. Adjusted net income is included in this filing because management believes that adjusted net income provides meaningful supplemental information for investors regarding the performance of our business and facilitates a meaningful evaluation of operating results on a comparable basis with historical results. Our management uses this non-GAAP financial measure in order to have comparable financial results to analyze changes in our underlying business from quarter to quarter. The following table presents a reconciliation of net income, the most directly comparable GAAP financial measure, to adjusted net income for the periods indicated below.
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
May 4,
|
|
May 5,
|
|
|
2019
|
|
2018
|
|
|
(in thousands)
|
Net income
|
|
$
|
35,722
|
|
$
|
25,461
|
Adjustments pre-tax:
|
|
|
|
|
|
|
Amortization of debt discount
(a)
|
|
|
11,689
|
|
|
7,272
|
Asset impairments and change in useful lives
(b)
|
|
|
3,476
|
|
|
—
|
Recall accrual
(c)
|
|
|
(1,615)
|
|
|
(254)
|
Loss on asset disposal reversal
(d)
|
|
|
—
|
|
|
(840)
|
Impact of inventory step-up
(e)
|
|
|
—
|
|
|
190
|
Legal costs
(f)
|
|
|
—
|
|
|
1,915
|
Subtotal adjusted items
|
|
|
13,550
|
|
|
8,283
|
Impact of income tax items
(g)
|
|
|
(4,084)
|
|
|
(3,158)
|
Adjusted net income
|
|
$
|
45,188
|
|
$
|
30,586
|
|
(a)
|
|
Under GAAP, certain convertible debt instruments that may be settled in cash on conversion are required to be separately accounted for as liability and equity components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate. Accordingly, in accounting for GAAP purposes for the $350 million aggregate principal amount of convertible senior notes that were issued in June 2014 (the “2019 Notes”), for the $300 million aggregate principal amount of convertible senior notes that were issued in June and July 2015 (the “2020 Notes”) and for the $335 million aggregate principal amount of convertible senior notes that were issued in June 2018 (the “2023 Notes”), we separated the 2019 Notes, 2020 Notes and 2023 Notes into liability (debt) and equity (conversion option) components and we are amortizing as debt discount an amount equal to the fair value of the equity components as interest expense on the 2019 Notes, 2020 Notes and 2023 Notes over their expected lives. The equity components represent the difference between the proceeds from the issuance of the 2019 Notes, 2020 Notes and 2023 Notes and the fair value of the liability components of the 2019 Notes, 2020 Notes and 2023 Notes, respectively. Amounts are presented net of interest capitalized for capital projects of $0.7 million and $0.6 million during the three months ended May 4, 2019 and May 5, 2018, respectively.
|
|
(b)
|
|
Represents the acceleration of depreciation expense of $3.0 million due to a change in the estimated useful lives of certain assets
, as well as a $0.5 million charge related to the termination of a service agreement associated with such assets.
|
|
(c)
|
|
Represents an adjustment to net revenues, increase in cost of goods sold and inventory charges associated with product recalls, as well as accrual adjustments and vendor claims. The recall adjustments had the following effect on our income before taxes:
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
May 4,
|
|
May 5,
|
|
|
2019
|
|
2018
|
|
|
(in thousands)
|
Reduction of net revenues
|
|
$
|
413
|
|
$
|
—
|
Impact on cost of goods sold
|
|
|
(2,061)
|
|
|
(254)
|
Impact on gross profit
|
|
|
(1,648)
|
|
|
(254)
|
Incremental selling, general and administrative expenses
|
|
|
33
|
|
|
—
|
Impact on income before income taxes
|
|
$
|
(1,615)
|
|
$
|
(254)
|
|
(d)
|
|
Represents the reversal of an estimated loss on disposal of asset due to negotiations of the sales price being finalized.
|
|
(e)
|
|
Represents the non-cash amortization of the inventory fair value adjustment recorded in connection with our acquisition of Waterworks.
|
|
(f)
|
|
Represents costs incurred in connection with a legal settlement.
|
|
(g)
|
|
Assumes a normalized tax rate of 26% for the three months ended May 4, 2019 and May 5, 2018.
|
|
(2)
|
|
EBITDA and Adjusted EBITDA are supplemental measures of financial performance that are not required by, or presented in accordance with, GAAP. We define EBITDA as consolidated net income before depreciation and amortization, interest expense, loss on extinguishment of debt and income tax expense. Adjusted EBITDA reflects further adjustments to EBITDA to eliminate the impact of non-cash compensation, as well as certain non-recurring and other items that we do not consider representative of our underlying operating performance. EBITDA and Adjusted EBITDA are included in this filing because management believes that these metrics provide meaningful supplemental information for investors regarding the performance of our business and facilitate a meaningful evaluation of operating results on a comparable basis with historical results. Our management uses these non-GAAP financial measures in order to have comparable financial results to analyze changes in our underlying business from quarter to quarter. Our measures of EBITDA and Adjusted EBITDA are not necessarily comparable to other similarly titled captions for other companies due to different methods of calculation
. The following table
|
presents a reconciliation of net income, the most directly comparable GAAP financial measure, to EBITDA and Adjusted EBITDA for the periods indicated below.
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
May 4,
|
|
May 5,
|
|
|
2019
|
|
2018
|
|
|
(in thousands)
|
Net income
|
|
$
|
35,722
|
|
$
|
25,461
|
Depreciation and amortization
|
|
|
27,189
|
|
|
22,745
|
Interest expense—net
|
|
|
21,118
|
|
|
15,098
|
Income tax expense
|
|
|
11,793
|
|
|
7,588
|
EBITDA
|
|
|
95,822
|
|
|
70,892
|
Stock-based compensation
(a)
|
|
|
5,695
|
|
|
7,997
|
Asset impairments and change in useful lives
(b)
|
|
|
483
|
|
|
—
|
Recall accrual
(b)
|
|
|
(1,615)
|
|
|
(254)
|
Loss on asset disposal reversal
(b)
|
|
|
—
|
|
|
(840)
|
Impact of inventory step-up
(b)
|
|
|
—
|
|
|
190
|
Legal costs
(b)
|
|
|
—
|
|
|
1,915
|
Adjusted EBITDA
|
|
$
|
100,385
|
|
$
|
79,900
|
|
(a)
|
|
Represents non-cash compensation related to equity awards granted to employees
.
|
|
(b)
|
|
Refer to the reconciliation of net income to adjusted net income table above and the related footnotes for additional information.
|
|
(3)
|
|
We define adjusted net capital expenditures as (i) capital expenditures from investing activities and (ii) cash outflows of capital related to construction activities to design and build landlord-owned leased assets, net of tenant allowances received.
|
The following tables present RH Gallery and Waterworks showroom metrics and exclude outlets:
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
May 4,
|
|
May 5,
|
|
|
2019
|
|
2018
|
|
|
|
|
Total Leased
|
|
|
|
Total Leased
|
|
|
|
|
Selling Square
|
|
|
|
Selling Square
|
|
|
Store Count
|
|
Footage
(1)
|
|
Store Count
|
|
Footage
(1)
|
|
|
|
|
|
(in thousands)
|
|
|
|
|
(in thousands)
|
Beginning of period
|
|
86
|
|
|
1,089
|
|
83
|
|
|
981
|
RH Galleries:
|
|
|
|
|
|
|
|
|
|
|
Dallas RH Modern Gallery (relocation)
|
|
—
|
|
|
(4.5)
|
|
—
|
|
|
—
|
Dallas RH Baby & Child Gallery
|
|
(1)
|
|
|
(3.7)
|
|
—
|
|
|
—
|
Dallas legacy Gallery (relocation)
|
|
—
|
|
|
(2.6)
|
|
—
|
|
|
—
|
Portland Design Gallery
|
|
—
|
|
|
—
|
|
1
|
|
|
26.0
|
Dallas RH Modern Gallery
|
|
—
|
|
|
—
|
|
1
|
|
|
8.2
|
Portland legacy Gallery
|
|
—
|
|
|
—
|
|
(1)
|
|
|
(4.7)
|
Waterworks Showrooms:
|
|
|
|
|
|
|
|
|
|
|
Waterworks Scottsdale Showroom
|
|
—
|
|
|
—
|
|
1
|
|
|
2.2
|
Waterworks Scottsdale Showroom
|
|
—
|
|
|
—
|
|
(1)
|
|
|
(1.1)
|
End of period
|
|
85
|
|
|
1,078
|
|
84
|
|
|
1,012
|
|
(1)
|
|
Leased selling square footage is retail space at our stores used to sell our products. Leased selling square footage excludes backrooms at retail stores used for storage, office space, food preparation, kitchen space or similar purpose, as well as exterior sales space located outside a store, such as courtyards, gardens and rooftops. Leased selling square footage for the three months ended May 4, 2019 includes approximately 11,600 square feet related
|
to two owned store locations. Leased selling square footage for the three months ended May 5, 2018 includes approximately 4,800 square feet related to one owned store location.
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
May 4,
|
|
May 5,
|
|
|
2019
|
|
2018
|
|
|
(in thousands)
|
Total leased square footage at end of period
(1)
|
|
1,454
|
|
1,358
|
Weighted-average leased square footage
(2)
|
|
1,461
|
|
1,323
|
Weighted-average leased selling square footage
(2)
|
|
1,084
|
|
984
|
|
(1)
|
|
Total leased square footage as of May 4, 2019 includes approximately 16,100 square feet related to two owned store locations. Total leased square footage as of May 5, 2018 includes approximately 5,400 square feet related to one owned store location
|
|
(2)
|
|
Weighted-average leased square footage and leased selling square footage is calculated based on the number of days a Gallery location was opened during the period divided by the total number of days in the period.
|
The following table sets forth our condensed consolidated statements of income as a percentage of total net revenues.
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
|
May
|
|
May 5,
|
|
|
|
2019
|
|
2018
|
|
Condensed Consolidated Statements of Income:
|
|
|
|
|
|
Net revenues
|
|
100.0
|
%
|
100.0
|
%
|
Cost of goods sold
|
|
61.1
|
|
62.4
|
|
Gross profit
|
|
38.9
|
|
37.6
|
|
Selling, general and administrative expenses
|
|
27.4
|
|
29.0
|
|
Income from operations
|
|
11.5
|
|
8.6
|
|
Interest expense—net
|
|
3.6
|
|
2.7
|
|
Income before income taxes
|
|
7.9
|
|
5.9
|
|
Income tax expense
|
|
1.9
|
|
1.3
|
|
Net income
|
|
6.0
|
%
|
4.6
|
%
|
Three Months Ended May 4, 2019 Compared to Three Months Ended May 5, 2018
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
May 4,
|
|
May 5,
|
|
|
2019
|
|
2018
|
|
|
RH Segment
|
|
Waterworks
(1)
|
|
Total
|
|
RH Segment
|
|
Waterworks
(1)
|
|
Total
|
|
|
(in thousands)
|
Net revenues
|
|
$
|
563,706
|
|
$
|
34,715
|
|
$
|
598,421
|
|
$
|
526,007
|
|
$
|
31,399
|
|
$
|
557,406
|
Cost of goods sold
|
|
|
345,763
|
|
|
19,844
|
|
|
365,607
|
|
|
330,301
|
|
|
17,772
|
|
|
348,073
|
Gross profit
|
|
|
217,943
|
|
|
14,871
|
|
|
232,814
|
|
|
195,706
|
|
|
13,627
|
|
|
209,333
|
Selling, general and administrative expenses
|
|
|
150,404
|
|
|
13,777
|
|
|
164,181
|
|
|
147,479
|
|
|
13,707
|
|
|
161,186
|
Income (loss) from operations
|
|
$
|
67,539
|
|
$
|
1,094
|
|
$
|
68,633
|
|
$
|
48,227
|
|
$
|
(80)
|
|
$
|
48,147
|
|
(1)
|
|
Waterworks results include non-cash amortization of $0.2 million related to the inventory fair value adjustment recorded in connection with our acquisition of Waterworks during the three months ended May 5, 2018. No amortization was recorded during the three months ended May 4, 2019.
|
Net revenues
Consolidated net revenues increased $41.0 million, or 7.4%, to $598.4 million in the three months ended May 4, 2019 compared to $557.4 million in the three months ended May 5, 2018.
RH Segment net revenues
RH Segment net revenues increased $37.7 million, or 7.2%, to $563.7 million in the three months ended May 4, 2019 compared to $526.0 million in the three months ended May 5, 2018. The below discussion highlights several significant factors that resulted in increased RH Segment net revenues, which are listed in order of magnitude.
RH Segment core net revenues increased primarily due to an increase in retail weighted-average selling square footage related to new store openings, including New York, Nashville and Yountville, and, to a lesser extent, due to increased revenues from our RH Hospitality operations and Contract business.
RH Segment outlet sales increased $12.4 million to $55.6 million in the three months ended May 4, 2019 compared to $43.2 million in the three months ended May 5, 2018 primarily due to an increase of eight outlet locations year over year.
RH Segment net revenues for the three months ended May 4, 2019 were negatively impacted by $0.4 million related to the reduction of revenue associated with product recalls. Product recalls and the establishment or adjustment of any related recall accruals can affect our results and cause quarterly fluctuations affecting the period-to-period comparisons of our results. No assurance can be provided that any accruals will be for the appropriate amount, and actual losses could be higher or lower than what we accrue from time to time, which could further affect results.
Waterworks net revenues
Waterworks net revenues increased $3.3 million, or 10.6%, to $34.7 million in the three months ended May 4, 2019 compared to $31.4 million in the three months ended May 5, 2018.
Gross profit
Consolidated gross profit increased $23.5 million, or 11.2%, to $232.8 million in the three months ended May 4, 2019 from $209.3 million in the three months ended May 5, 2018. As a percentage of net revenues, consolidated gross margin increased 1.3% to 38.9% of net revenues in the three months ended May 4, 2019 from 37.6% of net revenues in the three months ended May 5, 2018.
RH Segment gross profit for the three months ended May 4, 2019 and May 5, 2018 was positively impacted by $1.6 million and $0.3 million, respectively, related to reserve adjustments associated with product recalls initiated in prior years, partially offset by the reduction of revenue and incremental costs associated with such product recalls. RH Segment gross profit for the three months ended May 4, 2019 was negatively impacted by $3.0 million related to the acceleration of depreciation due to a change in the estimated useful lives of certain assets.
Waterworks gross profit for the three months ended May 5, 2018 was negatively impacted by
$0.2 million
of amortization related to the inventory fair value adjustment recorded in connection with the acquisition.
Excluding the product recall adjustments and the impact of the amortization related to the inventory fair value adjustment mentioned above, consolidated gross margin would have increased 1.6% to 39.1% of net revenues in the three months ended May 4, 2019 from 37.5% of net revenues in the three months ended May 5, 2018.
RH Segment gross profit
RH Segment gross profit increased $22.2 million, or 11.4%, to $217.9 million in the three months ended May 4, 2019 from $195.7 million in the three months ended May 5, 2018. As a percentage of net revenues, RH Segment gross
margin increased 1.5% to 38.7% of net revenues in the three months ended May 4, 2019 from 37.2% of net revenues in the three months ended May 5, 2018.
Excluding the product recall and acceleration of depreciation adjustments mentioned above, RH Segment gross margin would have increased 1.7% to 38.9% of net revenues in the three months ended May 4, 2019 from 37.2% of net revenues in the three months ended May 5, 2018. The increase was related to improvements in our core merchandise margins, as well as, leverage in our occupancy costs primarily related to our distribution center network redesign, and leverage in our delivery expense. The overall increase was partially offset by lower outlet product margins due to increased promotional activity and discounts as compared to the first quarter of fiscal 2018.
Waterworks gross profit
Waterworks gross profit increased $1.2 million, or 9.1%, to $14.9 million in the three months ended May 4, 2019 from $13.6 million in the three months ended May 5, 2018. As a percentage of net revenues, Waterworks gross margin decreased 0.6% to 42.8% of net revenues in the three months ended May 4, 2019 from 43.4% of net revenues in the three months ended May 5, 2018.
Excluding the impact of the amortization related to the inventory fair value adjustment mentioned above, Waterworks gross margin would have decreased 1.2% to 42.8% of net revenues in the three months ended May 4, 2019 from 44.0% of net revenues in the three months ended May 5, 2018.
Selling, general and administrative expenses
Consolidated selling, general and administrative expenses increased $3.0 million, or 1.9%, to $164.2 million in the three months ended May 4, 2019 compared to $161.2 million in the three months ended May 5, 2018.
RH Segment selling, general and administrative expenses
RH Segment selling, general and administrative expenses increased $2.9 million, or 2.0%, to $150.4 million in the three months ended May 4, 2019 compared $147.5 million in the three months ended May 5, 2018.
RH Segment selling, general and administrative expenses for the three months ended May 4, 2019 included advertising and marketing costs which increased $4.8 million primarily due to an increase in circulation and pages of our Source Books. This was partially offset by a decrease in corporate expenses of $2.4 million, primarily due to reduced preopening expense associated with our Design Gallery openings and other corporate costs. Selling, general and administrative expenses also included a $0.5 million charge related to a loss on disposal of an asset.
RH Segment selling, general and administrative expenses for the three months ended May 5, 2018 included $1.9 million of costs incurred in connection with a legal settlement, partially offset by a $0.8 million reversal of an estimated loss on disposal of asset.
RH Segment selling, general and administrative expenses were 26.6% and 27.8% of net revenues for the three months ended May 4, 2019 and May 5, 2018, respectively, excluding the costs incurred in connection with a legal settlement and reversal of an estimated loss on disposal of asset mentioned above. The decrease in selling, general and administrative expenses as a percentage of net revenues was primarily driven by leverage in our employment and employment related costs as a result of our organization redesign and, to a lesser extent, leverage in our corporate expenses. This decrease was partially offset by an increase in advertising and marketing costs.
Waterworks selling, general and administrative expenses
Waterworks selling, general and administrative expenses increased $0.1 million, or 0.5%, to $13.8 million in the three months ended May 4, 2019 compared to $13.7 million in the three months ended May 5, 2018. Waterworks selling, general and administrative expenses were 39.7% and 43.7% of net revenues for the three months ended May 4, 2019 and May 5, 2018, respectively.
Interest expense—net
Interest expense—net increased $6.0 million to $21.1 million for the three months ended May 4, 2019 compared to $15.1 million for the three months ended May 5, 2018. Interest expense—net consisted of the following:
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
May 4,
|
|
May 5,
|
|
|
2019
|
|
2018
|
|
|
(in thousands)
|
Amortization of convertible senior notes debt discount
|
|
$
|
12,377
|
|
$
|
7,881
|
Finance lease interest expense
|
|
|
5,514
|
|
|
3,092
|
Term loans
|
|
|
1,724
|
|
|
1,004
|
Amortization of debt issuance costs and deferred financing fees
|
|
|
1,090
|
|
|
787
|
Asset based credit facility
|
|
|
687
|
|
|
2,480
|
Promissory notes
|
|
|
432
|
|
|
576
|
Other interest expense
|
|
|
395
|
|
|
340
|
Capitalized interest for capital projects
|
|
|
(819)
|
|
|
(900)
|
Interest income
|
|
|
(282)
|
|
|
(162)
|
Total interest expense—net
|
|
$
|
21,118
|
|
$
|
15,098
|
Income tax expense
Income tax expense was $11.8 million and $7.6 million in the three months ended May 4, 2019 and May 5, 2018, respectively. Our effective tax rate was 24.8% and 23.0% for the three months ended May 4, 2019 and May 5, 2018, respectively. The increase in our effective tax rate is primarily due to lower discrete tax benefits related to net excess tax windfalls from stock-based compensation in the three months ended May 4, 2019.
Liquidity and Capital Resources
General
The primary cash needs of our business have historically been for merchandise inventories, payroll, Source Books, store rent, capital expenditures associated with opening new stores and updating existing stores, as well as the development of our infrastructure and information technology. We seek out and evaluate opportunities for effectively managing and deploying capital in ways that improve working capital and support and enhance our business initiatives and strategies. In fiscal 2017, we completed two share repurchase programs in an aggregate amount of $1 billion. A $300 million share repurchase was completed during the first quarter of fiscal 2017 and a $700 million share repurchase was completed during the second quarter of fiscal 2017. In October 2018, our Board of Directors approved a new $700 million share repurchase program, of which $250 million in share repurchases were completed in fiscal 2018, and the $700 million authorization amount was replenished by the Board of Directors in March 2019. During the three months ended May 4, 2019, we repurchased approximately 2.2 million shares of our common stock for an aggregate repurchase amount of approximately $250 million, with $450 million still available under the $700 million repurchase program. Refer to “Share Repurchase Programs” below. We intend to evaluate our capital allocation from time to time and may engage in future share repurchases in circumstances where buying shares of our common stock represents a good value and provides a favorable return for our shareholders.
We have $985 million in aggregate principal amount of convertible notes outstanding, of which $350 million mature in June 2019, $300 million mature in June 2020 and $335 million mature in June 2023. In addition, the $350 million principal amount of convertible senior notes that matures in June 2019 became convertible by the holders beginning on March 15, 2019 and remain convertible through the close of business on the second schedule trading day immediately preceding June 15, 2019. Upon the earlier of conversion and maturity of the 2019 Notes, we intend to settle the principal value with existing cash and cash equivalents and restricted cash, as well as borrowings under our currently undrawn asset based credit facility.
Based on anticipated strong cash flow generation in 2019 and beyond, we expect to repay the outstanding principal of the remaining $635 million convertible notes at maturity in June 2020 and June 2023 in cash to minimize dilution. While we anticipate using excess cash, free cash flow and borrowings on our revolving line of credit to repay the convertible notes in cash to minimize dilution, we may need to pursue additional sources of liquidity to repay such convertible notes in cash at their respective maturity dates. There can be no assurance as to the availability of capital to fund such repayments, or that if capital is available through additional debt issuances or refinancing of the convertible notes, that such capital will be available on terms that are favorable to us. We believe the strength of our business and the reduction in leverage we have achieved during the past year puts us in a strong position to take advantage of the capital markets opportunistically. We believe we have multiple financing alternatives available to us on favorable terms that could provide us with additional financial flexibility with respect to capital allocation.
We extended and amended our revolving line of credit in June 2017, which has a total availability of $600 million, of which $10 million is available to Restoration Hardware Canada, Inc., and includes a $200 million accordion feature under which the revolving line of credit may be expanded by agreement of the parties from $600 million to up to $800 million if and to the extent the lenders revise their credit commitments to encompass a larger facility. The revolving line of credit has a maturity date of June 28, 2022.
We believe that cash expected to be generated from operations, net cash proceeds from the issuance of the convertible senior notes, borrowing availability under the asset based credit facility and other financing arrangements will be sufficient to meet working capital requirements, anticipated capital expenditures and other capital needs for the next 12 months.
Our business has relied on cash flows from operations, net cash proceeds from the issuance of the convertible senior notes, as well as borrowings under our credit facilities as our primary sources of liquidity. We have pursued in the past, and may pursue in the future, additional strategies to generate liquidity for our operations, including through the strategic sale of assets, utilization of our credit facilities, and entry into new debt financing arrangements that present attractive terms.
We may pursue strategies in the future, through the use of existing assets and debt facilities, or through the pursuit of new external sources of liquidity and debt financings, to fund our strategies to enhance stockholder value. There can be no assurance that additional capital, whether raised through the sale of assets, utilization of our existing debt financing sources, or pursuit of additional debt financing sources, will be available to us on a timely manner, on favorable terms or at all. To the extent we pursue additional debt as a source of liquidity, our capitalization profile may change and may include significant leverage, and as a result we may be required to use future liquidity to repay such indebtedness and may be subject to additional terms and restrictions which affect our operations and future uses of capital.
In addition, our capital needs may change in the future due to changes in our business or new opportunities that we choose to pursue. We have invested significant capital expenditures in remodeling and opening new Design Galleries, and these capital expenditures have increased in the past and may continue to increase in future periods as we open additional Design Galleries, which may require us to undertake upgrades to historical buildings or construction of new buildings.
Our adjusted net capital expenditures include (i) capital expenditures from investing activities and (ii) cash outflows of capital related to construction activities to design and build landlord leased assets, net of tenant allowances received. We anticipate our adjusted net capital expenditures to be $165 million to $185 million in fiscal 2019, primarily related to our efforts to continue our growth and expansion, including construction of new Design Galleries and infrastructure investments. We anticipate that our fiscal 2019 adjusted net capital expenditures will be partially offset by proceeds from sales of assets of $50 million to $60 million. During the three months ended May 4, 2019, adjusted net capital expenditures were $12.5 million, inclusive of cash received related to landlord tenant allowances of $10.8 million.
Certain lease arrangements require the landlord to fund a portion of the construction related costs through payments directly to us. Other lease arrangements for our new Design Galleries require the landlord to fund a portion of
the construction related costs directly to third parties, rather than through traditional construction allowances and accordingly, under these arrangements we do not expect to receive contributions directly from our landlords related to the building of our Design Galleries. As we develop new Galleries, as well as other potential strategic initiatives in the future like our integrated hospitality experience, we may explore other models for our real estate, which could include longer lease terms or further purchases of, or joint ventures or other forms of equity ownership in, real estate interests associated with new sites and buildings. These approaches might require greater capital investment on our part than a traditional store lease with a landlord. We also believe there is an opportunity to transition our real estate strategy from a leasing model to a development model, where we potentially buy and develop our Design Galleries then recoup the investments through a sale leaseback arrangement resulting in lower capital investment and lower rent. In the event that such capital and other expenditures require us to pursue additional funding sources, we can provide no assurances that we will be successful in securing additional funding on attractive terms or at all.
There can be no assurance that we will have sufficient financial resources, or will be able to arrange financing on favorable terms to the extent necessary to fund all of our initiatives, or that sufficient incremental debt will be available to us in order to fund our cash payments in respect of the repayment of our outstanding convertible senior notes in an aggregate principal amount of $985 million at maturity of such senior convertible notes. In addition, agreements governing existing or new debt facilities may restrict our ability to operate our business in the manner we currently expect or to make required payments with respect to existing commitments including the repayment of the principal amount of our convertible senior notes in cash upon maturity of such senior notes. To the extent we need to seek waivers from any provider of debt financing, or we fail to observe the covenants or other requirements of existing or new debt facilities, any such event could have an impact on our other commitments and obligations including triggering cross defaults or other consequences with respect to other indebtedness. Our current level of indebtedness, and any additional indebtedness that we may incur, exposes us to certain risks with regards to interest rate increases and fluctuations. Our ability to make interest payments or to refinance any of our indebtedness to manage such interest rates may be limited or negatively affected by credit market conditions, macroeconomic trends and other risks.
Any weakening of, or other adverse developments in, the U.S. or global credit markets could affect our ability to manage our debt obligations and our ability to access future debt. We cannot assure you that we will be able to raise necessary funds on favorable terms, if at all, or that future financing requirements would not require us to raise money through an equity financing or by other means that could be dilutive to holders of our capital stock. If we fail to raise sufficient additional funds, we may be required to delay or abandon some of our planned future expenditures or aspects of our current operations.
Cash Flow Analysis
A summary of operating, investing, and financing activities is set forth in the following table:
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
May 4,
|
|
May 5,
|
|
|
|
2019
|
|
2018
|
|
|
|
(in thousands)
|
Provided by (used in) operating activities
|
|
$
|
38,824
|
|
$
|
(3,234)
|
|
Used in investing activities
|
|
|
(7,916)
|
|
|
(17,674)
|
|
Provided by financing activities
|
|
|
65,833
|
|
|
18,335
|
|
Increase (decrease) in cash and cash equivalents, restricted cash and restricted cash equivalents
|
|
|
96,747
|
|
|
(2,635)
|
|
Cash and cash equivalents, restricted cash and restricted cash equivalents at end of period
|
|
|
102,550
|
|
|
22,679
|
|
|
|
|
|
|
|
|
|
Net Cash Provided By (Used In) Operating Activities
Operating activities consist primarily of net income adjusted for non-cash items including depreciation and amortization, stock-based compensation, amortization of debt discount and the effect of changes in working capital and other activities.
For the three months ended May 4, 2019, net cash provided by operating activities was $38.8 million and consisted of net income of $35.7 million and non-cash items of $66.4 million, partially offset by a decrease in cash used for working capital and other activities of $63.3 million. Working capital and other activities consisted primarily of decreases in accounts payable and accrued expense of $38.6 million related to timing of payments, decreases in operating lease liabilities of $27.1 million primarily due to payments made under the agreements, as well as increases in prepaid expenses and other assets of $17.8 million and landlord assets under construction of $4.5 million. These decreases to working capital were partially offset by increases in deferred revenue and customer deposits of $21.6 million.
For the three months ended May 5, 2018, net cash used in operating activities was $3.2 million and consisted of a decrease in cash provided by working capital and other activities of $88.4 million partially offset by non-cash items of $59.7 million and net income of $25.5 million. Working capital and other activities consisted primarily of decreases in accounts payable and accrued expense of $46.7 million related to timing of payments, increases in prepaid expenses and other assets of $31.5 million, increase in landlord assets under construction of $18.6 million, as well as decreases in operating lease liabilities of $16.6 million primarily due to payments made under the agreements. These decreases to working capital were partially offset by increases in deferred revenue and customer deposits of $28.2 million.
Net Cash Used In Investing Activities
Investing activities consist primarily of investments in capital expenditures related to investments in information technology and systems infrastructure, and supply chain investments, as well as retail stores.
For the three months ended May 4, 2019 and May 5, 2018, net cash used in investing activities was $7.9 million and $17.7 million, respectively, due to investments in information technology and systems infrastructure, supply chain investments, and retail stores.
Net Cash Provided By Financing Activities
Financing activities consist primarily of borrowings related to credit facilities and other financing arrangements, as well as share repurchases, principal payments under finance lease agreements and other equity related transactions.
For the three months ended May 4, 2019, net cash provided by financing activities was $65.8 million primarily due to net borrowings of debt of $321.5 million, including the issuance of a $200.0 million second lien term loan, a $120.0 million FILO term loan and $60.0 million of promissory notes secured by certain equipment, partially offset by net repayments of $57.5 million under the asset based credit facility and repayments of $1.0 million on our promissory notes. We incurred costs of $4.5 million related to the debt issuances. We repurchased approximately 2.2 million shares of our common stock for an aggregate repurchase amount of $250.0 million. Principal payments under finance lease agreements totaled $2.1 million.
For the three months ended May 5, 2018, net cash provided by financing activities was $18.3 million primarily due to net borrowings under the asset based credit facility of $19.0 million and proceeds from exercise of employee stock options of $2.9 million. Principal payments under finance lease agreements totaled $1.8 million and we made payments on our promissory notes of $1.5 million.
Convertible Senior Notes
0.00% Convertible Senior Notes due 2023
In June 2018, we issued in a private offering $300 million principal amount of 0.00% convertible senior notes due 2023 and issued an additional $35 million principal amount in connection with the overallotment option granted to the initial purchasers as part of the offering (collectively, the “2023 Notes”). The 2023 Notes are governed by the terms of an indenture between us and U.S. Bank National Association, as the Trustee. The 2023 Notes will mature on June 15, 2023, unless earlier purchased by us or converted. The 2023 Notes will not bear interest, except that the 2023 Notes will be subject to “special interest” in certain limited circumstances in the event of our failure to perform certain of our
obligations under the indenture governing the 2023 Notes. The 2023 Notes are unsecured obligations and do not contain any financial covenants or restrictions on the payments of dividends, the incurrence of indebtedness or the issuance or repurchase of securities by us or any of our subsidiaries. Certain events are also considered “events of default” under the 2023 Notes, which may result in the acceleration of the maturity of the 2023 Notes, as described in the indenture governing the 2023 Notes.
The initial conversion rate applicable to the 2023 Notes is 5.1640 shares of common stock per $1,000 principal amount of 2023 Notes, which is equivalent to an initial conversion price of approximately $193.65 per share. The conversion rate will be subject to adjustment upon the occurrence of certain specified events, but will not be adjusted for any accrued and unpaid special interest. In addition, upon the occurrence of a “make-whole fundamental change” as defined in the indenture, we will, in certain circumstances, increase the conversion rate by a number of additional shares for a holder that elects to convert its 2023 Notes in connection with such make-whole fundamental change.
Prior to March 15, 2023, the 2023 Notes will be convertible only under the following circumstances: (1) during any calendar quarter commencing after September 30, 2018, if, for at least 20 trading days (whether or not consecutive) during the 30 consecutive trading day period ending on the last trading day of the immediately preceding calendar quarter, the last reported sale price of our common stock on such trading day is greater than or equal to 130% of the applicable conversion price on such trading day; (2) during the five consecutive business day period after any ten consecutive trading day period in which, for each day of that period, the trading price per $1,000 principal amount of 2023 Notes for such trading day was less than 98% of the product of the last reported sale price of our common stock and the applicable conversion rate on such trading day; or (3) upon the occurrence of specified corporate transactions. As of May 4, 2019, none of these conditions have occurred and, as a result, the 2023 Notes were not convertible as of May 4, 2019. On and after March 15, 2023, until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may convert all or a portion of their 2023 Notes at any time, regardless of the foregoing circumstances. Upon conversion, the 2023 Notes will be settled, at our election, in cash, shares of our common stock, or a combination of cash and shares of our common stock.
We may not redeem the 2023 Notes; however, upon the occurrence of a fundamental change (as defined in the indenture governing the notes), holders may require us to purchase all or a portion of their 2023 Notes for cash at a price equal to 100% of the principal amount of the 2023 Notes to be purchased plus any accrued and unpaid special interest to, but excluding, the fundamental change purchase date.
Under GAAP, certain convertible debt instruments that may be settled in cash on conversion are required to be separately accounted for as liability and equity components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate. Accordingly, in accounting for the issuance of the 2023 Notes, we separated the 2023 Notes into liability and equity components. The carrying amount of the liability component was calculated by measuring the fair value of a similar liability that does not have an associated convertible feature. The carrying amount of the equity component, which is recognized as a debt discount, represents the difference between the proceeds from the issuance of the 2023 Notes and the fair value of the liability component of the 2023 Notes. The excess of the principal amount of the liability component over its carrying amount (“debt discount”) will be amortized to interest expense using an effective interest rate of 6.35% over the expected life of the 2023 Notes. The equity component is not remeasured as long as it continues to meet the conditions for equity classification.
In accounting for the debt issuance costs related to the issuance of the 2023 Notes, we allocated the total amount incurred to the liability and equity components based on their relative values. Debt issuance costs attributable to the liability component are amortized to interest expense using the effective interest method over the expected life of the 2023 Notes, and debt issuance costs attributable to the equity component are netted with the equity component in stockholders’ equity (deficit).
Debt issuance costs related to the 2023 Notes were comprised of discounts upon original issuance of $1.7 million and third party offering costs of $4.6 million. Discounts and third party offering costs attributable to the liability component are recorded as a contra-liability and are presented net against the convertible senior notes due 2023 balance on the condensed consolidated balance sheets.
2023 Notes—Convertible Bond Hedge and Warrant Transactions
In connection with the offering of the 2023 Notes and the exercise of the overallotment option in June 2018, we entered into convertible note hedge transactions whereby we have the option to purchase a total of approximately 1.7 million shares of our common stock at a price of approximately $193.65 per share. The total cost of the convertible note hedge transactions was $91.9 million. In addition, we sold warrants whereby the holders of the warrants have the option to purchase a total of approximately 1.7 million shares of our common stock at a price of $309.84 per share. The warrants contain certain adjustment mechanisms whereby the total number of shares to be purchased under such warrants may be increased up to a cap of 3.5 million shares of common stock (which cap may also be subject to adjustment). We received $51.0 million in cash proceeds from the sale of these warrants. Taken together, the purchase of the convertible note hedges and sale of the warrants are intended to offset any actual earnings dilution from the conversion of the 2023 Notes until our common stock is above approximately $309.84 per share. As these transactions meet certain accounting criteria, the convertible note hedges and warrants are recorded in stockholders’ equity (deficit), are not accounted for as derivatives and are not remeasured each reporting period. The net costs incurred in connection with the convertible note hedge and warrant transactions were recorded as a reduction to additional paid-in capital on the condensed consolidated balance sheets.
We recorded a deferred tax liability of $22.3 million in connection with the debt discount associated with the 2023 Notes and recorded a deferred tax asset of $22.5 million in connection with the convertible note hedge transactions. The deferred tax liability and deferred tax asset are recorded in deferred tax assets on the condensed consolidated balance sheets.
0.00% Convertible Senior Notes due 2020
In June 2015, we issued in a private offering $250 million principal amount of 0.00% convertible senior notes due 2020 and, in July 2015, we issued an additional $50 million principal amount pursuant to the exercise of the overallotment option granted to the initial purchasers as part of our June 2015 offering (collectively, the “2020 Notes”). The 2020 Notes are governed by the terms of an indenture between us and U.S. Bank National Association, as the Trustee. The 2020 Notes will mature on July 15, 2020, unless earlier purchased by us or converted. The 2020 Notes will not bear interest, except that the 2020 Notes will be subject to “special interest” in certain limited circumstances in the event of our failure to perform certain of our obligations under the indenture governing the 2020 Notes. The 2020 Notes are unsecured obligations and do not contain any financial covenants or restrictions on the payments of dividends, the incurrence of indebtedness or the issuance or repurchase of securities by us or any of our subsidiaries. Certain events are also considered “events of default” under the 2020 Notes, which may result in the acceleration of the maturity of the 2020 Notes, as described in the indenture governing the 2020 Notes. The 2020 Notes are guaranteed by our primary operating subsidiary, Restoration Hardware, Inc., as Guarantor. The guarantee is the unsecured obligation of the Guarantor and is subordinated to the Guarantor’s obligations from time to time with respect to its credit agreement and ranks equal in right of payment with respect to Guarantor’s other obligations.
The initial conversion rate applicable to the 2020 Notes is 8.4656 shares of common stock per $1,000 principal amount of 2020 Notes, which is equivalent to an initial conversion price of approximately $118.13 per share. The conversion rate will be subject to adjustment upon the occurrence of certain specified events, but will not be adjusted for any accrued and unpaid special interest. In addition, upon the occurrence of a “make-whole fundamental change” as defined in the indenture, we will, in certain circumstances, increase the conversion rate by a number of additional shares for a holder that elects to convert its 2020 Notes in connection with such make-whole fundamental change.
Prior to March 15, 2020, the 2020 Notes will be convertible only under the following circumstances: (1) during any calendar quarter commencing after September 30, 2015, if, for at least 20 trading days (whether or not consecutive) during the 30 consecutive trading day period ending on the last trading day of the immediately preceding calendar quarter, the last reported sale price of our common stock on such trading day is greater than or equal to 130% of the applicable conversion price on such trading day; (2) during the five consecutive business day period after any ten consecutive trading day period in which, for each day of that period, the trading price per $1,000 principal amount of 2020 Notes for such trading day was less than 98% of the product of the last reported sale price of our common stock and the applicable conversion rate on such trading day; or (3) upon the occurrence of specified corporate transactions. As
of May 4, 2019, none of these conditions have occurred and, as a result, the 2020 Notes were not convertible as of May 4, 2019. On and after March 15, 2020, until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may convert all or a portion of their 2020 Notes at any time, regardless of the foregoing circumstances. Upon conversion, the 2020 Notes will be settled, at our election, in cash, shares of our common stock, or a combination of cash and shares of our common stock.
We may not redeem the 2020 Notes; however, upon the occurrence of a fundamental change (as defined in the indenture governing the notes), holders may require us to purchase all or a portion of their 2020 Notes for cash at a price equal to 100% of the principal amount of the 2020 Notes to be purchased plus any accrued and unpaid special interest to, but excluding, the fundamental change purchase date.
Under GAAP, certain convertible debt instruments that may be settled in cash on conversion are required to be separately accounted for as liability and equity components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate. Accordingly, in accounting for the issuance of the 2020 Notes, we separated the 2020 Notes into liability and equity components. The carrying amount of the liability component was calculated by measuring the fair value of a similar liability that does not have an associated convertible feature. The carrying amount of the equity component, which is recognized as a debt discount, represents the difference between the proceeds from the issuance of the 2020 Notes and the fair value of the liability component of the 2020 Notes. The debt discount will be amortized to interest expense using an effective interest rate of 6.47% over the expected life of the 2020 Notes. The equity component is not remeasured as long as it continues to meet the conditions for equity classification.
In accounting for the debt issuance costs related to the issuance of the 2020 Notes, we allocated the total amount incurred to the liability and equity components based on their relative values. Debt issuance costs attributable to the liability component are amortized to interest expense using the effective interest method over the expected life of the 2020 Notes, and debt issuance costs attributable to the equity component are netted with the equity component in stockholders’ equity (deficit).
Debt issuance costs related to the 2020 Notes were comprised of discounts upon original issuance of $3.8 million and third party offering costs of $2.3 million. Discounts and third party offering costs attributable to the liability component are recorded as a contra-liability and are presented net against the convertible senior notes due 2020 balance on the condensed consolidated balance sheets.
2020 Notes—Convertible Bond Hedge and Warrant Transactions
In connection with the offering of the 2020 Notes in June 2015 and the exercise in full of the overallotment option in July 2015, we entered into convertible note hedge transactions whereby we have the option to purchase a total of approximately 2.5 million shares of our common stock at a price of approximately $118.13 per share. The total cost of the convertible note hedge transactions was $68.3 million. In addition, we sold warrants whereby the holders of the warrants have the option to purchase a total of approximately 2.5 million shares of our common stock at a price of $189.00 per share. The warrants contain certain adjustment mechanisms whereby the total number of shares to be purchased under such warrants may be increased up to a cap of 5.1 million shares of common stock (which cap may also be subject to adjustment). We received $30.4 million in cash proceeds from the sale of these warrants. Taken together, the purchase of the convertible note hedges and sale of the warrants are intended to offset any actual earnings dilution from the conversion of the 2020 Notes until our common stock is above approximately $189.00 per share. As these transactions meet certain accounting criteria, the convertible note hedges and warrants are recorded in stockholders’ equity (deficit), are not accounted for as derivatives and are not remeasured each reporting period. The net costs incurred in connection with the convertible note hedge and warrant transactions were recorded as a reduction to additional paid-in capital on the condensed consolidated balance sheets.
We recorded a deferred tax liability of $32.8 million in connection with the debt discount associated with the 2020 Notes and recorded a deferred tax asset of $26.6 million in connection with the convertible note hedge transactions. The deferred tax liability and deferred tax asset are recorded in deferred tax assets on the condensed consolidated balance sheets.
0.00% Convertible Senior Notes due 2019
In June 2014, we issued $350 million aggregate principal amount of 0.00% convertible senior notes due 2019 (the “2019 Notes”) in a private offering. The 2019 Notes are governed by the terms of an indenture between us and U.S. Bank National Association, as the Trustee. The 2019 Notes will mature on June 15, 2019, unless earlier purchased by us or converted. The 2019 Notes will not bear interest, except that the 2019 Notes will be subject to “special interest” in certain limited circumstances in the event of our failure to perform certain of our obligations under the indenture governing the 2019 Notes. The 2019 Notes are unsecured obligations and do not contain any financial covenants or restrictions on the payments of dividends, the incurrence of indebtedness or the issuance or repurchase of securities by us or any of our subsidiaries. Certain events are also considered “events of default” under the 2019 Notes, which may result in the acceleration of the maturity of the 2019 Notes, as described in the indenture governing the 2019 Notes.
The initial conversion rate applicable to the 2019 Notes is 8.6143 shares of common stock per $1,000 principal amount of 2019 Notes, which is equivalent to an initial conversion price of approximately $116.09 per share. The conversion rate will be subject to adjustment upon the occurrence of certain specified events, but will not be adjusted for any accrued and unpaid special interest. In addition, upon the occurrence of a “make-whole fundamental change,” we will, in certain circumstances, increase the conversion rate by a number of additional shares for a holder that elects to convert its 2019 Notes in connection with such make-whole fundamental change.
Prior to March 15, 2019, the 2019 Notes will be convertible only under the following circumstances: (1) during any calendar quarter commencing after September 30, 2014, if, for at least 20 trading days (whether or not consecutive) during the 30 consecutive trading day period ending on the last trading day of the immediately preceding calendar quarter, the last reported sale price of our common stock on such trading day is greater than or equal to 130% of the applicable conversion price on such trading day; (2) during the five consecutive business day period after any ten consecutive trading day period in which, for each day of that period, the trading price per $1,000 principal amount of 2019 Notes for such trading day was less than 98% of the product of the last reported sale price of our common stock and the applicable conversion rate on such trading day; or (3) upon the occurrence of specified corporate transactions. As of May 4, 2019, none of these conditions have occurred and, as a result, the 2019 Notes were not convertible as of May 4, 2019. On and after March 15, 2019, until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may convert all or a portion of their 2019 Notes at any time, regardless of the foregoing circumstances. Upon the earlier of conversion and maturity of the 2019 Notes, we intend to settle the principal value with existing cash and cash equivalents and restricted cash, as well as borrowings under our currently undrawn asset based credit facility.
We may not redeem the 2019 Notes; however, upon the occurrence of a fundamental change (as defined in the indenture governing the notes), holders may require us to purchase all or a portion of their 2019 Notes for cash at a price equal to 100% of the principal amount of the 2019 Notes to be purchased plus any accrued and unpaid special interest to, but excluding, the fundamental change purchase date.
Under GAAP, certain convertible debt instruments that may be settled in cash on conversion are required to be separately accounted for as liability and equity components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate. Accordingly, in accounting for the issuance of the 2019 Notes, we separated the 2019 Notes into liability and equity components. The carrying amount of the liability component was calculated by measuring the fair value of a similar liability that does not have an associated convertible feature. The carrying amount of the equity component, which is recognized as a debt discount, represents the difference between the proceeds from the issuance of the 2019 Notes and the fair value of the liability component of the 2019 Notes. The debt discount will be amortized to interest expense using an effective interest rate of 4.51% over the expected life of the 2019 Notes. The equity component is not remeasured as long as it continues to meet the conditions for equity classification.
In accounting for the debt issuance costs related to the issuance of the 2019 Notes, we allocated the total amount incurred to the liability and equity components based on their relative values. Debt issuance costs attributable to the liability component are amortized to interest expense using the effective interest method over the expected life of the 2019 Notes, and debt issuance costs attributable to the equity component are netted with the equity component in stockholders’ equity (deficit).
Debt issuance costs related to the 2019 Notes were comprised of discounts and commissions payable to the initial purchasers of $4.4 million and third party offering costs of $1.0 million. Discounts, commissions payable to the initial purchasers and third party offering costs attributable to the liability component are recorded as a contra-liability and are presented net against the convertible senior notes due 2019 balance on the condensed consolidated balance sheets.
2019 Notes—Convertible Bond Hedge and Warrant Transactions
In connection with the offering of the 2019 Notes, we entered into convertible note hedge transactions whereby we have the option to purchase a total of approximately 3.0 million shares of our common stock at a price of approximately $116.09 per share. The total cost of the convertible note hedge transactions was $73.3 million. In addition, we sold warrants whereby the holders of the warrants have the option to purchase a total of approximately 3.0 million shares of our common stock at a price of $171.98 per share. The warrants contain certain adjustment mechanisms whereby the total number of shares to be purchased under such warrants may be increased up to a cap of 6.0 million shares of common stock (which cap may also be subject to adjustment). We received $40.4 million in cash proceeds from the sale of these warrants. Taken together, the purchase of the convertible note hedges and sale of the warrants are intended to offset any actual dilution from the conversion of the 2019 Notes and to effectively increase the overall conversion price from $116.09 per share to $171.98 per share. As these transactions meet certain accounting criteria, the convertible note hedges and warrants are recorded in stockholders’ equity and are not accounted for as derivatives. The net costs incurred in connection with the convertible note hedge and warrant transactions were recorded as a reduction to additional paid-in capital on the condensed consolidated balance sheets.
We recorded a deferred tax liability of $27.5 million in connection with the debt discount associated with the 2019 Notes and recorded a deferred tax asset of $28.6 million in connection with the convertible note hedge transactions. The deferred tax liability and deferred tax asset are recorded in deferred tax assets on the condensed consolidated balance sheets.
Asset Based Credit Facility
In August 2011, Restoration Hardware, Inc., along with its Canadian subsidiary, Restoration Hardware Canada, Inc., entered into a credit agreement with Bank of America, N.A., as administrative agent, and certain other lenders. On June 28, 2017, Restoration Hardware, Inc. entered into an eleventh amended and restated credit agreement (the “Credit Agreement”) among Restoration Hardware, Inc., Restoration Hardware Canada, Inc., various subsidiaries of RH named therein as borrowers or guarantors, the lenders party thereto and Bank of America, N.A., as administrative agent and collateral agent (“First Lien Administrative Agent”). The Credit Agreement has a revolving line of credit with initial availability of up to $600.0 million, of which $10.0 million is available to Restoration Hardware Canada, Inc., and includes a $200.0 million accordion feature under which the revolving line of credit may be expanded by agreement of the parties from $600.0 million to up to $800.0 million if and to the extent the lenders, whether existing lenders or new lenders, agree to increase their credit commitments. In addition, the Credit Agreement established an $80.0 million last in, last out (“LILO”) term loan facility which was repaid in full in June 2018. The Credit Agreement has a maturity date of June 28, 2022.
On June 12, 2018, Restoration Hardware, Inc. entered into a First Amendment to the Credit Agreement (the “First Amendment”). The First Amendment (i) changed the Credit Agreement’s definition of “Eligible In-Transit Inventory” to clarify the requirements to be fulfilled by the borrowers with respect to such in-transit inventory, and (ii) clarified that no default or event of default was caused by any prior non-compliance with such requirements with respect to in-transit inventory. Eligible In-Transit Inventory consists of inventory being shipped from vendor locations outside of the United States. Qualifying in-transit inventory is included within the borrowing base for eligible collateral for purposes of determining the amount of borrowing available to borrowers under the Credit Agreement.
On November 23, 2018, Restoration Hardware, Inc. entered into a Consent and Second Amendment to the Credit Agreement (the “Second Amendment”). The Second Amendment included certain clarifying changes to, among other things: (a) address the processing of payments from insurance proceeds in connection with casualty or other insured losses with respect to property or assets of a Loan Party, and (b) add an additional category of permitted restricted
payment to allow the lead borrower to make annual restricted payments of up to $3.0 million per fiscal year to cover payments of certain administrative and other obligations of RH in the ordinary course of business.
On April 4, 2019, Restoration Hardware, Inc., entered into a Third Amendment to the Credit Agreement (the “Third Amendment”). The Third Amendment, among other things, (a) established a $120.0 million first in, last out (“FILO”) term loan facility, which amount was fully borrowed as of April 4, 2019 and which incurs interest at a rate that is 1.25% greater than the interest rate applicable to the revolving loans under the Credit Agreement, (b) provided for additional Permitted Indebtedness, as defined in the Credit Agreement, that the loan parties can incur, and (c) modified the borrowing availability under the Credit Agreement in certain circumstances. The FILO term loan facility has a maturity date of June 28, 2022.
The availability of credit at any given time under the Credit Agreement is limited by reference to a borrowing base formula based upon numerous factors, including the value of eligible inventory and eligible accounts receivable. As a result of the borrowing base formula, actual borrowing availability under the revolving line of credit could be less than the stated amount of the revolving line of credit (as reduced by the actual borrowings and outstanding letters of credit under the revolving line of credit). All obligations under the Credit Agreement are secured by substantially all of the assets, including accounts receivable, inventory, intangible assets, property, equipment, goods and fixtures of Restoration Hardware, Inc., Restoration Hardware Canada, Inc., RH US, LLC, Waterworks Operating Co., LLC and Waterworks IP Co., LLC.
Borrowings under the revolving line of credit are subject to interest, at the borrowers’ option, at either the bank’s reference rate or London Inter-bank Offered Rate (“LIBOR”) (or, in the case of the revolving line of credit, the Bank of America “BA” Rate or the Canadian Prime Rate, as such terms are defined in the Credit Agreement, for Canadian borrowings denominated in Canadian dollars or the United States Index Rate or LIBOR for Canadian borrowings denominated in United States dollars) plus an applicable margin rate, in each case.
In addition, under the Credit Agreement, we are required to meet specified financial ratios in order to undertake certain actions, and we may be required to maintain certain levels of excess availability or meet a specified consolidated fixed-charge coverage ratio (“FCCR”). Subject to certain exceptions, the trigger for the FCCR occurs if the domestic availability under the revolving line of credit is less than the greater of (i) $40.0 million and (ii) 10% of the sum of (a) the lesser of (x) the aggregate revolving commitments under the Credit Agreement and (y) the aggregate revolving borrowing base, plus (b) the lesser of (x) the then outstanding amount of the LILO term loan or (y) the LILO term loan borrowing base. If the availability under the Credit Agreement is less than the foregoing amount, then Restoration Hardware, Inc. is required subject to certain exceptions to maintain an FCCR of at least one to one.
The Credit Agreement requires a daily sweep of all cash receipts and collections to prepay the loans under the agreement while (i) an event of default exists or (ii) the availability under the revolving line of credit for extensions of credit is less than the greater of (A) $40.0 million and (B) 10% of the sum of (a) the lesser of (x) the aggregate revolving commitments under the credit agreement and (y) the aggregate revolving borrowing base, plus (b) the lesser of (x) the then outstanding amount of the LILO term loan or (y) the LILO term loan borrowing base.
As of May 4, 2019, Restoration Hardware, Inc. had no outstanding borrowings under the revolving line of credit. The Credit Agreement provides for a borrowing amount based on the value of eligible collateral and a formula linked to certain borrowing percentages based on certain categories of collateral. Under the terms of such provisions, the amount under the revolving line of credit borrowing base that could be available pursuant to the Credit Agreement as of May 4, 2019 was $139.4 million, net of $285.0 million reserved for the upcoming repayment of the 2019 Notes, as well as $12.8 million in outstanding letters of credit.
As previously reported, on May 31, 2019, Restoration Hardware, Inc. entered into a fourth amendment to the Credit Agreement (the “Fourth Amendment”). The Fourth Amendment, among other things, amends the Credit Agreement to (a) extend the time to deliver monthly financial statements to the lenders for the fiscal months ending February 2019 and March 2019 until June 19, 2019; (b) remove the requirement to deliver monthly financial statements to the lenders for the last fiscal month of any fiscal quarter; and (c) waive any default or event of default under the Credit
Agreement relating to the delivery of monthly financial statements or other information to lenders for the fiscal months ending February 2019 and March 2019.
The Credit Agreement contains various restrictive and affirmative covenants, including, among others, required financial reporting, limitations on the ability to incur liens, make loans or other investments, incur additional debt, issue additional equity, merge or consolidate with or into another person, sell assets, pay dividends or make other distributions, or enter into transactions with affiliates, along with other restrictions and limitations typical to credit agreements of this type and size. As a result of the Fourth Amendment, Restoration Hardware, Inc. was deemed to be in compliance as of May 4, 2019 with all applicable covenants of the Credit Agreement.
Second Lien Credit Agreement
On April 10, 2019, Restoration Hardware, Inc., entered into a credit agreement, dated as of April 9, 2019 and effective as of April 10, 2019 (the “Second Lien Credit Agreement”), among (i) Restoration Hardware, Inc., as lead borrower, (ii) the guarantors party thereto, (iii) the lenders party thereto, each of whom are funds and accounts managed or advised by either Benefit Street Partners L.L.C. and its affiliated investment managers or Apollo Capital Management, L.P. and its affiliated investment managers, as applicable, and (iv) BSP Agency, LLC, as administrative agent and collateral agent (the “Second Lien Administrative Agent”) with respect to a second lien term loan in an aggregate principal amount equal to $200.0 million with a maturity date of April 9, 2024 (the “Second Lien Term Loan”).
The Second Lien Term Loan bears interest at an annual rate generally based on LIBOR plus 6.50%. This rate is a floating rate that resets periodically based upon changes in LIBOR rates during the life of the Second Lien Term Loan. At the date of the initial borrowing, the rate was set at one month LIBOR plus 6.50%.
All obligations under the Second Lien Term Loan are secured by a second lien security interest in substantially all of the assets of the loan parties, including inventory, receivables and certain types of intellectual property. The second lien security interest encumbers substantially the same collateral that secures the credit. The second lien ranks junior in priority and is subordinated to the first lien in favor of the lenders with respect to the Credit Agreement.
The borrowings under the Second Lien Credit Agreement may be prepaid in whole or in part at any time, subject to certain minimum payment requirements, and including (i) a prepayment premium in the amount of 2.0% of the principal amount of the Second Lien Term Loan being prepaid during the first year after the effective date of the Second Lien Credit Agreement, (ii) 1.0% of the principal amount of the Second Lien Term Loan being prepaid during the second year after the effective date of the Second Lien Credit Agreement, and (iii) no prepayment premium after the second anniversary of the effective date of the Second Lien Credit Agreement.
The Second Lien Credit Agreement contains a financial ratio covenant not found in the Credit Agreement based upon a net senior secured leverage ratio of consolidated secured debt to consolidated EBITDA, as defined in the Credit Agreement, as follows:
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The net senior secured leverage ratio test is based on the ratio of (i) the sum of (a) all obligations outstanding under the Second Lien Term Loan and the Credit Agreement plus (b) all other secured indebtedness of RH and certain of its subsidiaries that is (x) senior or pari passu to the lien on the Second Lien Term Loan collateral or (y) secured by property that does not constitute Second Lien Term Loan collateral under the Second Lien Term Loan, less (c) all unrestricted cash and cash equivalents of RH and certain of its subsidiaries subject to a blocked account control agreement, to (ii) consolidated EBITDA of RH and certain of its subsidiaries (the “Net Senior Secured Leverage Ratio”).
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The Net Senior Secured Leverage Ratio may not exceed 3.50 to 1.00 as of the last day of any fiscal quarter. The Second Lien Credit Agreement also contains a consolidated fixed charge coverage ratio generally based on the same formulation set forth in the Credit Agreement such that the borrower may not make certain “restricted payments” in the event that the ratio of (i) consolidated EBITDA minus certain
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costs to the amount of (ii) debt service costs plus certain other costs is not less than 1.00 to 1.00 and the level of unused availability under the Credit Agreement meets certain levels.
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The Second Lien Credit Agreement also contains certain events of default and other customary terms and conditions typical to a second lien credit agreement.
As of May 4, 2019, the Company had $200.0 million in outstanding borrowings and no availability under the Second Lien Credit Agreement.
As previously reported, on May 31, 2019, Restoration Hardware, Inc. entered into a first amendment to the Second Lien Credit Agreement (the “First Amendment”). The First Amendment, among other things, amends the Second Lien Credit Agreement to (a) remove the requirement to deliver monthly financial statements to the lenders for the last fiscal month of any fiscal quarter and (b) waive any default or event of default under the Second Lien Credit Agreement relating to the delivery of monthly financial statements or other information to lenders for the fiscal months ending February 2019 and March 2019.
The Second Lien Credit Agreement contains various restrictive and affirmative covenants generally in line with the covenants and restrictions contained in the Credit Agreement, including required financial reporting, limitations on the ability to incur liens, make loans or other investments, incur additional debt, issue additional equity, merge or consolidate with or into another person, sell assets, pay dividends or make other distributions, or enter into transactions with affiliates, along with other restrictions and limitations typical to credit agreements of a similar type and size. As a result of the First Amendment, Restoration Hardware, Inc. was deemed to be in compliance as of May 4, 2019 with all applicable covenants of the Second Lien Credit Agreement.
Intercreditor Agreement
On April 10, 2019, in connection with the Second Lien Credit Agreement, Restoration Hardware, Inc. entered into an Intercreditor Agreement (the “Intercreditor Agreement”), dated as of April 9, 2019 and effective as of April 10, 2019, with the First Lien Administrative Agent and the Second Lien Administrative Agent. The Intercreditor Agreement establishes various customary inter-lender terms, including, without limitation, with respect to priority of liens, permitted actions by each party, application of proceeds, exercise of remedies in case of default, releases of liens and certain limitations on the amendment of the Credit Agreement and the Second Lien Credit Agreement without the consent of the other party.
Equipment Loan Facility
On September 5, 2017, Restoration Hardware, Inc. entered into a Master Loan and Security Agreement with Banc of America Leasing & Capital, LLC (“BAL”) pursuant to which BAL and we agreed that BAL would finance certain equipment of ours from time to time, with each such equipment financing to be evidenced by an equipment security note setting forth the terms for each particular equipment loan. Each equipment loan is secured by a purchase money security interest in the financed equipment. As of May 4, 2019, we had $59.0 million in aggregate amounts outstanding under the equipment security notes, of which $18.4 million was included in other current liabilities and $40.6 million was included in other non-current obligations on the condensed consolidated balance sheets. The maturity dates of the equipment security notes vary, but generally have a maturity of three or four years. We are required to make monthly installment payments under the equipment security notes.
Share Repurchase Programs
We regularly review share repurchase activity and consider various factors in determining whether and when to execute share repurchases, including, among others, current cash needs, capacity for leverage, cost of borrowings, results of operations and the market price of the our common stock. We believe that these share repurchase programs will continue to be an excellent allocation of capital for the long-term benefit of our shareholders. We may undertake other repurchase programs in the future with respect to our securities.
$300 Million Repurchase Program (Completed)
On February 21, 2017, our Board of Directors authorized a share repurchase program of up to $300 million (the “$300 Million Repurchase Program”) through open market purchases, privately negotiated transactions or other means, including through Rule 10b18 open market repurchases, Rule 10b5‑1 trading plans or through the use of other techniques such as accelerated share repurchases. During the three months ended April 29, 2017, we repurchased approximately 7.8 million shares of our common stock under the $300 Million Repurchase Program at an average price of $38.24 per share, for an aggregate repurchase amount of approximately $300 million. No additional shares will be repurchased in future periods under the $300 Million Repurchase Program.
$700 Million Repurchase Program (Completed)
Following completion of the $300 Million Repurchase Program, our Board of Directors authorized on May 2, 2017 an additional share repurchase program of up to $700 million (the “$700 Million Repurchase Program”) through open market purchases, privately negotiated transactions or other means, including through Rule 10b18 open market repurchases, Rule 10b5‑1 trading plans or through the use of other techniques such as accelerated share repurchases including through privately-negotiated arrangements in which a portion of the share repurchase program is committed in advance through a financial intermediary and/or in transactions involving hedging or derivatives. During the three months ended July 29, 2017, we repurchased approximately 12.4 million shares of our common stock under the $700 Million Repurchase Program at an average price of $56.60 per share, for an aggregate repurchase amount of approximately $700 million. No additional shares will be repurchased in future periods under the $700 Million Repurchase Program.
$950 Million Repurchase Program (Existing)
On October 10, 2018, our Board of Directors authorized a share repurchase program of up to $700 million through open market purchases, privately negotiated transactions or other means, including through Rule 10b18 open market repurchases, Rule 10b5‑1 trading plans or through the use of other techniques such as accelerated share repurchases including through privately-negotiated arrangements in which a portion of the share repurchase program is committed in advance through a financial intermediary and/or in transactions involving hedging or derivatives, of which $250.0 million in share repurchases were completed in fiscal 2018. The $700.0 million authorization amount was replenished by the Board of Directors on March 25, 2019 (as replenished, the “$950 Million Repurchase Program”). During the three months ended May 4, 2019, we repurchased approximately 2.2 million shares of our common stock under the $950 Million Repurchase Program at an average price of $115.36 per share, for an aggregate repurchase amount of approximately $250.0 million. As of May 4, 2019, there was $450 million remaining for future share repurchases under this program.
Contractual Obligations
As of May 4, 2019, there were no material changes to our contractual obligations described in the
Management’s Discussion and Analysis of Financial Condition and Results of Operations
—
Contractual Obligations
in the 2018 Form 10-K.
Off Balance Sheet Arrangements
We have no material off balance sheet arrangements as of May 4, 2019.
Critical Accounting Policies and Estimates
The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect amounts reported in our consolidated financial statements and related notes, as well as the related disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management evaluates its accounting policies, estimates, and judgments on an on-going basis. Management bases its estimates and
judgments on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions and conditions and such differences could be material to the consolidated financial statements.
Management evaluated the development and selection of its critical accounting policies and estimates and believes that the following involve a higher degree of judgment or complexity and are most significant to reporting our consolidated results of operations and financial position, and are therefore discussed as critical:
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Merchandise Inventories
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Stock-Based Compensation
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In the first quarter of fiscal 2019, we adopted Accounting Standards Update 2016‑02—
Leases
. The adoption of this standard resulted in a material change to the “Lease Accounting” critical accounting policy in fiscal 2019. Please refer below for our updated “Lease Accounting” critical accounting policy. There have been no material changes to the other critical accounting policies and estimates listed above from the disclosures included in the 2018 Form 10‑K. For further discussion regarding these policies, refer to
Management’s Discussion and Analysis of Financial Condition and Results of Operations
—
Critical Accounting Policies and Estimates
in the 2018 Form 10‑K.
Lease Accounting
We lease nearly all of our retail and outlet store locations, corporate headquarters, distribution and home delivery facilities, as well as other storage and office space. The initial lease terms of our real estate leases generally range from ten to fifteen years, and certain leases contain renewal options for up to an additional 25 years, the exercise of which is at our sole discretion. In recognizing the lease right-of-use assets and lease liabilities, we utilize the lease term for which we are reasonably certain to use the underlying asset, including consideration of options to extend or terminate the lease. We also lease certain equipment with lease terms generally ranging from three to seven years. Our lease agreements generally do not contain any material residual value guarantees or material restrictions or covenants.
Leases, or lease extensions, with a term of twelve months or less are not recorded on the condensed consolidated balance sheets, and we recognize lease expense for these leases on a straight-line basis over the lease term.
We account for lease and non-lease components as a single lease component for real estate leases, and for all other asset classes we account for the components separately. We determine the lease classification and begin to recognize lease and any related financing expenses upon the lease’s commencement, which for real estate leases is generally upon store opening or, to a lesser extent, when we take possession or control of the asset.
As most of our leases do not include an implicit interest rate, we determine the discount rate for each lease based upon the incremental borrowing rate (“IBR”) in order to calculate the present value of lease payments at the commencement date. The IBR is computed as the rate of interest that we would have to pay to (i) borrow on a collateralized basis (ii) over a similar term (iii) an amount equal to the total lease payments and (iv) in a similar economic environment. We utilize our asset based credit facility as the basis for determining the applicable IBR for each lease.
Certain of our lease agreements include rental payments based on a percentage of retail sales over contractual levels. Due to the variable and unpredictable nature of such payments, we do not recognize a lease right-of-use asset and lease liability related to such payments. Estimated variable rental payments are included in accounts payable and accrued expenses on the condensed consolidated balance sheets.
We have a small group of leases that include rental payments periodically adjusted for inflation (e.g., based on the consumer price index). We include these variable payments in the initial measurement of the lease right-of-use asset and lease liability if such increases have a minimum rent escalation (e.g., floor). However, we exclude these variable payments from the initial measurement of the lease right-of-use asset and lease liability in the case of lease arrangements that do not specify a minimum rent escalation.
We rent or sublease certain real estate to third parties under operating leases and recognize rental income received on a straight-line basis over the lease term, which is included in selling, general and administrative expenses on the condensed consolidated statements of income.
Lease arrangements may require the landlord to provide tenant allowances directly to us. Standard tenant allowances received from landlords, typically those received under operating lease agreements, are recorded as cash and cash equivalents with an offset recorded in lease right-of-use assets on the condensed consolidated balance sheets. In certain instances tenant allowances are provided for us to design and build the leased asset. Tenant allowances received from landlords during the construction phase of a leased asset and prior to lease commencement are recorded as cash and cash equivalents with an offset recorded in other non-current assets (to the extent we have incurred related capital expenditure for construction costs) or in other current liabilities (to the extent that payments are received prior to capital construction expenditures by us) on the condensed consolidated balance sheets. After the leased asset is constructed and the lease commences, we reclassify the tenant allowance from other non-current assets or other current liabilities to lease right-of-use assets on the condensed consolidated balance sheets.
Lease Classification
Certain of our real estate and property and equipment are held under finance leases. Lease related assets are included in finance lease right-of-use assets within property and equipment—net on the condensed consolidated balance sheets.
Leases that do not meet the definition of a finance lease are considered operating leases. Lease related assets are included in operating lease right-of-use assets on the condensed consolidated balance sheets.
Construction Related Activities
We are sometimes involved in the construction of leased stores for certain of our newer Design Galleries. Prior to construction commencement, we evaluate whether or not we, as lessee, control the asset being constructed and, depending on the extent to which we are involved, may be the “deemed owner” of the leased asset for accounting purposes during the construction period.
If we are not the “deemed owner” for accounting purposes during the construction period, such lease is classified as either an operating or finance lease upon lease commencement. During the construction period and prior to lease commencement, any capital amounts contributed by us toward the construction of the leased asset (excluding normal leasehold improvements, which are recorded within property and equipment—net) are recorded as “Landlord assets under construction” within other non-current assets on the condensed consolidated balance sheets (refer to Note 3—
Prepaid Expense and Other Assets
). Upon completion of the construction project, and upon lease commencement, we reclassify amounts of the construction project determined to be the landlord asset to lease right-of-use assets on the condensed consolidated balance sheets. The construction costs determined not to be part of the leased asset are classified as property and equipment—net on the condensed consolidated balance sheets.
If we are the “deemed owner” for accounting purposes, upon commencement of the construction project, we are required to capitalize (i) costs incurred by us and (ii) the cash and non-cash assets contributed by the landlord for construction as property and equipment on its condensed consolidated balance sheets as build-to-suit assets, with an offsetting financing obligation for the amount funded by the landlord. The contributions by the landlord toward construction, including the building, existing site improvements at construction commencement and any amounts paid by the landlord to those responsible for construction, are included as property and equipment additions due to build-to-suit lease transactions within the non-cash section of the consolidated statements of cash flows. Over the lease term,
these non-cash additions to property and equipment do not impact our cash outflows, nor do they impact net income within the consolidated statements of income.
Upon completion of the construction project, we perform a sale-leaseback analysis to determine if we can derecognize the build-to-suit asset and corresponding financing obligation. If the asset and liability cannot be derecognized, we account for the agreement as a debt-like arrangement.
Recent Accounting Pronouncements
Refer to Note 2—
Recently Issued Accounting Standards
in our condensed consolidated financial statements for a description of recently proposed accounting standards which may impact our consolidated financial statements in future reporting periods.
Item 3. Quantitative and Qualitative Disclosure of Market Risks
Interest Rate Risk
We currently do not engage in any interest rate hedging activity and we have no intention to do so in the foreseeable future.
We are subject to interest rate risk in connection with borrowings under our revolving line of credit which bears interest at variable rates and we may incur additional indebtedness that bears interest at variable rates. As of May 4, 2019, no amounts were outstanding under the revolving line of credit. The Credit Agreement provides for a borrowing amount based on the value of eligible collateral and a formula linked to certain borrowing percentages based on certain categories of collateral. Under the terms of such provisions, the amount under the revolving line of credit borrowing base that could be available pursuant to the Credit Agreement as of May 4, 2019 was $139.4 million, net of $285.0 million reserved for the upcoming repayment of the 2019 Notes, as well as $12.8 million in outstanding letters of credit. Based on the average interest rate on the revolving line of credit during the three months ended May 4, 2019, and to the extent that borrowings were outstanding on such line of credit, we do not believe that a 10% change in the interest rate would have a material effect on our consolidated results of operations or financial condition. To the extent that we incur additional indebtedness, we may increase our exposure to risk from interest rate fluctuations.
As of May 4, 2019, we had $350 million principal amount of 0.00% convertible senior notes due 2019 outstanding (the “2019 Notes”). As this instrument does not bear interest, we do not have interest rate risk exposure related to this debt.
As of May 4, 2019, we had $300 million principal amount of 0.00% convertible senior notes due 2020 outstanding (the “2020 Notes”). As this instrument does not bear interest, we do not have interest rate risk exposure related to this debt.
As of May 4, 2019, we had $335 million principal amount of 0.00% convertible senior notes due 2023 outstanding (the “2023 Notes”). As this instrument does not bear interest, we do not have interest rate risk exposure related to this debt.
Market Price Sensitive Instruments
0.00% Convertible Senior Notes due 2019
In connection with the issuance of the 2019 Notes, we entered into privately-negotiated convertible note hedge transactions with certain counterparties. The convertible note hedge transactions relate to, collectively, 3.0 million shares of our common stock, which represents the number of shares of our common stock underlying the 2019 Notes, subject to anti-dilution adjustments substantially similar to those applicable to the 2019 Notes. These convertible note hedge transactions are expected to reduce the potential earnings dilution with respect to our common stock upon conversion of
the 2019 Notes and/or reduce our exposure to potential cash or stock payments that may be required upon conversion of the 2019 Notes.
We also entered into separate warrant transactions with the same group of counterparties initially relating to the number of shares of our common stock underlying the convertible note hedge transactions, subject to customary anti-dilution adjustments. The warrant transactions will have a dilutive effect with respect to our common stock to the extent that the price per share of our common stock exceeds the strike price of the warrants unless we elect, subject to certain conditions, to settle the warrants in cash. The strike price of the warrant transactions is initially $171.98 per share. Refer to Note 8—
Convertible Senior Notes
in our condensed consolidated financial statements.
0.00% Convertible Senior Notes due 2020
In connection with the issuance of the 2020 Notes, we entered into privately-negotiated convertible note hedge transactions with certain counterparties. The convertible note hedge transactions relate to, collectively, 2.5 million shares of our common stock, which represents the number of shares of our common stock underlying the 2020 Notes, subject to anti-dilution adjustments substantially similar to those applicable to the 2020 Notes. These convertible note hedge transactions are expected to reduce the potential earnings dilution with respect to our common stock upon conversion of the 2020 Notes and/or reduce our exposure to potential cash or stock payments that may be required upon conversion of the 2020 Notes.
We also entered into separate warrant transactions with the same group of counterparties initially relating to the number of shares of our common stock underlying the convertible note hedge transactions, subject to customary anti-dilution adjustments. The warrant transactions will have a dilutive effect with respect to our common stock to the extent that the price per share of our common stock exceeds the strike price of the warrants unless we elect, subject to certain conditions, to settle the warrants in cash. The strike price of the warrant transactions is initially $189.00 per share. Refer to Note 8—
Convertible Senior Notes
in our condensed consolidated financial statements.
0.00% Convertible Senior Notes due 2023
In connection with the issuance of the 2023 Notes, we entered into privately-negotiated convertible note hedge transactions with certain counterparties. The convertible note hedge transactions relate to, collectively, 1.7 million shares of our common stock, which represents the number of shares of our common stock underlying the 2023 Notes, subject to anti-dilution adjustments substantially similar to those applicable to the 2023 Notes. These convertible note hedge transactions are expected to reduce the potential earnings dilution with respect to our common stock upon conversion of the 2023 Notes and/or reduce our exposure to potential cash or stock payments that may be required upon conversion of the 2023 Notes.
We also entered into separate warrant transactions with the same group of counterparties initially relating to the number of shares of our common stock underlying the convertible note hedge transactions, subject to customary anti-dilution adjustments. The warrant transactions will have a dilutive effect with respect to our common stock to the extent that the price per share of our common stock exceeds the strike price of the warrants unless we elect, subject to certain conditions, to settle the warrants in cash. The strike price of the warrant transactions is initially $309.84 per share. Refer to Note 8—
Convertible Senior Notes
in our condensed consolidated financial statements.
Impact of Inflation
Our results of operations and financial condition are presented based on historical cost. While it is difficult to accurately measure the impact of inflation due to the imprecise nature of the estimates required, we believe the effects of inflation, if any, on our consolidated results of operations and financial condition have been immaterial.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a‑15(e) and 15d‑15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this quarterly report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that as of the end of the period covered by this report our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and include controls and procedures designed to ensure that the information required to be disclosed by us in such reports is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.
Changes in Internal Control Over Financial Reporting
During fiscal year 2018 and the first fiscal quarter of 2019, we implemented key system functionality and modified our internal controls to ensure we adequately assessed the impact of the new accounting standard related to leases, which standard was effective for us in the first fiscal quarter of 2019. There were no other changes in our internal control over financial reporting that occurred during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.