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Management's Discussion of Results of Operations (Excerpts)

For purposes of readability, Zenith attempts to strip out all tables in excerpts from the Management Discussion. That information is contained elsewhere in our articles. The idea of this summary is simply to review how well we believe Management does its reporting. Also, this highlights what Management believes is important.

In our Decision Matrix at the end of each article, a company with 0 to 2 gets a "-1", and 3 to 5 gets a "+1."

On a scale of 0 to 5, 5 being best, Zenith rates this company's Management's Discussion as a 3.


Overview

We are a leading luxury retailer in the home furnishings marketplace. Our 
curated and fully-integrated assortments are presented consistently across our 
sales channels in sophisticated and unique lifestyle settings that we believe 
are on par with world-class interior designers. We offer dominant merchandise 
assortments across a growing number of categories, including furniture, 
lighting, textiles, bathware, décor, outdoor and garden, and child and teen 
furnishings. We position our Galleries as showrooms for our brand, while our 
Source Books and websites act as virtual extensions of our stores. In 2015 we 
began to introduce an integrated hospitality experience, including cafés, wine 
vaults and barista bars, into a number of our new Gallery locations. We believe 
this has created a unique new retail experience that cannot be replicated 
online, and that the addition of hospitality is helping to drive incremental 
sales of home furnishings in these Galleries.

Our business is fully integrated across our multiple channels of distribution, 
consisting of our stores, Source Books and websites. As of February 2, 2019, we 
operated a total of 86 retail Galleries, consisting of 20 Design Galleries, 43 
legacy Galleries, 2 RH Modern Galleries and 6 RH Baby & Child Galleries 
throughout the United States and Canada, and 15 Waterworks showrooms throughout 
the United States and in the U.K. As of February 2, 2019, 6 of our Design 
Galleries include an integrated RH Hospitality experience and we plan to 
incorporate hospitality, including cafés, wine vaults and barista bars in many 
of the new Galleries that we open in the future. As of February 2, 2019, we 
operated 39 outlet stores throughout the United States and Canada.

Key Value Driving Strategies

In order to drive growth across our business, we are focused on the following 
long-term key strategies:

• Transform Our Real Estate Platform. We believe we have an opportunity to 
significantly increase our sales by transforming our real estate platform from 
our existing legacy retail footprint to a portfolio of Design Galleries that 
are sized to the potential of each market and the size of our assortment.


New Design Gallery sites are identified based on a variety of factors, such as 
the availability of suitable new site locations based on several store specific 
aspects including geographic location, demographics, and proximity to affluent 
consumers, and the negotiation of favorable economic terms to us for the new 
location, as well as satisfactory and timely completion of real estate 
development including procurement of permits and completion of construction. 
Based on our analysis, we believe we have the opportunity to operate Design 
Galleries in 60 to 70 locations in the United States and Canada. The number of 
Design Galleries we open in any fiscal year is highly dependent upon these 
variables and individual new Design Galleries may be subject to delay or 
postponement depending on the circumstances of specific projects.

We opened our Portland Design Gallery in March 2018, our Nashville Design 
Gallery in June 2018, as well as our New York Design Gallery and our Design 
Gallery in Yountville, California in the Napa Valley, in September 2018. Our 
Galleries in Nashville, New York and Yountville include integrated cafés, wine 
vaults and barista bars.

We have identified key learnings from our real estate transformation that have 
supported the development of a new multi-tier market approach that we believe 
will optimize both market share and return on invested capital.

First, we have developed a new RH prototype Design Gallery that is an 
innovative and flexible blueprint which we believe will enable us to more 
quickly place our disruptive product assortment and immersive retail experience 
into the market. The new model is a standard we will utilize in the future that 
is based on key learnings from our recent Gallery openings and will range in 
size from 33,000 leased selling square feet inclusive of our integrated 
hospitality experience to 29,000 leased selling square feet without. These new 
Galleries will represent our assortments from RH Interiors, Modern, Baby & 
Child, Teen and Outdoor and contain interior design offices and presentation 
rooms where design professionals can work with clients on their projects. Due 
to the reduced square footage compared to our recent Design Gallery openings 
and efficient design, this new model will be more capital efficient with less 
time and cost risk, but yield similar productivity. We anticipate the new 
prototype Design Galleries will represent approximately two thirds of our 
target markets. Future prototype location examples include Edina, MN, Corte 
Madera, CA, Columbus, OH and Charlotte, NC.

Second, we will continue to develop and open larger Bespoke Design Galleries in 
the top metropolitan markets, similar to those we opened in New York and 
Chicago. These iconic locations are highly profitable statements for our brand, 
and we believe they create a long-term competitive advantage that will be 
difficult to duplicate.

Third, we will continue to open indigenous Bespoke Galleries in the best second 
home markets where the wealthy and affluent visit and vacation. These Galleries 
are tailored to reflect the local culture and are sized to the potential of 
each market. Examples of indigenous Bespoke Galleries include the Hamptons, 
Palm Beach, Yountville and Aspen.

Fourth, we are developing a new Gallery model tailored to secondary markets. 
Targeted to be 10,000 to 18,000 square feet, we believe these smaller 
expressions of our brand will enable us to gain share in markets currently only 
served by smaller competitors. Examples of target secondary markets include 
Hartford, CT, Oklahoma City, OK and Milwaukee, WI, among others. We expect 
these Galleries to require a substantially smaller net investment than our 
larger Design Galleries and to pay back our capital investment within two years 
in most instances. Our plan is to test a few of these Galleries over the next 
several years, and if proven successful, this format could lead to an increase 
in our long-term Gallery targets.

We believe our multi-tier market approach to transforming our real estate will 
enable us to ramp our opening cadence from 3 to 5 new Galleries per year, to a 
pace of 5 to 7 new Galleries per year.

We continue to evaluate potential opportunities for standalone RH Baby & Child, 
RH Teen and RH Modern Galleries in select markets.

Like our evolving multi-tier Gallery strategy, we have developed a multi-tier 
real estate strategy that is designed to significantly increase our unit level 
profitability and return on invested capital. Our three primary deal constructs 
are outlined below:

• First, due to the productivity and proof of concept of our recent new 
Galleries, and the addition of a powerful, traffic-generating hospitality 
experience, we are able to negotiate “capital light” leasing deals, where as 
much as 65% to 100% of the capital requirement would be funded by the landlord, 
versus 35% to 50% previously. We currently have 15 potential capital light 
deals in the development pipeline that would be scheduled to open in fiscal 
2019 and beyond.


• Second, in several of our current projects, we are migrating from a leasing 
to a development model. We currently have two Galleries, Yountville and Edina, 
using this new model, and have an additional four potential development 
projects in the pipeline. In the case of Yountville and Edina, we expect to 
complete a sale-leaseback that should allow us to recoup all or a large portion 
of our capital. In some cases we believe we may be able to pre-sell the 
property and structure the transaction where the capital to build the project 
is advanced by the buyer during construction, which could require zero upfront 
capital from us.


• Third, we are working on joint venture projects, where we share the upside of 
a development with the developer/landlord. An example of this new model would 
be our future Gallery and Guesthouse in Aspen, where we are contributing the 
value of our lease to the development in exchange for a profits interest in the 
project. The developer will deliver to RH a substantially turnkey Gallery and 
Guesthouse, while we continue to retain a 20% and 25% profits interest in the 
properties, respectively. We would expect to monetize the profits interest at 
the time of sale of the properties during the first five years. The net result 
should be a minimal capital investment to operationalize the business, with the 
expectation for a net positive capital benefit at time of monetization of the 
profits interest.


We anticipate that all of the above deal structures should lead to lower 
capital requirements, higher unit profitability, and significantly higher 
return on invested capital versus our prior Gallery development strategies.

• Expand Our Offering and Increase Our Market Share. We believe we have a 
significant opportunity to increase our market share by:


• transforming our real estate platform;


• growing our merchandise assortment and introducing new products and 
categories;


• expanding our service offerings, including design services and cafes, wine 
vaults and coffee bars at our Design Galleries;


• exploring and testing new business opportunities complementary to our core 
business; and


• increasing our brand awareness and customer loyalty through our Source Book 
circulation strategy, membership program, our digital marketing initiatives, 
advertising, and public relations activities and events.


During fiscal 2017 and fiscal 2018 we deferred the introduction of major new 
product category expansions other than the ongoing development of RH 
Hospitality in conjunction with new Design Galleries. We plan a return to our 
product and business expansion strategy in fiscal 2019, which has been on hold 
as we focus on the architecture of a new operating platform.

We also plan to increase our investment in RH Interior Design in fiscal 2019 
with a goal of building the leading interior design firm in North America. We 
believe there is a significant revenue opportunity by offering world class 
design and installation services as we move the brand beyond creating and 
selling products, to conceptualizing and selling spaces.

• Architect New Operating Platform. We have spent the last three years 
architecting a new operating platform, inclusive of transitioning from a 
promotional to membership model, our distribution center network redesign, the 
redesign of our reverse logistics and outlet business, and the 
reconceptualization of our home delivery and customer experience, enable us to 
drive lower costs and inventory levels, and higher earnings and inventory 
turns. Looking forward, we expect this multi-year effort to result in a 
dramatically improved customer experience, continued margin enhancement and 
significant cost savings over the next several years.


• Maximize Cash Flow and Optimize the Allocation of Capital in the Business. In 
fiscal 2017 and 2018, we have focused on maximizing cash flow in our business 
and the allocation of capital. We believe that our operations and current 
initiatives are providing a significant opportunity to optimize the allocation 
of capital in our business, including generating free cash flow and optimizing 
our balance sheet, as well as deploying capital to repay debt and repurchase 
shares of our common stock, which we believe creates a long term benefit to our 
shareholders.


In October 2018, our Board of Directors approved a share repurchase program, in 
an aggregate amount of $700 million of which (x) $250.0 million in share 
repurchases were completed in fiscal 2018, and (y) the $700 million 
authorization amount was replenished by the Board of Directors in March, 2019. 
During fiscal 2018 we repurchased approximately 2.0 million shares of our 
common stock pursuant to this repurchase program which represented 10% of the 
shares outstanding as of the end of fiscal 2017. During fiscal 2017, we 
repurchased approximately 20.2 million shares of our common stock under two 
separate repurchase programs for an aggregate repurchase amount of 
approximately $1 billion. This represented 50% of the shares outstanding as of 
the end of fiscal 2016. Our focus on cash also resulted in our generating $163 
million and $415 million in free cash flow in fiscal 2018 and fiscal 2017, 
respectively (refer to “Share Repurchase Programs” below for our free cash flow 
calculation).

• Increase Operating Margins. During the period from fiscal 2016 through fiscal 
2018, we have substantially increased the operating margins in our business. We 
anticipate continued improvements in operating margins as a result of our focus 
on a number of our strategic initiatives including (i) the occupancy leverage 
we expect to gain from our real estate transformation, (ii) product margin 
expansion as we continue to drive higher full price selling in our core 
business, and (iii) the continued cost savings of improvements to our operating 
platform and organizational structure.


Business Initiatives

We are undertaking a large number of new business initiatives in support of our 
key value driving strategies. In particular, during fiscal 2016 through fiscal 
2018, we have pursued a range of strategic efforts to improve our business and 
operations including the following:

• Introduction of Membership Model. In March 2016, we introduced the RH Members 
Program, an exclusive membership model that reimagines and simplifies the 
shopping experience. For an annual fee, the RH Members Program provides a set 
discount every day across all RH brands in addition to other benefits including 
complimentary interior design services through the RH Interior Design program 
and eligibility for preferred financing plans on the RH Credit Card, among 
others. We believe that transitioning our business from a promotional to 
membership model has enhanced our brand, simplified and streamlined our 
business as well as allowed us to develop deeper connections with our 
customers.


• For the year ended February 2, 2019, our members drove approximately 95% of 
sales in our core RH business, and we had approximately 418,000 members at year 
end. Our core RH business reflects the product categories that the membership 
discount can be applied to, and as a result sales generated via Outlet, 
Contract, Hospitality or Waterworks are excluded.


• We believe that the shift to a membership model has positively affected the 
financial results of our business. Specifically, we believe some of the 
benefits include:


Improved customer experience. Our interior design professionals can now work 
with customers based on their timeline and project deadlines, as opposed to our 
prior promotional calendar. We believe this will lead to larger overall sales 
transactions for individual customer design projects.

Lower cancellations and returns. As a result of the elimination of time-limited 
promotional events and the associated pressure of placing an order before a 
promotion expires, we believe the shift to a membership model has also resulted 
lower rates of cancelled orders and returns.

Improved operational costs. The volume of sales, orders and shipments in our 
business under the prior promotional model was characterized by large spikes in 
customer orders based upon promotional events followed by lower orders and 
sales after the end of an event. This buying pattern also affected numerous 
other aspects of our business, including staffing and costs as we required 
elevated staffing levels to service the increased number of customers during 
peak sales events. Likewise, significant fluctuations in sales had downstream 
implications for our supply chain related to merchandise orders, manufacturing 
and production, shipment to our distribution centers and final delivery to our 
customers. All of these aspects of our operations are experiencing improved 
efficiencies as a result of the membership model whereby sales are more evenly 
distributed throughout the year as opposed to the peaks and valleys of orders 
and sales under the prior model.

• Distribution Center Network Redesign. As a result of our work to redesign our 
distribution network and optimize inventory, in fiscal 2017 we were able to 
forego building a fifth furniture distribution center planned to open and 
consolidate our current furniture distribution center network from four primary 
locations to two primary locations (Northern California and Baltimore, Maryland 
area). In fiscal 2017, we completed the closure of our furniture distribution 
centers in Los Angeles and Dallas, eliminating 1.75 million square feet of 
distribution center space, resulting in savings in excess of $20 million 
annually. In fiscal 2018, we completed the closure of a smaller furniture 
distribution center in Essex, Maryland, eliminating 500,000 square feet of 
distribution center space, resulting in savings in excess of $5 million 
annually. We believe managing our business in fewer facilities while decreasing 
our on-hand inventory will reduce fulfillment complexity, lower inventory 
transfer costs, increase inventory turns, improve working capital and should 
result in higher gross margins over time.


• Reconceptualize Reverse Logistics Business. In fiscal 2017, we implemented 
initiatives to re-conceptualize our Outlet and reverse logistics business. 
Previously, returns of furniture would be transferred via our home delivery 
hubs back to a furniture distribution center, then eventually to one of our 
Outlet locations. Now, returns of furniture are transferred directly from our 
home delivery hubs to Outlets, which has reduced transportation and handling 
costs, and improved selling margins across our Outlet network. We believe this 
initiative yielded substantial savings and margin enhancement of approximately 
$20 million annually.


• Luxury In-Home Furniture Delivery Experience. We believe there is an 
opportunity to improve the customer experience by taking greater control of the 
final mile in-home delivery. While we have in-sourced the majority of our home 
delivery hub facilities, we continue to use third-party providers for furniture 
delivery into our customer’s home. We believe that many third-party furniture 
delivery providers are designed to support mass and mid-market companies and 
that significant opportunity exists for developing improved solutions for the 
luxury market. We have achieved significant scale such that we can now explore 
and test alternative solutions in certain markets, including the use of our own 
trucks and drivers, and believe we can dramatically enhance the customer 
experience while driving down return rates, damages and deliveries per order.


• Elevate the Customer Experience. We are focused on improving the end-to-end 
customer experience. As we have elevated our brand, especially at retail, we 
are also working to enhance the brand experience in other aspects of our 
business. We are making changes in many aspects of our business processes that 
affect our customers, including the in-home delivery experience, improvements 
in product quality and enhancements in sourcing, product availability, and all 
aspects of customer care and service. We also believe that the introduction of 
experiential brand-enhancing products and services, such as expanded design 
ateliers, the RH Interior Design program and the launch of an integrated 
hospitality experience in a number of our new Galleries, will further enhance 
our customers’ in-store experience, allowing us to further disrupt the highly 
fragmented home furnishings landscape and achieve market share gains.


• Development and Refinement of Hospitality Experience. In 2015 we began to 
introduce an integrated hospitality experience, including cafés, wine vaults 
and barista bars, into a number of our new Gallery locations. The success of 
our initial hospitality offering in Chicago led us to broaden this initiative 
by adding hospitality to a number of our other new Gallery locations. We 
believe this has created a unique new retail experience that cannot be 
replicated online, and that the addition of hospitality is helping to drive 
incremental sales of home furnishings in these Galleries.


• Pursue International Expansion. We believe that our luxury brand positioning 
and unique aesthetic will have strong international appeal. As such, we believe 
there is tremendous opportunity for the RH brand to expand globally and are 
currently exploring opportunities for Design Galleries in several locations 
outside the United States, including the United Kingdom and Europe.


We continue to pursue and test numerous initiatives to improve many aspects of 
our business including through efforts to optimize inventory, elevate the home 
delivery experience, simplify our distribution network and improve our 
organizational design including by streamlining and realigning our home office 
operations, as well as to expand our product offering and transform our real 
estate using a range of different models for specific real estate development 
projects. There can be no assurance as to the timing and extent of the 
operational benefits and financial contributions of these strategic efforts. In 
addition, our pursuit of multiple initiatives with respect to our business in 
any given period may result in period-to-period changes in, and increased 
fluctuation in, our results of operations. For example, our efforts to optimize 
our distribution network could cause us to incur costs and expenses in the 
short term with respect to changes in the way in which we operate our business. 
Delays in completion of our real estate development projects or costs overruns 
could also negatively affect our results of operation. Further, macroeconomic 
or political events outside of our control could impact our ability to pursue 
our initiatives or the success of such initiatives. For example, in recent 
periods the stock market has experienced significant volatility as well as 
periods of significant decline, which may negatively affect the financial 
health and demand levels of high-end consumers. The housing market is affected 
by a range of factors including home prices and interest rates and slowdowns in 
the housing market can have a negative impact on demand for our products. 
Factors that affect the higher end housing market in particular may have an 
outsized influence on our levels of consumer demand since our business is 
geared toward the higher end of the home furnishings market. The above factors 
and other current and future operational initiatives may create additional 
uncertainty with respect to our consolidated net revenues and profit in the 
near term.

Factors Affecting Our Results of Operations

Various factors affected our results for the periods presented in this 
“Management’s Discussion and Analysis of Financial Condition and Results of 
Operations,” and such discussion generally lists the factors in order of 
magnitude based on their impact. The below are certain factors that affect our 
results of operations:

Our Strategic Initiatives. We are in the process of implementing a number of 
significant business initiatives that have had and will continue to have an 
impact on our results of operations, including:

• the introduction and expansion of new product categories and services;


• the timing and progress of the opening of new Design Galleries that are under 
development;


• the pursuit of our multi-tier market approach to our real estate 
transformation;


• the redesign of our distribution center network;


• the introduction of an integrated hospitality experience, including the roll 
out of an integrated food and beverage experience in a number of our new Design 
Galleries;


• changes in our Source Book circulation strategy including the depth, 
frequency and timing of mailings as well as the scope of product offerings 
displayed in our Source Books;


• changes in the overall opening cadence for new Galleries;


• changes in our reverse logistics model resulting in transferring customer 
returns direct from our home delivery hubs to Outlets;


• efforts to elevate the customer experience including architecting a new fully 
integrated back-end operating platform, inclusive of the supply chain network, 
the home delivery experience as well as a new metric driven quality system and 
company-wide decision data, vendor product initiatives and changes to the way 
we operate our distribution centers, home delivery hubs and customer service 
centers; and


• leveraging the above strategic initiatives across both our RH Segment and 
Waterworks to drive the performance of each business.


As a result of the number of current business initiatives we are pursuing, we 
have experienced in the past and may experience in the future significant 
period-to-period variability in our financial performance and results of 
operations. While we anticipate that these initiatives will support the growth 
of our business, costs and timing issues associated with pursuing these 
initiatives can negatively affect our growth rates in the short term and may 
amplify fluctuations in our growth rates from quarter to quarter. In addition, 
we anticipate that our net revenues, adjusted net income and other performance 
metrics will remain variable as our business model continues to emphasize high 
growth and numerous, concurrent and evolving business initiatives.

Our Ability to Source and Distribute Products Effectively. Our net revenues and 
gross profit are affected by our ability to purchase our merchandise in 
sufficient quantities at competitive prices. Our current and anticipated 
demand, and our level of net revenues have been adversely affected in prior 
periods by constraints in our supply chain, including the inability of our 
vendors to produce sufficient quantities of some merchandise in a manner that 
was able to match market demand from our customers, leading to higher levels of 
customer back orders and lost sales. For example, some of our vendors 
experienced difficulty in producing goods in sufficient quantity to meet 
initial customer demand for RH Modern when it was launched in October 2015.

Consumer Preferences and Demand. Our ability to maintain our appeal to existing 
customers and attract new customers depends on our ability to originate, 
develop and offer a compelling product assortment responsive to customer 
preferences and design trends. We have successfully introduced a large number 
of new products in past periods, which we believe has been a contributing 
factor in our sales growth and results of operations. Periods in which our 
products have achieved strong customer acceptance generally have had more 
favorable results. If we misjudge the market for our products or the product 
lines that we acquire, we may be faced with excess inventories for some 
products and may be required to become more promotional in our selling 
activities, which would impact our net revenues and gross profit.

Overall Economic Trends. The industry in which we operate is cyclical, and 
consequently our net revenues are affected by general economic conditions 
including conditions that affect the housing market. We target consumers of 
high-end home furnishings. As a result, we believe that our sales are sensitive 
to a number of macroeconomic factors that influence consumer spending 
generally, but that our sales are particularly affected by the health of the 
higher end customer and demand levels from that customer demographic. While the 
overall home furnishings market may be influenced by factors such as employment 
levels, interest rates, demographics of new household formation and the 
affordability of homes for the first time home buyer, the higher end of the 
housing market may be disproportionately influenced by other factors, including 
stock market prices, the number of second and third homes being bought and 
sold, the number of foreign buyers in higher end real estate markets in the 
U.S., tax policies and interest rates, and the perceived prospect for capital 
appreciation in higher end real estate. We have in the past experienced 
volatility in our sales trends related to many of these factors and believe our 
sales may be impacted by these economic factors in future periods. 
Additionally, we have seen a weakness in consumer spending at the luxury end of 
the retail market. These headwinds tied to macroeconomic factors may continue 
in future quarters. For more information, refer to Item 1A—Risk Factors—Changes 
in consumer spending and factors that influence spending of the specific 
consumers we target, including the health of the high-end housing market, may 
significantly impact our revenue and results of operations.

Fluctuation in Quarterly Results. Our quarterly results vary depending upon a 
variety of factors, including our product offerings, store openings, shifts in 
the timing of holidays and the timing of Source Book releases, promotional 
events and the timing and extent of our realization of the costs and benefits 
of our numerous strategic initiatives, among other things. As a result of these 
factors, our working capital requirements and demands on our product 
distribution and delivery network may fluctuate during the year. Unique factors 
in any given quarter may affect period-to-period comparisons between the 
quarters being compared, and the results for any quarter are not necessarily 
indicative of the results that we may achieve for a full fiscal year.

How We Assess the Performance of Our Business

In assessing the performance of our business, we consider a variety of 
financial and operating measures that affect our results of operations, 
including:

Net Revenues. Net revenues reflect our sale of merchandise plus shipping and 
handling revenue collected from our customers, less returns and discounts. 
Revenues are recognized when a customer obtains control of the merchandise. We 
collect annual membership fees related to the RH Members Program, which are 
recorded as deferred revenue when collected from customers and recognized as 
revenue based on expected product revenues over the annual membership period.

Gross Profit. Gross profit is equal to our net revenues less cost of goods 
sold. Gross profit as a percentage of our net revenues is referred to as gross 
margin. Cost of goods sold include the direct cost of purchased merchandise; 
inventory shrinkage, inventory adjustments due to obsolescence, including 
excess and slow-moving inventory and lower of cost or net realizable value 
reserves; inbound freight; all freight costs to get merchandise to our stores; 
design, buying and allocation costs; occupancy costs related to store 
operations and our supply chain, such as rent and common area maintenance for 
our leases; depreciation and amortization of leasehold improvements, equipment 
and other assets in our stores and distribution centers. In addition, cost of 
goods sold include all logistics costs associated with shipping product to our 
customers, which are partially offset by shipping income collected from 
customers (recorded in net revenues). We expect gross profit to increase to the 
extent that we successfully grow our net revenues and leverage the fixed 
portion of cost of goods sold.

Our gross profit can be favorably impacted by sales volume increases, as 
occupancy and certain other costs that are largely fixed do not necessarily 
increase proportionally with volume increases. Changes in the mix of our 
products may also impact our gross profit. We review our inventory levels on an 
ongoing basis in order to identify slow-moving merchandise and use product 
markdowns and our outlet stores to efficiently sell these products. The timing 
and level of markdowns are driven primarily by customer acceptance of our 
merchandise. The primary drivers of the costs of individual goods are raw 
materials costs, which fluctuate based on a number of factors beyond our 
control, including commodity prices, changes in supply and demand, general 
economic conditions, competition, import duties, tariffs and government 
regulation, logistics costs (which may increase in the event of, for example, 
expansions of or interruptions in the operation of our distribution centers, 
furniture home delivery hubs and customer service center or damage or 
interruption to our information systems) and labor costs in the countries where 
we source our merchandise. We place orders with merchandise vendors primarily 
in United States dollars and, as a result, are not exposed to significant 
foreign currency exchange risk.

Our gross profit may not be comparable to other specialty retailers, as some 
companies may not include all or a portion of the costs related to their 
distribution network and store occupancy in calculating gross profit as we and 
many other retailers do, but instead may include them in selling, general and 
administrative expenses. In addition, certain of our store leases are accounted 
for as build-to-suit lease transactions which result in our recording a portion 
of our rent payments under these agreements in interest expense on the 
consolidated statements of income.

Selling, General and Administrative Expenses. Selling, general and 
administrative expenses include all operating costs not included in cost of 
goods sold. These expenses include payroll and payroll related expenses, store 
expenses other than occupancy and expenses related to many of our operations at 
our corporate headquarters, including utilities, depreciation and amortization, 
credit card fees and marketing expense, which primarily includes Source Book 
production, mailing and print advertising costs. All store pre-opening costs 
are included in selling, general and administrative expenses and are expensed 
as incurred. We expect certain of these expenses to continue to increase as we 
continue to open new stores, develop new product categories and otherwise 
pursue our current business initiatives. Selling, general and administrative 
expenses as a percentage of net revenues are usually higher in lower-volume 
quarters and lower in higher-volume quarters because a significant portion of 
the costs are relatively fixed.

In addition, in recent periods we have experienced increased selling, general 
and administrative expenses, including certain non-cash compensation and costs 
associated with reorganizations and distribution center closures, product 
recalls, and asset impairments and lease losses, as discussed in “Basis of 
Presentation and Results of Operations” below.

Adjusted EBITDA and Adjusted Net Income. We believe that adjusted EBITDA and 
adjusted net income are useful measures of operating performance, as the 
adjustments eliminate non-recurring and other items that are not reflective of 
underlying business performance, facilitate a comparison of our operating 
performance on a consistent basis from period-to-period and provide for a more 
complete understanding of factors and trends affecting our business. We also 
use adjusted EBITDA and adjusted net income as methods for planning and 
forecasting overall expected performance and for evaluating on a quarterly and 
annual basis actual results against such expectations.

We define adjusted EBITDA as consolidated net income before depreciation and 
amortization, interest expense, provision for income taxes and non-cash 
compensation, adjusted for the impact of certain non-recurring and other items 
that we do not consider representative of our underlying operating performance. 
Because adjusted EBITDA omits non-cash items, we feel that it is less 
susceptible to variances in actual performance resulting from depreciation, 
amortization and other non-cash charges and can be more reflective of our 
operating performance.

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. Refer to Item 
6—Selected Consolidated Financial Data for further information.

Comparable Brand Revenue. We believe that comparable brand revenue is a 
meaningful metric to evaluate period-to-period changes in net revenue 
performance given the integrated multi-channel nature of our business, the 
synergies between our retail stores, websites and Source Books, and the fact 
that customers shop across all of these channels.

Comparable brand revenue growth includes direct net revenues and retail 
comparable store sales, including RH Baby & Child, RH Modern Galleries and RH 
Hospitality. Comparable brand revenue growth excludes retail non-comparable 
store sales, closed store sales and outlet net revenues. Comparable store sales 
have been calculated based upon retail stores, excluding outlet stores, that 
were open at least fourteen full months as of the end of the reporting period 
and did not change square footage by more than 20% between periods. If a store 
is closed for seven days during a month, that month will be excluded from 
comparable store sales. Membership revenue was included in comparable brand 
revenue growth beginning April 2017, which is the first full month following 
the one-year anniversary of the program launch. Waterworks revenue was included 
in comparable brand revenue growth beginning June 2017, which is the first full 
month following the one-year anniversary of the acquisition. The impact on net 
revenues related to the product recalls in fiscal 2018, fiscal 2017 and fiscal 
2016 has been excluded from comparable brand revenue growth. Because fiscal 
2017 was a 53-week year, comparable brand revenue growth percentage for fiscal 
2017 excludes the extra week of revenue.

As the comparable brand revenue metric includes changes in retail store net 
revenues (i.e. comparable store sales) on a period-to-period basis and also 
incorporates changes in net revenues resulting from Source Book and websites 
sales, we believe this metric provides better information to investors in terms 
of evaluating our business performance and a better basis to compare 
performance to that of key competitors.

Basis of Presentation and Results of Operations

Stores data represents sales originating in retail stores, including Waterworks 
showrooms, and outlet stores. Net revenues for outlet stores, which include 
warehouse sales, were $179.0 million, $205.7 million and $144.6 million, for 
fiscal 2018, fiscal 2017 and fiscal 2016, respectively.

Direct net revenues include sales originating from our Source Books, websites, 
and phone orders, including our Contract business and a portion of our Trade 
business.

Comparable brand revenue growth includes direct net revenues and retail 
comparable store sales, including RH Baby & Child, RH Modern Galleries and RH 
Hospitality. Comparable brand revenue growth excludes retail non-comparable 
store sales, closed store sales and outlet net revenues. Comparable store sales 
have been calculated based upon retail stores, excluding outlet stores, that 
were open at least fourteen full months as of the end of the reporting period 
and did not change square footage by more than 20% between periods. If a store 
is closed for seven days during a month, that month will be excluded from 
comparable store sales. Membership revenue was included in comparable brand 
revenue growth beginning April 2017, which is the first full month following 
the one-year anniversary of the program launch. Waterworks revenue was included 
in comparable brand revenue growth beginning June 2017, which is the first full 
month following the one-year anniversary of the acquisition. The impact on net 
revenues related to the product recalls in fiscal 2018, fiscal 2017 and fiscal 
2016 has been excluded from comparable brand revenue growth. Because fiscal 
2017 was a 53-week year, comparable brand revenue growth percentage for fiscal 
2017 excludes the extra week of revenue.

Waterworks results include non-cash amortization of $0.4 million and $2.5 
million related to the inventory fair value adjustment recorded in connection 
with our acquisition of Waterworks during fiscal 2018 and fiscal 2017, 
respectively.


Net revenues

Consolidated net revenues increased $65.5 million, or 2.7%, to $2,505.7 million 
in fiscal 2018 compared to $2,440.2 million in fiscal 2017. Stores net revenues 
increased $40.8 million, or 3.0%, to $1,412.1 million in fiscal 2018 compared 
to $1,371.3 million in fiscal 2017. Direct net revenues increased $24.7 
million, or 2.3%, to $1,093.5 million in fiscal 2018 compared to $1,068.8 
million in fiscal 2017. Comparable brand revenue was 4% for fiscal 2018.

RH Segment net revenues

RH Segment net revenues increased $56.1 million, or 2.4%, to $2,375.5 million 
in fiscal 2018 compared to $2,319.3 million in fiscal 2017. The below 
discussion highlights several significant factors that resulted in increased RH 
Segment net revenues. Given the overall increase in RH Segment net revenues, 
our discussion below first lists, which we believe are in order of magnitude, 
all factors that contributed to the increase and then lists the factors that 
partially offset the overall increase.

RH Segment core net revenues increased due to timing and an increase in total 
pages circulated of our Source Book mailings, as well as the introduction of 
new products and new product categories, including the strong performance of 
our Outdoor product line in fiscal 2018 as compared to fiscal 2017. In 
addition, RH Segment core net revenues increased due to an increase in retail 
weighted-average leased selling square footage related to new store openings, 
including New York, West Palm Beach, Toronto, Portland, Nashville and 
Yountville. RH Segment core net revenues also increased during fiscal 2018 due 
to increased revenues from our Contract business, RH Hospitality operations and 
Membership. The overall increase in RH Segment core net revenues was partially 
offset by additional discounts offered on discontinued merchandise related to 
the optimization of our inventory and SKU rationalization. In addition, we 
believe that our net revenues were negatively impacted by a decline in sales in 
the fourth quarter resulting from stock market fluctuations and negative trends 
in high-end housing.

Outlet sales decreased $26.7 million in fiscal 2018 compared to fiscal 2017 
primarily as a result of our inventory optimization efforts in fiscal 2017 as 
we increased our outlet promotional activity and offered higher discounts. 
Similar promotions and discounts were not offered to the same extent in fiscal 
2018. This overall decrease was partially offset by an increase of seven outlet 
locations year over year, resulting in an approximate 15% increase in outlet 
selling square footage.

RH Segment net revenues decreased approximately $40.6 million due to fiscal 
2017 representing fifty-three weeks of results, whereas fiscal 2018 included 
fifty-two weeks of results.

RH Segment net revenues for fiscal 2018 and fiscal 2017 were negatively 
impacted by $4.7 million and $3.2 million, respectively, related to the 
reduction of revenue associated with product recalls.

Waterworks net revenues

Waterworks net revenues increased $9.3 million, or 7.7%, to $130.2 million in 
fiscal 2018 compared to $120.8 million in fiscal 2017, primarily due to new 
product launches, particularly fittings for bath and kitchen. The overall 
increase in net revenues is partially offset by a decrease in net revenues due 
to Waterworks fiscal 2017, which included fifty-three weeks of results, whereas 
fiscal 2018 included fifty-two weeks of results.

Gross profit

Consolidated gross profit increased $151.8 million, or 17.9%, to $1,000.8 
million in fiscal 2018 compared to $849.1 million in fiscal 2017. As a 
percentage of net revenues, gross margin increased 5.1% to 39.9% of net 
revenues in fiscal 2018 compared to 34.8% of net revenues in fiscal 2017.

RH Segment gross profit for fiscal 2018 was negatively impacted by $2.6 million 
related to acceleration of depreciation due to a change the estimated useful 
life of certain assets, $1.5 million related to costs associated with 
distribution center closures, $1.2 million due to inventory impairment related 
to Holiday merchandise and $0.6 million related to product recalls, including 
(i) the reduction of revenue, (ii) incremental costs and (iii) inventory 
charges, partially offset by (iv) insurance reimbursements.

RH Segment gross profit for fiscal 2017 was negatively impacted by $7.5 million 
related to product recalls, including (i) the reduction of revenue, (ii) 
incremental costs and (iii) inventory charges, and $1.7 million related to 
costs associated with distribution center closures. RH Segment gross profit for 
fiscal 2017 was positively impacted by $2.2 million related to the release of 
the remaining reserve for potential claims regarding anti-dumping duties which 
we believe have lapsed.

Waterworks gross profit for fiscal 2018 and fiscal 2017 was negatively impacted 
by $0.4 million and $2.5 million, respectively, of amortization related to the 
inventory fair value adjustment recorded in connection with the acquisition.

Excluding the accelerated asset depreciation, costs associated with the 
distribution center closures, inventory impairment, product recall adjustments, 
impact of the amortization related to the inventory fair value adjustment and 
release of the anti-dumping duty reserve mentioned above, consolidated gross 
margin would have increased 5.0% to 40.1% of net revenues in fiscal 2018 
compared to 35.1% of net revenues in fiscal 2017.

51



RH Segment gross profit

RH Segment gross profit increased $147.3 million, or 18.4%, to $949.3 million 
in fiscal 2018 compared to $802.0 million in fiscal 2017. As a percentage of 
net revenues, RH Segment gross margin increased 5.4% to 40.0% of net revenues 
in fiscal 2018 compared to 34.6% of net revenues in fiscal 2017.

Excluding the accelerated asset depreciation, costs associated with 
distribution center closures, inventory impairment, product recall adjustments 
and release of the anti-dumping duty reserve mentioned above, RH Segment gross 
margin would have increased 5.3% to 40.1% of net revenues in fiscal 2018 
compared to 34.8% of net revenues in fiscal 2017. The increase was related to 
improvements in our core merchandise margins as our SKU rationalization efforts 
had a reduced impact on our margins this year compared to last year, as well as 
increased outlet product margins due to higher outlet and warehouse sales 
during fiscal 2017 driven by increased promotions and higher discounts versus 
fiscal 2018. In addition, we achieved leverage in our occupancy costs primarily 
related to our distribution center network redesign. The overall increase in 
gross margin was partially offset by higher delivery costs and our investment 
in the ramping of our new RH Hospitality locations.

Waterworks gross profit

Waterworks gross profit increased $4.5 million, or 9.5%, to $51.5 million in 
fiscal 2018 compared to $47.1 million in fiscal 2017. As a percentage of net 
revenues, Waterworks gross margin increased 0.6% to 39.6% of net revenues in 
fiscal 2018 compared to 39.0% of net revenues in fiscal 2017. Excluding the 
impact of the amortization related to the inventory fair value adjustment 
mentioned above, Waterworks gross margin would have decreased 1.1% to 39.9% of 
net revenues in fiscal 2018 compared to 41.0% of net revenues in fiscal 2017. 
The decrease in gross margin is primarily due to SKU rationalization efforts in 
fiscal 2018, as well as deleverage in occupancy costs resulting from lower than 
expected revenue growth.

Selling, general and administrative expenses

Consolidated selling, general and administrative expenses decreased $6.1 
million, or 0.9%, to $711.6 million in fiscal 2018 compared to $717.8 million 
in fiscal 2017.

RH Segment selling, general and administrative expenses

RH Segment selling, general and administrative expenses decreased $7.5 million, 
or 1.1%, to $658.5 million in fiscal 2018 compared $666.1 million in fiscal 
2017.

RH Segment selling, general and administrative expenses for fiscal 2018 
included a $10.0 million charge related to reorganizations primarily due to 
streamlining and realigning our home office operations, as well as due to 
distribution center closures, $3.4 million related to remeasurement of RH 
Contemporary Art lease loss liability, $1.0 million related to product recalls, 
$0.3 million related to costs associated with distribution center closures and 
a favorable $5.3 million legal settlement, net of related legal expenses.

RH Segment selling, general and administrative expenses for fiscal 2017 
included $23.9 million related to a fully vested option grant made to Mr. 
Friedman in May 2017, $4.4 million related to remeasurement of RH Contemporary 
Art lease loss liability, $3.1 million costs associated with distribution 
center closures, $0.9 million reorganization charges, $0.2 million incremental 
costs associated with product recalls and a gain of $2.1 million related to the 
sale of building and land.

Employment and employee related costs, excluding the fully vested option grant 
to Mr. Friedman, and the severance costs associated with the reorganizations 
and distribution center closures mentioned above, increased $10.5 million 
during fiscal 2018 as compared to fiscal 2017, primarily related to incentive 
compensation.

Corporate expenses increased $9.5 million, primarily due to an increase in 
preopening expense associated with our Design Gallery openings and, to a lesser 
extent, an increase in credit card fees due to an increase in revenues.

Advertising and marketing costs decreased $8.9 million primarily due to the 
adoption of Topic 606 in the first quarter of fiscal 2018, which resulted in 
the costs associated with Source Books being fully expensed upon delivery to 
the carrier, as well as the timing of our Source Book mailings.

RH Segment selling, general and administrative expenses were 27.3% and 27.4% of 
net revenues for fiscal 2018 and fiscal 2017, respectively, excluding the 
reorganizations, the remeasurement of the lease liability associated with RH 
Contemporary Art, the product recalls, the distribution center closures, the 
legal settlement, the fully vested option grant made to Mr. Friedman in May 
2017 and the gain related to the sale of building and land mentioned above. The 
decrease in selling, general and administrative expenses as a percentage of net 
revenues was primarily driven by advertising and marketing, partially offset by 
preopening expense associated with our Design Gallery openings.

Waterworks selling, general and administrative expenses

Waterworks selling, general and administrative expenses increased $1.4 million, 
or 2.6%, to $53.1 million in fiscal 2018 compared to $51.7 million in fiscal 
2017. Waterworks selling, general and administrative expenses were 40.8% and 
42.8% of net revenues in fiscal 2018 and fiscal 2017, respectively. The 
decrease in selling, general and administrative expenses as a percentage of net 
revenues was primarily driven by leverage in corporate costs.

Interest expense—net

Interest expense increased $12.5 million to $75.1 million in fiscal 2018 
compared to $62.6 million in fiscal 2017.

Goodwill and tradename impairment

We incurred a $32.1 million goodwill and tradename impairment charge in fiscal 
2018 and a $33.7 million goodwill impairment charge in fiscal 2017 for our 
Waterworks reporting unit. Refer to “Impairment” within Note 3—Significant 
Accounting Policies in our consolidated financial statements for details 
regarding the impairment.

Loss on extinguishment of debt

We incurred a $0.9 million loss on extinguishment of debt in fiscal 2018 due to 
the repayment in full of the LILO term loan, the promissory note secured by our 
aircraft and the equipment security notes in June 2018, which includes 
acceleration of amortization of debt issuance costs of $0.6 million and a 
prepayment penalty of $0.3 million. We incurred a $4.9 million loss on 
extinguishment of debt in fiscal 2017 due to the repayment in full of the 
second lien term loan in October 2017, which includes a prepayment penalty of 
$3.0 million and acceleration of amortization of debt issuance costs of $1.9 
million.

Income tax expense

Income tax expense was $30.5 million in fiscal 2018 compared to $28.0 million 
in fiscal 2017. Our effective tax rate was 16.8% in fiscal 2018 compared to 
92.8% in fiscal 2017. The effective tax rate in fiscal 2018 was significantly 
impacted by discrete tax benefits related to net excess tax windfalls from 
stock-based compensation of $15.9 million resulting from increased option 
exercise activity and appreciation of the stock price, the Waterworks reporting 
unit goodwill impairment, as well as the reduction in the U.S. corporate income 
tax rate from 35% to 21% effective January 1, 2018 due to the passage of the 
Tax Cuts and Jobs Act (the “Tax Act”.) The effective tax rate in fiscal 2017 
was significantly impacted by non-deductible stock-based compensation related 
to the May 2017 grant to Mr. Friedman of an option to purchase 1,000,000 shares 
of the Company’s common stock. Refer to Note 16—Stock-Based Compensation in our 
consolidated financial statements for a description of the option grant to Mr. 
Friedman. In addition, the effective tax rate in fiscal 2017 was impacted by 
tax reform and the Waterworks reporting unit goodwill impairment. The fiscal 
2017 effective tax rate was favorably impacted by net excess tax benefits from 
stock-based compensation of $7.0 million.

The United States enacted the Tax Cuts and Jobs Act (the “Tax Act”) on December 
22, 2017. The new legislation contains several key tax provisions that affect 
us and, as required, we have included reasonable estimates of the income tax 
effects of the changes in tax law and tax rate in our fiscal 2017 financial 
results. Since the Tax Act was passed in the fourth quarter of fiscal 2017, we 
considered the accounting for the transition tax, deferred tax re-measurements, 
and other items to be provisional. As of February 2, 2019, we finalized our 
estimates within the one-year measurement period allowed by the SEC and 
completed our accounting for the tax effects of enactment of the Tax Act.

Our provision for income taxes in fiscal 2017 included $7.0 million of income 
tax expense as a result of the Tax Act, including $6.0 million for the 
provisional re-measurement of our net deferred tax assets for the reduction in 
the U.S. corporate income tax rate from 35% to 21% and a $1.0 million charge 
for our provisional estimate of the transition tax. We completed our accounting 
for re-measurement of our deferred tax assets and recorded $0.5 million of 
income tax expense as a result. No additional income tax expense or benefit was 
recorded relating to the completion of our transition tax liability.

Fiscal 2017 Compared to Fiscal 2016

Prior to the Waterworks acquisition on May 27, 2016, we had one reportable 
segment. As we acquired the Waterworks business on May 27, 2016, reportable 
segment information presented below for Waterworks includes results for 
thirty-five weeks during fiscal 2016 and includes results for fifty-three weeks 
during fiscal 2017. The RH Segment includes results for fifty-two weeks during 
fiscal 2016 and fifty-three weeks during fiscal 2017.

Waterworks results include non-cash amortization of $2.5 million and $6.8 
million related to the inventory fair value adjustment recorded in connection 
with our acquisition of Waterworks during fiscal 2017 and fiscal 2016, 
respectively. Waterworks results for fiscal 2016 also include a non-cash 
compensation charge of $3.7 million related to the fully vested option grants 
made in connection with our acquisition of Waterworks.


Net revenues

Consolidated net revenues increased $305.3 million, or 14.3%, to $2,440.2 
million in fiscal 2017 compared to $2,134.9 million in fiscal 2016. Stores net 
revenues increased $192.5 million, or 16.3%, to $1,371.3 million in fiscal 2017 
compared to $1,178.9 million in fiscal 2016. Direct net revenues increased 
$112.8 million, or 11.8%, to $1,068.8 million in fiscal 2017 compared to $956.0 
million in fiscal 2016. Comparable brand revenue was 6% for fiscal 2017.


RH Segment net revenues

RH Segment net revenues increased $259.3 million, or 12.6%, to $2,319.3 million 
in fiscal 2017 compared to $2,060.0 million in fiscal 2016. The below 
discussion highlights several significant factors that resulted in increased RH 
Segment net revenues, which are listed in order of magnitude.

RH Segment core net revenues increased due to the performance of our new Design 
Galleries and an increase in retail weighted-average leased selling square 
footage, as well as our decision to move the mailing of our 2016 Interiors 
Source Book to the fall of 2016. The 2016 Interiors Source Book mailing was 
complete in mid-December and therefore was a contributor to net revenues in 
fiscal 2017, whereas fiscal 2016 did not benefit from a similarly timed 
mailing.

Outlet sales, which include sales via warehouse locations, increased $61.1 
million in fiscal 2017 compared to fiscal 2016, representing 23.5% of the RH 
Segment net revenues growth. Increased outlet sales occurred primarily as a 
result of our inventory optimization efforts as we increased our outlet 
promotional activity and offered higher discounts, including through warehouse 
sales. We also increased outlet selling square footage by approximately 33% 
compared to the prior period.

In addition, RH Segment net revenues increased approximately $40.6 million due 
to fiscal 2017 representing fifty-three weeks of results, whereas fiscal 2016 
only included fifty-two weeks of results.

We introduced our membership program in March 2016, which provided a greater 
level of discount to our customers in most instances, but our recognition of 
membership fee revenue did not coincide with the timing of a customer order 
since the membership fee is recognized ratably over the 12 month period of 
membership. In fiscal 2017, we passed the first year anniversary of the launch 
of RH membership and as a result we were able to recognize a larger amount of 
Membership revenue versus 2016 and therefore we had an increase in Membership 
revenue recognized of $21.4 million.

During fiscal 2016, RH Segment net revenues were reduced by an estimated $16 
million due to customer accommodation and related expenses as a result of our 
initiative to elevate the customer experience, including in response to 
production delays related to RH Modern. We did not experience similar 
production delays during fiscal 2017. Additionally, RH Segment net revenues for 
fiscal 2017 and fiscal 2016 were negatively impacted by $3.2 million and $3.4 
million, respectively, related to the reduction of revenue associated with 
product recalls.

Waterworks net revenues

On May 27, 2016, we acquired a controlling interest in Waterworks. As a result 
of this acquisition, we acquired 15 Waterworks showrooms and included such 
additional retail stores in our weighted-average leased selling square footage 
for both fiscal 2017 and part of fiscal 2016. Waterworks net revenues increased 
$46.0 million, or 61.5%, to $120.8 million in fiscal 2017 compared to $74.8 
million in fiscal 2016. Waterworks net revenues represented 5.0% and 3.5% of 
our net revenues for fiscal 2017 and fiscal 2016, respectively. The increase in 
Waterworks net revenues is primarily due to fiscal 2017 representing 
fifty-three weeks of results, whereas fiscal 2016 only included thirty-five 
weeks of results as Waterworks was acquired on May 27, 2016.

Gross profit

Consolidated gross profit increased $169.3 million, or 24.9%, to $849.1 million 
in fiscal 2017 compared to $679.8 million in fiscal 2016. As a percentage of 
net revenues, gross margin increased 3.0% to 34.8% of net revenues in fiscal 
2017 compared to 31.8% of net revenues in fiscal 2016.

RH Segment gross profit for fiscal 2017 was positively impacted by $2.2 million 
related to the release of the remaining reserve for potential claims regarding 
anti-dumping duties which we believe have lapsed. RH Segment gross profit for 
fiscal 2016 was negatively impacted by $7.7 million related to the estimated 
cumulative impact of coupons redeemed in connection with a legal claim alleging 
that the Company violated California’s Song-Beverly Credit Card Act of 1971 by 
requesting and recording ZIP codes from customers paying with credit cards. The 
coupons expired in March 2016. RH Segment gross profit for fiscal 2016 was also 
negatively impacted by $4.0 million related to the reduction of revenue and 
costs associated with product recalls and $2.2 million due to inventory 
impairments related to RH Contemporary Art and RH Kitchen. RH Segment gross 
profit for fiscal 2017 was negatively impacted by $7.5 million related to the 
reduction of revenue, incremental costs and inventory charges associated with 
product recalls and $1.7 million related to costs associated with distribution 
center closures.

Waterworks gross profit for fiscal 2017 and fiscal 2016 was negatively impacted 
by $2.5 million and $6.8 million, respectively, of amortization related to the 
inventory fair value adjustment recorded in connection with the acquisition.

Excluding the release of the anti-dumping duty reserve, impact of the coupons 
redeemed in connection with the legal claim, product recall costs, RH 
Contemporary Art and RH Kitchen impairments, costs associated with the 
distribution center closures and amortization related to the inventory fair 
value adjustment mentioned above, consolidated gross margin would have 
increased 2.3% to 35.1% of net revenues in fiscal 2017 compared to 32.8% of net 
revenues in fiscal 2016.

RH Segment gross profit

RH Segment gross profit increased $145.8 million, or 22.2%, to $802.0 million 
in fiscal 2017 compared to $656.2 million in fiscal 2016. As a percentage of 
net revenues, RH Segment gross margin increased 2.7% to 34.6% of net revenues 
in fiscal 2017 compared to 31.9% of net revenues in fiscal 2016. Excluding the 
release of the anti-dumping duty reserve, impact of the coupons redeemed in 
connection with the legal claim, product recall costs, RH Contemporary Art and 
RH Kitchen impairments, and costs associated with distribution center closures 
mentioned above, RH Segment gross margin would have increased 2.3% to 34.8% of 
net revenues in fiscal 2017 compared to 32.5% of net revenues in fiscal 2016.

Merchandise margins were impacted by our SKU rationalization efforts that had a 
reduced impact on our margins this year compared to last year, partially offset 
by higher outlet and warehouse sales driven by increased promotions and higher 
discounts. In addition, gross margin increased due to leverage in our fiscal 
2017 shipping expense, as well as incremental shipping charges incurred during 
fiscal 2016 related to RH Modern production delays and our investment to 
elevate the customer experience. We also experienced cost leverage due to 
savings related to our newly introduced reverse logistics strategy. During 
fiscal 2017, we experienced leverage in our fixed distribution occupancy costs, 
partially offset by increased outlet occupancy costs.

Waterworks gross profit

Waterworks gross profit increased $23.5 million, or 99.5%, to $47.1 million in 
fiscal 2017 compared to $23.6 million in fiscal 2016. The increase in 
Waterworks gross profit is primarily due to fiscal 2017 representing 
fifty-three weeks of results, whereas fiscal 2016 included thirty-five weeks of 
results as Waterworks was acquired on May 27, 2016. As a percentage of net 
revenues, Waterworks gross margin increased 7.5% to 39.0% of net revenues in 
fiscal 2017 compared to 31.5% of net revenues in fiscal 2016. Excluding the 
impact of the amortization related to the inventory fair value adjustment 
mentioned above, Waterworks gross margin would have increased 0.3% to 41.0% of 
net revenues in fiscal 2017 compared to 40.7% of net revenues in fiscal 2016. 
The increase in gross margin is primarily due to a decline in product related 
reserves year over year, partially offset by deleverage in occupancy costs.

Selling, general and administrative expenses

Consolidated selling, general and administrative expenses increased $91.0 
million, or 14.5%, to $717.8 million in fiscal 2017 compared to $626.8 million 
in fiscal 2016.

RH Segment selling, general and administrative expenses

RH Segment selling, general and administrative expenses increased $75.8 
million, or 12.8%, to $666.1 million in fiscal 2017 compared $590.3 million in 
fiscal 2016. Employment and employment related costs increased $47.5 million in 
fiscal 2017 compared to fiscal 2016, which includes the fully vested option 
grant made to Mr. Friedman and severance expense associated with the 
distribution center closures and reorganization discussed below. Excluding the 
fully vested option grant and severance expense, the remaining increase in 
employment costs is primarily related to incentive compensation due to the 
Company achieving certain internal performance targets in fiscal 2017. In 
addition, advertising and marketing costs increased $26.3 million in fiscal 
2017 as compared to fiscal 2016, primarily due to the timing of our Source Book 
mailings. In fiscal 2017 we amortized costs related to our 2016 Interiors 
Source Book which was circulated in the fall of 2016. The 2016 Interiors Source 
Book mailing was complete in mid-December and therefore resulted in amortized 
costs in fiscal 2017, whereas fiscal 2016 did not incur similarly timed 
expenses.

RH Segment selling, general and administrative expenses for fiscal 2017 
included $23.9 million related to a fully vested option grant made to Mr. 
Friedman in May 2017, $4.4 million related to remeasurement of RH Contemporary 
Art lease loss liability, $3.1 million costs associated with distribution 
center closures, $0.9 million reorganization charges, $0.2 million incremental 
costs associated with product recalls and a gain of $2.1 million related to the 
sale of building and land.

RH Segment selling, general and administrative expenses for fiscal 2016 
included a $10.6 million impairment associated with RH Contemporary Art, $5.7 
million associated with a reorganization, including severance and related 
taxes, $4.8 million related to the impairment recorded due to the decision to 
sell an aircraft, $2.8 million related to charges and expenses incurred as a 
result of the Waterworks transaction, $1.0 million related to the estimated 
cumulative impact of coupons redeemed in connection with a legal claim alleging 
that the Company violated California’s Song-Beverly Credit Card Act of 1971 by 
requesting and recording ZIP codes from customers paying with credit cards, and 
$0.6 million in costs associated with product recalls.

RH Segment selling, general and administrative expenses were 27.4% of net 
revenues for both fiscal 2017 and fiscal 2016, respectively, excluding the 
fully vested option grant made to Mr. Friedman in May 2017, costs associated 
with distribution center closures, impairment and subsequent remeasurement of 
the lease liability associated with RH Contemporary Art, the product recall 
costs, the gain related to the sale of building and land, the reorganization 
costs, the impairment recorded due to the decisions to sell an aircraft, the 
charges and expenses incurred as a result of the Waterworks transaction, and 
the impact of coupons redeemed in connection with the legal claim mentioned 
above. Selling, general and administrative expenses as a percentage of net 
revenues decreased due to leverage in our employment and corporate occupancy 
costs, which was offset by an increase in advertising and marketing costs, as 
well as increased incentive compensation costs.

Waterworks selling, general and administrative expenses

Waterworks selling, general and administrative expenses increased $15.2 
million, or 41.8%, to $51.7 million in fiscal 2017 compared $36.5 million in 
fiscal 2016.

The increase in Waterworks selling, general and administrative expenses is 
primarily due to fiscal 2017 representing fifty-three weeks of results, whereas 
fiscal 2016 only includes thirty-five weeks of results as Waterworks was 
acquired on May 27, 2016. This increase is partially offset by stock-based 
compensation of $3.7 million related to the fully vested option grants made in 
connection with our acquisition of Waterworks in fiscal 2016.

Excluding the fully vested option grants made in connection with our 
acquisition of Waterworks, Waterworks selling, general and administrative 
expenses would have been 42.8% and 43.8% of net revenues in fiscal 2017 and 
fiscal 2016, respectively, with such decrease driven by leverage in corporate 
costs and advertising expenses partially offset by deleverage in employment and 
employment related costs.

Interest expense—net

Interest expense increased $18.1 million to $62.6 million in fiscal 2017 
compared to $44.5 million in fiscal 2016.

Goodwill and tradename impairment

We incurred a $33.7 million goodwill impairment in fiscal 2017 for our 
Waterworks reporting unit.

Loss on extinguishment of debt

We incurred a $4.9 million loss on extinguishment of debt in fiscal 2017 due to 
the repayment in full of the second lien term loan in October 2017, which 
includes a prepayment penalty of $3.0 million and acceleration of amortization 
of debt issuance costs of $1.9 million.

Income tax expense

Income tax expense was $28.0 million in fiscal 2017 compared to $3.2 million in 
fiscal 2016. Our effective tax rate was 92.8% in fiscal 2017 compared to 36.9% 
in fiscal 2016. The effective tax rate in fiscal 2017 was significantly 
impacted by non-deductible stock-based compensation related to the May 2017 
grant to Mr. Friedman of an option to purchase 1,000,000 shares of the 
Company’s common stock. Refer to Note 16—Stock-Based Compensation in our 
consolidated financial statements for a description of the option grant to Mr. 
Friedman. In addition, the effective tax rate in fiscal 2017 was impacted by 
tax reform and the Waterworks reporting unit goodwill impairment. The effective 
tax rate was favorably impacted by net excess tax benefits from stock-based 
compensation of $7.0 million.

The United States enacted the Tax Cuts and Jobs Act (the “Tax Act”) on December 
22, 2017. The new legislation contains several key tax provisions that affect 
us and, as required, we included reasonable estimates of the income tax effects 
of the changes in tax law and tax rate in our fiscal 2017 financial results. 
Since the Tax Act was passed in the fourth quarter of fiscal 2017, we 
considered the accounting for the transition tax, deferred tax re-measurements, 
and other items to be provisional as the charge may be adjusted due to changes 
in interpretations and assumptions we have made, guidance that may be issued, 
and actions we may take as a result of the tax legislation. As of February 2, 
2019, we finalized our estimates within the one-year measurement period allowed 
by the SEC.

Our provision for income taxes in fiscal 2017 included $7.0 million of income 
tax expense as a result of the Tax Act, including $6.0 million for the 
provisional re-measurement of our net deferred tax assets for the reduction in 
the U.S. corporate income tax rate from 35% to 21% and a $1.0 million charge 
for our provisional estimate of the transition tax.

Quarterly Results

Our quarterly results vary depending upon a variety of factors, including our 
product offerings, store openings, shifts in the timing of holidays, the timing 
of Source Book releases and promotional events, among other things. As a result 
of these factors, our working capital requirements and demands on our product 
distribution and delivery network may fluctuate during the year and results of 
a period shorter than a full year may not be indicative of results expected for 
the entire year.

Comparable brand revenue growth includes direct net revenues and retail 
comparable store sales, including RH Baby & Child, RH Modern Galleries and RH 
Hospitality. Comparable brand revenue growth excludes retail non-comparable 
store sales, closed store sales and outlet net revenues. Comparable store sales 
have been calculated based upon retail stores, excluding outlet stores, that 
were open at least fourteen full months as of the end of the reporting period 
and did not change square footage by more than 20% between periods. If a store 
is closed for seven days during a month, that month will be excluded from 
comparable store sales. Membership revenue was included in comparable brand 
revenue growth beginning April 2017, which is the first full month following 
the one-year anniversary of the program launch. Waterworks revenue was included 
in comparable brand revenue growth beginning June 2017, which is the first full 
month following the one-year anniversary of the acquisition. The impact on net 
revenues related to the product recalls in the second and fourth quarters of 
fiscal 2017 and second, third and fourth quarters of fiscal 2018 has been 
excluded from comparable brand revenue growth. Because fiscal 2017 was a 
53-week year, comparable brand revenue growth percentage for the fourth quarter 
of fiscal 2017 excludes the extra week of revenue.

Adjusted net income is a supplemental measure of financial performance that is 
not required by, or presented in accordance with, GAAP. We define adjusted net 
income as 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 
management 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 management uses this non-GAAP financial measure in 
order to have comparable financial results to analyze changes in our underlying 
business from quarter to quarter. Under GAAP, certain convertible debt 
instruments that may be settled in cash on conversion are required to be 
separately accounted for as liability and equity components of the instrument 
in a manner that reflects the issuer’s non-convertible debt borrowing rate. 
Accordingly, in accounting for GAAP purposes for the $350 million aggregate 
principal amount of convertible senior notes that were issued in June 2014 (the 
“2019 Notes”), for the $300 million aggregate principal amount of convertible 
senior notes that were issued in June and July 2015 (the “2020 Notes”) and for 
the $335 million aggregate principal amount of convertible senior notes that 
were issued in June 2018 (the “2023 Notes”), we separated the 2019 Notes, 2020 
Notes and 2023 Notes into liability (debt) and equity (conversion option) 
components and we are amortizing as debt discount an amount equal to the fair 
value of the equity components as interest expense on the 2019 Notes, 2020 
Notes and 2023 Notes over their expected lives. The equity components represent 
the difference between the proceeds from the issuance of the 2019 Notes, 2020 
Notes and 2023 Notes and the fair value of the liability components of the 2019 
Notes, 2020 Notes and 2023 Notes, respectively. Amounts are presented net of 
interest capitalized for capital projects of $0.7 million, $0.8 million, $0.8 
million and $0.2 million during the first, second, third and fourth quarters of 
fiscal 2017, respectively. Amounts are presented net of interest capitalized 
for capital projects of $0.6 million, $0.8 million, $0.7 million and $0.6 
million during the first, second, third and fourth quarters of fiscal 2018, 
respectively.

The adjustment for the second quarter of fiscal 2018 represents the loss on 
extinguishment of debt related to the LILO term loan, the promissory note 
secured by our aircraft and the equipment security notes, all of which were 
repaid in full in June 2018. The adjustment for the third quarter of fiscal 
2017 represents the loss on extinguishment of debt related to the second lien 
term loan which was repaid in full in October 2017.

The adjustments to calculate income tax expense for the first and third 
quarters of fiscal 2017 represent the tax effect of the adjusted items based on 
our effective tax rates of 36.2% and 32.1%, respectively. The adjustment for 
the second quarter of fiscal 2017 assumes a normalized tax rate of 39%. The 
adjustment for the fourth quarter of fiscal 2017 is based on an adjusted tax 
rate of 34.0% which excludes the impact of tax reform, including the $6.0 
million revaluation of the net deferred tax assets and $1.0 million 
transitional tax, as well as the $5.9 million tax impact associated with the 
Waterworks reporting unit goodwill impairment. The adjustments to calculate 
income tax expense for the first, second and third quarters of fiscal 2018 
represent the tax effect of the adjusted items based on our effective tax rates 
of 23.3%, 4.4% and 18.9%, respectively. The adjustment for the fourth quarter 
of fiscal 2018 is based on an adjusted tax rate of 21.8% and excludes a $3.6 
million tax impact associated with the Waterworks reporting unit goodwill 
impairment.

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, goodwill and tradename impairment, loss on extinguishment of 
debt and provision for income taxes. Adjusted EBITDA reflects further 
adjustments to EBITDA to eliminate the impact of non-cash compensation, as well 
as certain non-recurring and other items that we do not consider representative 
of our underlying operating performance. EBITDA and Adjusted EBITDA are 
included in this filing because management believes that these metrics provide 
meaningful supplemental information for investors regarding the performance of 
our business and facilitate a meaningful evaluation of operating results on a 
comparable basis with historical results. Our management uses this non-GAAP 
financial measure 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.


Liquidity and Capital Resources

General

The primary cash needs of our business have historically been for merchandise 
inventories, payroll, Source Books, store rent, capital expenditures associated 
with opening new stores and updating existing stores, as well as the 
development of our infrastructure and information technology. We seek out and 
evaluate opportunities for effectively managing and deploying capital in ways 
that improve working capital and support and enhance our business initiatives 
and strategies. In fiscal 2017, we completed two share repurchase programs in 
an aggregate amount of $1 billion. A $300 million share repurchase was 
completed during the first quarter of fiscal 2017 and a $700 million share 
repurchase was completed during the second quarter of fiscal 2017. In October 
2018, our Board of Directors approved a new $700 million share repurchase 
program, pursuant to which, during fiscal 2018, we repurchased approximately 
2.0 million shares of our common stock for an aggregate repurchase amount of 
approximately $250 million. Refer to “Share Repurchase Programs” below. We 
intend to evaluate our capital allocation from time to time and may engage in 
future share repurchases in circumstances where buying shares of our common 
stock represents a good value and provides a favorable return for our 
shareholders.

We have $985 million in aggregate principal amount of convertible notes 
outstanding, of which $350 million mature in June 2019, $300 million mature in 
June 2020 and $335 million mature in June 2023. In addition, the $350 million 
principal amount of convertible senior notes that matures in June 2019 becomes 
convertible by the holders on and after March 15, 2019 through the close of 
business on the second schedule trading day immediately preceding June 15, 
2019. At the time the notes become due, and prior to maturity to the extent the 
notes become convertible and a holder exercises such conversion right, the 
trading price of our common stock may be such that we find it necessary to 
settle the notes in cash. Based on free cash flow of $163 million in fiscal 
2018 and anticipated strong cash flow generation in 2019 and beyond, we expect 
to repay the outstanding principal of our $985 million convertible notes at 
maturity in June 2019, June 2020 and June 2023 in cash to minimize dilution. 
While we anticipate using free cash flow and borrowings on our revolving line 
of credit to repay the convertible notes in cash to minimize dilution, we may 
need to pursue additional sources of liquidity to repay such convertible notes 
in cash at their respective maturity dates. There can be no assurance as to the 
availability of capital to fund such repayments, or that if capital is 
available through additional debt issuances or refinancing of the convertible 
notes, that such capital will be available on terms that are favorable to us. 
We believe the strength of our business and the reduction in leverage we have 
achieved during the past year puts us in a strong position to take advantage of 
the capital markets opportunistically. We believe we have multiple financing 
alternatives available to us on favorable terms that could provide us with 
additional financial flexibility with respect to capital allocation.

We extended and amended our revolving line of credit in June 2017, which has a 
total availability of $600.0 million, of which $10.0 million is available to 
Restoration Hardware Canada, Inc., and includes a $200.0 million accordion 
feature under which the revolving line of credit may be expanded by agreement 
of the parties from $600.0 million to up to $800.0 million if and to the extent 
the lenders revise their credit commitments to encompass a larger facility. The 
revolving line of credit has a maturity date of June 28, 2022.

We believe that cash expected to be generated from operations, net cash 
proceeds from the issuance of the convertible senior notes, borrowing 
availability under the asset based credit facility and other financing 
arrangements will be sufficient to meet working capital requirements, 
anticipated capital expenditures and other capital needs for the next 12 
months.

Our business has relied on cash flows from operations, net cash proceeds from 
the issuance of the convertible senior notes, as well as borrowings under our 
credit facilities as our primary sources of liquidity. We have pursued in the 
past, and may pursue in the future, additional strategies to generate liquidity 
for our operations, including through the strategic sale of assets, utilization 
of our credit facilities, and entry into new debt financing arrangements that 
present attractive terms.

During the first quarter of fiscal 2017, we received cash of $4.9 million for 
the sale of an aircraft, net of $0.3 million of costs to dispose of the 
aircraft, which was classified as an asset held for sale, and during the second 
quarter of fiscal 2017 we received cash of $10.2 million for the sale of a real 
estate parcel that we owned on which one of our retail Galleries was located, 
which was classified as an asset held for sale. We may in the future pursue 
additional strategies, through the use of existing assets and debt facilities, 
or through the pursuit of new external sources of liquidity and debt 
financings, to fund our strategies to enhance stockholder value. There can be 
no assurance that additional capital, whether raised through the sale of 
assets, utilization of our existing debt financing sources, or pursuit of 
additional debt financing sources, will be available to us on a timely manner, 
on favorable terms or at all. To the extent we pursue additional debt as a 
source of liquidity, our capitalization profile may change and may include 
significant leverage, and as a result we may be required to use future 
liquidity to repay such indebtedness and may be subject to additional terms and 
restrictions which affect our operations and future uses of capital.

In addition, our capital needs may change in the future due to changes in our 
business or new opportunities that we choose to pursue. We have invested 
significant capital expenditures in remodeling and opening new Design 
Galleries, and these capital expenditures have increased in the past and may 
continue to increase in future periods as we open additional Design Galleries, 
which may require us to undertake upgrades to historical buildings or 
construction of new buildings. During fiscal 2018, our investments in capital 
expenditures totaled $136.7 million.

We anticipate our gross capital expenditures to be $165 million to $185 million 
in fiscal 2019, primarily related to our efforts to continue our growth and 
expansion, including construction of new Design Galleries and infrastructure 
investments. We anticipate that our fiscal 2019 capital expenditures will be 
partially offset by proceeds from sales of assets of $50 million to $60 
million.

Certain of our current 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, we do not expect to receive contributions directly from our 
landlords related to the building of our Design Galleries under these 
arrangements. Other lease arrangements require the landlord to fund a portion 
of the construction related costs through payments directly to us. As we 
develop new Galleries, as well as other potential strategic initiatives in the 
future like our integrated hospitality experience, we may explore other models 
for our real estate, which could include longer lease terms or further 
purchases of, or joint ventures or other forms of equity ownership in, real 
estate interests associated with new sites and buildings. These approaches 
might require greater capital investment on our part than a traditional store 
lease with a landlord. We also believe there is an opportunity to transition 
our real estate strategy from a leasing model to a development model, where we 
potentially buy and develop our Design Galleries then recoup the investments 
through a sale leaseback arrangement resulting in lower capital investment and 
lower rent. In the event that such capital and other expenditures require us to 
pursue additional funding sources, we can provide no assurances that we will be 
successful in securing additional funding on attractive terms or at all.

There can be no assurance that we will have sufficient financial resources, or 
will be able to arrange financing on favorable terms to the extent necessary to 
fund all of our initiatives, or that sufficient incremental debt will be 
available to us in order to fund our cash payments in respect of the repayment 
of our outstanding convertible senior notes in an aggregate principal amount of 
$985 million at maturity of such senior convertible notes. In addition, 
agreements governing existing or new debt facilities may restrict our ability 
to operate our business in the manner we currently expect or to make required 
payments with respect to existing commitments including the repayment of the 
principal amount of our convertible senior notes in cash upon maturity of such 
senior notes. To the extent we need to seek waivers from any provider of debt 
financing, or we fail to observe the covenants or other requirements of 
existing or new debt facilities, any such event could have an impact on our 
other commitments and obligations including triggering cross defaults or other 
consequences with respect to other indebtedness. Our current level of 
indebtedness, and any additional indebtedness that we may incur, exposes us to 
certain risks with regards to interest rate increases and fluctuations. Our 
ability to make interest payments or to refinance any of our indebtedness to 
manage such interest rates may be limited or negatively affected by credit 
market conditions, macroeconomic trends and other risks.

Any weakening of, or other adverse developments in, the U.S. or global credit 
markets could affect our ability to manage our debt obligations and our ability 
to access future debt. We cannot assure you that we will be able to raise 
necessary funds on favorable terms, if at all, or that future financing 
requirements would not require us to raise money through an equity financing or 
by other means that could be dilutive to holders of our capital stock. If we 
fail to raise sufficient additional funds, we may be required to delay or 
abandon some of our planned future expenditures or aspects of our current 
operations.

Cash Flow Analysis

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 fiscal 2018, net cash provided by operating activities was $300.6 million 
and consisted of net income of $150.6 million, non-cash items of $190.8 
million, partially offset by an increase in cash used for working capital and 
other activities of $40.8 million. Working capital and other activities 
consisted primarily of increases in prepaid expenses and other current assets 
of $28.5 million related to (i) adoption of Topic 606, (ii) vendor deposits and 
(iii) federal and state tax receivables due to prepayments, increases in 
accounts receivable of $8.9 million and increases in inventory of $7.4 million. 
These decreases to working capital were partially offset by increases in 
deferred revenue and customer deposits of $8.4 million.

For fiscal 2017, net cash provided by operating activities was $556.8 million 
and consisted of net income of $2.2 million, non-cash items of $218.6 million 
and a decrease in cash used for working capital and other activities of $336.0 
million. Working capital and other activities consisted primarily of decreases 
in inventory of $220.8 million due to our SKU rationalization initiative, 
outlet inventory optimization efforts and revised supply chain strategy, as 
well as increases in accounts payable and accrued liabilities of $64.5 million 
related to timing of payments. We also had decreases in prepaid expenses and 
other current assets of $44.3 million primarily due to amortization of our 
capitalized catalog costs, reduction in prepaid rent and a reduction of federal 
and state tax receivables.

For fiscal 2016, net cash provided by operating activities was $80.5 million 
and consisted of net income of $5.4 million and non-cash items of $150.8 
million, partially offset by an increase in cash used for working capital and 
other activities of $75.7 million. Working capital and other activities 
consisted primarily of decreases in accounts payable and accrued liabilities of 
$50.3 million related to timing of payments, increases in prepaid expenses of 
$35.2 million related to the timing of the distribution of our Interiors Source 
Book and estimated federal tax payments and decreases in other current 
liabilities of $23.8 million related to payments for federal and state tax 
liabilities. This was partially offset by increases in deferred revenue and 
customer deposits of $24.0 million and an increase in other non-current 
obligations of $8.7 million primarily due to a deferred contract incentive 
payment.

Net Cash Provided By (Used In) Investing Activities

Investing activities consist primarily of investments in capital expenditures 
related to new Design Galleries, investments in supply chain and systems 
infrastructure, acquisition of businesses, as well as activities associated 
with investing in available-for-sale securities.

For fiscal 2018, net cash used in investing activities was $136.7 million due 
to investments in new Galleries, information technology and systems 
infrastructure, and supply chain investments.

For fiscal 2017, net cash provided by investing activities was $44.7 million 
primarily as a result of sales and maturities of investments in 
available-for-sale securities of $145.0 million and $46.9 million, 
respectively, the proceeds of which were used to fund the share repurchases 
made under the Fiscal 2017 $300 Million Repurchase Program. In addition, we had 
net proceeds from the sale of building and land and the sale of an aircraft of 
$10.2 million and $4.9 million, respectively. These increases to cash were 
partially offset by investments in new Galleries, information technology and 
systems infrastructure, and supply chain investments of $146.2 million and 
purchases of investments in available-for-sale securities of $16.1 million.

For fiscal 2016, net cash used in investing activities was $310.5 million 
primarily due to $170.0 million of investments in new Galleries, information 
technology and systems infrastructure, supply chain, and other corporate 
assets, as well as our acquisition of Waterworks, net of cash acquired, of 
$116.1 million. In addition, we made purchases of investments in 
available-for-sale securities of $248.5 million, partially offset by maturities 
and sales of such investments of $187.3 million and $37.1 million, 
respectively.

Net Cash Used In Financing Activities

Financing activities consist primarily of borrowings related to the convertible 
senior notes offerings, credit facilities and other financing arrangements, as 
well as share repurchases and other equity related transactions.

For fiscal 2018, net cash used in financing activities was $183.2 million 
primarily due to net repayments of debt of $254.4 million under the asset based 
credit facility, LILO term loan, equipment loans and promissory note secured by 
our aircraft, as well as due to $250 million of share repurchases made under 
the Fiscal 2018 $700 Million Repurchase Program. The repayments of debt 
described above were partially funded by the $335 million convertible senior 
notes issued in June 2018, which provided net proceeds of $287.8 million after 
taking into consideration the convertible note hedge and warrant transactions, 
as well as discounts upon original issuance and offering costs. Equity related 
transactions provided $34.5 million due to $44.0 million of proceeds from 
exercise of employee stock options, partially offset by $9.5 million of cash 
paid for employee taxes related to net settlement of equity awards

For fiscal 2017, net cash used in financing activities was $691.4 million 
primarily due to $1.0 billion of share repurchases made under the Fiscal 2017 
$300 Million Repurchase Program and Fiscal 2017 $700 Million Repurchase 
Program. Cash funding for the share repurchase programs was provided by 
available cash balances, net borrowings under the asset based credit facility 
of $200.0 million, as well as borrowings under the term loans of $180.0 
million, borrowings under loans secured by certain equipment of $20.0 million 
and borrowings under a promissory note secured by our aircraft of $14.0 
million. Proceeds from exercise of employee stock options were $24.9 million. 
The cash provided by these financing activities was partially offset by the 
repayment of the second lien term loan, including the prepayment penalty, of 
$103.0 million, $10.2 million of payments on build-to-suit lease transactions, 
debt issuance costs of $8.3 million and $5.8 million cash paid for employee 
taxes related to net settlement of equity awards.

For fiscal 2016, net cash used in financing activities was $2.2 million 
primarily due to tax shortfalls from the exercise of stock options of $3.3 
million and cash paid for employee taxes related to net settlement of equity 
awards of $1.6 million. The cash used in these financing activities was 
partially offset by net proceeds from the exercise of stock options of $3.3 
million.

Non-Cash Transactions

Non-cash transactions consist of non-cash additions of property and equipment 
and the issuance of notes payable related to share repurchases from former 
employees.

Build-to-Suit Lease Transactions

The non-cash additions of property and equipment due to build-to-suit lease 
transactions are the result of the accounting requirements of Accounting 
Standards Codification (“ASC”) 840—Leases (“ASC 840”) for those construction 
projects for which we are the “deemed owner” of the construction project given 
the extent to which we are involved in constructing the leased asset. If we are 
the “deemed owner” for accounting purposes, upon commencement of the 
construction project, we are required to capitalize contributions by the 
landlord toward construction as property and equipment on our consolidated 
balance sheets. The contributions by the landlord toward construction, 
including the building, existing site improvements at construction commencement 
and any amounts paid by the landlord to those responsible for construction, are 
included as property and equipment additions due to build-to-suit lease 
transactions within the non-cash section of our consolidated statements of cash 
flows.

Over the lease term, these non-cash additions to property and equipment due to 
build-to-suit lease transactions do not impact our cash outflows, nor do they 
impact net income within our consolidated statements of income.

Convertible Senior Notes

0.00% Convertible Senior Notes due 2023

In June 2018, we issued in a private offering $300 million principal amount of 
0.00% convertible senior notes due 2023 and issued an additional $35 million 
principal amount in connection with the overallotment option granted to the 
initial purchasers as part of the offering (collectively, the “2023 Notes”). 
The 2023 Notes are governed by the terms of an indenture between us and U.S. 
Bank National Association, as the Trustee. The 2023 Notes will mature on June 
15, 2023, unless earlier purchased by us or converted. The 2023 Notes will not 
bear interest, except that the 2023 Notes will be subject to “special interest” 
in certain limited circumstances in the event of our failure to perform certain 
of our obligations under the indenture governing the 2023 Notes. The 2023 Notes 
are unsecured obligations and do not contain any financial covenants or 
restrictions on the payments of dividends, the incurrence of indebtedness or 
the issuance or repurchase of securities by us or any of our subsidiaries. 
Certain events are also considered “events of default” under the 2023 Notes, 
which may result in the acceleration of the maturity of the 2023 Notes, as 
described in the indenture governing the 2023 Notes.

The initial conversion rate applicable to the 2023 Notes is 5.1640 shares of 
common stock per $1,000 principal amount of 2023 Notes, which is equivalent to 
an initial conversion price of approximately $193.65 per share. The conversion 
rate will be subject to adjustment upon the occurrence of certain specified 
events, but will not be adjusted for any accrued and unpaid special interest. 
In addition, upon the occurrence of a “make-whole fundamental change” as 
defined in the indenture, we will, in certain circumstances, increase the 
conversion rate by a number of additional shares for a holder that elects to 
convert its 2023 Notes in connection with such make-whole fundamental change.

Prior to March 15, 2023, the 2023 Notes will be convertible only under the 
following circumstances: (1) during any calendar quarter commencing after 
September 30, 2018, if, for at least 20 trading days (whether or not 
consecutive) during the 30 consecutive trading day period ending on the last 
trading day of the immediately preceding calendar quarter, the last reported 
sale price of our common stock on such trading day is greater than or equal to 
130% of the applicable conversion price on such trading day; (2) during the 
five consecutive business day period after any ten consecutive trading day 
period in which, for each day of that period, the trading price per $1,000 
principal amount of 2023 Notes for such trading day was less than 98% of the 
product of the last reported sale price of our common stock and the applicable 
conversion rate on such trading day; or (3) upon the occurrence of specified 
corporate transactions. As of February 2, 2019, none of these conditions have 
occurred and, as a result, the 2023 Notes are not convertible as of February 2, 
2019. On and after March 15, 2023, until the close of business on the second 
scheduled trading day immediately preceding the maturity date, holders may 
convert all or a portion of their 2023 Notes at any time, regardless of the 
foregoing circumstances. Upon conversion, the 2023 Notes will be settled, at 
our election, in cash, shares of our common stock, or a combination of cash and 
shares of our common stock.

We may not redeem the 2023 Notes; however, upon the occurrence of a fundamental 
change (as defined in the indenture governing the notes), holders may require 
us to purchase all or a portion of their 2023 Notes for cash at a price equal 
to 100% of the principal amount of the 2023 Notes to be purchased plus any 
accrued and unpaid special interest to, but excluding, the fundamental change 
purchase date.

Under GAAP, certain convertible debt instruments that may be settled in cash on 
conversion are required to be separately accounted for as liability and equity 
components of the instrument in a manner that reflects the issuer’s 
non-convertible debt borrowing rate. Accordingly, in accounting for the 
issuance of the 2023 Notes, we separated the 2023 Notes into liability and 
equity components. The carrying amount of the liability component was 
calculated by measuring the fair value of a similar liability that does not 
have an associated convertible feature. The carrying amount of the equity 
component, which is recognized as a debt discount, represents the difference 
between the proceeds from the issuance of the 2023 Notes and the fair value of 
the liability component of the 2023 Notes. The excess of the principal amount 
of the liability component over its carrying amount (“debt discount”) will be 
amortized to interest expense using an effective interest rate of 6.35% over 
the expected life of the 2023 Notes. The equity component is not remeasured as 
long as it continues to meet the conditions for equity classification.

In accounting for the debt issuance costs related to the issuance of the 2023 
Notes, we allocated the total amount incurred to the liability and equity 
components based on their relative values. Debt issuance costs attributable to 
the liability component are amortized to interest expense using the effective 
interest method over the expected life of the 2023 Notes, and debt issuance 
costs attributable to the equity component are netted with the equity component 
in stockholders’ equity (deficit).

Debt issuance costs related to the 2023 Notes were comprised of discounts upon 
original issuance of $1.7 million and third party offering costs of $4.6 
million. Discounts and third party offering costs attributable to the liability 
component were recorded as a contra-liability and are presented net against the 
convertible senior notes due 2023 balance on the consolidated balance sheets.

2023 Notes—Convertible Bond Hedge and Warrant Transactions

In connection with the offering of the 2023 Notes and the exercise of the 
overallotment option in June 2018, we entered into convertible note hedge 
transactions whereby we have the option to purchase a total of approximately 
1.7 million shares of our common stock at a price of approximately $193.65 per 
share. The total cost of the convertible note hedge transactions was $91.9 
million. In addition, we sold warrants whereby the holders of the warrants have 
the option to purchase a total of approximately 1.7 million shares of our 
common stock at a price of $309.84 per share. The warrants contain certain 
adjustment mechanisms whereby the total number of shares to be purchased under 
such warrants may be increased up to a cap of 3.5 million shares of common 
stock (which cap may also be subject to adjustment). We received $51.0 million 
in cash proceeds from the sale of these warrants. Taken together, the purchase 
of the convertible note hedges and sale of the warrants are intended to offset 
any actual earnings dilution from the conversion of the 2023 Notes until our 
common stock is above approximately $309.84 per share. As these transactions 
meet certain accounting criteria, the convertible note hedges and warrants are 
recorded in stockholders’ equity (deficit), are not accounted for as 
derivatives and are not remeasured each reporting period. The net costs 
incurred in connection with the convertible note hedge and warrant transactions 
were recorded as a reduction to additional paid-in capital on the consolidated 
balance sheets.

We recorded a deferred tax liability of $22.3 million in connection with the 
debt discount associated with the 2023 Notes and recorded a deferred tax asset 
of $22.5 million in connection with the convertible note hedge transactions. 
The deferred tax liability and deferred tax asset are recorded in deferred tax 
assets on the consolidated balance sheets.

0.00% Convertible Senior Notes due 2020

In June 2015, we issued in a private offering $250 million principal amount of 
0.00% convertible senior notes due 2020 and, in July 2015, we issued an 
additional $50 million principal amount pursuant to the exercise of the 
overallotment option granted to the initial purchasers as part of our June 2015 
offering (collectively, the “2020 Notes”). The 2020 Notes are governed by the 
terms of an indenture between us and U.S. Bank National Association, as the 
Trustee. The 2020 Notes will mature on July 15, 2020, unless earlier purchased 
by us or converted. The 2020 Notes will not bear interest, except that the 2020 
Notes will be subject to “special interest” in certain limited circumstances in 
the event of our failure to perform certain of our obligations under the 
indenture governing the 2020 Notes. The 2020 Notes are unsecured obligations 
and do not contain any financial covenants or restrictions on the payments of 
dividends, the incurrence of indebtedness or the issuance or repurchase of 
securities by us or any of our subsidiaries. Certain events are also considered 
“events of default” under the 2020 Notes, which may result in the acceleration 
of the maturity of the 2020 Notes, as described in the indenture governing the 
2020 Notes. The 2020 Notes are guaranteed by our primary operating subsidiary, 
Restoration Hardware, Inc., as Guarantor. The guarantee is the unsecured 
obligation of the Guarantor and is subordinated to the Guarantor’s obligations 
from time to time with respect to its credit agreement and ranks equal in right 
of payment with respect to Guarantor’s other obligations.

The initial conversion rate applicable to the 2020 Notes is 8.4656 shares of 
common stock per $1,000 principal amount of 2020 Notes, which is equivalent to 
an initial conversion price of approximately $118.13 per share. The conversion 
rate will be subject to adjustment upon the occurrence of certain specified 
events, but will not be adjusted for any accrued and unpaid special interest. 
In addition, upon the occurrence of a “make-whole fundamental change” as 
defined in the indenture, we will, in certain circumstances, increase the 
conversion rate by a number of additional shares for a holder that elects to 
convert its 2020 Notes in connection with such make-whole fundamental change.

Prior to March 15, 2020, the 2020 Notes will be convertible only under the 
following circumstances: (1) during any calendar quarter commencing after 
September 30, 2015, if, for at least 20 trading days (whether or not 
consecutive) during the 30 consecutive trading day period ending on the last 
trading day of the immediately preceding calendar quarter, the last reported 
sale price of our common stock on such trading day is greater than or equal to 
130% of the applicable conversion price on such trading day; (2) during the 
five consecutive business day period after any ten consecutive trading day 
period in which, for each day of that period, the trading price per $1,000 
principal amount of 2020 Notes for such trading day was less than 98% of the 
product of the last reported sale price of our common stock and the applicable 
conversion rate on such trading day; or (3) upon the occurrence of specified 
corporate transactions. As of February 2, 2019, none of these conditions have 
occurred and, as a result, the 2020 Notes are not convertible as of February 2, 
2019. On and after March 15, 2020, until the close of business on the second 
scheduled trading day immediately preceding the maturity date, holders may 
convert all or a portion of their 2020 Notes at any time, regardless of the 
foregoing circumstances. Upon conversion, the 2020 Notes will be settled, at 
our election, in cash, shares of our common stock, or a combination of cash and 
shares of our common stock.

We may not redeem the 2020 Notes; however, upon the occurrence of a fundamental 
change (as defined in the indenture governing the notes), holders may require 
us to purchase all or a portion of their 2020 Notes for cash at a price equal 
to 100% of the principal amount of the 2020 Notes to be purchased plus any 
accrued and unpaid special interest to, but excluding, the fundamental change 
purchase date.

Under GAAP, certain convertible debt instruments that may be settled in cash on 
conversion are required to be separately accounted for as liability and equity 
components of the instrument in a manner that reflects the issuer’s 
non-convertible debt borrowing rate. Accordingly, in accounting for the 
issuance of the 2020 Notes, we separated the 2020 Notes into liability and 
equity components. The carrying amount of the liability component was 
calculated by measuring the fair value of a similar liability that does not 
have an associated convertible feature. The carrying amount of the equity 
component, which is recognized as a debt discount, represents the difference 
between the proceeds from the issuance of the 2020 Notes and the fair value of 
the liability component of the 2020 Notes. The debt discount will be amortized 
to interest expense using an effective interest rate of 6.47% over the expected 
life of the 2020 Notes. The equity component is not remeasured as long as it 
continues to meet the conditions for equity classification.

In accounting for the debt issuance costs related to the issuance of the 2020 
Notes, we allocated the total amount incurred to the liability and equity 
components based on their relative values. Debt issuance costs attributable to 
the liability component are amortized to interest expense using the effective 
interest method over the expected life of the 2020 Notes, and debt issuance 
costs attributable to the equity component are netted with the equity component 
in stockholders’ equity (deficit).

Debt issuance costs related to the 2020 Notes were comprised of discounts upon 
original issuance of $3.8 million and third party offering costs of $2.3 
million. Discounts and third party offering costs attributable to the liability 
component were recorded as a contra-liability and are presented net against the 
convertible senior notes due 2020 balance on the consolidated balance sheets.

2020 Notes—Convertible Bond Hedge and Warrant Transactions

In connection with the offering of the 2020 Notes in June 2015 and the exercise 
in full of the overallotment option in July 2015, we entered into convertible 
note hedge transactions whereby we have the option to purchase a total of 
approximately 2.5 million shares of our common stock at a price of 
approximately $118.13 per share. The total cost of the convertible note hedge 
transactions was $68.3 million. In addition, we sold warrants whereby the 
holders of the warrants have the option to purchase a total of approximately 
2.5 million shares of our common stock at a price of $189.00 per share. The 
warrants contain certain adjustment mechanisms whereby the total number of 
shares to be purchased under such warrants may be increased up to a cap of 5.1 
million shares of common stock (which cap may also be subject to adjustment). 
We received $30.4 million in cash proceeds from the sale of these warrants. 
Taken together, the purchase of the convertible note hedges and sale of the 
warrants are intended to offset any actual earnings dilution from the 
conversion of the 2020 Notes until our common stock is above approximately 
$189.00 per share. As these transactions meet certain accounting criteria, the 
convertible note hedges and warrants are recorded in stockholders’ equity 
(deficit), are not accounted for as derivatives and are not remeasured each 
reporting period. The net costs incurred in connection with the convertible 
note hedge and warrant transactions were recorded as a reduction to additional 
paid-in capital on the consolidated balance sheets.

We recorded a deferred tax liability of $32.8 million in connection with the 
debt discount associated with the 2020 Notes and recorded a deferred tax asset 
of $26.6 million in connection with the convertible note hedge transactions. 
The deferred tax liability and deferred tax asset are recorded in deferred tax 
assets on the consolidated balance sheets.

Our provision for income taxes in fiscal 2017 included $1.1 million of income 
tax benefit as a result of the Tax Act for the provisional re-measurement of 
the deferred tax asset and liability related to the 2020 Notes for the 
reduction in the U.S. corporate income tax rate from 35% to 21%.

0.00% Convertible Senior Notes due 2019

In June 2014, we issued $350 million aggregate principal amount of 0.00% 
convertible senior notes due 2019 (the “2019 Notes”) in a private offering. The 
2019 Notes are governed by the terms of an indenture between us and U.S. Bank 
National Association, as the Trustee. The 2019 Notes will mature on June 15, 
2019, unless earlier purchased by us or converted. The 2019 Notes will not bear 
interest, except that the 2019 Notes will be subject to “special interest” in 
certain limited circumstances in the event of our failure to perform certain of 
our obligations under the indenture governing the 2019 Notes. The 2019 Notes 
are unsecured obligations and do not contain any financial covenants or 
restrictions on the payments of dividends, the incurrence of indebtedness or 
the issuance or repurchase of securities by us or any of our subsidiaries. 
Certain events are also considered “events of default” under the 2019 Notes, 
which may result in the acceleration of the maturity of the 2019 Notes, as 
described in the indenture governing the 2019 Notes.

The initial conversion rate applicable to the 2019 Notes is 8.6143 shares of 
common stock per $1,000 principal amount of 2019 Notes, which is equivalent to 
an initial conversion price of approximately $116.09 per share. The conversion 
rate will be subject to adjustment upon the occurrence of certain specified 
events, but will not be adjusted for any accrued and unpaid special interest. 
In addition, upon the occurrence of a “make-whole fundamental change,” we will, 
in certain circumstances, increase the conversion rate by a number of 
additional shares for a holder that elects to convert its 2019 Notes in 
connection with such make-whole fundamental change.

Prior to March 15, 2019, the 2019 Notes will be convertible only under the 
following circumstances: (1) during any calendar quarter commencing after 
September 30, 2014, if, for at least 20 trading days (whether or not 
consecutive) during the 30 consecutive trading day period ending on the last 
trading day of the immediately preceding calendar quarter, the last reported 
sale price of our common stock on such trading day is greater than or equal to 
130% of the applicable conversion price on such trading day; (2) during the 
five consecutive business day period after any ten consecutive trading day 
period in which, for each day of that period, the trading price per $1,000 
principal amount of 2019 Notes for such trading day was less than 98% of the 
product of the last reported sale price of our common stock and the applicable 
conversion rate on such trading day; or (3) upon the occurrence of specified 
corporate transactions. As of February 2, 2019, none of these conditions have 
occurred and, as a result, the 2019 Notes are not convertible as of February 2, 
2019. On and after March 15, 2019, until the close of business on the second 
scheduled trading day immediately preceding the maturity date, holders may 
convert all or a portion of their 2019 Notes at any time, regardless of the 
foregoing circumstances. Upon conversion, the 2019 Notes will be settled, at 
our election, in cash, shares of our common stock, or a combination of cash and 
shares of our common stock.

We may not redeem the 2019 Notes; however, upon the occurrence of a fundamental 
change (as defined in the indenture governing the notes), holders may require 
us to purchase all or a portion of their 2019 Notes for cash at a price equal 
to 100% of the principal amount of the 2019 Notes to be purchased plus any 
accrued and unpaid special interest to, but excluding, the fundamental change 
purchase date.

Under GAAP, certain convertible debt instruments that may be settled in cash on 
conversion are required to be separately accounted for as liability and equity 
components of the instrument in a manner that reflects the issuer’s 
non-convertible debt borrowing rate. Accordingly, in accounting for the 
issuance of the 2019 Notes, we separated the 2019 Notes into liability and 
equity components. The carrying amount of the liability component was 
calculated by measuring the fair value of a similar liability that does not 
have an associated convertible feature. The carrying amount of the equity 
component, which is recognized as a debt discount, represents the difference 
between the proceeds from the issuance of the 2019 Notes and the fair value of 
the liability component of the 2019 Notes. The debt discount will be amortized 
to interest expense using an effective interest rate of 4.51% over the expected 
life of the 2019 Notes. The equity component is not remeasured as long as it 
continues to meet the conditions for equity classification.

In accounting for the debt issuance costs related to the issuance of the 2019 
Notes, we allocated the total amount incurred to the liability and equity 
components based on their relative values. Debt issuance costs attributable to 
the liability component are amortized to interest expense using the effective 
interest method over the expected life of the 2019 Notes, and debt issuance 
costs attributable to the equity component are netted with the equity component 
in stockholders’ equity (deficit).

Debt issuance costs related to the 2019 Notes were comprised of discounts and 
commissions payable to the initial purchasers of $4.4 million and third party 
offering costs of $1.0 million. Discounts, commissions payable to the initial 
purchasers and third party offering costs attributable to the liability 
component were recorded as a contra-liability and are presented net against the 
convertible senior notes due 2019 balance on the consolidated balance sheets.

2019 Notes—Convertible Bond Hedge and Warrant Transactions

In connection with the offering of the 2019 Notes, we entered into convertible 
note hedge transactions whereby we have the option to purchase a total of 
approximately 3.0 million shares of our common stock at a price of 
approximately $116.09 per share. The total cost of the convertible note hedge 
transactions was $73.3 million. In addition, we sold warrants whereby the 
holders of the warrants have the option to purchase a total of approximately 
3.0 million shares of our common stock at a price of $171.98 per share. The 
warrants contain certain adjustment mechanisms whereby the total number of 
shares to be purchased under such warrants may be increased up to a cap of 6.0 
million shares of common stock (which cap may also be subject to adjustment). 
We received $40.4 million in cash proceeds from the sale of these warrants. 
Taken together, the purchase of the convertible note hedges and sale of the 
warrants are intended to offset any actual dilution from the conversion of the 
2019 Notes and to effectively increase the overall conversion price from 
$116.09 per share to $171.98 per share. As these transactions meet certain 
accounting criteria, the convertible note hedges and warrants are recorded in 
stockholders’ equity (deficit) and are not accounted for as derivatives. The 
net costs incurred in connection with the convertible note hedge and warrant 
transactions were recorded as a reduction to additional paid-in capital on the 
consolidated balance sheets.

We recorded a deferred tax liability of $27.5 million in connection with the 
debt discount associated with the 2019 Notes and recorded a deferred tax asset 
of $28.6 million in connection with the convertible note hedge transactions. 
The deferred tax liability and deferred tax asset are recorded in deferred tax 
assets on the consolidated balance sheets.

Our provision for income taxes in fiscal 2017 included $0.1 million of income 
tax expense as a result of the Tax Act for the provisional re-measurement of 
the deferred tax asset and liability related to the 2019 Notes for the 
reduction in the U.S. corporate income tax rate from 35% to 21%.

Asset Based Credit Facility

In August 2011, Restoration Hardware, Inc., along with its Canadian subsidiary, 
Restoration Hardware Canada, Inc., entered into a credit agreement with Bank of 
America, N.A., as administrative agent, and certain other lenders. On June 28, 
2017, Restoration Hardware, Inc. entered into an eleventh amended and restated 
credit agreement among Restoration Hardware, Inc., Restoration Hardware Canada, 
Inc., various subsidiaries of RH named therein as borrowers or guarantors, the 
lenders party thereto and Bank of America, N.A. as administrative agent and 
collateral agent (the “credit agreement”). The credit agreement has a revolving 
line of credit with availability of up to $600.0 million, of which $10.0 
million is available to Restoration Hardware Canada, Inc., and includes a 
$200.0 million accordion feature under which the revolving line of credit may 
be expanded by agreement of the parties from $600.0 million to up to $800.0 
million if and to the extent the lenders revise their credit commitments to 
encompass a larger facility. In addition, the credit agreement established an 
$80.0 million LILO term loan facility which was repaid in full in June 2018. As 
a result of the repayment, we incurred a $0.5 million loss on extinguishment of 
debt in the nine months ended November 3, 2018, which represents the 
acceleration of amortization of debt issuance costs. We did not incur any 
prepayment penalties upon the early extinguishment of the LILO term loan.

On June 12, 2018, Restoration Hardware, Inc. entered into a First Amendment 
(the “First Amendment”) to the credit agreement. The First Amendment (i) 
changes the credit agreement’s definition of “Eligible In-Transit Inventory” to 
clarify the requirements to be fulfilled by the borrowers with respect to such 
in-transit inventory, and (ii) clarifies that no Default or Event of Default 
was caused by any prior non-compliance with such requirements with respect to 
in-transit inventory. Eligible In-Transit Inventory consists of inventory being 
shipped from vendor locations outside of the United States. Qualifying 
in-transit inventory is included within the borrowing base for eligible 
collateral for purposes of determining the amount of borrowing available to 
borrowers under the credit agreement.

On November 23, 2018, Restoration Hardware, Inc. entered into a Consent and 
Second Amendment (the “Second Amendment”) to the credit agreement. The Second 
Amendment includes certain clarifying changes to among other things: (a) 
address the processing of payments from insurance proceeds in connection with 
casualty or other insured losses with respect to property or assets of a Loan 
Party, and (b) add an additional category of permitted restricted payment to 
allow the lead borrower to make annual restricted payments of up to $3 million 
per fiscal year to cover payments of certain administrative and other 
obligations of RH in the ordinary course of business.

The availability of credit at any given time under the credit agreement is 
limited by reference to a borrowing base formula based upon numerous factors, 
including the value of eligible inventory and eligible accounts receivable. As 
a result of the borrowing base formula, actual borrowing availability under the 
revolving line of credit could be less than the stated amount of the revolving 
line of credit (as reduced by the actual borrowings and outstanding letters of 
credit under the revolving line of credit). All obligations under the credit 
agreement are secured by substantially all of the assets, including accounts 
receivable, inventory, intangible assets, property, equipment, goods and 
fixtures of Restoration Hardware, Inc., Restoration Hardware Canada, Inc., RH 
US, LLC, Waterworks Operating Co., LLC and Waterworks IP Co., LLC.

Borrowings under the revolving line of credit are subject to interest, at the 
borrowers’ option, at either the bank’s reference rate or LIBOR (or, in the 
case of the revolving line of credit, the Bank of America “BA” Rate or the 
Canadian Prime Rate, as such terms are defined in the credit agreement, for 
Canadian borrowings denominated in Canadian dollars or the United States Index 
Rate or LIBOR for Canadian borrowings denominated in United States dollars) 
plus an applicable margin rate, in each case.

The credit agreement contains various restrictive covenants, including, among 
others, limitations on the ability to incur liens, make loans or other 
investments, incur additional debt, issue additional equity, merge or 
consolidate with or into another person, sell assets, pay dividends or make 
other distributions or enter into transactions with affiliates, along with 
other restrictions and limitations typical to credit agreements of this type 
and size. As of February 2, 2019, Restoration Hardware, Inc. was in compliance 
with all applicable covenants of the credit agreement.

In addition, under our credit agreement, we are required to meet specified 
financial ratios in order to undertake certain actions, and we may be required 
to maintain certain levels of excess availability or meet a specified 
consolidated fixed-charge coverage ratio (“FCCR”). The trigger for the FCCR 
occurs if the domestic availability under the revolving line of credit is less 
than the greater of (i) $40.0 million and (ii) 10% of the sum of (a) the lesser 
of (x) the aggregate revolving commitments under the credit agreement and (y) 
the aggregate revolving borrowing base, plus (b) the lesser of (x) the then 
outstanding amount of the LILO term loan or (y) the LILO term loan borrowing 
base. If the availability under the credit agreement is less than the foregoing 
amount, then Restoration Hardware, Inc. is required to maintain an FCCR of at 
least one to one.

The credit agreement requires a daily sweep of all cash receipts and 
collections to prepay the loans under the agreement while (i) an event of 
default exists or (ii) the availability under the revolving line of credit for 
extensions of credit is less than the greater of (A) $40.0 million and (B) 10% 
of the sum of (a) the lesser of (x) the aggregate revolving commitments under 
the credit agreement and (y) the aggregate revolving borrowing base, plus (b) 
the lesser of (x) the then outstanding amount of the LILO term loan or (y) the 
LILO term loan borrowing base.

As of February 2, 2019, Restoration Hardware, Inc. had $57.5 million in 
outstanding borrowings and $378.9 million of availability under the revolving 
line of credit, net of $13.6 million in outstanding letters of credit. As a 
result of the consolidated FCCR restriction that limits the last 10% of 
borrowing availability, actual incremental borrowing available to the Company 
and the other affiliated parties under the revolving line of credit would be 
approximately $333.9 million as of February 2, 2019.

Second Lien Credit Agreement

On July 7, 2017, Restoration Hardware, Inc., a wholly-owned subsidiary of RH, 
entered into the second lien credit agreement, dated as of July 7, 2017, among 
Restoration Hardware, Inc., as lead borrower, the guarantors party thereto, the 
lenders party thereto, each of whom are funds and accounts managed or advised 
by Apollo Capital Management, L.P., and its affiliated investment managers, and 
Wilmington Trust, National Association as administrative agent and collateral 
agent with respect to the second lien term loan in an aggregate principal 
amount equal to $100.0 million with a maturity date of January 7, 2023. The 
second lien term loan of $100.0 million was repaid in full on October 10, 2017. 
As a result of the repayment, we incurred a $4.9 million loss on extinguishment 
of debt in fiscal 2017, which includes a prepayment penalty of $3.0 million and 
acceleration of amortization of debt issuance costs of $1.9 million.

Intercreditor Agreement

On July 7, 2017, in connection with the second lien credit agreement, 
Restoration Hardware, Inc. entered into an intercreditor agreement (the 
“intercreditor agreement”) with the administrative agent and collateral agent 
under the credit agreement and the administrative agent and collateral agent 
under the second lien credit agreement. The intercreditor agreement established 
various customary inter-lender terms, including, without limitation, with 
respect to priority of liens, permitted actions by each party, application of 
proceeds, exercise of remedies in case of default, releases of liens and 
certain limitations on the amendment of the credit agreement and the second 
lien credit agreement without the consent of the other party. The intercreditor 
agreement was terminated upon repayment of the second lien term loan on October 
10, 2017.

Share Repurchase Programs

During fiscal 2017, we repurchased approximately 20.2 million shares of our 
common stock under two separate repurchase programs for an aggregate repurchase 
amount of approximately $1 billion. During fiscal 2018, we repurchased 
approximately 2.0 million shares of our common stock under a separate 
repurchase program for an aggregate repurchase amount of approximately $250 
million. Total repurchases made in fiscal 2018 and fiscal 2017 represented 
54.5% of the shares outstanding as of the end of fiscal 2016.

We generated $163 million and $415 million in free cash flow in fiscal 2018 and 
fiscal 2017, respectively, which supported our share repurchase programs. Free 
cash flow is calculated as net cash provided by operating activities, net 
proceeds from sale of assets held for sale and borrowing on build-to-suit lease 
transactions, less capital expenditures, payments on build-to-suit lease 
transactions and payments on capital leases. Free cash flow excludes all 
non-cash items, such as the non-cash additions of property and equipment due to 
build-to-suit lease transactions. Free cash flow is included in this filing 
because management 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 management uses this non-GAAP 
financial measure in order to have comparable financial results to analyze 
changes in our underlying business from quarter to quarter.

Fiscal 2017 $300 Million Share Repurchase Program

On February 21, 2017, our Board of Directors authorized a share repurchase 
program of up to $300 million (the “Fiscal 2017 $300 Million Repurchase 
Program”) through open market purchases, privately negotiated transactions or 
other means, including through Rule 10b18 open market repurchases, Rule 10b5-1 
trading plans or through the use of other techniques such as accelerated share 
repurchases. During the three months ended April 29, 2017, we repurchased 
approximately 7.8 million shares of our common stock under the Fiscal 2017 $300 
Million Repurchase Program at an average price of $38.24 per share, for an 
aggregate repurchase amount of approximately $300 million. No additional shares 
will be repurchased in future periods under the Fiscal 2017 $300 Million 
Repurchase Program.

Fiscal 2017 $700 Million Share Repurchase Program

Following completion of the Fiscal 2017 $300 Million Repurchase Program, our 
Board of Directors authorized on May 2, 2017 an additional share repurchase 
program of up to $700 million (the “Fiscal 2017 $700 Million Repurchase 
Program”) through open market purchases, privately negotiated transactions or 
other means, including through Rule 10b18 open market repurchases, Rule 10b5-1 
trading plans or through the use of other techniques such as accelerated share 
repurchases including through privately-negotiated arrangements in which a 
portion of the share repurchase program is committed in advance through a 
financial intermediary and/or in transactions involving hedging or derivatives. 
During the three months ended July 29, 2017, we repurchased approximately 12.4 
million shares of our common stock under the Fiscal 2017 $700 Million 
Repurchase Program at an average price of $56.60 per share, for an aggregate 
repurchase amount of approximately $700 million. No additional shares will be 
repurchased in future periods under the Fiscal 2017 $700 Million Repurchase 
Program.

Fiscal 2018 $700 Million Share Repurchase Program

On October 10, 2018, our Board of Directors authorized a share repurchase 
program of up to $700 million (the “Fiscal 2018 $700 Million Repurchase 
Program”) through open market purchases, privately negotiated transactions or 
other means, including through Rule 10b18 open market repurchases, Rule 10b5-1 
trading plans or through the use of other techniques such as accelerated share 
repurchases including through privately-negotiated arrangements in which a 
portion of the share repurchase program is committed in advance through a 
financial intermediary and/or in transactions involving hedging or derivatives. 
During fiscal 2018, we repurchased approximately 2.0 million shares of our 
common stock under the Fiscal 2018 $700 Million Repurchase Program at an 
average price of $122.10 per share, for an aggregate repurchase amount of 
approximately $250 million. As of February 2, 2019, there was $450 million 
available under the Fiscal 2018 $700 Million Share Repurchase Program.

Contractual Obligations

We enter into operating leases in the normal course of business. Most lease 
arrangements provide us with the option to renew the leases at defined terms. 
The table above does not include future obligations for renewal options that 
have not yet been exercised. The future operating lease obligations would 
change if we were to exercise these options. Amounts above do not include 
estimated contingent rent due under operating leases. Our obligation for 
contingent rent as of February 2, 2019 was $4.9 million.

Other non-current obligations include estimated payments for rent associated 
with build-to-suit lease transactions. These amounts may be reduced in the 
event we are able to effect a sale-leaseback on any of these locations.

Other Commitments

The Company enters into various cancellable commitments related to the 
procurement of merchandise inventory. As of February 2, 2019, these merchandise 
inventory purchase commitments were $490.7 million.

As of February 2, 2019, the liability of $3.0 million for unrecognized tax 
benefits associated with uncertain tax positions (refer to Note 13—Income Taxes 
in our consolidated financial statements) has not been included in the 
contractual obligations table above as we are not able to reasonably estimate 
when cash payments for these liabilities will occur or the amount by which 
these liabilities will increase or decrease over time.

Off Balance Sheet Arrangements

We have no material off balance sheet arrangements as of February 2, 2019.


Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with accounting 
principles generally accepted in the United States requires management to make 
estimates and assumptions that affect amounts reported in our consolidated 
financial statements and related notes, as well as the related disclosure of 
contingent assets and liabilities at the date of the financial statements and 
the reported amounts of revenues and expenses during the reporting period. 
Management evaluates its accounting policies, estimates, and judgments on an 
on-going basis. Management bases its estimates and judgments on historical 
experience and various other factors that are believed to be reasonable under 
the circumstances. Actual results may differ from these estimates under 
different assumptions and conditions and such differences could be material to 
the consolidated financial statements.

Revenue Recognition

We recognize revenues and the related cost of goods sold when a customer 
obtains control of the merchandise, which is when the customer has the ability 
to direct the use of and obtain the benefits from the merchandise. Revenue 
recognized for merchandise delivered via the home-delivery channel is 
recognized upon delivery. Revenue recognized for merchandise delivered via all 
other delivery channels will be recognized upon shipment. Revenues from 
“cash-and-carry” store sales are recognized at the point of sale in the store. 
Discounts or other accommodations provided to customers are accounted for as a 
reduction of sales.

We account for shipping and handling as activities to fulfill the promise to 
transfer the merchandise to our customers. We apply this policy consistently 
across all of our distribution channels. In instances where revenue is 
recognized for the related merchandise prior to delivery to customers (i.e., 
revenue recognized upon shipment), the related costs of shipping and handling 
activities will be accrued for in the same period. Costs of shipping and 
handling are included in cost of goods sold.

We defer revenue associated with merchandise delivered via the home-delivery 
channel. As we recognize revenue when the merchandise is delivered to our 
customers, it is included as deferred revenue on the consolidated balance 
sheets while in-transit.

We collect annual membership fees related to the RH Members Program. New 
membership fees are recorded as deferred revenue when collected from customers 
and recognized as revenue based on expected product revenues over the annual 
membership period, based on historical trends of sales to members. Membership 
renewal fees are recorded as deferred revenue when collected from customers and 
are recognized as revenue on a straight-line basis over the membership period, 
or one year.

Sales tax collected is not recognized as revenue but is included in accounts 
payable and accrued expenses on the consolidated balance sheets as it is 
ultimately remitted to governmental authorities.

We reserve for projected merchandise returns. Merchandise returns are often 
resalable merchandise and are refunded by issuing the same payment tender of 
the original purchase. Merchandise exchanges of the same product and price are 
not considered merchandise returns and, therefore, are excluded when 
calculating the sales returns reserve.

Our customers may return purchased items for a refund. We provide an allowance 
for sales returns based on historical return rates, which is presented on a 
gross basis. We present the allowance for sales returns within other current 
liabilities and the estimated value of the right of return asset for 
merchandise within prepaid expense and other assets on the consolidated balance 
sheets.

Merchandise Inventories

Our merchandise inventories are comprised of finished goods and are carried at 
the lower of cost or net realizable value, with cost determined on a 
weighted-average cost method. To determine if the value of inventory should be 
marked down below original cost, we consider current and anticipated demand, 
customer preference and the merchandise age. The inventory value is adjusted 
periodically to reflect current market conditions, which requires management 
judgments that may significantly affect the ending inventory valuation, as well 
as gross margin. The significant estimates used in inventory valuation are 
obsolescence (including excess and slow-moving inventory and lower of cost or 
net realizable value reserves) and estimates of inventory shrinkage. We adjust 
our inventory for obsolescence based on historical trends, aging reports, 
specific identification and our estimates of future retail sales prices.

Reserves for shrinkage are estimated and recorded throughout the period as a 
percentage of net sales based on historical shrinkage results and current 
inventory levels. Actual shrinkage is recorded throughout the year based upon 
periodic cycle counts and the results of our annual physical inventory counts. 
Actual inventory shrinkage and obsolescence can vary from estimates due to 
factors including the mix of our inventory (which ranges from large furniture 
to décor) and execution against loss prevention initiatives in our stores, 
distribution centers, off-site storage locations and with third-party 
transportation providers.

Due to these factors, our obsolescence and shrinkage reserves contain 
uncertainties. Both estimates have calculations that require management to make 
assumptions and to apply judgment regarding a number of factors, including 
market conditions, the selling environment, historical results and current 
inventory trends. If actual obsolescence or shrinkage change from our original 
estimates, we adjust our inventory reserves accordingly throughout the period. 
Management does not believe that changes in the assumptions used in these 
estimates would have a significant effect on our net income or inventory 
balances. We have not made any material changes to our assumptions included in 
the calculations of the obsolescence and shrinkage reserves during the periods 
presented or recorded significant adjustments related to the physical inventory 
process.

Impairment

Goodwill

We evaluate goodwill annually to determine whether it is impaired or whenever 
events occur or circumstances change that would indicate that the fair value of 
a reporting unit is less than its carrying amount. Conditions that may indicate 
impairment include, but are not limited to, a significant adverse change in 
customer demand or business climate that could affect the value of an asset; 
general economic conditions, such as increasing Treasury rates or unexpected 
changes in gross domestic product growth; a change in our market share; 
budget-to-actual performance and consistency of operating margins and capital 
expenditures; a product recall or an adverse action or assessment by a 
regulator; or changes in management or key personnel.

We perform our annual goodwill impairment testing in the fourth fiscal quarter 
by comparing the fair value of a reporting unit with its carrying amount. We 
would recognize an impairment charge for the amount by which the carrying 
amount exceeds the reporting unit’s fair value.

We determine fair values using the discounted cash flow approach (“income 
approach”) or the market multiple valuation approach (“market approach”), when 
available and appropriate, or a combination of both. We assess the valuation 
methodology based upon the relevance and availability of the data at the time 
we perform the valuation. If multiple valuation methodologies are used, the 
results are weighted appropriately.

Under the income approach, fair value is determined based on the present value 
of estimated future cash flows, discounted at an appropriate risk-adjusted 
rate. We use our internal forecasts to estimate future cash flows and include 
an estimate of long-term future growth rates based on our most recent views of 
the long-term outlook for each respective reporting unit. Actual results may 
differ from those assumed in our forecasts. We derive our discount rates using 
a capital asset pricing model and analyzing published rates for industries 
relevant to our reporting units to estimate the cost of equity financing. We 
use discount rates that are commensurate with the risks and uncertainty 
inherent in the respective businesses and in our internally developed 
forecasts.

Valuations using the market approach are derived from metrics of publicly 
traded companies or historically completed transactions of comparable 
businesses. The selection of comparable businesses is based on the markets in 
which the reporting units operate giving consideration to risk profiles, size, 
geography, and diversity of products and services. A market approach is limited 
to reporting units for which there are publicly traded companies that have the 
characteristics similar to our businesses.

Estimating the fair value of reporting units requires the use of estimates and 
significant judgments that are based on a number of factors including actual 
operating results. It is reasonably possible that the judgments and estimates 
described above could change in future periods.

A reporting unit is an operating segment or a business unit one level below 
that operating segment for which discrete financial information is prepared and 
regularly reviewed by the Chief Operating Decision Maker (“CODM”). We have 
deemed RH Segment and Waterworks to be the reporting units for which goodwill 
is independently tested, as these operating segments are the lowest level for 
which discrete financial information is prepared and regularly reviewed by the 
CODM.

RH Segment Reporting Unit

During fiscal 2018, fiscal 2017 and fiscal 2016, we reviewed the RH Segment 
reporting unit goodwill for impairment by assessing qualitative factors to 
determine whether it was more likely than not that the fair value of the 
reporting unit was less than its carrying amount. Based on the qualitative 
tests performed in each fiscal year, we determined that it was not more likely 
than not that the fair value of the reporting unit was less than its carrying 
amount for fiscal 2018, fiscal 2017 and fiscal 2016, and therefore we did not 
recognize goodwill impairment with respect to the RH Segment in any such fiscal 
year.

Waterworks Reporting Unit

During the fourth fiscal quarters of 2018 and 2017, we conducted our annual 
strategic planning process. Based upon the outcome of this process in each 
fiscal year, management identified indicators that there could be an impairment 
of the Waterworks reporting unit. These indicators included (i) an updated 
long-range financial plan provided by the Waterworks segment management that 
indicated a reduction of revenues and EBITDA as compared to prior long-range 
financial plans, (ii) a review of the strategic initiatives of the Waterworks 
segment and (iii) the Waterworks segment not achieving revenue and operating 
income objectives compared to plans.

In determining the Waterworks reporting unit estimated fair value using the 
income approach in both fiscal 2018 and fiscal 2017, we projected future cash 
flows based on management’s estimates and long-term plans and applied a 
discount rate based on a weighted average cost of capital. This analysis 
required management to make judgments about revenues, expenses, fixed asset and 
working capital requirements, the impact of updated tax legislation and other 
subjective inputs. In determining the Waterworks reporting unit estimated fair 
value using the market approach, management considered assumptions that it 
believes market participants would use in valuing the Waterworks reporting 
unit, based on EBITDA multiples and including the application of a control 
premium. For purposes of this analysis, in both fiscal years, we weighted the 
results 80% towards the income approach and 20% towards the market approach.

Based on the estimated fair value of the Waterworks reporting unit as of the 
assessment date of each of its fiscal 2018 and fiscal 2017 analysis, we 
recorded a $17.4 million and $33.7 million non-cash impairment in the fourth 
quarter of fiscal 2018 and fiscal 2017, respectively, to reduce the carrying 
value of goodwill in the Waterworks reporting unit.

Tradenames, Trademarks and Domain Names

We annually evaluate whether tradenames, trademarks and domain names continue 
to have an indefinite life. Tradenames, trademarks and domain names are 
reviewed for impairment annually in the fourth quarter and may be reviewed more 
frequently if indicators of impairment are present. Conditions that may 
indicate impairment include, but are not limited to, a significant adverse 
change in customer demand or business climate that could affect the value of an 
asset, a product recall or an adverse action or assessment by a regulator.

We qualitatively assesses indefinite-lived intangible asset impairment to 
determine whether it is more likely than not that the fair value of the asset 
is less than its carrying amount. If tradenames, trademarks and domain names 
are not qualitatively assessed or if such intangible assets are qualitatively 
assessed and it is determined it is not more likely than not that the asset’s 
fair value is greater than its carrying amount, an impairment review is 
performed by comparing the carrying value to the estimated fair value, 
determined using a discounted cash flow methodology. Factors used in the 
valuation of intangible assets with indefinite lives include, but are not 
limited to, management’s plans for future operations, brand initiatives, recent 
results of operations and projected future cash flows.

RH Segment Reporting Unit

During fiscal 2018, fiscal 2017 and fiscal 2016, we qualitatively assessed the 
RH Segment reporting unit indefinite-lived intangible asset for impairment and 
determine it was more likely than not that the fair value of the assets were 
greater than their carrying amounts. Based on the qualitative tests performed 
in each fiscal year, we did not perform quantitative impairment tests in any 
year. We did not recognize any impairment with respect to intangible assets for 
the RH Segment reporting unit in fiscal 2018, fiscal 2017, or fiscal 2016.

Waterworks Reporting Unit

In connection with the goodwill impairment test performed for the Waterworks 
reporting unit in fiscal 2017, described above, we performed an impairment test 
on the tradenames allocated to the reporting unit which utilized the discounted 
cash flow methodology under the relief-from-royalty method. Under the 
relief-from-royalty method, our significant assumptions include the forecasted 
future revenues and the estimated royalty rate, expressed as a percentage of 
revenues. Based on the quantitative impairment test performed, which resulted 
in fair value of the tradename in excess of book value by approximately 26%, we 
concluded that the tradename allocated to the Waterworks reporting unit was not 
impaired as of February 3, 2018 and did not recognize any impairment with 
respect to the tradename for the Waterworks reporting unit in fiscal 2017.

At the end of each of the first three fiscal quarters of 2018, we determined 
that there were no events or circumstances that indicated any impairment for 
the Waterworks reporting unit tradename. During the fourth fiscal quarter of 
2018, management updated the fiscal 2019 budget and financial projections 
beyond fiscal 2019 for the Waterworks reporting unit. There were certain 
factors that caused the key financial inputs for the tradename valuation model 
to significantly decrease from the previous inputs, the most significant of 
which was a reduction of future forecasted net revenues resulting from an 
expected shift in product mix, challenges in continuing to grow the showrooms 
business and supply chain constraints.

These factors arising during the fourth fiscal quarter of 2018 had a 
significant and negative impact on the estimated future cash flows of the 
Waterworks reporting unit. In connection with the goodwill impairment test 
performed for the Waterworks reporting unit in fiscal 2018, described above, we 
performed an impairment test on the tradename allocated to the reporting unit 
which utilized the discounted cash flow methodology under the 
relief-from-royalty method. Under the relief-from-royalty method, our 
significant assumptions include the forecasted future revenues and the 
estimated royalty rate, expressed as a percentage of revenues. Based on the 
quantitative impairment test performed and the result of changes in forecasted 
revenues and the valuation assumption around future royalty rates, we concluded 
that the Waterworks reporting unit tradename was impaired as of February 2, 
2019. As a result, we recognized a $14.6 million non-cash impairment with 
respect to the tradename for the Waterworks reporting unit in fiscal 2018.

Long-Lived Assets

Long-lived assets, such as property and equipment and intangible assets subject 
to amortization, are reviewed for impairment whenever events or changes in 
circumstances indicate that the carrying amount of an asset may not be 
recoverable. Conditions that may indicate impairment include, but are not 
limited to, a significant adverse change in customer demand or business climate 
that could affect the value of an asset, a product recall or an adverse action 
or assessment by a regulator. If the sum of the estimated undiscounted future 
cash flows related to the asset is less than the carrying value, we recognize a 
loss equal to the difference between the carrying value and the fair value, 
usually determined by the estimated discounted cash flow analysis of the 
assets.

Since there is typically no active market for our long-lived tangible assets, 
we estimate fair values based on the expected future cash flows of the asset or 
asset group, using a discount rate commensurate with the related risk. The 
asset group is defined as the lowest level for which identifiable cash flows 
are available and largely independent of the cash flows of other groups of 
assets, which for our stores is the individual gallery level. We estimate 
future cash flows based on gallery-level historical results, current trends, 
and operating and cash flow projections. Our estimates are subject to 
uncertainty and may be affected by a number of factors outside our control, 
including general economic conditions and the competitive environment. While we 
believe our estimates and judgments about future cash flows are reasonable, 
future impairment charges may be required if the expected cash flow estimates, 
as projected, do not occur or if events change requiring us to revise our 
estimates.

Lease Accounting

We lease stores, distribution facilities, office space and, less significantly, 
certain machinery and equipment. We classify leases at the inception of the 
lease as a capital lease or an operating lease.

Build-to-Suit Lease Transactions

We are sometimes involved in the construction of leased stores, which, 
depending on the extent to which we are involved, we may be the “deemed owner” 
of the leased premises for accounting purposes during the construction period 
pursuant to ASC 840. If we are the “deemed owner” for accounting purposes, upon 
commencement of the construction project, we are required to capitalize the 
cash and non-cash assets contributed by the landlord for construction as 
property and equipment on our consolidated balance sheets. The contributions by 
the landlord toward construction, including the building, existing site 
improvements at construction commencement and any amounts paid by the landlord 
to those responsible for construction, are included as property and equipment 
additions due to build-to-suit lease transactions within the non-cash section 
of our consolidated statements of cash flows. Over the lease term, these 
non-cash additions to property and equipment due to build-to-suit lease 
transactions do not impact our cash outflows, nor do they impact net income 
within our consolidated statements of income.

Upon completion of the construction project, we perform a sale-leaseback 
analysis to determine if we do not have any forms of “continuing involvement” 
and therefore can remove the assets and related liabilities from our 
consolidated balance sheets. If the assets and related liabilities cannot be 
removed from our consolidated balance sheets, we account for the transactions 
as a financing lease. These lease transactions are referred to as build-to-suit 
lease transactions.

Rent expense relating to the land is recognized on a straight-line basis once 
construction begins, which is determined using the fair value of the leased 
land at construction commencement and our incremental borrowing rate. Once cash 
payments commence under the lease, all amounts in excess of land rent expense 
are recorded as a debt-service payment and are recognized as interest expense 
and a reduction of the financing obligation.

Similar to capital leases, the expense recorded within the consolidated 
statements of income over the lease term is equal to the cash rent payments 
made under the lease. The primary difference in the consolidated statements of 
income between build-to-suit lease transactions and operating leases is the 
timing of recognition and the classification of expenses. Expenses related to 
operating leases are classified as rent expense compared to expenses related to 
build-to-suit lease transactions which are classified as a combination of rent 
expense, depreciation expense and interest expense.

Operating and Capital Leases

In a capital or an operating lease, the expected lease term begins with the 
date that we take possession of the equipment or the leased space for 
construction and other purposes. The expected lease term may also include the 
exercise of renewal options if the exercise of the option is determined to be 
reasonably assured. The expected term is also used in the determination of 
whether a store is a capital or operating lease.

Certain of our property and equipment are held under capital leases. These 
assets are included in property and equipment and depreciated over the lesser 
of the useful life of the asset or the lease term. For buildings held under 
capital leases, unless the fair value of the land at lease inception exceeds 
25% of the aggregate fair value of the leased land and buildings, rent payments 
under the leases are recognized using the effective interest method as a 
reduction of the capital lease obligation and interest expense. Pursuant to ASC 
840, at lease inception, if the fair value of the underlying land exceeds 25% 
of the fair value of the real estate (land and buildings), we allocate a 
portion of the cash payments under the lease to land rent expense equal to the 
product of the fair value of the leased land at construction commencement and 
our incremental borrowing rate. The remaining cash payment is treated as 
debt-service payments and recognized as a reduction of the capital lease 
obligation and an increase in interest expense.

All other leases are considered operating leases in accordance with ASC 840. 
Assets subject to an operating lease and the related lease payments are not 
recorded on the consolidated balance sheets. For leases that contain lease 
incentives, premiums and minimum rent expenses, we recognize rent expense on a 
straight-line basis over the lease term. Tenant improvement allowances received 
from landlords under operating leases are recorded in deferred rent and lease 
incentives on the consolidated balance sheets, and are amortized on a 
straight-line basis over the lease term.

Stock-Based Compensation

We use the straight-line method of accounting for stock-based compensation, 
which we believe is the predominant method used in our industry. We recognize 
the fair value of stock-based compensation in the consolidated financial 
statements as compensation expense over the requisite service period. In 
addition, excess tax benefits related to stock-based compensation awards are 
reflected as financing cash flows. For service-only awards, compensation 
expense is recognized on a straight-line basis, net of forfeitures, over the 
requisite service period for the fair value of awards that actually vest. Fair 
value for restricted stock units is valued using the closing price of our stock 
on the date of grant. The fair value of each option award granted under our 
award plan is estimated on the date of grant using a Black-Scholes Merton 
option pricing model which requires the input of subjective assumptions 
regarding the expected term, expected volatility, dividend yield and risk-free 
interest rate. We elected to calculate the expected term of the option awards 
using the “simplified method.” This election was made based on the lack of 
sufficient historical exercise data to provide a reasonable basis upon which to 
estimate expected term. Under the “simplified” calculation method, the expected 
term is calculated as an average of the vesting period and the contractual life 
of the options.

Income Taxes

We account for income taxes under an asset and liability approach that requires 
the recognition of deferred tax assets and liabilities for the expected future 
tax consequences of events that have been recognized in our consolidated 
financial statements or tax returns. In estimating future tax consequences, we 
generally take into account all expected future events then known to us, other 
than changes in the tax law or rates which have not yet been enacted and which 
are not permitted to be considered. Accordingly, we may record a valuation 
allowance to reduce our net deferred tax assets to the amount that is 
more-likely-than-not to be realized. The determination as to whether a deferred 
tax asset will be realized is made on a jurisdictional basis and is based upon 
management’s best estimate of the recoverability of our net deferred tax 
assets. Future taxable income and ongoing prudent and feasible tax planning are 
considered in determining the amount of the valuation allowance, and the amount 
of the allowance is subject to adjustment in the future. Specifically, in the 
event we are to determine that we are not more-likely-than-not able to realize 
our net deferred tax assets in the future, an adjustment to the valuation 
allowance would decrease income in the period such determination is made. This 
allowance does not alter our ability to utilize the underlying tax net 
operating loss and credit carryforwards in the future, the utilization of which 
is limited to achieving future taxable income.

In assessing the need for a valuation allowance, we consider both positive and 
negative evidence related to the likelihood of realization of the deferred tax 
assets. If, based on the weight of available evidence, it is 
more-likely-than-not the deferred tax assets will not be realized, we record a 
valuation allowance. The weight given to the positive and negative evidence is 
commensurate with the extent to which the evidence may be objectively verified. 
As such, it is generally difficult for positive evidence regarding projected 
future taxable income exclusive of reversing taxable temporary differences to 
outweigh objective negative evidence of recent financial reporting losses. 
United States GAAP states that cumulative losses in recent years are a 
significant piece of negative evidence that is difficult to overcome in 
determining that a valuation allowance is not needed against deferred tax 
assets.

As of February 2, 2019, we had $1.6 million in valuation allowances against 
deferred tax assets in certain state and foreign jurisdictions due to 
historical losses.

The accounting standard for uncertainty in income taxes prescribes a 
recognition threshold that a tax position is required to meet before being 
recognized in the financial statements and provides guidance on derecognition, 
measurement, classification, interest and penalties, accounting in interim 
periods, disclosure and transition issues. Differences between tax positions 
taken in a tax return and amounts recognized in the financial statements 
generally result in an increase in a liability for income taxes payable or a 
reduction of an income tax refund receivable, or a reduction in a deferred tax 
asset or an increase in a deferred tax liability, or both. We recognize 
interest and penalties related to unrecognized tax benefits in tax expense.


Quantitative and Qualitative Disclosure of Market Risks

Interest Rate Risk

We currently do not engage in any interest rate hedging activity and we have no 
intention to do so in the foreseeable future.

We are subject to interest rate risk in connection with borrowings under our 
revolving line of credit which bears interest at variable rates and we may 
incur additional indebtedness that bears interest at variable rates. At 
February 2, 2019, $57.5 million was outstanding under the revolving line of 
credit. As of February 2, 2019, the undrawn borrowing availability under the 
revolving line of credit was $378.9 million, net of $13.6 million in 
outstanding letters of credit. As a result of the FCCR restriction that limits 
the last 10% of borrowing availability, actual incremental borrowing available 
under the revolving line of credit would be approximately $333.9 million. Based 
on the average interest rate on the revolving line of credit during the three 
months ended February 2, 2019, and to the extent that borrowings were 
outstanding on such line of credit, we do not believe that a 10% change in the 
interest rate would have a material effect on our consolidated results of 
operations or financial condition. To the extent that we incur additional 
indebtedness, we may increase our exposure to risk from interest rate 
fluctuations.

As of February 2, 2019, we had $350 million principal amount of 0.00% 
convertible senior notes due 2019 outstanding (the “2019 Notes”). As this 
instrument does not bear interest, we do not have interest rate risk exposure 
related to this debt.

As of February 2, 2019, we had $300 million principal amount of 0.00% 
convertible senior notes due 2020 outstanding (the “2020 Notes”). As this 
instrument does not bear interest, we do not have interest rate risk exposure 
related to this debt.

As of February 2, 2019, we had $335 million principal amount of 0.00% 
convertible senior notes due 2023 outstanding (the “2023 Notes”). As this 
instrument does not bear interest, we do not have interest rate risk exposure 
related to this debt.

Market Price Sensitive Instruments

0.00% Convertible Senior Notes due 2019

In connection with the issuance of the 2019 Notes, we entered into 
privately-negotiated convertible note hedge transactions with certain 
counterparties. The convertible note hedge transactions relate to, 
collectively, 3.0 million shares of our common stock, which represents the 
number of shares of our common stock underlying the 2019 Notes, subject to 
anti-dilution adjustments substantially similar to those applicable to the 2019 
Notes. These convertible note hedge transactions are expected to reduce the 
potential earnings dilution with respect to our common stock upon conversion of 
the 2019 Notes and/or reduce our exposure to potential cash or stock payments 
that may be required upon conversion of the 2019 Notes.

We also entered into separate warrant transactions with the same group of 
counterparties initially relating to the number of shares of our common stock 
underlying the convertible note hedge transactions, subject to customary 
anti-dilution adjustments. The warrant transactions will have a dilutive effect 
with respect to our common stock to the extent that the price per share of our 
common stock exceeds the strike price of the warrants unless we elect, subject 
to certain conditions, to settle the warrants in cash. The strike price of the 
warrant transactions is initially $171.98 per share.

0.00% Convertible Senior Notes due 2020

In connection with the issuance of the 2020 Notes, we entered into 
privately-negotiated convertible note hedge transactions with certain 
counterparties. The convertible note hedge transactions relate to, 
collectively, 2.5 million shares of our common stock, which represents the 
number of shares of our common stock underlying the 2020 Notes, subject to 
anti-dilution adjustments substantially similar to those applicable to the 2020 
Notes. These convertible note hedge transactions are expected to reduce the 
potential earnings dilution with respect to our common stock upon conversion of 
the 2020 Notes and/or reduce our exposure to potential cash or stock payments 
that may be required upon conversion of the 2020 Notes.

We also entered into separate warrant transactions with the same group of 
counterparties initially relating to the number of shares of our common stock 
underlying the convertible note hedge transactions, subject to customary 
anti-dilution adjustments. The warrant transactions will have a dilutive effect 
with respect to our common stock to the extent that the price per share of our 
common stock exceeds the strike price of the warrants unless we elect, subject 
to certain conditions, to settle the warrants in cash. The strike price of the 
warrant transactions is initially $189.00 per share.

0.00% Convertible Senior Notes due 2023

In connection with the issuance of the 2023 Notes, we entered into 
privately-negotiated convertible note hedge transactions with certain 
counterparties. The convertible note hedge transactions relate to, 
collectively, 1.7 million shares of our common stock, which represents the 
number of shares of our common stock underlying the 2023 Notes, subject to 
anti-dilution adjustments substantially similar to those applicable to the 2023 
Notes. These convertible note hedge transactions are expected to reduce the 
potential earnings dilution with respect to our common stock upon conversion of 
the 2023 Notes and/or reduce our exposure to potential cash or stock payments 
that may be required upon conversion of the 2023 Notes.

We also entered into separate warrant transactions with the same group of 
counterparties initially relating to the number of shares of our common stock 
underlying the convertible note hedge transactions, subject to customary 
anti-dilution adjustments. The warrant transactions will have a dilutive effect 
with respect to our common stock to the extent that the price per share of our 
common stock exceeds the strike price of the warrants unless we elect, subject 
to certain conditions, to settle the warrants in cash. The strike price of the 
warrant transactions is initially $309.84 per share.

Impact of Inflation

Our results of operations and financial condition are presented based on 
historical cost. While it is difficult to accurately measure the impact of 
inflation due to the imprecise nature of the estimates required, we believe the 
effects of inflation, if any, on our consolidated results of operations and 
financial condition have been immaterial.