Edgar Filing: RH - Form 10-Q

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company

Emerging growth company

rh-10q_20181103.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

☒	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended November 3, 2018

☐	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number: 001-35720

(Exact name of registrant as specified in its charter)

Delaware		45-3052669
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

15 Koch Road, Suite K Corte Madera, CA		94925
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (415) 924-1005

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

As of November 30, 2018, 21,216,240 shares of registrant’s common stock were outstanding.

INDEX TO FORM 10-Q

		Page

PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements	3
	Condensed Consolidated Balance Sheets (Unaudited) as of November 3, 2018, and February 3, 2018	3
	Condensed Consolidated Statements of Income (Unaudited) for the three and nine months ended November 3, 2018, and October 28, 2017	4
	Condensed Consolidated Statements of Comprehensive Income (Unaudited) for the three and nine months ended November 3, 2018, and October 28, 2017	5
	Condensed Consolidated Statements of Cash Flows (Unaudited) for the nine months ended November 3, 2018, and October 28, 2017	6
	Notes to Condensed Consolidated Financial Statements (Unaudited)	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	31
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	59
Item 4.	Controls and Procedures	60

PART II. OTHER INFORMATION
Item 1.	Legal Proceedings	61
Item 1A.	Risk Factors	61
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	77
Item 3.	Defaults Upon Senior Securities	77
Item 4.	Mine Safety Disclosures	77
Item 5.	Other Information	77
Item 6.	Exhibits	78
Signatures		79

PART I

Item 1. Financial Statements

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)

(Unaudited)

	November 3,			February 3,
	2018			2018
				As Revised
ASSETS
Current assets:
Cash and cash equivalents	$	7,755		$	17,907
Accounts receivable—net		42,748			31,412
Merchandise inventories		566,117			527,026
Prepaid expense and other current assets		77,418			68,585
Total current assets		694,038			644,930
Property and equipment—net		856,230			800,698
Goodwill		141,824			141,893
Trademarks and other intangible assets		100,663			100,702
Deferred tax assets		29,049			23,311
Other non-current assets		21,521			21,332
Total assets	$	1,843,325		$	1,732,866
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
Current liabilities:
Accounts payable and accrued expenses	$	306,860		$	318,765
Deferred revenue and customer deposits		165,065			149,404
Convertible senior notes due 2019—net		339,707			—
Other current liabilities		53,441			51,166
Total current liabilities		865,073			519,335
Asset based credit facility		107,500			199,970
Term loan—net		—			79,499
Convertible senior notes due 2019—net		—			327,731
Convertible senior notes due 2020—net		266,506			252,994
Convertible senior notes due 2023—net		244,944			—
Financing obligations under build-to-suit lease transactions		220,708			229,323
Deferred rent and lease incentives		54,501			54,983
Other non-current obligations		52,073			76,367
Total liabilities		1,811,305			1,740,202
Commitments and contingencies (Note 14)		—			—
Stockholders’ equity (deficit):
Preferred stock, $0.0001 par value per share, 10,000,000 shares authorized, no shares issued or outstanding as of November 3, 2018 and February 3, 2018		—			—
Common stock, $0.0001 par value per share, 180,000,000 shares authorized, 42,593,751 shares issued and 21,209,940 shares outstanding as of November 3, 2018; 41,737,470 shares issued and 21,517,338 shares outstanding as of February 3, 2018		2			2
Additional paid-in capital		934,199			840,765
Accumulated other comprehensive loss		(2,300	)		(171	)
Retained earnings		245,870			152,394
Treasury stock—at cost, 21,383,811 shares as of November 3, 2018 and 20,220,132 shares as of February 3, 2018		(1,145,751	)		(1,000,326	)
Total stockholders’ equity (deficit)		32,020			(7,336	)
Total liabilities and stockholders’ equity (deficit)	$	1,843,325		$	1,732,866

The accompanying notes are an integral part of these unaudited Condensed Consolidated Financial Statements.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except share and per share amounts)

(Unaudited)

	Three Months Ended				Nine Months Ended
	November 3,		October 28,		November 3,		October 28,
	2018		2017		2018		2017
Net revenues	$	636,558	$	592,473	$	1,834,762	$	1,769,879
Cost of goods sold		382,047		378,148		1,096,616		1,179,485
Gross profit		254,511		214,325		738,146		590,394
Selling, general and administrative expenses		207,495		171,163		552,154		528,213
Income from operations		47,016		43,162		185,992		62,181
Other expenses
Interest expense—net		19,371		18,915		53,886		45,496
Loss on extinguishment of debt		—		4,880		917		4,880
Total other expenses		19,371		23,795		54,803		50,376
Income before income taxes		27,645		19,367		131,189		11,805
Income tax expense		5,234		6,216		16,677		9,886
Net income	$	22,411	$	13,151	$	114,512	$	1,919
Weighted-average shares used in computing basic net income per share		22,082,141		21,221,848		21,850,955		29,076,556
Basic net income per share	$	1.01	$	0.62	$	5.24	$	0.07
Weighted-average shares used in computing diluted net income per share		27,703,319		23,535,617		26,810,035		30,593,382
Diluted net income per share	$	0.81	$	0.56	$	4.27	$	0.06

The accompanying notes are an integral part of these unaudited Condensed Consolidated Financial Statements.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In thousands)

(Unaudited)

	Three Months Ended						Nine Months Ended
	November 3,			October 28,			November 3,			October 28,
	2018			2017			2018			2017
Net income	$	22,411		$	13,151		$	114,512		$	1,919
Net gains (losses) from foreign currency translation		(382	)		(723	)		(2,129	)		154
Net unrealized holding gains on available-for-sale investments		—			—			—			11
Total comprehensive income	$	22,029		$	12,428		$	112,383		$	2,084

The accompanying notes are an integral part of these unaudited Condensed Consolidated Financial Statements.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Nine Months Ended
	November 3,			October 28,
	2018			2017
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	114,512		$	1,919
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		53,180			51,092
Lease impairment adjustment		4,438			—
Non-cash charges resulting from inventory step-up		380			2,108
Amortization of debt discount		29,669			22,685
Stock-based compensation expense		17,777			42,929
Loss on extinguishment of debt		917			4,880
Other non-cash interest expense		4,245			4,914
Change in assets and liabilities:
Accounts receivable		(11,398	)		(319	)
Merchandise inventories		(39,815	)		190,620
Prepaid expense and other assets		(52,294	)		38,745
Accounts payable and accrued expenses		(23,601	)		10,491
Deferred revenue and customer deposits		20,893			20,617
Other current liabilities		11,670			448
Deferred rent and lease incentives		(353	)		846
Other non-current obligations		(2,628	)		(1,887	)
Net cash provided by operating activities		127,592			390,088
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures		(104,403	)		(104,233	)
Proceeds from sale of assets held for sale—net		—			15,123
Purchase of investments		—			(16,109	)
Maturities of investments		—			46,890
Sales of investments		—			145,020
Net cash provided by (used in) investing activities		(104,403	)		86,691
CASH FLOWS FROM FINANCING ACTIVITIES
Borrowing under asset based credit facility		656,000			446,000
Repayments under asset based credit facility		(748,470	)		(105,000	)
Borrowing under term loans		—			180,000
Repayments under term loans		(80,000	)		(103,000	)
Borrowing under promissory and equipment security notes		—			34,000
Repayments under promissory and equipment security notes		(31,974	)		(841	)
Debt issuance costs		—			(8,298	)
Proceeds from issuance of convertible senior notes		335,000			—
Proceeds from issuance of warrants		51,021			—
Purchase of convertible note hedges		(91,857	)		—
Debt issuance costs related to convertible senior notes		(6,349	)		—
Repurchases of common stock—including commissions		(145,182	)		(1,000,326	)
Proceeds from exercise of stock options		35,827			15,369
Tax withholdings related to issuance of stock-based awards		(8,947	)		(4,881	)
Borrowing on build-to-suit financing obligations		3,539			—
Payments on build-to-suit lease transactions		(7,733	)		(8,734	)
Payments on capital leases		(494	)		(258	)
Net cash used in financing activities		(39,619	)		(555,969	)
Effects of foreign currency exchange rate translation		(136	)		22
Net decrease in cash and cash equivalents and restricted cash equivalents		(16,566	)		(79,168	)
Cash and cash equivalents
Beginning of period—cash and cash equivalents		17,907			87,023
Beginning of period—restricted cash equivalents (construction related deposits)		7,407			28,044
Beginning of period—cash and cash equivalents and restricted cash equivalents		25,314			115,067

End of period—cash and cash equivalents		7,755			22,162
End of period—restricted cash equivalents (construction related deposits)		993			13,737
End of period—cash and cash equivalents and restricted cash equivalents	$	8,748		$	35,899

Non-cash transactions:
Property and equipment additions in accounts payable and accrued expenses at period-end	$	27,711		$	24,081
Property and equipment additions due to build-to-suit lease transactions		9,312			35,463
Property and equipment acquired under capital lease		1,534			753
Property and equipment additions from unpaid construction related deposits		809			3,478
Issuance of non-current notes payable related to share repurchases from former employees		243			—
Property and equipment reduction due to build-to-suit lease transaction termination		(8,143	)		—

The accompanying notes are an integral part of these unaudited Condensed Consolidated Financial Statements.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1—THE COMPANY

Nature of Business

RH, a Delaware corporation, together with its subsidiaries (collectively, the “Company”), is a luxury home furnishings retailer that offers a growing number of categories including furniture, lighting, textiles, bathware, décor, outdoor and garden, tableware, and child and teen furnishings. These products are sold through the Company’s stores, catalogs and websites.

As of November 3, 2018, the Company operated a total of 86 retail Galleries and 37 outlet stores in 32 states, the District of Columbia and Canada, and includes 15 Waterworks showrooms in the United States and in the U.K., and had sourcing operations in Shanghai and Hong Kong.

Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements have been prepared from the Company’s records and, in management’s opinion, include all adjustments, consisting of normal recurring adjustments, necessary to fairly state the Company’s financial position as of November 3, 2018, and the results of operations for the three and nine months ended November 3, 2018 and October 28, 2017. The Company’s current fiscal year, which consists of 52 weeks, ends on February 2, 2019 (“fiscal 2018”).

Certain information and disclosures normally included in the notes to annual consolidated financial statements prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) have been condensed or omitted for purposes of these interim condensed consolidated financial statements.

These unaudited interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended February 3, 2018 (the “2017 Form 10-K”). Certain prior year amounts have been reclassified for consistency with the current period presentation. This reclassification had no effect on the previously reported consolidated financial position or consolidated results of operations, and did not have a material effect on the previously reported consolidated cash flows.

The results of operations for the three and nine months ended November 3, 2018 presented herein are not necessarily indicative of the results to be expected for the full fiscal year.

Convertible Senior Notes

In June 2018, the Company 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 (collectively, the “2023 Notes”). In connection with the issuance of these notes, the Company entered into convertible note hedge transactions for which it paid an aggregate amount of $91.9 million. In addition, the Company sold warrants for which it received aggregate proceeds of $51.0 million. Taken together, the Company received total cash proceeds of $287.8 million, net of discounts upon original issuance and offering costs of $6.3 million. Refer to Note 7—Convertible Senior Notes.

Revision

During the third quarter of fiscal 2018, management determined that the Company had incorrectly reported the impact during the fiscal year ended February 3, 2018 of retiring its common stock in accordance with Accounting Standards Codification (“ASC”) 505—Equity. The common stock being retired was related to shares repurchased under the Company’s equity plans. This resulted in an overstatement of treasury stock of $19.5 million and an overstatement of additional paid-in capital of $19.5 million on the consolidated balance sheets as of February 3, 2018, May 5, 2018 and August 4, 2018. There was no impact on the consolidated statements of income or cash flows related to this misstatement. This error was not considered to be material to any of the previously issued annual or interim financial statements.

The following are selected line items from the Company’s condensed consolidated balance sheets and consolidated statements of stockholders’ equity illustrating the effect of the revision (in thousands):

	Condensed Consolidated Balance Sheets
	February 3, 2018
	As Reported			Adjustment			As Revised
Stockholders’ equity:
Common stock	$	2		$	—		$	2
Additional paid-in capital		860,288			(19,523	)		840,765
Accumulated other comprehensive income		(171	)		—			(171	)
Retained earnings		152,394			—			152,394
Treasury stock		(1,019,849	)		19,523			(1,000,326	)
Total stockholders’ equity	$	(7,336	)	$	—		$	(7,336	)

	Unaudited Condensed Consolidated Balance Sheets
	May 5, 2018
	As Reported			Adjustment			As Revised
Stockholders’ equity:
Common stock	$	2		$	—		$	2
Additional paid-in capital		870,751			(19,523	)		851,228
Accumulated other comprehensive income		(1,436	)		—			(1,436	)
Retained earnings		159,417			—			159,417
Treasury stock		(1,020,092	)		19,523			(1,000,569	)
Total stockholders’ equity	$	8,642		$	—		$	8,642

	Unaudited Condensed Consolidated Balance Sheets
	August 4, 2018
	As Reported			Adjustment			As Revised
Stockholders’ equity:
Common stock	$	2		$	—		$	2
Additional paid-in capital		944,610			(19,523	)		925,087
Accumulated other comprehensive income		(1,918	)		—			(1,918	)
Retained earnings		223,459			—			223,459
Treasury stock		(1,020,092	)		19,523			(1,000,569	)
Total stockholders’ equity	$	146,061		$	—		$	146,061

NOTE 2—RECENTLY ISSUED ACCOUNTING STANDARDS

Revenue from Contracts with Customers

In May 2014, the Financial Accounting Standards Board (“FASB”) and International Accounting Standards Board issued their converged accounting standards update on revenue recognition, Accounting Standards Update 2014-09—Revenue from Contracts with Customers (Topic 606). This guidance outlines a single comprehensive model for companies to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The core principle of the revenue model is that revenue is recognized when a customer obtains control of a good or service. A customer obtains control when it has the ability to direct the use of and obtain the benefits from the good or service. Under the new guidance, transfer of control is no longer the same as transfer of risks and rewards as indicated in the prior guidance.

Adoption and Accounting Policy

The Company adopted Topic 606 on February 4, 2018 using the modified retrospective transition method and recorded a decrease to opening retained earnings of $21.0 million, inclusive of the tax impact. Results reported within the Company’s condensed consolidated financial statements for reporting periods beginning February 4, 2018 are presented under Topic 606 while prior periods are not adjusted and continue to be reported in accordance with the Company’s historic accounting under ASC 605—Revenue Recognition (Topic 605).

Under Topic 606, changes were made to the recognition timing or classification of revenues and expenses for the following:

Description	Policy under Topic 605	Policy under Topic 606
Advertising expenses	Costs associated with Source Books were capitalized and amortized over their expected period of future benefit. Expense was amortized based upon the ratio of actual revenues to the total of actual and estimated future revenues on an individual Source Book basis, generally over a twelve-month period after they were mailed.	Costs associated with Source Books are expensed upon the delivery of the Source Books to the carrier. In the case of multiple printings of a Source Book, the creative costs will be expensed in full upon the initial delivery of Source Books to the carrier.
Gift card breakage	Recognized gift card breakage (amounts not expected to be redeemed) within selling, general and administrative expenses.	Recognize gift card breakage within net revenues proportional to actual gift card redemptions.
Membership revenue	Annual fees for new memberships in the RH Members Program and renewals were recorded as deferred revenue when collected from customers and recognized as revenue on a straight-line basis over the twelve month membership period.	Annual fees for new memberships in the RH Members Program are recorded as deferred revenue when collected from customers and recognized as revenue based on expected product revenues over the annual membership period, using historical trends of sales to members. RH Members Program renewal fees are recorded as deferred revenue when collected from customers and will continue to be recognized as revenue on a straight-line basis over the twelve month membership period.
Revenue recognition	Revenue for merchandise that is not delivered via the home-delivery channel was recognized upon delivery.	Revenue for merchandise that is not delivered via the home-delivery channel will be recognized upon shipment.
Allowance for sales returns	Recognized an allowance for sales returns as a net liability within other current liabilities.	Recognize an allowance for sales returns on a gross basis as a liability within other current liabilities and a right of return asset for merchandise within prepaid expense and other current assets.

Advertising expenses—The adoption of Topic 606 materially impacts the timing of recognizing advertising expense related to direct response advertising, including costs associated with the Company’s Source Books. Under Topic 606, the Company will recognize expense associated with the Source Books upon the delivery of the Source Books to the carrier. In the case of multiple printings of a Source Book, the creative costs will be expensed in full upon the initial delivery of Source Books to the carrier. Prior to adoption of Topic 606, costs associated with Source Books were capitalized and amortized over their expected period of future benefit. Such amortization was based upon the ratio of actual revenues to the total of actual and estimated future revenues on an individual Source Book basis. Each Source Book was generally fully amortized within a twelve-month period after they were mailed and the majority of the amortization occurred within the first five to nine months, with the exception of the Holiday Source Books, which were generally fully amortized within a three-month period after they were mailed. Upon adoption of Topic 606, capitalized costs associated with Source Books of $37.8 million that had been delivered to the carrier prior to or on February 3, 2018 were reclassified to retained earnings on the consolidated balance sheets, resulting in a decrease to the opening retained earnings balance.

Gift card breakage—Under Topic 606, the Company recognizes gift card breakage proportional to actual gift card redemptions and such breakage is recorded within net revenues on the condensed consolidated statements of income. Gift card breakage was previously recorded as a reduction to selling, general and administrative expenses when the likelihood of redemption was remote. Upon adoption of Topic 606, gift card liabilities of $6.0 million were reclassified to retained earnings on the consolidated balance sheets, resulting in an increase to the opening retained earnings balance.

Membership revenue—Under Topic 606, the annual fee for new memberships in the RH Members Program is recorded as deferred revenue when collected from customers and recognized as revenue based on expected product revenues over the annual membership period, using historical trends of sales to members. Prior to the adoption of Topic 606, new memberships were recorded as deferred revenue when collected from customers and recognized as revenue on a straight-line basis over the twelve month membership period. This will result in a majority of revenue being recognized during the first six months of the membership period. The adoption of Topic 606 will not have an impact on membership renewal fees, which will continue to be recognized as revenue on a straight-line basis over the twelve month membership period, until the Company has more information regarding membership renewal purchasing trends. Upon adoption of Topic 606, deferred membership revenue of $3.8 million was reclassified to retained earnings on the consolidated balance sheets, resulting in an increase to the opening retained earnings balance.

Revenue recognition—Under Topic 606, the Company will continue to recognize revenue for merchandise delivered via the home-delivery channel upon delivery. Under Topic 606, revenue for merchandise delivered via all other delivery channels will be recognized upon shipment, whereas previously such revenue was recognized upon delivery. Upon adoption of Topic 606, deferred revenue (net of cost of goods sold) of $1.3 million was reclassified to retained earnings on the consolidated balance sheets, resulting in an increase to the opening retained earnings balance.

The Company adopted the practical expedient related to shipping and handling activities. Under this option, 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 continue to be included in cost of goods sold.

Allowance for sales returns—In connection with adoption of Topic 606, the Company is required to recognize its allowance for sales returns on a gross basis rather than as a net liability. Upon adoption, this resulted in an increase to prepaid and other current assets (“right of return asset for merchandise”), with a corresponding increase to other current liabilities on the consolidated balance sheets, and did not impact the consolidated statements of income. As of November 3, 2018, the right of return asset for merchandise was $5.9 million.

Sales tax collection from customers—Under Topic 606, the Company has not changed its policy regarding sales tax collected from customers. 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.

In connection with adoption of Topic 606, the Company recorded a $6.6 million tax adjustment associated with the charges listed above to retained earnings on the consolidated balance sheets, resulting in an increase to the opening retained earnings balance.

Contract Liabilities

The Company defers revenue associated with merchandise delivered via the home-delivery channel. As the Company recognizes revenue when the merchandise is delivered to our customers, it is included as deferred revenue on the consolidated balance sheets while in-transit. Customer deposits represent payments made by customers on custom orders. At the time of order placement the Company collects deposits for all custom orders equivalent to 50% of the purchase price. Custom order deposits are recognized as revenue when a customer obtains control of the merchandise. In addition, the Company collects 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, using 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. The Company expects that substantially all of the deferred revenue, customer deposits and deferred membership fees as of November 3, 2018 will be recognized within the next six months as the performance obligations are satisfied.

In addition, the Company defers revenue when cash payments are received in advance of performance for unsatisfied obligations related to its gift cards and merchandise credits. Customer liabilities related to gift cards and merchandise credits was $20.1 million and $24.1 million as of November 3, 2018 and February 3, 2018, respectively. As discussed above, $6.0 million of the decrease was due to the reclassification of gift card liabilities to retained earnings upon adoption of Topic 606. During the three and nine months ended November 3, 2018, the Company recognized $5.9 million and $15.6 million of revenue related to previous deferrals related to its gift cards and merchandise credits, respectively, and recorded gift card breakage of $0.4 million and $1.2 million, respectively. The Company expects that approximately 70% of the remaining gift card and merchandise credit liabilities will be recognized when the gift cards are redeemed by customers.

Disaggregated Revenue

The Company recognizes revenue from its stores and direct sales channels. Stores net revenues represent sales originating in retail stores, including Waterworks showrooms, and outlet stores. Direct net revenues include sales through the Company’s Source Books, websites, and phone orders, including its Contract business and a portion of its Trade business. During the three months ended November 3, 2018, net revenues recognized from the stores and direct sales channels were $370.4 million and $266.2 million, respectively. During the nine months ended November 3, 2018, net revenues recognized from the stores and direct sales channels were $1,046.8 million and $788.0 million, respectively.

Adoption Impact on Fiscal 2018 Results

The following tables summarize the impact of adopting Topic 606 on the Company’s condensed consolidated statements of income (in thousands):

	Three Months Ended November 3, 2018
	As Reported		Adjustments			Balances without Adoption of Topic 606
Net revenues	$	636,558	$	(1,066	)	$	635,492
Cost of goods sold		382,047		(80	)		381,967
Gross profit		254,511		(986	)		253,525
Selling, general and administrative expenses		207,495		(11,693	)		195,802
Income from operations		47,016		10,707			57,723
Other expenses
Interest expense—net		19,371		—			19,371
Loss on extinguishment of debt		—		—			—
Total other expenses		19,371		—			19,371
Income before income taxes		27,645		10,707			38,352
Income tax expense		5,234		2,015			7,249
Net income	$	22,411	$	8,692		$	31,103

	Nine Months Ended November 3, 2018
	As Reported		Adjustments			Balances without Adoption of Topic 606
Net revenues	$	1,834,762	$	(10,361	)	$	1,824,401
Cost of goods sold		1,096,616		(3,730	)		1,092,886
Gross profit		738,146		(6,631	)		731,515
Selling, general and administrative expenses		552,154		(18,995	)		533,159
Income from operations		185,992		12,364			198,356
Other expenses
Interest expense—net		53,886		—			53,886
Loss on extinguishment of debt		917		—			917
Total other expenses		54,803		—			54,803
Income before income taxes		131,189		12,364			143,553
Income tax expense		16,677		520			17,197
Net income	$	114,512	$	11,844		$	126,356

The following table summarizes the impact of adopting Topic 606 on certain line items of the Company’s condensed consolidated balance sheets (in thousands):

	As of November 3, 2018
	As Reported		Adjustments			Balances without Adoption of Topic 606
Prepaid expense and other current assets	$	77,418	$	46,972		$	124,390
Deferred tax assets		29,049		(6,561	)		22,488
Accounts payable and accrued expenses		306,860		(789	)		306,071
Deferred revenue and customer deposits		165,065		10,006			175,071
Other current liabilities		53,441		(1,686	)		51,755
Retained earnings		245,870		32,880			278,750

Financial Instruments

In January 2016, the FASB issued Accounting Standards Update 2016-01—Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, which amends various aspects of the recognition, measurement, presentation and disclosure for financial instruments. The new standard is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted only for certain provisions. The Company adopted this new accounting standard in the first quarter of fiscal 2018 and such adoption did not have an impact on its consolidated financial statements.

Cash Flow Classification

In August 2016, the FASB issued Accounting Standards Update No. 2016-15—Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. The new guidance addresses eight specific cash flow issues with the objective of reducing existing diversity in practice regarding the manner in which certain cash receipts and payments are presented and classified in the consolidated statements of cash flows. The new guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted. The Company adopted this new accounting standard in the first quarter of fiscal 2018 which resulted in a change to the presentation of the loss on early extinguishment of debt within the statement of cash flows for the nine months ended October 28, 2017. Adoption of this new accounting standard resulted in an increase in the loss on extinguishment of debt amount in cash flows from operating activities of $3.0 million and an increase in repayments under term loans in cash flows from financing activities of $3.0 million for the nine months ended October 28, 2017.

In November 2016, the FASB issued Accounting Standards Update No. 2016-18—Statement of Cash Flows (Topic 230): Restricted Cash. The new guidance requires that a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts on the statement of cash flows. The new guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted. Adoption of the standard will be applied using a retrospective transition method to each period presented. The Company adopted this new accounting standard in the first quarter of fiscal 2018 which resulted in a change to the presentation of the construction related deposits within the statement of cash flows. The Company considers the construction related deposits to be “restricted cash equivalents” and therefore, under the new accounting guidance, is required to include such deposits in beginning and ending “cash and cash equivalents and restricted cash equivalents” on the statement of cash flows. Previously, funding of the construction related deposit accounts was included within the “investing” section of the statement of cash flows and usage of the deposits was presented as a non-cash transaction. Under the new accounting guidance, funding of the construction related deposit accounts will not be presented within the statement of cash flows and the usage of the deposits will be presented within the “capital expenditures” line item under the “investing” section. Adoption of this new accounting standard resulted in an increase of the beginning and ending “cash and cash equivalents and restricted cash equivalents” amounts of $28.0 million and $13.7 million, respectively, as well as resulted in an increase in capital expenditures of $27.4 million and a decrease in construction related deposits of $12.8 million in cash flows from investing activities for the nine months ended October 28, 2017.

Income Taxes: Intra-Entity Asset Transfers

In October 2016, the FASB issued Accounting Standards Update No. 2016-16—Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory. The new guidance requires the recognition of the income tax consequences of an intercompany asset transfer, other than transfers of inventory, when the transfer occurs. For intercompany transfers of inventory, the income tax effects will continue to be deferred until the inventory has been sold to a third party. The new guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted. The Company adopted this new accounting standard in the first quarter of fiscal 2018 and such adoption did not have an impact on its consolidated financial statements.

Stock-Based Compensation

In May 2017, the FASB issued Accounting Standards Update No. 2017-09—Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting. The new guidance clarifies when modification accounting should be applied for changes to terms or conditions of a share-based payment award. The new guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within that reporting period, with early adoption permitted. The standard will be applied prospectively. The Company adopted this new accounting standard in the first quarter of fiscal 2018 and such adoption did not have an impact on its consolidated financial statements.

Accounting for Leases

In February 2016, the FASB issued Accounting Standards Update 2016-02—Leases, which, for operating leases, requires a lessee to recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in its balance sheet. The standard also requires a lessee to recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term, on a generally straight-line basis. In July 2018, the FASB issued Accounting Standards Update 2018-10—Codification Improvements to Topic 842 (Leases), and Accounting Standards Update 2018-11—Leases (Topic 842)—Targeted Improvements, which (i) narrows amendments to clarify how to apply certain aspects of the new lease standard, (ii) provides entities with an additional transition method to adopt the new standard, and (ii) provides lessors with a practical expedient for separating components of a contract.

The Company continues to assess all potential impacts of the ASUs. The Company plans to elect to adopt the transition practical expedients, however, it does not expect to apply the hindsight practical expedient upon adoption. The Company plans to adopt the lease and non-lease component policy election for certain asset classes, as well as the short-term lease policy election offered under the ASUs.

The ASUs are effective for public companies for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company will adopt the ASUs in the first quarter of fiscal 2019. The Company plans to elect to adopt using a retrospective approach and to apply the new accounting standard to each prior reporting period presented. The Company continues to evaluate the effects that the adoption of this guidance will have on its consolidated financial statements and anticipates the new guidance will significantly impact its consolidated financial statements given that the Company has a significant number of leases.

Cloud Computing

In August 2018, the FASB issued Accounting Standards Update 2018-15—Intangibles—Goodwill and Other—Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement that is a Service Contract, which amends Accounting Standards Update 2015-05—Customers Accounting for Fees in a Cloud Computing Agreement. The amendments in this ASU more closely align the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal use software license). The ASU is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted. The Company is currently evaluating the effects that the adoption of this new accounting standard will have on its consolidated financial statements.

NOTE 3—PREPAID EXPENSE AND OTHER ASSETS

Prepaid expense and other current assets consist of the following (in thousands):

	November 3,		February 3,
	2018		2018
Federal and state tax receivable	$	19,513	$	—
Vendor deposits		15,931		9,701
Capitalized catalog costs		10,138		44,122
Right of return asset for merchandise		5,881		—
Prepaid expense and other current assets		25,955		14,762
Total prepaid expense and other current assets	$	77,418	$	68,585

Other non-current assets consist of the following (in thousands):

	November 3,		February 3,
	2018		2018
Promissory note receivable, including interest	$	5,042	$	—
Deferred financing fees		3,665		4,446
Construction related deposits		993		7,407
Other deposits		5,102		4,997
Other non-current assets		6,719		4,482
Total other non-current assets	$	21,521	$	21,332

NOTE 4—GOODWILL AND TRADEMARKS AND DOMAIN NAMES

The following sets forth the goodwill and trademarks and domain names activity for the RH Segment and Waterworks for the nine months ended November 3, 2018 (in thousands):

Foreign

February 3,

Currency

November 3,

2018

Translation

2018

RH Segment