Rh Q3 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by. And welcome to the RH Third Quarter 2020 Q&A Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. As a reminder, today’s call is being recorded. I would now like to turn the call over to your host, Ms. Allison Malkin of ICR.

Allison, are you on mute? Sorry. I think we are ready to go right into Q&A.

Oh! No. It’s okay. I will start. Thank you. Good afternoon, everyone. Thank you for joining us for our third quarter fiscal 2020 Q&A conference call. Joining me today are Gary Friedman, Chairman and CEO; and Jack Preston, CFO. Before we start, I would like to remind you of our legal disclaimer that we will make certain statements today that are forward-looking within the meaning of the federal securities laws, including statements about the outlook for our business and other matters referenced in our press release issued today. These forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please refer to our SEC filings, as well as our press release issued today, for a more detailed description of the risk factors that may affect our results. Please also note that these forward-looking statements reflect our opinions only as of the date of this call, and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Also, during this call, we may discuss non-GAAP financial measures, which adjust our GAAP results to eliminate the impact of certain items. You will find additional information regarding these non-GAAP financial measures and a reconciliation of this non-GAAP to GAAP measures in today’s financial results released. A live broadcast of this call is also available on the Investor Relations section of our website at ir.rh.com. With that, I will turn the call over to the operator to begin our Q&A session. Operator, we are ready for questions.

Thank you. Our first question comes from Adrienne Yih of Barclays. Your line is open.

Great. Thank you very much. Good afternoon. And I just have to say, wow. I mean, this is a really remarkable performance. So congratulations to everybody at RH. Gary, I guess, my first question for you is, in the past, you have mentioned two macro drivers that benefit the company. One being high-end housing growth and the second being robust stock market returns to where the market that we have both. And based on the historical perspective, what’s been the lag in terms of the effect, and obviously, we are seeing it sort of immediate today. But what’s been the duration of the positive impact to your business from that? And then my second question is, the sales galleries in Europe, what size will they be and how should we think about, I guess, the annual sales contribution of each of those? Thank you very much and congratulations.

Thank you. It's difficult to specify a duration as it largely depends on the intensity of corrections in the markets. We've observed that sharp movements in the stock market can sometimes cause consumers, especially those at the high end, to pause. Therefore, it's challenging to provide a specific number or range. However, we believe consumer behavior will vary based on the severity of marketplace changes. I can say that we see a robust home market. Recently, I've been asked about how I feel regarding the consumers in cities where we have galleries, especially with some moving away from densely populated areas due to the pandemic, and the surge in suburban and second-home markets. Overall, we are indifferent because people moving and purchasing homes is a positive trend. Our galleries are situated in every major market, so everything tends to balance out. Key markets like New York attract customers from surrounding suburbs due to our best selection being there. As for the increase in the housing market and its longevity, we don't have predictive capabilities. Generally, there is a longer effect since purchasing or moving into a new home often leads to significant spending on home-related needs, which can be quite involved.

Yeah.

It takes a long time. We believe the effects from the recent housing market changes look promising. However, it's challenging to predict the stock market's response to the ongoing pandemic and how it will differ between stay-at-home stocks and others. We prefer not to concentrate too much on factors beyond our control. When considering our galleries in Europe and their sales contributions, the situation is quite different, especially from a work perspective. In the U.S., nearly all new galleries are replacing existing ones, which carries a positive aspect because it minimizes risk, and we have established history. For instance, we know a gallery generating $18 million can potentially double to $36 million within the first 12 to 36 months, providing us with a reference point in each market. Conversely, when opening internationally, we are not replacing stores, presenting a level of uncertainty. This can be a downside due to the increased guesswork and limited data available. Nevertheless, we are generally accurate in forecasting performance in the U.S., even when entering new markets. Internationally, we have less data and uncertainty about market reactions. On the brighter side, we should consider that we’re not just entering a market but an entire country. For example, California is currently a $500 million market for us based on the existing galleries, and this could grow to over $700 million as we expand and establish ourselves as a dominant brand, potentially reaching close to $1 billion in the long term. Similarly, the U.K. has a population of 68 million, compared to California’s 39 million, with comparable demographics and wealth distribution. Opening a gallery in London, for instance, aligns with our unique strategic vision, and we plan to launch an impressive gallery at a stunning estate in Oxfordshire, just minutes from Soho Farmhouse, which has been dubbed the coolest house in Great Britain.

That’s very helpful. Thank you very much.

Yeah.

Thank you. Our next question comes from Max Rakhlenko of Cowen and Company. Your line is open.

Hey, guys. Thanks a lot for taking my question and congrats on the nice quarter. So it’s really good to see that your cancel rates are below last year. Do you think that that could remain the case over the coming or could there be some risk as supply will trail demand for a bit longer than you previously anticipated? And then just separately, how are you guys thinking about cash allocation priorities at this point? Your free cash flow is starting to ramp and with fewer major capital-heavy projects, as well as debt maturities, do you think we could see accelerated share repurchase, special dividends M&A? Just want to hear your thoughts on that? Thank you.

The cancellation rates have been decreasing for several quarters, which suggests there’s little to no risk. I believe this is due to our unique market position; we are among the few retailers that offer high-end luxury home furnishings, and typically, customers face longer wait times for custom orders elsewhere. The demand for our products remains strong, and our inventory levels indicate that we have the highest back orders the company has seen in my 20 years here, while cancellation rates are near all-time lows. This likely means consumers have limited choices and are willing to wait for our products. The recent data over the last few quarters supports this view, and while things could change, we currently have high confidence in converting orders into revenue. We've tracked consistent trends in back orders which have been lower compared to last year, while rising demand has led to increased orders. Even as we managed a compound increase in back orders, we fell behind because demand exceeded our expectations. It's noteworthy that despite the rising demand, cancellation rates have remained stable. As we look at our cash allocation priorities, we are navigating a rapidly changing environment, and retail operations are facing restrictions with reduced foot traffic in malls due to the pandemic. The drop in sales over the recent holiday period was unprecedented, and discussions with other retailers highlighted a significant decline in business. However, our orders picked back up after the holiday as consumer behaviors shifted. With this level of uncertainty in our business, we remain flexible and focused. We're optimistic about our market segment compared to others that are severely impacted. While we are cautiously optimistic, our long-term strategy remains intact, and we won’t allow short-term challenges to distract us. We have made substantial changes in our operational model to create long-term value and have done our best to communicate this in our shareholder letters. Currently, we’re hesitant to commit to specific capital allocation strategies like buybacks or mergers due to the fluid situation. We've made small acquisitions that bolster our brand, but significant repurchases are not likely in this environment. Our approach during the pandemic allowed us to maintain optionality and avoid high-cost debt. While some viewed our buybacks of almost 60% of the company as risky, we understood the situation well and planned our actions accordingly, believing they were more calculated than risky. As we assess the current environment and provide forecasts, it's important to look at the next two years as a whole. We see this as an opportunity to strengthen the company and remain focused on building it into a great business.

Got it. Thanks a lot, Gary, and happy holidays to everyone.

Thank you. Happy holidays to you.

Thank you. Our next question comes from Steven Forbes of Guggenheim Securities. Your line is open.

Good afternoon. Hey, Gary. Maybe to start, on the last call, you talked a lot about the reallocation of human and financial capital, right? And I wonder if you can provide more context around the potential benefits here, right, as you digest those moves and is the launch of RH Contemporary, right, and RH Color like a result of these efforts or how do you sort of speak to the potential benefits, right, of that strategic change and not dropping the sourcebook in the fall?

Not releasing the sourcebook in the fall was a strategic decision due to our inventory struggling to keep up with demand. Mailing the book would have increased pressure and potentially frustrated customers with delays. We accepted a trade-off in topline revenue by not sending out the books, but we believed it was better for the long-term health of the business amidst the pandemic. Our focus shifted towards other initiatives, including the development of contemporary products. Despite not mailing any new books, our core business demand has rebounded by 39%. While we could have seen higher numbers if we had provided new offerings, it would have complicated our operations, which we have experienced before. The market currently reflects a surge in promotional activities, but in the long run, this approach may cause issues as we face tough comparisons next year. Looking ahead, we anticipate a strong demand cycle, potentially even impacted by this quarter's lower numbers, but with many new products planned for next year, we are optimistic. We aim to be strategic in our offerings, ensuring they enhance our brand's value. Moreover, we have attractive new talent collaborating with us, like Alison Berger, a renowned lighting designer, who brings exciting designs to our platform. The momentum we have in our brand, along with the skilled teams contributing to various areas, builds a promising future for RH. Our focus on thoughtful actions rather than temporary fixes positions us for sustained success. Investments we make now will elevate our brand in the marketplace. Despite recent stock fluctuations, we remain committed to long-term growth. Our company culture is rooted in leadership, not management; we prioritize building value and creating remarkable products. The essence of our brand lies in our focus on extraordinary outcomes, which will drive our continued progress and success in the market.

And then maybe just a quick follow-up for Jack. I don’t know if you can sort of speak to what’s the right level of expenses as we look out to 2021 or if you just want to sort of based on the third quarter here and maybe help us conceptualize what some of the transitory factors were, right, like the removal of the sales structure and so forth as we think about our 2021 models?

We do not provide guidance. Our outlook demonstrates our confidence in the business and its operational structure. There are several areas where we aim to enhance both gross margin and product margin, which are important aspects of our narrative. We believe we can achieve a 25% margin in our long-term outlook, and these factors are key to our story. However, we are not in a position to share specific details for 2021 at this moment. I'll check with Gary to see if there’s anything more to add.

We believe we will achieve double-digit revenue growth and expanding operating margins. We will gain more insights each week and month as the pandemic evolves and the world moves towards a more normalized environment. However, we will remain prudent with our costs. It’s difficult to predict, so we need to be smart in our approach. This is why we are confident that margins will continue to expand; we have a good handle on expenses and visibility into our product pipeline, which is crucial for our margin structure. We maintain a disciplined approach to investments based on expected returns. As long as we uphold this discipline and avoid becoming complacent or arrogant about current business trends, we will retain our competitive edge. We remain serious and critical, always striving for improvement, allowing us to continue delivering excellent results. I believe we provide more substantial data than most, and our shareholder letter contains valuable information.

Thank you both. Happy holidays.

Happy holidays, Steve.

Thank you. Our next question comes from Chuck Grom of Gordon Haskett. Your line is open.

Hey. Thanks. Good evening. Can you guys put into some context how big of an opportunity the outdoor furniture market could be for you guys? And then, for Jack, just trying to understand the connection between deferred revenue and customer deposits in your balance sheet there, I believe over 60% year-over-year and then your demand comp, which is lower than that. Just wondering if you could connect those two dots for us?

The outdoor business is quite similar to the overall RH business. When you build a brand like ours, you often create a market. We inspire people to choose our products over other options based on what they see. Similar to how Apple created a new market with smartphones and the iPhone, we can create a new market for high-end outdoor furniture. Currently, there are not many consumer-facing outdoor furniture stores, and purchasing options tend to be seasonal and difficult to find. Many people may remember Smith & Hawken, which initially struggled due to high rent for their seasonal business. Our approach involves showcasing 20 to 30 outdoor collections in our new galleries, which effectively caters to customers in ways that others do not. Our physical presence allows us to create a new market in outdoor furniture with a strong return on invested capital. Others may not match our scale or control of real estate, making it challenging for them to replicate our success. Unlike online stores, which are less visible and easily overlooked, our physical locations allow continual exposure and unique product presentations. This visibility helps us take market share and, more importantly, create a new market altogether. Jack, could you elaborate on the relationship between deposits and revenue?

Yeah.

Yeah.

Certainly. Given the strength of the business, high demand, and the supply chain constraints we've discussed, these are the two key factors that will influence growth in customer deposits and our special order business, which contributes to those deposits. As the business expands, we can also expect an increase in the deferred revenue balance. Looking at the numbers year-over-year, I would recommend considering the sequential growth from Q2 to Q3, which showed an 18% increase. It's important to analyze both metrics, but for understanding the impact of demand on revenue growth, focusing on that sequential growth is crucial. As I mentioned, the 18% growth was anticipated based on the business's trajectory.

That’s a good color. I will look at it sequentially then. And then just my follow-up would be just wondering if you guys and it’s probably a little bit more art than science. But just any sense for how much of your revenue growth is coming from consumers who are actually buying second homes and/or people who are shifting out of cities into larger suburban homes?

We have reviewed the data, and it aligns with our expectations. Suburban homes show high growth rates, while second home markets are experiencing the highest growth. Additionally, as Gary mentioned, there is a trend of people leaving cities. However, we are present in all these markets, and our customers, regardless of whether they have a primary home in an urban area and are moving out, contribute positively to our business. We haven't delved into further detail, but I believe the trends indicate that the second home market shows the strongest growth, followed closely by suburban areas, with urban markets trailing behind. It's somewhat of an obvious observation, as we sometimes put it. Gary, do you have anything more to add?

Our business has always been primarily focused on the suburban market, where there are more large homes with additional bedrooms, living space, and outdoor furniture areas. It’s no surprise that this segment is the largest part of our business. The suburban market continues to grow as more people move into it, which is beneficial for us. However, based on the data we have, it doesn’t indicate that we need to change our strategy or expectations. There aren't any new markets where we see unexpected demand for our products that would prompt us to open a new gallery immediately. For example, we've been looking at opportunities in Palm Desert for years, and it's performing really well. Our Chief Gallery Officer mentioned the need for a gallery there after visiting his grandparents, and I agree it's on our list. If he feels strongly about it, we can find a location quickly. However, I don’t think this will drastically change our overall strategy; it’s just a minor adjustment. We are well-positioned to adapt to shifts within the North American market, and we appreciate that the market is improving. We can capitalize on these changes regardless of where people move within North America, but we currently lack representation in places like Montreal and Hawaii.

Naples?

We are not in Naples.

Yeah.

We plan to be in Naples, but we do great business in Naples even though we are not there.

Got it. Thanks very much.

Thank you. Our next question comes from Michael Lasser of UBS. Your line is open.

Good evening. Thanks a lot for taking my question. Gary, can you give us a flavor of the customer behavior that you are experiencing that drive this strong demand growth? How much is coming from new customers versus repeat customers and how much is coming from larger basket? Are you seeing a trend of customers who are more often buying furniture more than one room in their house and that where you are seeing a strong demand growth?

Our interior design business continues to grow significantly. Initially, we saw a surge in outdoor-related sales as many realized they wouldn't be traveling for summer and would be spending more time at home. Consumer behavior indicates that we have both new customers and increased spending from existing ones, and our metrics suggest no need for major changes in our strategy. Our business is expanding, particularly concerning the size of purchases. We have transitioned from merely selling products to creating and selling complete spaces. We are investing in a national interior design platform, evident in our new galleries that feature dedicated office spaces for our designers and meeting areas. This will help establish a lasting strategic advantage. Our ongoing investments aim to enhance our brand value in the long term, and we are focused on a decade-long vision. When asked about stock purchases, I emphasize the distinction between investors and traders. If you're a trader looking for short-term gains, our stock might not be for you due to its volatility. However, for long-term investors, our company represents an excellent opportunity. Ten years ago and even five years ago, I expressed confidence that staying invested in RH stock would be beneficial. Fidelity, our largest shareholder, has kept their stake since our IPO, and their commitment reflects their belief in our long-term potential. Despite fluctuations, they invested when our stock was at $24 and have not sold since. My focus remains on the long-term outlook, reinforcing that our company is a solid investment, as echoed by the composition of our shareholder base.

Yes.

Yeah.

My follow-up question is these periods of disruption are always an opportune time to learn how to operate differently, given the extremes on the cost side in the third quarter and recognizing that some of the SG&A decline was from mainly in the sourcebook. Is RH now able to operate its model less cost intensively with a lower amount of labor so we shouldn’t necessarily expect the same amount of labor expense moving forward, and how would you think about reinvesting some of that back in the business?

The models will continue to evolve. For instance, moving from a legacy gallery to a design gallery could potentially double the business within one to three years. We won’t be mailing sourcebooks into that market anymore, aside from possibly a small announcement when opening a new gallery. The advertising costs change significantly at this level, and many people overlook the dynamics at play. They see a large gallery and assume it’s very expensive without considering how it can actually drive business growth. I haven’t seen anyone take a productive legacy store and simply change its format to double their business before. We can achieve this consistently across the country. When considering advertising costs, this gives us substantial leverage. The pandemic has given us a temporary situation that we can learn from, but reinvesting and sending out books again will need to be carefully tested. We'll analyze data and explore ways to optimize while ensuring we don't underinvest in the business. Our model indicates we can potentially double our retail revenue, which heavily influences our corporate cost structure and distribution centers. This increased revenue provides leverage. As we focus on enhancing quality and desirability and increasing prices, we’re committed to continuously improving our performance. We are pursuing various initiatives and investments that we believe will yield beneficial returns, making our operations more efficient and profitable. This isn’t just about labor savings; it’s about leveraging our business strategies for greater profitability. Looking back, we achieved an 11.4% operating margin and then surpassed that with 14.1%. Now, we are aiming for a 21% operating margin on approximately 7% revenue growth. The key takeaway is that it doesn’t matter how those revenues were generated throughout the year; rather, achieving a 21% margin on that growth is what's significant. If the pandemic hadn’t occurred, it’s uncertain if we would’ve reached a 20% margin, as the pandemic didn’t directly enhance our operating margin this year; rather, it made us less efficient. We're generating $80 million to $100 million in future revenue as a result of engaging customers and doing design work, but we aren’t reaping those benefits this year. If you account for that future revenue, our operating margins would be higher than 21%. This reflects our long-term vision; we clearly see a path to the projected growth ahead of us. If we don’t experience a recession, we anticipate steady economic performance. If our growth averages 8% to 12% per year, we’re in a strong position. The lost revenue from our New York restaurant also plays a role since it’s a high-volume establishment. As vaccinations roll out, we expect customer traffic will return, positively impacting our galleries. The restaurant traffic is pivotal for driving business to our brand. Even though our restaurant business was down recently, once things recover, we will see increased foot traffic in RH Galleries. In summary, it's essential not to lose sight of the bigger picture amidst the pandemic's challenges. Despite a modest revenue increase, our operating margins remain strong. I have confidence in our model and in this team; we have consistently met and exceeded expectations, transforming the company and establishing a brand with no equal. We approach each day with a focus on what’s next, striving for greatness. As a sizable shareholder, I am optimistic about the next decade, grounded in the long-term vision we have. For those who prefer short-term investments, this may not be the right fit.

That’s very helpful. Thank you very much and have a nice holiday.

Thank you.

Thank you. Our next question comes from Curtis Nagle of Bank of America. Your line is open.

Hi, good evening. Thanks very much. I want to ask about the RH contemporary line and get more details regarding the vision and strategy. Gary, you mentioned it as a bridge between the interior and modern lines. I assume there’s a strong likelihood that you wouldn't pursue this if it posed a risk to existing business. So, I'm curious about what gives you the confidence that this will be a successful incremental business compared to the other lines. How should we think about it?

We are really excited about the direction we’re heading, and you should be too. Our enthusiasm is for products we genuinely want to buy. There’s a lot of new offerings that will broaden the brand’s reach. Our teams are working hard to excel in every area, focusing particularly on color. While we have a reputation for neutrals, we recognize that there’s a market for color, albeit a smaller one. Just like our beach house and ski house themes expanded our brand’s conversation, we believe that a focus on color will generate more dialogue. We’ve heard from many people eager about our ski house book, showing interest in these new introductions. Internally, we emphasize that to engage in the conversation, we need to initiate it. Contemporary design and color will help foster that dialogue. We need to execute these concepts exceptionally well, which is why we’re excited about the future. While I can’t specify precisely what it will look like, it will be fresh and familiar, reflecting great design references that resonate with our audience. When we strike the right balance of freshness and familiarity, we tend to see strong results.

Got it. I'm excited to see it when you release it. Just a quick follow-up about Europe. Do you think that, despite the many moving pieces and it being early, the profit contribution could eventually be higher than in the U.S.? This might happen as you gain more scale, especially considering your comments about possibly adopting a less dense category strategy and the additional international exposure you might see from being in major capital cities.

Yeah. All our research and due diligence would say the potential is for higher margins than the U.S. And a lot of brands as you know have higher margins and higher profitability outside the U.S. than they do inside the U.S. And that’s because you are getting a lot of leverage off your cost structure, right, if you set it up well if you are not overly redundant. And for us, right, we don’t have to set up any kind of redundant buying organizations or inventory organizations or things like that. I mean think about it. We don’t have any cash and carry, what is our cash and carry business these days?

Less than a 1%.

I’d say, 1%.

Yeah.

It’s almost zero. We don’t really sell anything. It used to be about 1 or 2 percent, and now it's nearly nonexistent. We have removed holiday items and ornaments, so occasionally someone buys some towels or similar items and leaves with them. For the most part, we don’t really stock inventory in our stores. Our model is quite simple compared to others; for instance, people mention that Home Depot or Target didn't perform well in Europe. However, those are retail stores that sell other brands, whereas most high-end luxury brands function effectively on a global scale. If you are the best in your category, which we believe we are, those brands tend to perform significantly better than others. It was strategic to give ourselves more time to consider Europe, allowing us to think about aspects like margin structure and pricing, and to deeply analyze the decisions we make to position the business correctly. All our research indicates that we should achieve higher profit margins in Europe. Although there will be minor short-term expenses as we build up the infrastructure, those should resolve quickly because of the large market we’ll reach by opening locations in the U.K., London, Paris, and potentially Munich, Dusseldorf, Madrid, and Brussels. Even with just a small footprint, we will have a vast audience thanks to the Internet and the online side of the business. By establishing ourselves in high-quality locations, we expect valuable insights. Although I was reluctant to delay the launch, it was ultimately the right business decision, as we are eager to learn. I believe your perspective is mostly accurate; it should be at least as profitable as our U.S. business, enabling leverage which should result in overall improved RH margins.

Got it. Thanks very much for the thought and happy holidays.

Thank you. Happy holidays to you.

Thank you. I am showing no further questions. I’d like to turn the call back over to management for any closing remarks.

Thank you, everyone. I would like to express my gratitude to our employees and partners worldwide who have worked diligently during these challenging times to enhance our brand and realize our vision each day. Our thoughts and prayers are with everyone affected by this pandemic, particularly those infected and their loved ones. We appreciate all the frontline workers striving to keep us safe and help us navigate through this situation. It has been a time of mixed emotions for our company; while many are suffering, we have experienced business success, which makes it difficult to fully celebrate when others are facing hardship. We hope for a swift resolution to this situation, as the world continues to progress and improve, and we remain committed to the long term. Thank you to everyone for their hard work, leadership, creativity, and dedication in bringing our goals to fruition. A special thank you to our frontline teams in our galleries, call centers, distribution centers, and those delivering our products to customers. They have navigated these challenges with great care and have represented our company and brand exceptionally well. We wish everyone a wonderful and safe holiday, and here’s to overcoming these challenges and returning to brighter days for everyone on this planet. Thank you.

Thank you. Ladies and gentlemen, this does conclude today’s conference. Thank you all for participating. You may have a great day. You may all disconnect.