Item 2. Management’s Discussion and Analysis
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 2020 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 section entitled Risk Factors in our Annual Report on Form 10-K for the fiscal year ended January 30, 2021 (the “2020 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 2020 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, whether as a result of new information, future events or otherwise, except as required by law.
Overview
We are a leading luxury retailer in the home furnishings market. Our curated and fully integrated assortments are presented consistently across our sales channels in sophisticated and unique lifestyle settings. We offer merchandise assortments across a 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 websites and Source Books act as virtual extensions of our physical spaces. Our retail business is fully integrated across our multiple channels of distribution, consisting of our retail locations, websites and Source Books. We have an integrated RH Hospitality experience in ten of our locations, which include Restaurants and wine bars.
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As of May 1, 2021, we operated the following number of Galleries, Outlets and Showrooms:
COUNT
RH
Design Galleries
24
Legacy Galleries
38
Modern Galleries
2
Baby & Child and TEEN Galleries
4
Total Galleries
68
Outlets
38
Waterworks Showrooms
14
The COVID-19 outbreak in the first quarter of fiscal 2020 caused disruption to our business operations. In our initial response to the health crisis we undertook immediate adjustments to our business operations including temporarily closing all of our retail locations and Restaurants, curtailing expenses, and delaying investments including scaling back some inventory orders while we assessed the status of our business. Our approach to the crisis evolved quickly as our business trends substantially improved during the second through fourth fiscal quarters of fiscal 2020 as a result of both the reopening of most of our retail locations and also strong consumer demand for our products. Operational restrictions related to the COVID-19 pandemic affecting our Galleries and hospitality locations continued to fluctuate in the first quarter of 2021 based upon changes in local conditions and regulations. As of June 4, 2021, substantially all of our Galleries, Outlets, and Restaurants were open, although many of our Restaurants and Galleries continue to conduct business with occupancy limitations and other operational restrictions.
Our overall customer demand in specific markets has generally correlated favorably with our customers’ ability to access our Galleries and Outlets. Although our business has strengthened during the period from the second quarter of fiscal 2020 and continuing into fiscal 2021, consumer spending patterns may shift away from spending on the home and home-related categories, such as home furnishings, as pandemic restrictions are lifted and consumers return to pre-COVID consumption trends, such as spending on travel and leisure and other activities. In addition, various constraints in our merchandise supply chain have resulted in some delays in our ability to convert business demand into revenues at normal historical rates. We anticipate that the backlog of orders for merchandise from our vendors, coupled with business conditions related to the pandemic, will continue to adversely affect the capacity of our vendors and supply chain to meet our merchandise demand levels during fiscal 2021. It may take several quarters for inventory receipts and manufacturing to catch up to the increase in customer demand and as a result the exact timing cannot be accurately predicted due to ongoing uncertainty of the continuing impact of the pandemic on our global supply chain. In particular, business circumstances and operational conditions in numerous international locations where our vendors operate are subject to ongoing risks, and regions in which our vendors have production facilities, such as India, have experienced various spikes in cases related to the pandemic. As a result, the pandemic may continue to adversely affect business operations in these jurisdictions, which could, in turn, have a negative impact on our vendors and therefore on our business as well, as including our ability to source products.
We will continue to closely manage our investments while considering both the overall economic environment as well as the needs of our business operations. In addition, our near-term decisions regarding the sources and uses of capital in our business will continue to reflect and adapt to changes in market conditions and our business including further developments with respect to the pandemic. For more information, refer to the section entitled “Risk Factors” in our 2020 Form 10-K.
Key Value Driving Strategies
In order to drive growth across our business, we are focused on the following long-term key strategies and business initiatives:
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Product Elevation . We have built the most comprehensive and compelling collection of luxury home furnishings under one brand in the world. Our products are presented across multiple collections, categories, and channels that we control, and their desirability and exclusivity has enabled us to achieve industry leading revenues and margins. Our customers know them as RH Interiors, RH Modern, RH Beach House, RH Ski House, RH Outdoor, RH Rugs, RH Lighting, RH Linens, RH Baby & Child, RH Teen, and Waterworks. Our strategy to elevate the design and quality of our product will continue as we introduce RH Contemporary in 2021 with a 400 page Source Book, dedicated website, national ad campaign, and a freestanding RH Contemporary Gallery in the San Francisco Design District. We also have plans to introduce RH Couture Upholstery, RH Bespoke Furniture and RH Color over the next several years.
Gallery Transformation . Our product is elevated and rendered more valuable by our architecturally inspiring Galleries. We believe our strategy to open new Design Galleries in every major market will unlock the value of our vast assortment, generating a revenue opportunity for our business of $5 to $6 billion in North America. We believe we can significantly increase our sales by transforming our real estate platform from our existing legacy retail footprint to a portfolio of Design Galleries that is sized to the potential of each market and the size of our assortment. In addition, we plan to incorporate Hospitality into most of the new Design Galleries that we open in the future, which further elevates and renders our product and brand more valuable. We believe Hospitality has created a unique new retail experience that cannot be replicated online, and that the addition of Hospitality will help drive incremental sales of home furnishings in these Galleries.
Brand Elevation . We are beginning to evolve the brand beyond curating and selling product, towards conceptualizing and selling spaces, by building an ecosystem of products, services, places, and spaces designed to elevate and render our product more valuable while establishing the RH brand as a thought leader, taste and place maker. We believe our seamlessly integrated ecosystem of immersive experiences inspires customers to dream, design, dine, travel and live in a world thoughtfully curated by RH, creating an impression and connection unlike any other brand in the world.
Digital Reimagination . Our strategy is to digitally reimagine the RH brand and business model both internally and externally. Internally regarding how we innovate, curate, and integrate all the dynamic aspects of our brand, and externally as we introduce our customers to The World of RH, a new digital portal presenting our Products, Services, Places and Spaces. This multi-year effort began internally last year with the reimagination of our Center of Innovation & Product Leadership, which will incorporate digitally integrated visuals and decision data designed to amplify the creative process from product ideation to product presentation.
Our external efforts will begin this fall with the launch of phase one of our new digital portal, The World of RH, which will include rich, immersive content with simplified navigation and search functionality, all designed to enhance the shopping experience and render our product and brand more valuable. We believe an opportunity exists to create similar strategic separation online as we have with our Galleries offline, reconceptualizing what a website can and should be.
Global Expansion . We believe that our luxury brand positioning and unique aesthetic have strong international appeal, and that pursuit of global expansion will provide RH a substantial long-term market opportunity to build a $20 to $25 billion global brand over time. Our view is the competitive environment globally is more fragmented and primed for disruption than the North American market, and there is no direct competitor of scale that possesses the product, operational platform, and brand of RH. As such, we are actively pursuing the expansion of the RH brand globally with the objective of launching international locations in Europe beginning in 2022. We have secured a number of locations in various markets in the United Kingdom and continental Europe in which we expect to introduce our first Galleries outside of the U.S. and Canada.
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Basis of Presentation and Results of Operations
Matters Affecting Comparability
The disruption to our business operations from the COVID-19 pandemic has had a significant impact on the comparability of certain ratios and year-over-year trends for our operating results for the three months ended May 1, 2021, as compared to the three months ended May 2, 2020. The primary negative impact to our revenues from store closures occurred during the first half of fiscal 2020, but despite the reopening of most of our Galleries during the second and third fiscal quarters and a strong resurgence in customer demand for our products, we have continued to address a range of business circumstances related to the pandemic including delays in manufacturing and inventory receipts as our supply chain recovers from the impact of the global health crisis. We have also changed the cadence of our expenses and investments as we have sought to address the impact of the pandemic on the business, and delayed the opening of certain new Gallery locations due to issues related to the pandemic including the extensive travel restrictions that have been in place for Europe. Beginning in the second quarter of fiscal 2020, we resumed many investments and previously deferred expenditures, and our decisions regarding these matters will continue to evolve in response to changing business circumstances, including further developments with respect to the pandemic. Direct and indirect effects of the pandemic will continue to affect the comparability of our results during fiscal 2021. Although we have experienced strong demand for our products since the second half of fiscal 2020, for example, some of the demand may have been driven by consumers electing to spend more money on home-related purchases due to stay-at-home restrictions that were in place throughout many parts of the United States and Canada. The relaxation of COVID-19-related restrictions may trigger a shift in consumer spending patterns toward other categories, such as travel and leisure activities, and away from the purchase of merchandise related to the home including home furnishings which could affect our results of operation in fiscal 2021.
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Results of Operations
The following table sets forth our condensed consolidated statements of operations and other financial and operating data:
THREE MONTHS ENDED
MAY 1,
MAY 2,
2021
2020
(in thousands)
Condensed Consolidated Statements of Operations:
Net revenues
$
860,792
$
482,895
Cost of goods sold
453,815
283,241
Gross profit
406,977
199,654
Selling, general and administrative expenses
219,089
164,201
Income from operations
187,888
35,453
Other expenses
Interest expense—net
13,308
19,629
Tradename impairment
—
20,459
Loss on extinguishment of debt
105
—
Total other expenses
13,413
40,088
Income (loss) before income taxes
174,475
(4,635)
Income tax expense (benefit)
41,724
(1,423)
Income (loss) before equity method investments
132,751
(3,212)
Share of equity method investments losses
(2,095)
—
Net income (loss)
$
130,656
$
(3,212)
Other Financial and Operating Data:
Adjusted net income (1)
$
142,250
$
29,949
Adjusted EBITDA (2)
$
228,258
$
77,427
Capital expenditures
$
50,251
$
16,632
Landlord assets under construction—net of tenant allowances
13,578
7,600
Adjusted capital expenditures (3)
$
63,829
$
24,232
(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 consolidated net income (loss), 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 our senior leadership team believes that adjusted net income provides meaningful supplemental information for investors regarding the performance of our business and facilitates a meaningful evaluation of actual results on a comparable basis with historical results. Our senior leadership team 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 (loss), the most directly comparable GAAP financial measure, to adjusted net income for the periods indicated below.
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THREE MONTHS ENDED
MAY 1,
MAY 2,
2021
2020
(in thousands)
Net income (loss)
$
130,656
$
(3,212)
Adjustments pre-tax:
Amortization of debt discount (a)
5,981
11,125
Non-cash compensation (b)
5,864
—
Recall accrual (c)
500
—
Loss on extinguishment of debt (d)
105
—
Tradename impairment (e)
—
20,459
Asset impairments and change in useful lives (f)
—
8,471
Reorganization related costs (g)
—
4,143
Subtotal adjusted items
12,450
44,198
Impact of income tax items (h)
(2,951)
(11,037)
Share of equity method investments losses (i)
2,095
—
Adjusted net income
$
142,250
$
29,949
(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 $300 million aggregate principal amount of convertible senior notes that were issued in June and July 2015 (the “2020 Notes”), the $335 million aggregate principal amount of convertible senior notes that were issued in June 2018 (the “2023 Notes”) and the $350 million aggregate principal amount of convertible senior notes that were issued in September 2019 (the “2024 Notes”), we separated the 2020 Notes, 2023 Notes and 2024 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 2020 Notes, 2023 Notes and 2024 Notes over their expected lives. The equity components represent the difference between the proceeds from the issuance of the 2020 Notes, 2023 Notes and 2024 Notes and the fair value of the liability components of the 2020 Notes, 2023 Notes and 2024 Notes, respectively. Amounts are presented net of interest capitalized for capital projects of $2.7 million and $1.8 million during the three months ended May 1, 2021 and May 2, 2020, respectively. The 2020 Notes matured on July 15, 2020 and did not impact amortization of debt discount post-maturity.
(b) Represents the amortization of the non-cash compensation charge related to an option grant made to Mr. Friedman in October 2020.
(c) Represents accruals associated with product recalls.
(d) Represents a loss on extinguishment of debt for a portion of the 2023 Notes that were early converted at the option of the noteholders.
(e) Represents tradename impairment related to the Waterworks reporting unit. Refer to “Waterworks Tradename Impairment” within Note 4— Goodwill, Tradenames, Trademarks and Other Intangible Assets in our condensed consolidated financial statements.
(f) Represents asset impairments of $4.8 million, inventory reserves of $2.4 million related to Outlet inventory resulting from retail closures in response to the COVID-19 pandemic and acceleration of depreciation expense of $1.3 million due to a change in the estimated useful lives of certain assets.
(g) Represents severance costs and related payroll taxes associated with a reorganization undertaken in response to the impact of retail closures on our business.
(h) The adjustment for the three months ended May 1, 2021 is based on an adjusted tax rate of 23.9%, which excludes the tax impact associated with our share of equity method investments losses. The adjustment for the three months ended May 2, 2020 is based on an adjusted tax rate of 24.3%, which excludes the tax impact associated with the Waterworks reporting unit tradename impairment.
(i) Represents our proportionate share of the losses of our equity method investments. Refer to Note 5— Equity Method Investments in our condensed consolidated financial statements.
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(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 (loss) before depreciation and amortization, interest expense—net and income tax expense (benefit). Adjusted EBITDA reflects further adjustments to EBITDA to eliminate the impact of non-cash compensation, 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 our senior leadership team 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 senior leadership team 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 (loss), the most directly comparable GAAP financial measure, to EBITDA and Adjusted EBITDA for the periods indicated below.
THREE MONTHS ENDED
MAY 1,
MAY 2,
2021
2020
Net income (loss)
$
130,656
$
(3,212)
Depreciation and amortization
23,886
24,870
Interest expense—net
13,308
19,629
Income tax expense (benefit)
41,724
(1,423)
EBITDA
209,574
39,864
Non-cash compensation (a)
15,307
5,828
Share of equity method investments losses (b)
2,095
—
Capitalized cloud computing amortization (c)
677
—
Recall accrual (b)
500
—
Loss on extinguishment of debt (b)
105
—
Tradename impairment (b)
—
20,459
Asset impairments (b)
—
7,133
Reorganization related costs (b)
—
4,143
Adjusted EBITDA
$
228,258
$
77,427
(a) Represents non-cash compensation related to equity awards granted to employees.
(b) Refer to the reconciliation of net income (loss) to adjusted net income table above and the related footnotes for additional information.
(c) Represents amortization associated with capitalized cloud computing costs.
(3) We define adjusted capital expenditures as capital expenditures from investing activities and cash outflows of capital related to construction activities to design and build landlord-owned leased assets, net of tenant allowances received.
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The following table presents RH Gallery and Waterworks Showroom metrics, and excludes Outlets:
THREE MONTHS ENDED
MAY 1,
MAY 2,
2021
2020
TOTAL LEASED
TOTAL LEASED
SELLING SQUARE
SELLING SQUARE
COUNT
FOOTAGE (1)
COUNT
FOOTAGE (1)
(in thousands)
(in thousands)
Beginning of period
82
1,162
83
1,111
RH Legacy Galleries:
Raleigh legacy Gallery
—
—
1
4.4
End of period
82
1,162
84
1,115
Total leased square footage at end of period (2)
1,559
1,502
Weighted-average leased square footage (3)
1,559
1,501
Weighted-average leased selling square footage (3)
1,162
1,114
(1) Leased selling square footage is retail space at our retail locations used to sell our products, as well as space for our Restaurants. Leased selling square footage excludes backrooms at retail locations used for storage, office space, food preparation, kitchen space or similar purpose, as well as exterior sales space located outside a retail location, such as courtyards, gardens and rooftops.
Leased selling square footage includes approximately 4,800 square feet as of May 1, 2021 related to one owned retail location and 37,700 square feet as of May 2, 2020 related to two owned retail locations.
(2) Total leased square footage includes approximately 5,400 square feet as of May 1, 2021 related to one owned retail location and 48,700 square feet as of May 2, 2020 related to two owned retail locations.
(3) Weighted-average leased square footage and leased selling square footage are calculated based on the number of days a retail location was opened during the period divided by the total number of days in the period.
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The following table sets forth our condensed consolidated statements of operations as a percentage of total net revenues:
THREE MONTHS ENDED
MAY 1,
MAY 2,
2021
2020
Condensed Consolidated Statements of Operations:
Net revenues
100.0
%
100.0
%
Cost of goods sold
52.7
58.7
Gross profit
47.3
41.3
Selling, general and administrative expenses
25.5
34.0
Income from operations
21.8
7.3
Other expenses
Interest expense—net
1.5
4.1
Tradename impairment
—
4.2
Loss on extinguishment of debt
—
—
Total other expenses
1.5
8.3
Income (loss) before income taxes
20.3
(1.0)
Income tax expense (benefit)
4.9
(0.3)
Income (loss) before equity method investments
15.4
(0.7)
Share of equity method investments losses
(0.2)
—
Net income (loss)
15.2
%
(0.7)
%
Three Months Ended May 1, 2021 Compared to Three Months Ended May 2, 2020
THREE MONTHS ENDED
MAY 1,
MAY 2,
2021
2020
RH SEGMENT
WATERWORKS
TOTAL
RH SEGMENT
WATERWORKS
TOTAL
(in thousands)
Net revenues
$
819,823
$
40,969
$
860,792
$
454,957
$
27,938
$
482,895
Cost of goods sold
433,270
20,545
453,815
267,195
16,046
283,241
Gross profit
386,553
20,424
406,977
187,762
11,892
199,654
Selling, general and administrative expenses
204,407
14,682
219,089
149,276
14,925
164,201
Income (loss) from operations
$
182,146
$
5,742
$
187,888
$
38,486
$
(3,033)
$
35,453
Net revenues
Consolidated net revenues increased $377.9 million, or 78.3%, to $860.8 million in the three months ended May 1, 2021 compared to $482.9 million in the three months ended May 2, 2020.
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RH Segment net revenues
RH Segment net revenues increased $364.9 million, or 80.2%, to $819.8 million in the three months ended May 1, 2021 compared to $455.0 million in the three months ended May 2, 2020. The below discussion highlights several significant factors that resulted in increased RH Segment net revenues, which are listed in order of magnitude.
RH Segment net revenues for the three months ended May 1, 2021 was driven by strong customer demand for our products. RH Segment net revenues for the three months ended May 2, 2020 was negatively impacted by Gallery closures and macroeconomic conditions resulting from the COVID-19 pandemic in March and April of 2020.
Outlet sales increased $50.1 million to $62.3 million in the three months ended May 1, 2021 compared to $12.2 million in the three months ended May 2, 2020 due to pandemic related retail closures in the first quarter of fiscal 2020. Additionally, RH Segment net revenues increased in our Contract business driven by increased commercial purchasing activities and in our RH Hospitality business as COVID-19 operating restrictions continued to ease during the quarter.
Despite our revenue growth during the three month period, the growth in demand outpaced the growth in revenue for our products primarily due to the effects of higher than anticipated consumer demand and disruptions across our global supply chain related to the pandemic, including difficulties in ramping vendor production, as well as delays in shipments of products. It may take several quarters for inventory receipts and manufacturing to catch up to the increase in customer demand and as a result the exact timing cannot be accurately predicted due to ongoing uncertainty of the continuing impact of the pandemic on our global supply chain.
Waterworks net revenues
Waterworks net revenues increased $13.0 million, or 46.6%, to $41.0 million in the three months ended May 1, 2021 compared to $27.9 million in the three months ended May 2, 2020 due to an increase in demand related to resumed construction activity and significant residential investments by high-end homeowners. Waterworks net revenues for the three months ended May 2, 2020 was negatively impacted by construction delays, as well as temporary showroom closures, in response to the pandemic.
Gross profit
Consolidated gross profit increased $207.3 million, or 103.8%, to $407.0 million in the three months ended May 1, 2021 compared to $199.7 million in the three months ended May 2, 2020. As a percentage of net revenues, consolidated gross margin increased 600 basis points to 47.3% of net revenues in the three months ended May 1, 2021 from 41.3% of net revenues in the three months ended May 2, 2020.
RH Segment gross profit for the three months ended May 2, 2020 includes inventory reserves of $2.4 million related to Outlet inventory resulting from retail closures in response to the pandemic.
Excluding the inventory reserves adjustment mentioned above, consolidated gross margin would have increased 550 basis points to 47.3% of net revenues in the three months ended May 1, 2021 from 41.8% of net revenues in the three months ended May 2, 2020.
RH Segment gross profit
RH Segment gross profit increased $198.8 million, or 105.9%, to $386.6 million in the three months ended May 1, 2021 from $187.8 million in the three months ended May 2, 2020. As a percentage of net revenues, RH Segment gross margin increased 590 basis points to 47.2% of net revenues in the three months ended May 1, 2021 from 41.3% of net revenues in the three months ended May 2, 2020.
Excluding the inventory reserves adjustment mentioned above related to the first quarter of fiscal 2020, RH Segment gross margin would have increased 540 basis points to 47.2% of net revenues in the three months ended May 1, 2021 from 41.8% of net revenues in the three months ended May 2, 2020. The increase in gross margin was primarily driven by price increases and product mix in our Core business. Additionally, we drove higher Outlet margins through price increases and leveraged our RH Segment occupancy costs during the three month period ended May 1, 2021.
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Waterworks gross profit
Waterworks gross profit increased $8.5 million, or 71.7%, to $20.4 million in the three months ended May 1, 2021 from $11.9 million in the three months ended May 2, 2020. As a percentage of net revenues, Waterworks gross margin increased 730 basis points to 49.9% of net revenues in the three months ended May 1, 2021 from 42.6% of net revenues in the three months ended May 2, 2020 primarily driven by higher revenues, favorable changes in product mix, and improved efficiency in the Waterworks supply chain.
Selling, general and administrative expenses
Consolidated selling, general and administrative expenses increased $54.9 million, or 33.4%, to $219.1 million in the three months ended May 1, 2021 from $164.2 million in the three months ended May 2, 2020.
RH Segment selling, general and administrative expenses
RH Segment selling, general and administrative expenses increased $55.1 million, or 36.9%, to $204.4 million in the three months ended May 1, 2021 compared $149.3 million in the three months ended May 2, 2020.
RH Segment selling, general and administrative expenses for the three months ended May 1, 2021 included amortization of the non-cash compensation of $5.9 million related to the option grant made to Mr. Friedman in October 2020.
RH Segment selling, general and administrative expenses for the three months ended May 2, 2020 included $4.1 million in severance costs and related payroll taxes associated with the termination of associates and a reorganization undertaken in response to the impact of retail closures on our business, $3.2 million related to asset impairments and $1.3 million related to the acceleration of depreciation due to a change in the estimated useful lives of certain assets.
RH Segment selling, general and administrative expenses were 24.2% and 30.9% of net revenues for the three months ended May 1, 2021 and May 2, 2020, respectively, excluding the costs incurred in connection with the adjustments mentioned above. The decrease in selling, general and administrative expenses as a percentage of net revenues was primarily driven by leverage in employment and employment related costs, advertising and corporate occupancy costs.
Waterworks selling, general and administrative expenses
Waterworks selling, general and administrative expenses decreased $0.2 million, or 1.6%, to $14.7 million in the three months ended May 1, 2021 compared to $14.9 million in the three months ended May 2, 2020.
Waterworks selling, general and administrative expenses for the three months ended May 1, 2021 included $0.5 million related to product recall and for the three months ended May 2, 2020 included $1.6 million related to asset impairments.
Waterworks selling, general and administrative expenses were 34.6% and 47.8% of net revenues for the three months ended May 1, 2021 and May 2, 2020, respectively, excluding the adjustments mentioned above.
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Interest expense—net
Interest expense—net decreased $6.3 million in the three months ended May 1, 2021 compared to the three months ended May 2, 2020, which consisted of the following in each period:
THREE MONTHS ENDED
MAY 1,
MAY 2,
2021
2020
(in thousands)
Amortization of convertible senior notes debt discount
$
8,670
$
12,916
Finance lease interest expense
6,150
5,781
Amortization of debt issuance costs and deferred financing fees
745
1,013
Other interest expense
464
443
Promissory notes
425
1,454
Asset based credit facility
—
102
Capitalized interest for capital projects
(2,801)
(1,886)
Interest income
(345)
(194)
Total interest expense—net
$
13,308
$
19,629
Tradename impairment
We incurred a $20.5 million tradename impairment charge during the three months ended May 2, 2020 for our Waterworks reporting unit. Refer to “Waterworks Tradename Impairment” within Note 4— Goodwill, Tradenames, Trademarks and Other Intangible Assets .
Loss on extinguishment of debt
During the three months ended May 1, 2021 we recognized a loss on extinguishment of debt for a portion of the 2023 Notes that were early converted at the option of the noteholders of $0.1 million.
Income tax expense (benefit)
Our income tax expense was $41.7 million and our income tax benefit was $1.4 million in the three months ended May 1, 2021 and May 2, 2020, respectively. Our effective tax rate was 24.2% and 30.7% for the three months ended May 1, 2021 and May 2, 2020, respectively. The decrease in our effective tax rate is attributable to higher net excess tax benefits from stock-based compensation and income reported in the current period compared to a reported loss in the prior year.
Equity method investments losses
Equity method investments losses consists of our proportionate share of the losses of our equity method investments by applying the hypothetical liquidation at book value methodology, which resulted in a $2.1 million loss during the three months ended May 1, 2021.
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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 the past we have pursued substantial repurchases of our common stock when we believed that such investments represented a good long term investment for the benefit of our shareholders. Refer to “Share Repurchase Programs” below. We evaluate our capital allocation from time to time and may engage in future investments in connection with existing or new share repurchase programs in circumstances where buying shares of our common stock or related investments, which may include investments in derivatives or other equity linked instruments, represent a good value and provides a favorable return for our shareholders. We have in the past been opportunistic in responding to favorable market conditions regarding both sources and uses of capital. Our use of convertible notes financings has enabled us to pursue various investments, such as our share repurchase programs which we consider to have been an excellent allocation of capital for the benefit of our shareholders. We regularly evaluate various debt and other financing alternatives, including convertible notes and other equity-linked instruments. Financing that we arrange through the sale of equity linked instruments such as our convertible notes financings may lead to substantial dilution to our investors if the price of our common stock exceeds the upper strike exercise price of the warrants in connection with our bond hedge transactions, which has been the case in connection with our convertible notes which matured in 2019 and 2020. At the same time, the investments we have previously made in connection with our share repurchase programs have more than offset the amount of dilution we experienced in relation to these warrants. We expect to continue to take an opportunistic approach regarding both sources and uses of capital in connection with our business.
We have $683 million remaining in aggregate principal amount of convertible notes outstanding as of May 1, 2021, of which $31 million of the 2023 Notes will be settled in July 2021 due to early conversions at the option of the noteholders, $302 million of the 2023 Notes will mature in June 2023 (absent further early conversion elections) and $350 million of the 2024 Notes will mature in September 2024 (absent any early conversion elections with respect thereto). Based on the strong cash flow generated in 2020 and continued strong cash flow anticipated in future years, we expect to repay the outstanding principal amount of our convertible notes at maturity in June 2023 and September 2024 in cash, in each case to minimize dilution. Likewise, we expect to pay the principal amount in cash with respect to any convertible notes for which the holder elects early conversion of such convertible notes in order to minimize dilution. While we purchased convertible note hedges and sold warrants with respect to each convertible note transaction, which are intended to offset any actual earnings dilution from the conversion of the 2024 Notes until our common stock is above approximately $338.24 per share and from the conversion of the 2023 Notes until our common stock is above approximately $309.84 per share, our shareholders may still experience dilution to the extent our common stock trades above such levels. While we anticipate using excess cash, free cash flow and borrowings on our asset based credit facility 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 or upon early conversion, as applicable. 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.
Our business has historically 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 continue to closely manage our business and our investments while considering both the overall economic environment as well as the needs of our operations. In addition, our near term decisions regarding the sources and uses of capital will continue to reflect and adapt to changes in market conditions and our business including further developments with respect to the pandemic. We believe our operating cash flows, in conjunction with available financing arrangements, will be sufficient to repay our debt obligations as they become due, meet working capital requirements and fulfill other capital needs for more than the next 12 months.
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While we have continued to serve our customers and operate our business through the ongoing COVID-19 health crisis, there can be no assurance that future events will not have an impact on our business, results of operations or financial condition since the extent and duration of the health crisis remains uncertain. Future adverse developments in connection with the COVID-19 crisis, including additional waves or resurgences of COVID-19 outbreaks, including with regard to new strains or variants of the virus, evolving international, federal, state and local restrictions and safety regulations in response to COVID-19 risks, changes in consumer behavior and health concerns, the pace of economic activity in the wake of the COVID-19 crisis, or other similar issues could adversely affect our business, results of operations or financial condition in the future, or our financial results and business performance for fiscal 2021 and beyond.
We extended and amended our asset based credit facility 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.
While we do not require additional debt to fund our operations, our goal continues to be in a position to take advantage of the many opportunities that we identify in connection with our business and operations. We have pursued in the past, and may pursue in the future, additional strategies to generate capital to pursue opportunities and investments, including through the strategic sale of existing assets, utilization of our credit facilities, entry into various second lien credit agreements and other new debt financing arrangements that present attractive terms. In addition to funding the normal operations of our business, we have used our liquidity to fund significant investments and strategies such as our share repurchase programs, various acquisitions and growth initiatives, including through joint ventures and real estate investments. For example, in fiscal 2019 we executed a sale-leaseback transaction for the Yountville Design Gallery for sales proceeds of $23.5 million and in fiscal 2020 we executed a sale-leaseback transaction for the Minneapolis Design Gallery for sales proceeds of $25.5 million, both of which qualified for sale-leaseback accounting in accordance with ASC 842.
In addition, our capital needs and uses of capital 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 developing 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 capital expenditures include capital expenditures from investing activities and cash outflows of capital related to construction activities to design and build landlord-owned leased assets, net of tenant allowances received. Given the pace at which business conditions are evolving in response to the COVID-19 health crisis, we may adjust our investments in various business initiatives including our capital expenditures over the course of fiscal 2021. We anticipate our adjusted capital expenditures to be $250 million to $300 million in fiscal 2021, primarily related to our efforts to continue our growth and expansion, including construction of new Design Galleries and infrastructure investments. During the three months ended May 1, 2021, adjusted capital expenditures were $63.8 million, net of cash received related to landlord tenant allowances of $5.9 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 different levels of 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. For example, we have used this strategy in fiscal 2019 through the sale-leaseback transaction for the Yountville Design Gallery and in July 2020 through the sale-leaseback transaction for the Minneapolis Design Gallery. 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.
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In addition, we continue to address the effects of the pandemic on our business with respect to real estate development and the introduction of new Galleries in both the US and internationally. A range of factors involved in the development of new Gallery and RH Hospitality may continue to be affected by the pandemic including delays in construction as well as permitting and other necessary governmental actions. In addition, the scope and cadence of investments by third parties including landlords and other real estate counterparties may be adversely affected by the health crisis. Actions taken by international as well as federal, state and local government authorities, and in some instances mall and shopping center owners, in response to the pandemic, may require changes to our real estate strategy and related capital expenditure and financing plans. In addition, we may continue to be required to make lease payments in whole or in part for our Galleries, Outlets and Restaurants that were temporarily closed or are required to close in the future in the event of resurgences in COVID-19 outbreaks or for other reasons. Any efforts to mitigate the costs of construction delays and deferrals, retail closures and other operational difficulties, including any such difficulties resulting from the pandemic, such as by negotiating with landlords and other third parties regarding the timing and amount of payments under existing contractual arrangements, may not be successful, and as a result, our real estate strategy may have ongoing significant liquidity needs even as we make changes to our planned operations and expansion cadence.
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 the remaining outstanding convertible senior notes in an aggregate principal amount of $683 million at maturity or early conversion of such senior convertible notes. To the extent we need to secure additional sources of liquidity, 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. Any adverse developments in the U.S. or global credit markets as a result of the pandemic or any other reason could affect our ability to manage our debt obligations and our ability to access future debt. 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.
Cash Flow Analysis
A summary of operating, investing, and financing activities is set forth in the following table:
THREE MONTHS ENDED
MAY 1,
MAY 2,
2021
2020
(in thousands)
Net cash provided by (used in) operating activities
$
190,875
$
(16,868)
Net cash used in investing activities
(51,423)
(16,632)
Net cash provided by (used in) financing activities
(11,032)
3,182
Net increase (decrease) in cash and cash equivalents and restricted cash equivalents
128,456
(30,450)
Cash and cash equivalents and restricted cash equivalents at end of period
235,527
17,208
Net Cash Provided By (Used In) Operating Activities
Operating activities consist primarily of net income (loss) adjusted for non-cash items including depreciation and amortization, impairments, stock-based compensation, amortization of debt discount and the effect of changes in working capital and other activities.
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For the three months ended May 1, 2021, net cash provided by operating activities was $190.9 million and consisted of net income of $130.7 million and an increase in non-cash items of $71.1 million, partially offset by a change in working capital and other activities of $10.9 million. The source of cash from working capital was primarily driven by an increase in deferred revenue and customer deposits of $82.7 million primarily due to strong consumer demand for our products and an increase in other current liabilities of $42.0 million. These sources of cash from working capital were partially offset by uses of cash driven by an increase in merchandise inventory of $49.5 million, a decrease in accounts payable and accrued expenses of $32.3 million, a decrease in operating lease liabilities of $19.4 million primarily due to payments made under the related lease agreements, an increase in landlord assets under construction of $13.6 million and an increase in prepaid expenses and other assets of $12.6 million.
For the three months ended May 2, 2020, net cash used in operating activities was $16.9 million and consisted of an increase in cash used for working capital and other activities of $105.3 million and a net loss of $3.2 million, partially offset by non-cash items of $91.7 million. The uses of cash from working capital and other activities consisted primarily of increases in merchandise inventories of $55.8 million and decreases in accounts payable and accrued expense of $53.0 million related to timing of payments. These uses of cash from working capital were partially offset by sources of cash driven by increases in deferred revenues and customer deposits of $26.7 million.
Net Cash Used In Investing Activities
Investing activities consist primarily of investments in capital expenditures related to investments in retail stores, information technology and systems infrastructure, as well as supply chain investments. Investing activities also include our strategic investments.
For the three months ended May 1, 2021, net cash used in investing activities was $51.4 million and was comprised of investments in retail stores, information technology and systems infrastructure of $50.3 million and additional funding of our equity method investments of $1.2 million.
For the three months ended May 2, 2020, net cash used in investing activities was $16.6 million and was comprised of investments in retail stores, information technology and systems infrastructure.
Net Cash Provided By (Used In) Financing Activities
Financing activities consist primarily of borrowings related to convertible senior notes, credit facilities and other financing arrangements, and cash used in connection with such financing activities include investments in share repurchase programs, repayment of indebtedness including principal payments under finance lease agreements and other equity related transactions such as the convertible note bond hedge and warrant transactions in connection with our convertible notes financings.
For the three months ended May 1, 2021, net cash used in financing activities was $11.0 million, primarily due to repayments of $5.8 million on equipment notes and principal payments under finance lease agreements of $3.7 million. In addition, $2.4 million of the 2023 Notes was repaid in the three months ended May 1, 2021 due to early conversion at the option of the noteholders, of which $2.1 million is presented as repayments of convertible senior notes within cash from financing activities and $0.3 million is reflected as non-cash accretion of debt discount upon settlement of debt within cash from operating activities.
For the three months ended May 2, 2020, net cash provided by financing activities was $3.2 million, primarily due to net borrowings under the asset based credit facility of $10.0 million, partially offset by repayments of $5.2 million on equipment notes and principal payments under finance lease agreements of $2.1 million.
Non-Cash Transactions
Non- cash transactions consist of non-cash additions of property and equipment and landlord assets and reclassification of assets from landlord assets under construction to finance lease right-of-use assets. In addition, non-cash transactions consist of shares issued and received related to the settlement of convertible senior note transactions.
Convertible Senior Notes
Refer to Note 9— Convertible Senior Notes in our condensed consolidated financial statements for further information on our 0.00% Convertible Senior Notes due 2024 and 0.00% Convertible Senior Notes due 2023.
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Asset Based Credit Facility
Refer to Note 10— Credit Facilities in our condensed consolidated financial statements for further information on our asset based credit facility.
Equipment Loan Facility
Refer to Note 10— Credit Facilities in our condensed consolidated financial statements for further information on our equipment loan facility.
Share Repurchase Program
We regularly review share repurchase activity and consider various factors in determining whether and when to execute investments in connection with our share repurchase programs, including, among others, current cash needs, capacity for leverage, cost of borrowings, results of operations and the market price of our common stock. We believe that 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.
Our free cash flow has historically supported our current and completed share repurchase programs. We generated $405 million, $330 million and $163 million in free cash flow in fiscal 2020, fiscal 2019 and fiscal 2018, respectively. Free cash flow excludes all non-cash items. Free cash flow is net cash provided by operating activities adjusted by the non-cash accretion of debt discount upon settlement of debt, proceeds from sale of asset, capital expenditures, principal payments under finance leases and equity method investments. Free cash flow is included in this filing because our senior leadership team believes that free cash flow 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 senior leadership team uses this non-GAAP financial measure in order to have comparable financial results to analyze changes in our underlying business. A reconciliation of our net cash provided by operating activities to free cash flow is as follows:
YEAR ENDED
JANUARY 30,
FEBRUARY 1,
FEBRUARY 2,
2021
2020
2019
(in thousands)
Net cash provided by operating activities
$
500,770
$
339,188
$
249,603
Accretion of debt discount upon settlement of debt
84,003
70,482
—
Proceeds from sale of assets
25,006
24,078
—
Capital expenditures
(111,126)
(93,623)
(79,992)
Principal payments under finance leases
(12,498)
(9,682)
(6,885)
Equity method investments
(80,723)
—
—
Free cash flow
$
405,432
$
330,443
$
162,726
$950 Million Share Repurchase Program
In 2018, our Board of Directors authorized a share repurchase program through open market purchases, privately negotiated transactions or other means, including through Rule 10b-18 open market repurchases, Rule 10b5-1 trading plans or through the use of other techniques such as the acquisition of other equity linked instruments, 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. We completed $250.0 million in share repurchases in fiscal 2018 under this program. In the first quarter of fiscal 2019, we repurchased approximately 2.2 million shares of our common stock at an average price of $115.36 per share, for an aggregate repurchase amount of approximately $250.0 million under this share repurchase program. We did not make any repurchases under this program during either the three months ended May 1, 2021 or May 2, 2020. The total current authorized size of this share purchase program is up to $950 million (the “950 Million Repurchase Program”), of which $450.0 million remained available as of May 1, 2021 for future share investments under this share repurchase program.
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Contractual Obligations
As of May 1, 2021, there were no material changes to our contractual obligations described within Management’s Discussion and Analysis of Financial Condition and Results of Operations—Contractual Obligations in the 2020 Form 10-K, other than lease agreements entered into in the normal course of business (refer to Note 8 —Leases ).
Off Balance Sheet Arrangements
We have no material off balance sheet arrangements as of May 1, 2021.
Critical Accounting Policies and Estimates
The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires senior leadership 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. We evaluate our accounting policies, estimates, and judgments on an on-going basis. We base our 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.
We evaluate the development and selection of our critical accounting policies and estimates and believe that certain of our significant accounting policies 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:
Merchandise Inventories—Reserves
Impairment
Tradenames, Trademarks and Other Intangible Assets
Long-Lived Assets
Lease Accounting
Reasonably Certain Lease Term
Incremental Borrowing Rate
Fair Value
Stock-Based Compensation—Performance-Based Awards
Equity Method Investments
There have been no material changes to the critical accounting policies and estimates listed above from the disclosures included in the 2020 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 2020 Form 10-K.
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.
Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.