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, in our Quarterly Report on Form 10-Q for the quarterly periods ended May 1, 2021 (the “First Quarter Form 10-Q”) and July 31, 2021 (the “Second Quarter Form 10-Q”) 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. As of October 30, 2021, we have an integrated RH Hospitality experience in 12 of our locations, which include Restaurants and Wine Bars.
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As of October 30, 2021, we operated the following number of Galleries, Outlets and Showrooms:
COUNT
RH
Design Galleries
26
Legacy Galleries
36
Modern Galleries
1
Baby & Child and TEEN Galleries
3
Total Galleries
66
Outlets
38
Waterworks Showrooms
14
The COVID-19 outbreak in the first quarter of fiscal 2020 caused disruption to our business operations beginning in the first quarter of fiscal 2020. The pandemic has continued since the initial outbreak and has included spikes and operating restrictions in various locations around the world, as well as new strains of the COVID-19 virus such as the “Delta” and other variants. In our initial response to the pandemic, 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 since the second quarter of fiscal 2020 as a result of both the reopening of most of our retail locations and strong consumer demand for our products. Operational restrictions related to the pandemic affecting our retail locations and Restaurants continued to fluctuate through the second quarter of 2021 based upon changes in local conditions and regulations. All of our retail locations and Restaurants were open during the third quarter of fiscal 2021.
While our business 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 supply chain, including port delays, 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 evolving nature of the pandemic, will continue to adversely affect the capacity of our vendors and supply chain to meet our merchandise demand levels during the remainder of 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, most notably Vietnam, have experienced various surges in outbreaks and, in some cases, facility closures and other restrictions related to the pandemic. As a result, the ongoing nature of the pandemic may continue to adversely affect our business operations in various jurisdictions, which could, in turn, have a negative impact on our vendors and supply chain, and therefore, our business.
Our 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 2022. 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, Places, Services 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, Places, Services 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 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 pandemic has had a significant impact on the comparability of year-over-year and sequential trends for our operating results for the three and nine months ended October 30, 2021, as compared to the three and nine months ended October 31, 2020. The initial negative impact to our revenues from closures occurred during the first half of fiscal 2020. Despite the reopening of most of our Galleries during the second and third quarters of fiscal 2020 and a strong resurgence in customer demand for our products, we have continued to address a range of business circumstances though the third quarter of fiscal 2021 related to the pandemic. The ongoing pandemic has resulted in disruptions to our supply chain, which continues to negatively impact our revenues and costs. These circumstances include delays in manufacturing and inventory receipts as our supply chain recovers from the impact of the global health crisis and responds to virus outbreaks and surges, including new strains such as the “Delta” variant, which has had a severe impact in certain jurisdictions, most notably Vietnam. We have also delayed the opening of certain new Gallery locations due to issues related to the pandemic, such as extensive travel restrictions that have been in place. 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. Although we have experienced strong demand for our products since the second quarter of fiscal 2020, 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 continued 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, of which could affect our results of operation in fiscal 2021. Additionally, resurgences of COVID-19 in various jurisdictions have had direct and indirect effects on our business and operations that have, and will continue to, affect the comparability of our results during fiscal 2021, including continued supply chain disruptions.
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Results of Operations
The following table sets forth our condensed consolidated statements of income and other financial and operating data:
THREE MONTHS ENDED
NINE MONTHS ENDED
OCTOBER 30,
OCTOBER 31,
OCTOBER 30,
OCTOBER 31,
2021
2020
2021
2020
(in thousands)
(in thousands)
Condensed Consolidated Statements of Income:
Net revenues
$
1,006,428
$
844,013
$
2,856,079
$
2,036,190
Cost of goods sold
501,174
435,683
1,456,172
1,095,787
Gross profit
505,254
408,330
1,399,907
940,403
Selling, general and administrative expenses
232,715
297,109
690,492
657,161
Income from operations
272,539
111,221
709,415
283,242
Other expenses
Interest expense—net
13,223
15,656
40,112
54,703
Tradename impairment
—
—
—
20,459
(Gain) loss on extinguishment of debt
18,513
—
21,784
(152)
Total other expenses
31,736
15,656
61,896
75,010
Income before income taxes
240,803
95,565
647,519
208,232
Income tax expense
54,391
49,154
99,124
66,610
Income before equity method investments
186,412
46,411
548,395
141,622
Share of equity method investments losses
(2,313)
—
(6,894)
—
Net income
$
184,099
$
46,411
$
541,501
$
141,622
Other Financial and Operating Data:
Adjusted net income (1)
$
208,601
$
166,457
$
602,476
$
319,419
Adjusted EBITDA (2)
$
310,663
$
258,013
$
829,291
$
521,227
Capital expenditures
$
71,636
$
24,224
$
153,774
$
71,755
Landlord assets under construction—net of tenant allowances
6,999
21,987
50,351
44,921
Adjusted capital expenditures (3)
$
78,635
$
46,211
$
204,125
$
116,676
(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, 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, the most directly comparable GAAP financial measure, to adjusted net income for the periods indicated below.
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THREE MONTHS ENDED
NINE MONTHS ENDED
OCTOBER 30,
OCTOBER 31,
OCTOBER 30,
OCTOBER 31,
2021
2020
2021
2020
(in thousands)
(in thousands)
Net income
$
184,099
$
46,411
$
541,501
$
141,622
Adjustments pre-tax:
(Gain) loss on extinguishment of debt (a)
18,513
—
21,784
(152)
Non-cash compensation (b)
5,831
111,218
17,559
111,218
Amortization of debt discount (c)
4,023
7,369
15,869
29,607
Asset impairments and change in useful lives (d)
—
2,091
7,354
11,901
Recall accrual (e)
340
781
840
5,561
Reorganization related costs (f)
—
—
449
7,027
Tradename impairment (g)
—
—
—
20,459
Loss on sale leaseback transaction (h)
—
—
—
9,352
Subtotal adjusted items
28,707
121,459
63,855
194,973
Impact of income tax items (i)
(6,518)
(1,413)
(9,774)
(17,176)
Share of equity method investments losses (j)
2,313
—
6,894
—
Adjusted net income
$
208,601
$
166,457
$
602,476
$
319,419
(a) The adjustment in each of the three and nine months ended October 30, 2021 represents a loss on extinguishment of debt for a portion of the 2023 Notes (defined below) and 2024 Notes (defined below) that were early converted at the option of the noteholders. The adjustment in the nine months ended October 31, 2020 represents a gain on extinguishment of debt upon the maturity and settlement of the 2020 Notes (defined below) in July 2020.
(b) Represents the amortization of the non-cash compensation charge related to a fully vested option grant made to Mr. Friedman in October 2020.
(c) 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 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 $2.8 million and $1.1 million during the three months ended October 30, 2021 and October 31, 2020, respectively. Amounts are presented net of interest capitalized for capital projects of $8.4 million and $4.2 million during the nine months ended October 30, 2021 and October 31, 2020, respectively. The 2020 Notes matured on July 15, 2020 and did not impact amortization of debt discount post-maturity.
(d) The adjustment in the nine months ended October 30, 2021 represents asset impairments. The adjustment includes the acceleration of depreciation expense due to a change in the estimated useful lives of certain assets of $1.3 million and $3.9 million for the three and nine months ended October 31, 2020, respectively. The adjustment in the three months ended October 31, 2020 also includes asset impairments of $0.8 million and the adjustment in the nine months ended October 31, 2020 also includes asset impairments of $5.6 million and inventory reserves of $2.4 million related to Outlet inventory resulting from retail closures in response to the pandemic.
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(e) Represents adjustments to net revenues, cost of goods sold and inventory charges associated with product recalls, as well as accrual adjustments. The recall adjustments had the following effect on our income before taxes:
THREE MONTHS ENDED
NINE MONTHS ENDED
OCTOBER 30,
OCTOBER 31,
OCTOBER 30,
OCTOBER 31,
2021
2020
2021
2020
(in thousands)
Decrease to net revenues
$
—
$
781
$
—
$
1,187
Increase to cost of goods sold
—
—
—
4,374
Decrease to gross profit
—
781
—
5,561
Increase to selling, general and administrative expenses
340
—
840
—
Decrease to income before income taxes
$
340
$
781
$
840
$
5,561
(f) Represents severance costs and related payroll taxes associated with reorganizations.
(g) 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.
(h) Represents the loss on a sale leaseback transaction related to our previously owned Design Galleries.
(i) The adjustment for the three and nine months ended October 30, 2021 is based on an adjusted tax rate of 22.6% and 15.3%, respectively, which excludes the tax impact associated with our share of equity method investments losses. The adjustment for the three months ended October 31, 2020 is based on an adjusted tax rate of 23.3%, which excludes the tax impact associated with the non-cash compensation charge related to a fully vested option grant made to Mr. Friedman in October 2020. The adjustment for the nine months ended October 31, 2020 is based on an adjusted tax rate of 20.8%, which excludes the tax impact associated with the non-cash compensation charge related to a fully vested option grant made to Mr. Friedman in October 2020 and the Waterworks reporting unit tradename impairment recorded in the first quarter of fiscal 2020.
(j) 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 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, the most directly comparable GAAP financial measure, to EBITDA and Adjusted EBITDA for the periods indicated below.
THREE MONTHS ENDED
NINE MONTHS ENDED
OCTOBER 30,
OCTOBER 31,
OCTOBER 30,
OCTOBER 31,
2021
2020
2021
2020
Net income
$
184,099
$
46,411
$
541,501
$
141,622
Depreciation and amortization
24,819
26,476
71,375
76,688
Interest expense—net
13,223
15,656
40,112
54,703
Income tax expense
54,391
49,154
99,124
66,610
EBITDA
276,532
137,697
752,112
339,623
Non-cash compensation (a)
11,995
118,783
37,426
131,472
(Gain) loss on extinguishment of debt (b)
18,513
—
21,784
(152)
Asset impairments (b)
—
752
7,354
7,885
Share of equity method investments losses (b)
2,313
—
6,894
—
Capitalized cloud computing amortization (c)
970
—
2,432
—
Recall accrual (b)
340
781
840
5,561
Reorganization related costs (b)
—
—
449
7,027
Loss on sale leaseback transaction (b)
—
—
—
9,352
Tradename impairment (b)
—
—
—
20,459
Adjusted EBITDA
$
310,663
$
258,013
$
829,291
$
521,227
(a) Represents non-cash compensation related to equity awards granted to employees, including the non-cash compensation charge related to a fully vested option grant made to Mr. Friedman in October 2020.
(b) Refer to the reconciliation of net income 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:
NINE MONTHS ENDED
OCTOBER 30,
OCTOBER 31,
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 Design Galleries:
Dallas Design Gallery
1
38.0
—
—
Marin Design Gallery
—
—
1
32.9
Charlotte Design Gallery
—
—
1
32.4
Oak Brook Design Gallery
1
37.7
—
—
RH Modern Galleries:
Dallas RH Modern Gallery
(1)
(3.9)
—
—
RH Baby & Child and TEEN Galleries:
Santa Monica Baby & Child and TEEN Gallery
(1)
(7.3)
—
—
RH Legacy Galleries:
Tysons legacy Gallery (relocation)
—
8.5
—
—
Dallas legacy Gallery
(1)
(8.4)
—
—
Oak Brook legacy Gallery
(1)
(10.0)
—
—
Raleigh legacy Gallery
—
—
1
4.4
Charlotte legacy Gallery
—
—
(1)
(7.0)
Corte Madera legacy Gallery
—
—
(1)
(7.0)
Westport legacy Gallery
—
—
(1)
(6.5)
Waterworks Showrooms:
New York 59th Street Showroom
—
—
(1)
(1.4)
End of period
80
1,217
82
1,159
Total leased square footage at end of period (2)
1,624
1,558
Weighted-average leased square footage (3)
1,583
1,528
Weighted-average leased selling square footage (3)
1,180
1,135
(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 both October 30, 2021 and October 31, 2020 related to one owned retail location.
(2) Total leased square footage includes approximately 5,400 square feet as of both October 30, 2021 and October 31, 2020 related to one owned retail location.
(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 income as a percentage of total net revenues.
THREE MONTHS ENDED
NINE MONTHS ENDED
OCTOBER 30,
OCTOBER 31,
OCTOBER 30,
OCTOBER 31,
2021
2020
2021
2020
Condensed Consolidated Statements of Income:
Net revenues
100.0
%
100.0
%
100.0
%
100.0
%
Cost of goods sold
49.8
51.6
51.0
53.8
Gross profit
50.2
48.4
49.0
46.2
Selling, general and administrative expenses
23.1
35.2
24.2
32.3
Income from operations
27.1
13.2
24.8
13.9
Other expenses
Interest expense—net
1.4
1.9
1.3
2.7
Tradename impairment
—
—
—
1.0
(Gain) loss on extinguishment of debt
1.8
—
0.8
—
Total other expenses
3.2
1.9
2.1
3.7
Income before income taxes
23.9
11.3
22.7
10.2
Income tax expense
5.4
5.8
3.5
3.2
Income before equity method investments
18.5
5.5
19.2
7.0
Share of equity method investments losses
(0.2)
—
(0.2)
—
Net income
18.3
%
5.5
%
19.0
%
7.0
%
Three Months Ended October 30, 2021 Compared to Three Months Ended October 31, 2020
THREE MONTHS ENDED
OCTOBER 30,
OCTOBER 31,
2021
2020
RH SEGMENT
WATERWORKS
TOTAL
RH SEGMENT
WATERWORKS
TOTAL
(in thousands)
Net revenues
$
964,859
$
41,569
$
1,006,428
$
812,782
$
31,231
$
844,013
Cost of goods sold
480,496
20,678
501,174
418,093
17,590
435,683
Gross profit
484,363
20,891
505,254
394,689
13,641
408,330
Selling, general and administrative expenses
214,103
18,612
232,715
285,676
11,433
297,109
Income from operations
$
270,260
$
2,279
$
272,539
$
109,013
$
2,208
$
111,221
Net revenues
Consolidated net revenues increased $162.4 million, or 19.2%, to $1.0 billion in the three months ended October 30, 2021 compared to $844.0 million in the three months ended October 31, 2020.
RH Segment net revenues
RH Segment net revenues increased $152.1 million, or 18.7%, to $964.9 million in the three months ended October 30, 2021 compared to $812.8 million in the three months ended October 31, 2020. The below discussion highlights several significant factors that resulted in an increase in RH Segment net revenues, which are listed in order of magnitude.
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The increase in RH Segment net revenues for the three months ended October 30, 2021 was driven primarily by continued strong customer demand for our products, aided by elements of our supply chain beginning to catch up with customer demand.
Outlet sales increased $14.4 million to $77.2 million in the three months ended October 30, 2021 compared to $62.8 million in the three months ended October 31, 2020. Additionally, RH Segment net revenues increased in our RH Hospitality business compared to the three months ended October 31, 2020 due to reduced operational restrictions in the third quarter of fiscal 2021 and new Restaurant openings in fiscal 2021.
Waterworks net revenues
Waterworks net revenues increased $10.3 million, or 33.1%, to $41.6 million in the three months ended October 30, 2021 compared to $31.2 million in the three months ended October 31, 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 October 31, 2020 was negatively impacted by construction delays, as well as temporary showroom closures, in response to the pandemic.
Gross profit
Consolidated gross profit increased $96.9 million, or 23.7%, to $505.3 million in the three months ended October 30, 2021 compared to $408.3 million in the three months ended October 31, 2020. As a percentage of net revenues, consolidated gross margin increased 180 basis points to 50.2% of net revenues in the three months ended October 30, 2021 from 48.4% of net revenues in the three months ended October 31, 2020.
RH Segment gross profit
RH Segment gross profit increased $89.7 million, or 22.7%, to $484.4 million in the three months ended October 30, 2021 from $394.7 million in the three months ended October 31, 2020. As a percentage of net revenues, RH Segment gross margin increased 160 basis points to 50.2% of net revenues in the three months ended October 30, 2021 from 48.6% of net revenues in the three months ended October 31, 2020. The increase in gross margin was primarily driven by higher product margins in the Core business in the three months ended October 30, 2021.
Waterworks gross profit
Waterworks gross profit increased $7.3 million, or 53.1%, to $20.9 million in the three months ended October 30, 2021 from $13.6 million in the three months ended October 31, 2020. As a percentage of net revenues, Waterworks gross margin increased 660 basis points to 50.3% of net revenues in the three months ended October 30, 2021 from 43.7% of net revenues in the three months ended October 31, 2020 primarily driven by higher revenues, favorable changes in product mix, and leverage in Waterworks occupancy costs, offset by an increase in shipping costs related to customer deliveries.
Selling, general and administrative expenses
Consolidated selling, general and administrative expenses decreased $64.4 million, or 21.7%, to $232.7 million in the three months ended October 30, 2021 compared to $297.1 million in the three months ended October 31, 2020.
RH Segment selling, general and administrative expenses
RH Segment selling, general and administrative expenses decreased $71.6 million, or 25.1%, to $214.1 million in the three months ended October 30, 2021 compared $285.7 million in the three months ended October 31, 2020.
RH Segment selling, general and administrative expenses for the three months ended October 30, 2021 include amortization of the non-cash compensation of $5.8 million related to a fully vested option grant made to Mr. Friedman in October 2020. RH Segment selling, general and administrative expenses for the three months ended October 31, 2020 includes a non-cash compensation charge of $111.2 million due to a fully vested option grant made to Mr. Friedman in October 2020, $1.3 million due to accelerated asset depreciation and $0.8 million due to asset impairments.
Excluding the adjustments mentioned above, RH Segment selling, general and administrative expenses would have been 21.6% and 21.2% of net revenues for the three months ended October 30, 2021 and October 31, 2020, respectively. The increase in selling, general and administrative expenses as a percentage of net revenues was primarily driven by increases in travel-related expenses and preopening costs associated with Gallery openings, partially offset by leverage in compensation and advertising costs.
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Waterworks selling, general and administrative expenses
Waterworks selling, general and administrative expenses increased $7.2 million, or 62.8%, to $18.6 million in the three months ended October 30, 2021 compared to $11.4 million in the three months ended October 31, 2020. Waterworks selling, general and administrative expenses increased to 44.8% from 36.6% of net revenues for the three months ended October 30, 2021 and October 31, 2020, respectively, primarily due to compensation related charges.
Interest expense—net
Interest expense—net decreased $2.4 million to $13.2 million for the three months ended October 30, 2021 compared to $15.7 million for the three months ended October 31, 2020. Interest expense—net consisted of the following:
THREE MONTHS ENDED
OCTOBER 30,
OCTOBER 31,
2021
2020
(in thousands)
Amortization of convertible senior notes debt discount
$
6,775
$
8,432
Finance lease interest expense
6,711
6,158
Term loan interest expense
1,935
—
Amortization of debt issuance costs and deferred financing fees
692
717
Other interest expense
469
441
Promissory notes
286
1,128
Asset based credit facility
—
112
Capitalized interest for capital projects
(3,073)
(1,109)
Interest income
(572)
(223)
Total interest expense—net
$
13,223
$
15,656
(Gain) loss on extinguishment of debt
During the three months ended October 30, 2021 we recognized a loss on extinguishment of debt for a portion of the 2023 Notes and 2024 Notes that were early converted at the option of the noteholders of $18.5 million (See Note 9— Convertible Senior Notes ). We did not incur any gain or loss on extinguishment of debt in the three months ended October 31, 2020.
Income tax expense
Income tax expense was $54.4 million and $49.2 million in the three months ended October 30, 2021 and October 31, 2020, respectively. Our effective tax rate was 22.8% and 51.4% for the three months ended October 30, 2021 and October 31, 2020, respectively. The decrease in our effective tax rate is primarily due to higher discrete tax benefits related to net excess tax windfalls from stock-based compensation in the three months ended October 30, 2021 as compared to the three months ended October 31, 2020 and non-deductible stock-based compensation related to a fully vested option grant made to Mr. Friedman in October 2020 in the three months ended October 31, 2020.
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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 $2.3 million loss during the three months ended October 30, 2021.
Nine Months Ended October 30, 2021 Compared to Nine Months Ended October 31, 2020
NINE MONTHS ENDED
OCTOBER 30,
OCTOBER 31,
2021
2020
RH SEGMENT
WATERWORKS
TOTAL
RH SEGMENT
WATERWORKS
TOTAL
(in thousands)
Net revenues
$
2,732,300
$
123,779
$
2,856,079
$
1,949,126
$
87,064
$
2,036,190
Cost of goods sold
1,394,317
61,855
1,456,172
1,046,194
49,593
1,095,787
Gross profit
1,337,983
61,924
1,399,907
902,932
37,471
940,403
Selling, general and administrative expenses
642,002
48,490
690,492
620,438
36,723
657,161
Income (loss) from operations
$
695,981
$
13,434
$
709,415
$
282,494
$
748
$
283,242
Net revenues
Consolidated net revenues increased $819.9 million, or 40.3%, to $2.9 billion in the nine months ended October 30, 2021 compared to $2.0 billion in the nine months ended October 31, 2020.
RH Segment net revenues
RH Segment net revenues increased $783.2 million, or 40.2%, to $2.7 billion in the nine months ended October 30, 2021 compared to $1.9 billion in the nine months ended October 31, 2020. The below discussion highlights several significant factors that resulted in an increase in RH Segment net revenues, which are listed in order of magnitude.
RH Segment net revenues for the nine months ended October 31, 2020 was negatively impacted by Gallery closures and macroeconomic conditions resulting from the COVID-19 pandemic. RH Segment net revenues for the nine months ended October 30, 2021 increased due to strong customer demand for our products, aided by elements of our supply chain beginning to catch up with customer demand.
Outlet sales increased $81.2 million to $207.8 million in the nine months ended October 30, 2021 compared to $126.6 million in the nine months ended October 31, 2020 due to pandemic-related retail closures in the first half of fiscal 2020. Additionally, RH Segment net revenues increased in our RH Hospitality business compared to the nine month ended October 31, 2020 due to reduced COVID-19 operational restrictions in the third quarter of fiscal 2021 and new Restaurant openings in fiscal 2021.
Waterworks net revenues
Waterworks net revenues increased $36.7 million, or 42.2%, to $123.8 million in the nine months ended October 30, 2021 compared to $87.1 million in the nine months ended October 31, 2020 due to an increase in demand related to resumed construction activity and significant residential investments by high-end homeowners.
Gross profit
Consolidated gross profit increased $459.5 million, or 48.9%, to $1.4 billion in the nine months ended October 30, 2021 from $940.4 million in the nine months ended October 31, 2020. As a percentage of net revenues, consolidated gross margin increased 280 basis points to 49.0% of net revenues in the nine months ended October 30, 2021 from 46.2% of net revenues in the nine months ended October 31, 2020.
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RH Segment gross profit for the nine months ended October 31, 2020 was negatively impacted by $5.6 million related to product recalls and includes inventory reserves of $2.4 million related to Outlet inventory resulting from retail closures in response to the COVID-19 pandemic. Product recalls and the establishment or adjustment of any related recall accruals can affect our results and cause quarterly fluctuations affecting the period-to-period comparisons of our results. No assurance can be provided that any accruals will be for the appropriate amount, and actual losses could be higher or lower than what we accrue from time to time, which could further affect results.
Excluding the adjustments mentioned above, consolidated gross margin would have increased 250 basis points to 49.0% of net revenues in the nine months ended October 30, 2021 from 46.5% of net revenues in the nine months ended October 31, 2020.
RH Segment gross profit
RH Segment gross profit increased $435.1 million, or 48.2%, to $1.3 billion in the nine months ended October 30, 2021 from $902.9 million in the nine months ended October 31, 2020. As a percentage of net revenues, RH Segment gross margin increased 270 basis points to 49.0% of net revenues in the nine months ended October 30, 2021 from 46.3% of net revenues in the nine months ended October 31, 2020.
Excluding the adjustments mentioned above, RH Segment gross margin would have increased 230 basis points to 49.0% of net revenues in the nine months ended October 30, 2021 from 46.7% of net revenues in the nine months ended October 31, 2020. The increase in gross margin was primarily driven by higher product margins in the Core and Outlet businesses and leverage in our RH Segment occupancy costs in the nine months ended October 30, 2021.
Waterworks gross profit
Waterworks gross profit increased $24.5 million, or 65.3%, to $61.9 million in the nine months ended October 30, 2021 from $37.5 million in the nine months ended October 31, 2020. As a percentage of net revenues, Waterworks gross margin increased 700 basis points to 50.0% of net revenues in the nine months ended October 30, 2021 from 43.0% of net revenues in the nine months ended October 31, 2020 primarily driven by higher revenues, favorable changes in product mix, and leverage in Waterworks occupancy costs, offset by an increase in shipping costs related to customer deliveries.
Selling, general and administrative expenses
Consolidated selling, general and administrative expenses increased $33.3 million, or 5.1%, to $690.5 million in the nine months ended October 30, 2021 compared to $657.2 million in the nine months ended October 31, 2020.
RH Segment selling, general and administrative expenses
RH Segment selling, general and administrative expenses increased $21.6 million, or 3.5%, to $642.0 million in the nine months ended October 30, 2021 compared to $620.4 million in the nine months ended October 31, 2020.
RH Segment selling, general and administrative expenses for the nine months ended October 30, 2021 include amortization of non-cash compensation of $17.6 million related to a fully vested option grant made to Mr. Friedman in October 2020, $7.4 million related to asset impairments and $0.4 million related to severance costs and related payroll taxes associated with reorganizations.
RH Segment selling, general and administrative expenses for the nine months ended October 31, 2020 includes a non-cash compensation charge of $111.2 million due to a fully vested option grant made to Mr. Friedman in October 2020, a loss of $9.4 million related to a sale leaseback transaction, $7.0 million related to 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, $5.6 million related to asset impairments and $3.9 million due to accelerated asset depreciation.
Excluding adjustments mentioned above, RH Segment selling, general and administrative expenses would have been 23.5% and 24.9% of net revenues for the nine months ended October 30, 2021 and October 31, 2020, respectively. The decrease in selling, general and administrative expenses as a percentage of net revenues was primarily driven by reduction in costs and leverage in advertising costs due to our decision to not mail the Spring 2021 Source Books, leverage in employment and employment-related costs, as well as leverage in our corporate occupancy expenses, partially offset by increased travel-related costs.
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Waterworks selling, general and administrative expenses
Waterworks selling, general and administrative expenses increased $11.8 million, or 32.0%, to $48.5 million in the nine months ended October 30, 2021 compared to $36.7 million in the nine months ended October 31, 2020.
Waterworks selling, general and administrative expenses for the nine months ended October 30, 2021 include $0.8 million related to product recalls and for the nine months ended October 31, 2020 include $1.6 million related to asset impairments.
Excluding the product recall and asset impairment adjustments mentioned above, Waterworks selling, general and administrative expenses would have been 38.5% and 40.4% of net revenues for the nine months ended October 30, 2021 and October 31, 2020.
Interest expense—net
Interest expense—net decreased $14.6 million to $40.1 million for the nine months ended October 30, 2021 compared to $54.7 million for the nine months ended October 31, 2020. Interest expense—net consisted of the following:
NINE MONTHS ENDED
OCTOBER 30,
OCTOBER 31,
2021
2020
(in thousands)
Amortization of convertible senior notes debt discount
$
24,236
$
33,810
Finance lease interest expense
19,468
17,887
Amortization of debt issuance costs and deferred financing fees
2,234
2,712
Term loan interest expense
1,935
—
Other interest expense
1,406
1,320
Promissory notes
1,063
3,654
Asset based credit facility
—
344
Capitalized interest for capital projects
(8,922)
(4,421)
Interest income
(1,308)
(603)
Total interest expense—net
$
40,112
$
54,703
(Gain) loss on extinguishment of debt
During the nine months ended October 30, 2021 we recognized a loss on extinguishment of debt for a portion of the 2023 Notes and 2024 Notes that were early converted at the option of the noteholders of $21.8 million. During the nine months ended October 31, 2020, we recognized a $0.2 million gain on extinguishment of debt related to the maturity and settlement of the 2020 Notes in July 2020.
Income tax expense
Income tax expense was $99.1 million and $66.6 million in the nine months ended October 30, 2021 and October 31, 2020, respectively. Our effective tax rate was 15.5% and 32.0% for the nine months ended October 30, 2021 and October 31, 2020, respectively. The decrease in our effective tax rate is primarily due to higher discrete tax benefits related to net excess tax windfalls from stock-based compensation in the nine months ended October 30, 2021 as compared to the nine months ended October 31, 2020 and non-deductible stock-based compensation related to a fully vested option grant made to Mr. Friedman in October 2020 in the nine months ended October 31, 2020.
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 $6.9 million loss during the nine months ended October 30, 2021.
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Liquidity and Capital Resources
Overview
Our principal sources of liquidity are cash flows generated from operations, our current balances of cash and cash equivalents, and amounts available under our ABL Credit Agreement. In fiscal 2021, we entered into the ABL Credit Agreement, which amended and extended our asset based credit facility, and issued the Term Loan in the amount of $2,000 million pursuant to the Term Loan Credit Agreement. The issuance of the Term Loan was assigned a Ba2 rating from Moody’s Investors Service and BB rating from S&P Global. Refer to Note 10— Credit Facilities .
A summary of our net debt, and availability under the ABL Credit Agreement, is set forth in the following table ( in millions ):
OCTOBER 30,
JANUARY 30,
2021
2021
Asset based credit facility
$
—
$
—
Term loan (a)
2,000
—
Equipment promissory notes (a)
21
38
Convertible senior notes due 2023 (a)
116
288
Convertible senior notes due 2024 (a)
240
284
Notes payable for share repurchases
1
1
Total debt
$
2,378
$
611
Cash and cash equivalents
(2,199)
(100)
Total net debt
$
179
$
511
Availability under the asset based credit facility—net (b)
$
354
$
272
(a) Amounts exclude discounts upon original issuance and third party offering and debt issuance costs.
(b) As of October 30, 2021 and January 30, 2021, the amount available for borrowing under the revolving line of credit under the ABL Credit Agreement is presented net of $20 million and $15 million in outstanding letters of credit, respectively.
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. We continuously evaluate our capital allocation strategy and may engage in future investments in connection with existing or new share repurchase programs (refer to “Share Repurchase Programs” below), which may include investments in derivatives or other equity linked instruments. We have in the past been, and continue to be, opportunistic in responding to favorable market conditions regarding both sources and uses of capital. Capital raised from debt financings has enabled us to pursue various investments. 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 continues to exceed the upper strike exercise price of the warrants in connection with our bond hedge transactions. We expect to continue to take an opportunistic approach regarding both sources and uses of capital in connection with our business.
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Credit Facilities and Debt Arrangements
We amended and restated our asset based credit facility in July 2021, which has an initial availability of up to $600 million, of which $10 million is available to Restoration Hardware Canada, Inc., and includes a $300 million accordion feature under which the revolving line of credit may be expanded by agreement of the parties from $600 million to up to $900 million if and to the extent the lenders revise their credit commitments to encompass a larger facility. The ABL Credit Agreement provides that the $300 million accordion, or a portion thereof, may be added as a first-in, last-out term loan facility if and to the extent the lenders revise their credit commitments for such facility. The ABL Credit Agreement further provides the borrowers may request a European sub-credit facility under the revolving line of credit or under the accordion feature for borrowing by certain European subsidiaries of RH if certain conditions set out in the asset based credit facility are met. The maturity date of the asset based credit facility is July 29, 2026.
We entered into a term loan credit agreement in October 2021. The Term Loan Credit Agreement provides for a Term Loan in an aggregate principal amount of $2,000 million and the maturity date of the Term Loan Credit Agreement is October 20, 2028.
We had $411 million remaining in aggregate principal amount of convertible notes outstanding as of October 30, 2021, comprised of $128 million of 2023 Notes and $283 million of 2024 Notes. Due to early conversions at the option of the noteholders, $54 million of the 2023 Notes and $57 million of the 2024 Notes were recorded within current liabilities on our condensed consolidated financial statements as of October 30, 2021. Absent further early conversion elections, the remaining 2023 Notes have a scheduled maturity in June 2023 and the remaining 2024 Notes have a scheduled maturity in September 2024. We anticipate having ample cash available in order to repay the principal amount of our convertible notes in cash with respect to any convertible notes for which the holder elects early conversion of such convertible notes, as well as upon maturity in June 2023 and September 2024, in each case in order to minimize dilution. Based upon the strength in our common stock price, we expect that holders of the convertible notes may continue to elect early conversion of such notes in advanced of the schedule maturity dates. 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 at the time of the maturity of the warrants with respect to the bond hedge and warrant transactions.
We believe our capital structure provides us with substantial optionality regarding our capital allocation. 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 existing cash balances and 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.
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 credit agreements and other new debt financing arrangements that present attractive terms. We expect to continue to use additional sources of debt financing in future periods as a source of additional capital to fund our various investments. 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.
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To the extent we choose to secure additional sources of liquidity through incremental debt financing, there can be no assurances that we will be able to raise such financing 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, whether upon stated maturity, early conversion or otherwise 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.
Capital
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. We anticipate our adjusted capital expenditures to be $250 million to $300 million in fiscal 2021, primarily related to our growth and expansion, including construction of new Design Galleries and infrastructure investments. Nevertheless, we may elect to pursue additional capital expenditures beyond those that are anticipated during any given fiscal period inasmuch as our strategy is to be opportunistic with respect to our investments and we may choose to pursue certain capital transactions based on the availability and timing of unique opportunities. During the nine months ended October 30, 2021, adjusted capital expenditures were $204 million, net of cash received related to landlord tenant allowances of $13 million. 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 remainder of fiscal 2021 and beyond.
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 may 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 some portion of our real estate strategy from a leasing model to a development model, where we potentially buy and develop our Design Galleries with the objective of (i) recouping a majority of the investment through a sale-leaseback arrangement and (ii) resulting in lower capital investment and lower rent. For example, in fiscal 2019 we executed a sale-leaseback transaction for the Yountville Design Gallery for sales proceeds of $24 million and in fiscal 2020 we executed a sale-leaseback transaction for the Minneapolis Design Gallery for sales proceeds of $26 million, both of which qualified for sale-leaseback accounting. In the event that such capital and other expenditures require us to pursue additional funding sources, we can provide no assurance that we will be successful in securing additional funding on attractive terms or at all. 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 may pursue.
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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 U.S. and internationally. A range of factors involved in the development of new Galleries 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.
Cash Flow Analysis
A summary of operating, investing, and financing activities is set forth in the following table:
NINE MONTHS ENDED
OCTOBER 30,
OCTOBER 31,
2021
2020
(in thousands)
Net cash provided by operating activities
$
533,682
$
347,263
Net cash used in investing activities
(158,590)
(67,301)
Net cash provided by (used in) financing activities
1,721,514
(230,826)
Net increase in cash and cash equivalents and restricted cash equivalents
2,096,640
49,126
Cash and cash equivalents and restricted cash equivalents at end of period
2,203,711
96,784
Net Cash Provided By Operating Activities
Operating activities consist primarily of net income 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.
For the nine months ended October 30, 2021, net cash provided by operating activities was $533.7 million and consisted of net income of $541.5 million and an increase in non-cash items of $198.2 million, partially offset by a change in working capital and other activities of $206.0 million. The source of cash from working capital was primarily driven by an increase in deferred revenue and customer deposits of $104.4 million primarily due to strong consumer demand for our products. This source of cash from working capital was partially offset by uses of cash driven by an increase in merchandise inventory of $89.2 million, a decrease in operating lease liabilities of $59.2 million primarily due to payments made under the related lease agreements, an increase in landlord assets under construction of $50.4 million, an increase in prepaid expenses and other assets of $39.2 million, and a decrease in other current liabilities of $28.1 million.
For the nine months ended October 31, 2020, net cash provided by operating activities was $347.3 million and consisted of net income of $141.6 million and non-cash items of $266.3 million, partially offset by cash used for working capital and other activities of $60.7 million. Working capital and other activities consisted primarily of an increase in merchandise inventory of $57.8 million, an increase in prepaid expenses and other assets of $47.3 million, an increase in landlord assets under construction of $44.9 million, a decrease in operating lease liabilities of $36.8 million primarily due to payments made under the related lease agreements, and a decrease in other non-current obligations of $20.8 million. These uses of cash from working capital were partially offset by increases in deferred revenue and customer deposits of $111.4 million primarily due to strong consumer demand for our products during the second and third quarters of fiscal 2020.
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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 nine months ended October 30, 2021, net cash used in investing activities was $158.6 million and was comprised of investments in retail stores, information technology and systems infrastructure of $153.8 million and additional funding of our equity method investments of $4.8 million.
For the nine months ended October 31, 2020, net cash used in investing activities was $67.3 million primarily due to investments in retail stores, information technology and systems infrastructure, and supply chain of $57.6 million, as well as the acquisition of building and land assets of $14.2 million. In August 2020, we completed the acquisition of a business and paid $13.1 million of the $15.0 million purchase price in the nine months ended October 31, 2020. In addition, we made $7.5 million of investments in joint ventures in the nine months ended October 31, 2020. Net cash used in investing activities was partially offset by net proceeds from the sale of building and land of $25.0 million.
Net Cash Provided By (Used In) Financing Activities
Financing activities consist primarily of borrowings and repayments 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 nine months ended October 30, 2021, net cash provided by financing activities was $1.7 billion, primarily due to the issuance of the Term Loan in October 2021 in the amount of $2,000 million pursuant to the Term Loan Credit Agreement. This source of cash was offset by uses of cash, partially due to the repayment of $274.2 million of the 2023 Notes and 2024 Notes in the nine months ended October 30, 2021 as a result of early conversion at the option of the noteholders, of which $235.1 million is presented as repayments of convertible senior notes within cash from financing activities and $39.1 million is reflected as cash paid attributable to accretion of debt discount upon settlement of debt within cash from operating activities. In addition, we incurred $22.7 million of debt issuance costs related to the Term Loan Credit Agreement and $3.7 million of debt issuance costs related to the ABL Credit Agreement, as well as made repayments of $17.2 million on our equipment notes and $10.5 million of principal payments under finance lease agreements. Equity related transactions provided $10.7 million due to $30.1 million of proceeds from exercise of employee stock options, partially offset by $19.4 million of cash paid for employee taxes related to net settlement of equity awards.
For the nine months ended October 31, 2020, net cash used in financing activities was $230.8 million. The $300 million 2020 Notes matured in July 2020, of which $215.8 million is presented within net cash used in financing activities and $84.0 million is reflected as non-cash accretion of debt discount upon settlement of debt presented in net cash provided by operating activities. Net cash used in financing activities also included repayments under promissory and equipment notes of $10.9 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.
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Free Cash Flow
A reconciliation of our net cash provided by operating activities to free cash flow is as follows:
NINE MONTHS ENDED
OCTOBER 30,
OCTOBER 31,
2021
2020
(in thousands)
Net cash provided by operating activities
$
533,682
$
347,263
Capital expenditures
(153,774)
(71,755)
Free cash flow (a)
$
379,908
$
275,508
(a) Free cash flow is net cash provided by operating activities less capital expenditures. Free cash flow for the nine months ended October 30, 2021 and October 31, 2020 includes the effect of $39.1 million and $84.0 million, respectively, relating to the portion of repayments of convertible senior notes attributable to debt discount upon settlement (such portion of the debt settlement reduces net cash provided by operating activities in the reported period).
Free cash flow is a non-GAAP financial measure and is included in this filing because we believe that this measure provides useful information to our senior leadership team and investors in understanding the strength of our liquidity, available cash and our ability to generate additional cash from our business operations. Free cash flow should not be considered in isolation or as an alternative to cash flows from operations calculated in accordance with GAAP, and should be considered alongside our other liquidity performance measures that are calculated in accordance with GAAP, such as net cash provided by operating activities and our other GAAP financial results. Additionally, our definition of free cash flow is not necessarily representative of residual cash flows from the business since free cash flow as reported is reduced by certain cash payments made in settlement of our convertible debt upon conversion or maturity, as well as other obligations or payments made for business acquisitions. Our senior leadership team uses this non-GAAP financial measure in order to have comparable financial results for the purpose of analyzing changes in our underlying business from quarter to quarter. Our measure of free cash flow is not necessarily comparable to other similarly titled measures for other companies due to different methods of calculation.
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.
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.
Term Loan
Refer to Note 10— Credit Facilities in our condensed consolidated financial statements for further information on our Term Loan.
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.
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$950 Million Share Repurchase Program
In 2018, our Board of Directors authorized the 950 Million 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 950 Million 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 the 950 Million Repurchase 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 the 950 Million Repurchase Program. We did not make any repurchases under the 950 Million Repurchase Program during either the three or nine months ended October 30, 2021 or October 31, 2020. The total current authorized size of this share repurchase program is up to $950 million, of which $450 million remained available as of October 30, 2021 for future share investments.
Contractual Obligations
As of October 30, 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 October 30, 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 Market 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.
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Recent Accounting Pronouncements
Refer to Note 2— Recently Issued Accounting Standards in our condensed consolidated financial statements for a description of recently issued accounting standards that may impact us 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.