Source: RH.com

Summary

RH (NYSE:RH) recently released its Q1 2019 earnings results, along with revised guidance. The size of the beat, in terms of adjusted EPS, came as a surprise for many. The company did beat guidance on net income, but what many had failed to appreciate, was the comparison to previous year would not be against the as reported figures for Q1 2018. Effective beginning FY 2019, the company adopted a revised accounting standard for leases, and also adopted a standard 26% income tax rate for calculating adjusted net income and adjusted EPS. These adjustments cause the company to guide for and also to report lower net income and EPS for Q1 2019 than would be the case if the standards and protocols in place in FY 2018 had continued unchanged. Yahoo! Finance, for one, compared analysts’ consensus estimates of adjusted EPS to the as reported adjusted EPS for Q1 2018. But that is comparing apples to oranges. In order to compare apples to apples, the as reported figures for Q1 2018 need to be converted to the same accounting bases as used in Q1 2019.

1. RH: Comparison Q1 2019 Adjusted Net Income, And Adjusted EPS To Q1 2018 – An Incremental Analysis

TABLE 1 below provides a detailed comparison of Q1 2019 adjusted net income and adjusted EPS to Q1 2018, restated to 2019 accounting basis.

TABLE 1

1.1 Impact of share repurchases

RH is actively engaged in repurchasing shares, spending $250MM in FY 2018 and another $250MM in Q1 2019. But the lower share count in Q1 2019 versus Q1 2018 is not the major reason for Q1 2019 adjusted EPS non-GAAP growing by 52.6% over Q1 2018. The main reason is the 47.7% growth in adjusted net income non-GAAP. Share count reduction contributes just 4.9 percentage points of the 52.6% growth, so RH is far from reliant on share repurchases to grow earnings.

1.2 Revenue and margin growth

Revenue growth, year on year, in Q4 2018 was 0.3%, while gross margin increased from 38.5% to 39.5%. Here is what RH Chairman and CEO Gary Friedman said about revenue and margin growth, in response to a question during the Q4 2018 earnings call,

…we told everybody we’re going to manage the business with a bias for earnings versus revenue growth as we try to optimize this model and build the most differentiated and profitable business in our space. And so if we were playing the old game in the fourth quarter, our business were to drop 10 points, we would have pulled a bunch of promotional levers, and we’ve done a lot of things like everybody else does, and you would have seen a zillion emails, that are at the end of the day, downward spiral and it’s detrimental to a brand and to your long term positioning. And we’re just not playing that game anymore. So we took the hit on the top line.

Revenue growth, year on year, in Q1 2019 was 4.5%, while gross margin increased from 37.5% to 38.6%. The effect of margin increase coupled with revenue growth is to magnify the effect on incremental gross margin. From TABLE 1, it can be seen the gross margin percentage on incremental revenue of $41.4MM was 52.9%, compared to overall gross margin of 38.6% for Q1 2019. This flies in the face of what is happening elsewhere in retail.

1.3 Selling, General & Administrative Expenses (SG&A)

Despite the increased revenues, SG&A was virtually unchanged, resulting in almost all of the gain in gross margin flowing through to operating income. As a result, incremental operating income of $21.3MM was 51.5% of incremental revenues, compared to overall operating income margin of 11.8% for Q1 2019.

1.4 Adjusted net income non-GAAP

Of the gain in gross margin of $21.9MM, an amount of $19.7MM flowed through to income before income taxes. As a result, after deducting income tax at 26%, Q1 2019 adjusted net income was up by $14.6MM (47.7%) on Q1 2018. Of the 47.7% increase, we can attribute 7.4 percentage points to revenue growth, and the balance 40.3 percentage points increase, primarily to percentage margin improvement.

2. RH: Comparison Q1 2019 Adjusted Net Income, And Adjusted EPS To Q1 2019 Guidance – An Incremental Analysis

TABLE 2 below, provides a detailed comparison of Q1 2019 adjusted net income, and adjusted EPS, to Q1 2019 guidance.

TABLE 2

2.1 Revenue and margin growth

RH guided for year-on-year growth in Q1 2019 of 4.4% to 5.5% for revenue, and 38.6% to 38.9% for gross margin. Revenue growth came in higher than guidance at 7.4%. Gross margin came in at 38.6%, meeting the lower end of guidance. Actual gross margin was $6.2MM higher than the lower end of guidance, and $2.1MM higher than the top end of guidance. Gross margin percentage on the incremental sales was 37.0% based on the low end of guidance, and 19.8% based on the high end of guidance.

2.2 Selling, General & Administrative Expenses (SG&A)

Despite the increased revenues, SG&A was $5.4MM less than guidance. As a result, margin on incremental operating income was ~69-70% of incremental revenues, for both low and high cases. If these savings on SG&A continue into second quarter, we could see another strong EPS beat announced in due course.

2.3 Adjusted net income non-GAAP

Income before income taxes was $61.1MM, $11.1MM better than the lower end of guidance, and $7.0MM better than the high end of guidance. These improvements came largely from the SG&A savings, plus the increase in gross margin due to higher sales revenues. As a result, after deducting income tax at 26%, Q1 2019 adjusted net income was up by $8.2MM (22.1%) on the lower end of guidance, and up $5.2MM (13.0%) on the higher end of guidance. In Q1 2019, adjusted EPS non-GAAP was up 25.9% compared to 22.1% for net income, based on the low end of guidance. Similarly, based on the high end of guidance, adjusted EPS non-GAAP was up 17.1% compared to 13.0% for net income. The higher growth rates in EPS versus net income are due to lower share count as a result of share repurchases. Repurchase of ~2.2MM shares in Q1 2019 was towards the end of the quarter, so the weighted average effect was ~0.7MM shares for Q1. The full effect will be felt in Q2 and subsequent quarters.

3. Rating The Quality Of RH Guidance

RH keeps on beating guidance, sometimes by a wide margin. It appears the quants are punishing RH for that, as shown in Figure 1 below, from SA Essential.

Figure 1

Figure 2 shows, for comparison purposes, the quant rating for Williams-Sonoma (WSM) –

Figure 2

Williams-Sonoma gets an A+ for EPS revisions, and an average quant rating of 3.44 compared to 2.63 for RH.

Here is the basis of that “F” (presumably a fail) rating on RH EPS revisions, from SA Essential –

Earnings Estimate Revisions:

Sell-side analysts EPS revisions have a very strong impact on stock price performance. Seeking Alpha has developed a unique factor for measuring a company’s EPS revisions against its given sector.

So the F for “fail” is based on the number of sell-side analysts’ EPS revisions, and not necessarily on the number of revisions by RH. It is useful to analyze the consistency of RH EPS from period to period, to assess whether the results are up and down from year to year, making estimating difficult, and leading to multiple revisions by sell-side analysts.

Figure 3 shows earnings surprises for RH

Figure 3

At first glance, the EPS results appear up and down. But if we compare on a quarterly basis (year over year) there is a consistent pattern of high growth quarter over prior-year quarter; i.e., Apr 2019 over Apr 2018, over Apr 2017. Similarly for Jan 2019 over Jan 2018, over Jan 2017, and so on. Now let us look at Williams-Sonoma’s performance, for comparison purposes.

Figure 4 shows earnings surprises for Williams-Sonoma –

Figure 4At first glance at Figure 4, Williams-Sonoma appears to display a far more regular pattern than that shown for RH in Figure 3. If we compare on a quarter to prior-year corresponding quarter, we find the same pattern of each quarter’s EPS beating the prior-year quarter. The difference is the rate of growth, quarter over prior-year quarter, is quite low for Williams-Sonoma. This likely results in sell-side analysts being able to estimate EPS with confidence, based on a continuation of past low, but predictable growth. RH also consistently grows EPS from prior-year quarter to current quarter, but the rate of growth is far higher than for Williams-Sonoma. The rate of growth by quarter is also far more variable than for Williams-Sonoma. Significant changes in actual growth rates from quarter to quarter are likely what leads to analysts regularly revising their forward estimates. I think I might prefer high growth rates, with some uncertainty about how high than predictably low growth rates.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment advisor and/or a tax advisor as to the suitability of such investments for their specific situation. Neither information nor any opinion expressed in this article constitutes a solicitation, an offer, or a recommendation to buy, sell, or dispose of any investment, or to provide any investment advice or service. An opinion in this article can change at any time without notice.

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2019-06-19