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

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

For the quarterly period ended May ~~5, 2018~~4, 2019

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

~~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~~001‑35720

(Exact name of registrant as specified in its charter)


Delaware		~~45-3052669~~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~~924‑1005

Securities registered pursuant to Section 12(b) of the Act:


Common Stock, $0.0001 par value	RH	New York Stock Exchange, Inc.
(Title of each class)	(Trading symbol)	(Name of each exchange on which registered)

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 ~~and posted on its corporate Web site, if any,~~ every Interactive Data File required to be submitted ~~and posted~~ 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 ~~and post~~ 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~~12b‑2 of the Exchange Act. ~~(Check one):~~

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~~12b‑2 of the Exchange Act). Yes ☐ No ☒

As of June ~~8, 2018, 21,634,290~~7, 2019, 18,363,482 shares of registrant’s common stock were outstanding.

Table of Contents

INDEX TO FORM ~~10-Q~~10‑Q


		Page

PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements	3
	Condensed Consolidated Balance Sheets (Unaudited) as of May ~~5, 2018,~~4, 2019 and February ~~3, 2018~~2, 2019	3
	Condensed Consolidated Statements of ~~Operations~~Income (Unaudited) for the three months ended May 4, 2019 and May 5, 2018 ~~and April 29, 2017~~	4
	Condensed Consolidated Statements of Comprehensive Income ~~(Loss)~~ (Unaudited) for the three months ended May 4, 2019 and May 5, 2018 ~~and April 29, 2017~~	5
	Condensed Consolidated Statements of Stockholders’ Equity (Deficit) (Unaudited) for the three months ended May 4, 2019 and May 5, 2018	6
	Condensed Consolidated Statements of Cash Flows (Unaudited) for the three months ended May 4, 2019 and May 5, 2018 ~~and April 29, 2017~~	6 7
	Notes to Condensed Consolidated Financial Statements (Unaudited)	7 8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	23 36
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	40 63
Item 4.	Controls and Procedures	41 65

PART II. OTHER INFORMATION
Item 1.	Legal Proceedings	43 66
Item 1A.	Risk Factors	43 66
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	44 69
Item 3.	Defaults Upon Senior Securities	44 69
Item 4.	Mine Safety Disclosures	44 69
Item 5.	Other Information	44 69
Item 6.	Exhibits	45 70
Signatures		46 71

Table of Contents

PART I~~PART~~ I

Item 1. Financial Statements

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)

(Unaudited)


							May 4,		February 2,
	May 5,			February 3,			2019		2019
	2018			2018
ASSETS
Current assets:
Cash and cash equivalents	$	20,796		$	17,907		$	37,550	$	5,803
Restricted cash								65,000		—
Accounts receivable—net		38,614			31,412			48,882		40,224
Merchandise inventories		530,657			527,026			530,190		531,947
Asset held for sale								21,795		21,795
Prepaid expense and other current assets		60,064			68,585			118,648		104,198
Total current assets		650,131			644,930			822,065		703,967
Property and equipment—net		811,369			800,698			954,142		952,957
Operating lease right-of-use assets								432,212		440,504
Goodwill		141,849			141,893			124,349		124,379
Trademarks and other intangible assets		100,678			100,702
Tradenames, trademarks and domain names								86,022		86,022
Deferred tax assets		30,014			23,311			35,752		35,603
Other non-current assets		14,920			21,332			91,290		79,586
Total assets	$	1,748,961		$	1,732,866		$	2,545,832	$	2,423,018
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
LIABILITIES AND STOCKHOLDERS’ DEFICIT
Current liabilities:
Accounts payable and accrued expenses	$	264,173		$	318,765		$	289,146	$	320,497
Deferred revenue and customer deposits		172,379			149,404			174,252		152,595
Convertible senior notes due 2019—net								347,918		343,789
Operating lease liabilities								56,601		66,249
Other current liabilities		59,944			51,166			143,693		109,456
Total current liabilities		496,496			519,335			1,011,610		992,586
Asset based credit facility		219,000			199,970			—		57,500
Term loan—net		79,528			79,499
Convertible senior notes due 2019—net		331,678			327,731
FILO term loan—net								119,065		—
Second lien term loan—net								197,140		—
Equipment promissory notes—net								40,208		—
Convertible senior notes due 2020—net		257,425			252,994			275,884		271,157
Financing obligations under build-to-suit lease transactions		227,979			229,323
Deferred rent and lease incentives		54,965			54,983
Convertible senior notes due 2023—net								253,424		249,151
Non-current operating lease liabilities								427,961		437,557
Non-current finance lease liabilities								436,228		421,245
Other non-current obligations		73,248			76,367			31,685		32,512
Total liabilities		1,740,319			1,740,202			2,793,205		2,461,708
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 May 5, 2018 and February 3, 2018		—			—
Common stock, $0.0001 par value per share, 180,000,000 shares authorized, 41,835,129 shares issued and 21,612,197 shares outstanding as of May 5, 2018; 41,737,470 shares issued and 21,517,338 shares outstanding as of February 3, 2018		2			2
Commitments and contingencies (Note 15)								—		—
Stockholders’ deficit:
Preferred stock, $0.0001 par value per share, 10,000,000 shares authorized, no shares issued or outstanding as of May 4, 2019 and February 2, 2019								—		—
Common stock, $0.0001 par value per share, 180,000,000 shares authorized, 20,528,012 shares issued and 18,357,816 shares outstanding as of May 4, 2019; 20,480,613 shares issued and 20,477,813 shares outstanding as of February 2, 2019								2		2
Additional paid-in capital		870,751			860,288			362,986		356,422
Accumulated other comprehensive loss		(1,436	)		(171	)		(3,270)		(2,333)
Retained earnings		159,417			152,394
Treasury stock—at cost, 20,222,932 shares as of May 5, 2018 and 20,220,132 shares as of February 3, 2018		(1,020,092	)		(1,019,849	)
Total stockholders’ equity (deficit)		8,642			(7,336	)
Total liabilities and stockholders’ equity (deficit)	$	1,748,961		$	1,732,866
Accumulated deficit								(356,816)		(392,538)
Treasury stock—at cost, 2,170,196 shares as of May 4, 2019 and 2,800 shares as of February 2, 2019								(250,275)		(243)
Total stockholders’ deficit								(247,373)		(38,690)
Total liabilities and stockholders’ deficit							$	2,545,832	$	2,423,018

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

Table of ContentsRH

CONDENSED CONSOLIDATED STATEMENTS OF ~~OPERATIONS~~INCOME

(In thousands, except share and per share amounts)

(Unaudited)


	Three Months Ended
	May 4,		May 5,
	2019		2018

Net revenues	$	598,421	$	557,406
Cost of goods sold		365,607		348,073
Gross profit		232,814		209,333
Selling, general and administrative expenses		164,181		161,186
Income from operations		68,633		48,147
Interest expense—net		21,118		15,098
Income before income taxes		47,515		33,049
Income tax expense		11,793		7,588
Net income	$	35,722	$	25,461
Weighted-average shares used in computing basic net income per share		19,976,858		21,545,025
Basic net income per share	$	1.79	$	1.18
Weighted-average shares used in computing diluted net income per share		24,933,987		25,230,228
Diluted net income per share	$	1.43	$	1.01

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

Three Months Ended

May 5,

April 29,

2018

2017

Net revenues

$
557,406

$
562,080

Cost of goods sold

345,371

391,824

Gross profit

212,035

170,256

Selling, general and administrative expenses

158,434

163,360

Income from operations

53,601

6,896

Interest expense—net

17,035

12,179

Income (loss) before income taxes

36,566

(5,283
)
Income tax expense (benefit)

8,507

(1,913
)
Net income (loss)

$
28,059

$
(3,370
)
Weighted-average shares used in computing basic net income (loss) per share

21,545,025

37,609,516

Basic net income (loss) per share

$
1.30

$
(0.09
)
Weighted-average shares used in computing diluted net income (loss) per share

25,230,228

37,609,516

Diluted net income (loss) per share

$
1.11

$
(0.09
)

Table of Contents

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In thousands)

(Unaudited)


	Three Months Ended
	May 4,		May 5,
	2019		2018

Net income	$	35,722	$	25,461
Net gains (losses) from foreign currency translation		(937)		(1,264)
Total comprehensive income	$	34,785	$	24,197

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

Table of Contents

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)

(In thousands, except share amounts)

(Unaudited)


						Accumulated		Retained					Total
				Additional		Other		Earnings					Stockholders’
	Common Stock			Paid-In		Comprehensive		(Accumulated		Treasury Stock			Equity
	Shares	Amount		Capital		Income (Loss)		Deficit)		Shares	Amount		(Deficit)
Balances—February 3, 2018	21,517,338	$	2	$	840,765	$	(171)	$	151,575	22,220,132	$	(1,000,326)	$	(8,155)
Stock-based compensation	—		—		7,891		—		—	—		—		7,891
Vested and delivered restricted stock units	20,110		—		(351)		—		—	—		—		(351)
Exercise of stock options	77,549		—		2,923		—		—	—		—		2,923
Repurchases of common stock	(2,800)		—		—		—		—	2,800		(243)		(243)
Impact of Topic 606 adoption	—		—		—		—		(21,036)	—		—		(21,036)
Net income	—		—		—		—		25,461	—		—		25,461
Net gains (losses) from foreign currency translation	—		—		—		(1,264)		—	—		—		(1,264)
Balances—May 5, 2018	21,612,197	$	2	$	851,228	$	(1,435)	$	156,000	22,222,932	$	(1,000,569)	$	5,226

Balances—February 2, 2019	20,477,813	$	2	$	356,422	$	(2,333)	$	(392,538)	2,800	$	(243)	$	(38,690)
Stock-based compensation	—		—		5,588		—		—	—		—		5,588
Vested and delivered restricted stock units	21,241		—		(250)		—		—	—		—		(250)
Exercise of stock options	26,158		—		1,226		—		—	—		—		1,226
Repurchases of common stock	(2,167,396)		—		—		—		—	2,167,396		(250,032)		(250,032)
Net income	—		—		—		—		35,722	—		—		35,722
Net gains (losses) from foreign currency translation	—		—		—		(937)		—	—		—		(937)
Balances—May 4, 2019	18,357,816	$	2	$	362,986	$	(3,270)	$	(356,816)	2,170,196	$	(250,275)	$	(247,373)

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

Table of Contents

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)


	Three Months Ended
	May 4,		May 5,
	2019		2018

CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	35,722	$	25,461
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		27,189		22,745
Non-cash amortization of operating lease right-of-use asset		16,279		17,040
Amortization of debt discount		12,377		7,881
Stock-based compensation expense		5,695		7,997
Finance leases interest expense		5,514		3,092
Product recalls		(1,786)		—
Net non-cash charges resulting from inventory step-up		—		190
Other non-cash interest expense		1,089		786
Change in assets and liabilities:
Accounts receivable		(7,218)		(6,943)
Merchandise inventories		1,653		(4,032)
Prepaid expense and other assets		(17,846)		(31,496)
Landlord assets under construction		(4,542)		(18,648)
Accounts payable and accrued expenses		(38,595)		(46,664)
Deferred revenue and customer deposits		21,641		28,159
Other current liabilities		15,231		12,191
Current and non-current operating lease liability		(27,131)		(16,589)
Other non-current obligations		(6,448)		(4,404)
Net cash provided by (used in) operating activities		38,824		(3,234)
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures		(7,916)		(17,674)
Net cash used in investing activities		(7,916)		(17,674)
CASH FLOWS FROM FINANCING ACTIVITIES
Borrowing under asset based credit facility		94,000		334,000
Repayments under asset based credit facility		(151,500)		(314,970)
Borrowings under term loans		320,000		—
Borrowing under equipment security notes		60,000		—
Repayments under promissory and equipment security notes		(983)		(1,491)
Debt issuance costs		(4,499)		—
Principal payments under finance leases		(2,129)		(1,776)
Repurchases of common stock—including commissions		(250,032)		—
Proceeds from exercise of stock options		1,226		2,923
Tax withholdings related to issuance of stock-based awards		(250)		(351)
Net cash provided by financing activities		65,833		18,335
Effects of foreign currency exchange rate translation		6		(62)
Net increase (decrease) in cash and cash equivalents and restricted cash equivalents		96,747		(2,635)
Cash and cash equivalents
Beginning of period—cash and cash equivalents		5,803		17,907
Beginning of period—restricted cash equivalents (construction related deposits)		—		7,407
Beginning of period—cash and cash equivalents and restricted cash equivalents	$	5,803	$	25,314

End of period—cash and cash equivalents		37,550		20,796
End of period—restricted cash		65,000		—
End of period—restricted cash equivalents (construction related deposits)		—		1,883
End of period—cash and cash equivalents, restricted cash and restricted cash equivalents	$	102,550	$	22,679
Non-cash transactions:
Property and equipment additions in accounts payable and accrued expenses at period-end	$	8,529	$	4,926
Landlord asset additions in accounts payable and accrued expenses at period-end		19,481		13,635
Landlord asset additions from unpaid construction related deposits		2,056		2,650
Issuance of non-current notes payable related to share repurchases from former employees		—		243

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

Table of ContentsRH

~~CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)~~RH

~~(In thousands)~~

~~(Unaudited)~~

Three Months Ended

May 5,

April 29,

2018

2017

Net income (loss)

$
28,059

$
(3,370
)
Net losses from foreign currency translation

(1,265
)

(1,192
)
Net unrealized holding gains on available-for-sale investments

—

11

Total comprehensive income (loss)

$
26,794

$
(4,551
)

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

~~CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS~~

~~(In thousands)~~

~~(Unaudited)~~

Three Months Ended

May 5,

April 29,

2018

2017

CASH FLOWS FROM OPERATING ACTIVITIES

Net income (loss)

$
28,059

$
(3,370
)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:

Depreciation and amortization

17,047

16,020

Lease impairment adjustment

(1,157
)

—

Non-cash charges resulting from inventory step-up

190

1,380

Amortization of debt discount

7,881

7,458

Stock-based compensation expense

7,997

5,289

Other non-cash interest expense

938

884

Change in assets and liabilities:

Accounts receivable

(7,243
)

8

Merchandise inventories

(4,032
)

66,067

Prepaid expense and other assets

(26,181
)

7,547

Accounts payable and accrued expenses

(57,215
)

1,219

Deferred revenue and customer deposits

28,159

22,232

Other current liabilities

13,838

(1,086
)
Deferred rent and lease incentives

44

726

Other non-current obligations

(569
)

(426
)
Net cash provided by operating activities

7,756

123,948

CASH FLOWS FROM INVESTING ACTIVITIES

Capital expenditures

(27,121
)

(21,173
)
Proceeds from sale of assets held for sale—net

—

4,900

Purchase of investments

—

(16,109
)
Maturities of investments

—

46,890

Sales of investments

—

145,020

Net cash provided by (used in) investing activities

(27,121
)

159,528

CASH FLOWS FROM FINANCING ACTIVITIES

Borrowing under asset based credit facility

334,000

—

Repayments under asset based credit facility

(314,970
)

—

Repayments under promissory and equipment security notes

(1,491
)

—

Repurchases of common stock—including commissions

—

(300,140
)
Payments on build-to-suit lease transactions

(3,207
)

(1,289
)
Proceeds from exercise of stock options

2,923

2,567

Tax withholdings related to issuance of stock-based awards

(351
)

(149
)
Payments on capital leases

(112
)

(76
)
Net cash provided by (used in) financing activities

16,792

(299,087
)
Effects of foreign currency exchange rate translation

(62
)

(86
)
Net decrease in cash and cash equivalents and restricted cash equivalents

(2,635
)

(15,697
)
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

20,796

80,150

End of period—restricted cash equivalents (construction related deposits)

1,883

19,220

End of period—cash and cash equivalents and restricted cash equivalents

$
22,679

$
99,370

Non-cash transactions:

Property and equipment additions in accounts payable and accrued expenses at period-end

$
18,560

$
14,498

Property and equipment additions from unpaid construction related deposits

$
2,650

$
4,913

Property and equipment additions due to build-to-suit lease transactions

$
1,887

$
18,283

Issuance of non-current notes payable related to share repurchases from former employees

$
243

$
—

~~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 May ~~5, 2018,~~4, 2019, the Company operated a total of ~~84 retail~~70 RH Galleries and 3240 RH outlet stores in 32 states, the District of Columbia and Canada, ~~and includes~~as well as 15 Waterworks showrooms inthroughout 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, and revisions due to the adoption of the new lease accounting standard described in Note 2—Recently Issued Accounting Standards, necessary to fairly state the Company’s financial position as of May ~~5, 2018,~~4, 2019, and the results of operations for the three months ended May 4, 2019 and May 5, ~~2018 and April 29, 2017.~~2018. The Company’s current fiscal year, which consists of 52 weeks, ends on February ~~2, 2019~~1, 2020 (“fiscal ~~2018”~~2019”).

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~~10‑K for the fiscal year ended February ~~3, 2018~~2, 2019 (the ~~“2017~~“2018 Form ~~10-K”~~10‑K”). Certain prior year amounts have been ~~reclassified for consistency with~~adjusted to conform to the current period ~~presentation. This reclassification had no effect on~~presentation due to the ~~previously reported consolidated financial position or consolidated results~~adoption of ~~operations, and did not have a material effect on~~ the ~~previously reported consolidated cash flows.~~new lease accounting standard. Refer to Note 2—Recently Issued Accounting Standards.

The results of operations for the three months ended May ~~5, 2018~~4, 2019 presented herein are not necessarily indicative of the results to be expected for the full fiscal year.

Revisions

As previously disclosed in our Annual Report on Form 10-K as of and for the year ended February 2, 2019, 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, which resulted in the Company revising its previously issued financial statements as of and for the year ended February 3, 2018. The common stock being retired was related to shares repurchased under the Company’s equity plans. This error resulted in an overstatement of additional paid-in capital of $19.5 million, from $870.8 million as reported to $851.2 million as revised, and an overstatement of treasury stock of $19.5 million, from $1,020.1 million as reported to $1,000.6 million as revised, on the condensed consolidated balance sheet as of May 5, 2018. There was no impact on the condensed consolidated statements of income or condensed cash flows related to this misstatement. Although this error was not considered to be material to any of the previously issued financial statements, the Company has revised the accompanying unaudited interim financial statements to reflect the correction of this error.

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During the adoption process of the new lease accounting standard (refer to Note 2—Recently Issued Accounting Standards), the Company identified a lease agreement that was incorrectly accounted for as an impaired lease under ASC 420—Exit or Disposal Cost Obligations in fiscal 2017 and the first quarter of fiscal 2018. This error resulted in an overstatement of net income of $1.4 million and $0.9 million for the year ended February 3, 2018 and the three months ended May 5, 2018, respectively. This error also resulted in an overstatement of retained earnings as of February 3, 2018 of $1.4 million, from $152.4 million as reported to $151.0 million as revised, and as of May 5, 2018 of $2.3 million, from $159.4 million as reported to $157.1 million as revised, prior to the impact of the modified retrospective application of the new lease accounting standard as further discussed in Note 2. In addition, as of February 2, 2019, this error resulted in an understatement of other non-current obligations of $3.3 million, an overstatement of other current liabilities of $1.0 million and understatement of accumulated deficit of $2.3 million, from $376.8 million as reported to $379.1 million as revised. Although these errors are not considered to be material to any of the previously issued financial statements, the Company has revised the accompanying unaudited interim financial statements to reflect the correction of these errors.

In addition, during the adoption process of the new lease accounting standard, the Company identified an error in its previously reported consolidated statement of cash flows for the quarterly and annual periods in fiscal 2018. This error resulted in an understatement of $9.2 million of net cash provided by operating activities and an understatement of $9.2 million of net cash used in investing activities for each reporting period in fiscal 2018. There was no impact on the condensed consolidated balance sheets, condensed consolidated statements of income or the condensed consolidated statement of stockholders’ equity (deficit) related to this error. Although these errors are not considered to be material to any of the previously issued financial statements, the Company has revised the accompanying unaudited interim financial statements to reflect the correction of these errors.

The following are selected line items from the Company’s condensed consolidated statements of cash flows illustrating the effect of the corrections, prior to the adoption of the modified retrospective application of the new lease accounting standard (in thousands):


	Three Months Ended May 5, 2018
	As Reported		Adjustment		As Revised
Cash flows from operating activities:
Change in accounts payable and accrued expenses	$	(57,215)	$	9,201	$	(48,014)
Net cash provided by operating activities		7,756		9,201		16,957
Cash flows from investing activities:
Capital expenditures		(27,121)		(9,201)		(36,322)
Net cash used in investing activities		(27,121)		(9,201)		(36,322)


	Six Months Ended August 4, 2018
	As Reported		Adjustment		As Revised
Cash flows from operating activities:
Change in accounts payable and accrued expenses	$	(42,717)	$	9,201	$	(33,516)
Net cash provided by operating activities		70,229		9,201		79,430
Cash flows from investing activities:
Capital expenditures		(61,212)		(9,201)		(70,413)
Net cash used in investing activities		(61,212)		(9,201)		(70,413)


	Nine Months Ended November 3, 2018
	As Reported		Adjustment		As Revised
Cash flows from operating activities:
Change in accounts payable and accrued expenses	$	(23,601)	$	9,201	$	(14,400)
Net cash provided by operating activities		127,592		9,201		136,793
Cash flows from investing activities:
Capital expenditures		(104,403)		(9,201)		(113,604)
Net cash used in investing activities		(104,403)		(9,201)		(113,604)

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	Fiscal Year Ended February 2, 2019
	As Reported		Adjustment		As Revised
Cash flows from operating activities:
Change in accounts payable and accrued expenses	$	(452)	$	9,201	$	8,749
Net cash provided by operating activities		300,556		9,201		309,757
Cash flows from investing activities:
Capital expenditures		(136,736)		(9,201)		(145,937)
Net cash used in investing activities		(136,736)		(9,201)		(145,937)

NOTE 2—RECENTLY ISSUED ACCOUNTING STANDARDS

~~Revenue from Contracts with Customers~~Accounting for Leases

In ~~May 2014,~~February 2016, the FASB ~~and International Accounting Standards Board~~ issued ~~their converged accounting standards update on revenue recognition,~~ Accounting Standards Update ~~2014-09—Revenue from Contracts~~2016‑02—Leases, which requires a lessee to distinguish all leases as operating leases or finance leases and recognize all leases on the balance sheet as a right-of-use asset with ~~Customers (Topic 606). This guidance outlines~~a corresponding lease liability representing the present value of lease payments. The standard also requires a lessee to recognize a single ~~comprehensive model~~lease cost 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~~operating leases, calculated so that the cost of the ~~revenue model~~lease is ~~that revenue~~allocated over the lease term, generally on a straight-line basis. The lease cost for finance leases includes both principal and interest components, and is ~~recognized when~~higher than the corresponding cash payment at the beginning of the lease term and declines over the lease term as the liability is reduced. 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 (iii) provides lessors with a ~~customer obtains control~~practical expedient for separating components 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~~contract. Accounting Standards Update 2016-02, Accounting Standards Update 2018-10 and Accounting ~~Policy~~Standards Update 2018-11 are collectively referred to as the “ASUs.”

The Company adopted ~~Topic 606 on~~the ASUs as of February ~~4, 2018~~3, 2019 using ~~the~~a modified retrospective ~~transition~~approach. Under this adoption method, ~~and~~ ~~recorded a decrease~~the results of prior comparative periods are presented with an adjustment to opening retained earnings of ~~$21.0~~the earliest comparative period presented. In addition, the Company elected to adopt the package of transition practical expedients, which permitted the Company not to reassess its prior conclusions regarding lease identification, lease classification and initial direct costs. The Company adopted the policy election to not separate lease and non-lease components for certain asset classes (such as real estate leases), as well as the short-term lease policy election offered under the ASUs whereby the Company does not recognize right of use assets and lease liabilities for leases with terms of 12 months or less. The Company did not apply the hindsight practical expedient upon adoption.

As a result of the adoption of the ASUs, the Company recorded an increase to the fiscal 2017 (earliest comparative period) opening retained earnings balance of $4.0 million, inclusive of the tax impact. ~~Results reported within~~

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The following table presents the impact of adopting the ASUs, as well as the correction of an immaterial error as discussed in Note 1—The Company, on 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~~ balance sheet (in ~~accordance with the Company’s historic accounting under ASC 605~~thousands~~—Revenue Recognition (Topic 605)~~.):


	February 2, 2019
	As Reported		Adjustments and Other (1)			As Adjusted and Revised
ASSETS
Current assets:
Cash and cash equivalents	$	5,803	$	—		$	5,803
Accounts receivable—net		40,224		—			40,224
Merchandise inventories		531,947		—			531,947
Asset held for sale		—		21,795	(2)		21,795
Prepaid expense and other current assets		104,719		(521)	(3)		104,198
Total current assets		682,693		21,274			703,967
Property and equipment—net		863,562		89,395	(4)		952,957
Operating lease right-of-use assets		—		440,504	(5)		440,504
Goodwill		124,379		—			124,379
Tradenames, trademarks and domain names		86,022		—			86,022
Deferred tax assets		30,033		5,570	(6)		35,603
Other non-current assets		19,345		60,241	(7)		79,586
Total assets	$	1,806,034	$	616,984		$	2,423,018
LIABILITIES AND STOCKHOLDERS’ DEFICIT
Current liabilities:
Accounts payable and accrued expenses	$	320,441	$	56	(8)	$	320,497
Deferred revenue and customer deposits		152,595		—			152,595
Convertible senior notes due 2019—net		343,789		—			343,789
Operating lease liabilities		—		66,249	(5)		66,249
Other current liabilities		101,347		8,109	(1)(9)		109,456
Total current liabilities		918,172		74,414			992,586
Asset based credit facility		57,500		—			57,500
Convertible senior notes due 2020—net		271,157		—			271,157
Convertible senior notes due 2023—net		249,151		—			249,151
Financing obligations under build-to-suit lease transactions		228,928		(228,928)	(10)		—
Deferred rent and lease incentives		53,742		(53,742)	(10)		—
Non-current operating lease liabilities		—		437,557	(5)		437,557
Non-current finance lease liabilities		—		421,245	(9)		421,245
Other non-current obligations		50,346		(17,834)	(1)(11)		32,512
Total liabilities		1,828,996		632,712			2,461,708
Stockholders’ deficit:
Preferred stock		—		—			—
Common stock		2		—			2
Additional paid-in capital		356,422		—			356,422
Accumulated other comprehensive loss		(2,333)		—			(2,333)
Accumulated deficit		(376,810)		(15,728)	(1)(12)		(392,538)
Treasury stock		(243)		—			(243)
Total stockholders’ deficit		(22,962)		(15,728)			(38,690)
Total liabilities and stockholders’ deficit	$	1,806,034	$	616,984		$	2,423,018

(1)

During the adoption process of the ASUs, the Company identified a lease agreement that was incorrectly accounted for as an impaired lease under ASC 420—Exit or Disposal Cost Obligations in fiscal 2017 and the first quarter of fiscal 2018. Refer to “Revisions” within Note 1—The Company.

(2)

Represents recognition of asset held for sale under a sale-leaseback transaction.

(3)

Represents reclassification of prepaid rent to operating lease liabilities and other current liabilities (for finance leases).

(4)

Represents (i) recognition of finance lease right-of-use assets, partially offset by (ii) derecognition of non-Company owned properties that were capitalized under previously existing build-to-suit accounting policies, (iii) reclassification of construction in progress assets determined to be landlord assets to other non-current assets and (iv) reclassification of initial direct costs related to operating leases to operating lease right-of-use assets.

(5)

Represents recognition of operating lease right-of-use assets and corresponding current and non-current lease liabilities. The operating lease right-of-use asset also includes the reclassification of deferred rent and unamortized lease incentives related to operating leases and the reclassification of initial direct costs from property and equipment—net.

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

~~Description~~	~~Policy under Topic 605~~(6)	~~Policy under Topic 606~~
~~Advertising expenses~~	~~Costs associated with Source Books were capitalized and amortized over their expected period~~Represents recognition of ~~future benefit. Expense was amortized based upon the ratio of actual revenues~~net deferred tax assets related to the ~~total~~adoption of ~~actual and estimated future revenues on an individual Source Book basis, generally over a twelve-month period after they were mailed.~~the ASUs.

~~Costs associated with Source Books are expensed upon~~(7)

Primarily represents reclassification from property and equipment—net of construction in progress assets determined to be landlord assets for which the ~~delivery~~lease has not yet commenced.

(8)

Represents a reclassification of an accrual for real estate taxes.

	(9)		Represents recognition 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~~current 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~~non-current finance lease liabilities.	~~Recognize an allowance for sales returns on a gross basis as a liability within~~ The other current liabilities line item also includes the reclassification of current obligations associated with leases previously reported as capital leases to finance lease liabilities.

(10)

Represents (i) derecognition of liabilities related to non-Company owned properties that were consolidated under previously existing build-to-suit accounting policies and (ii) reclassification of deferred rent and unamortized lease incentives to operating lease right-of-use assets upon adoption of the ASUs.

(11)

Represents (i) derecognition of the net lease loss liabilities as such balances were reclassified to operating lease right-of-use assets and operating current and non-current liabilities and (ii) the reclassification of non-current obligations associated with leases previously reported as capital leases to finance lease liabilities.

(12)

Represents a ~~right~~decrease to the consolidated net income for fiscal 2017 and fiscal 2018, as well as an increase of ~~return asset for merchandise within prepaid expense and other current assets.~~$4.0 million to beginning fiscal 2017 retained earnings related to the adoption of the ASUs.

~~Advertising expenses~~—Refer to Note 7—Leases for discussion of the Company’s revised accounting policy for 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 ~~adoption of Topic 606 materially impacts~~amendments in this ASU more closely align the ~~timing of recognizing advertising expense related to direct response advertising, including~~requirements for capitalizing implementation costs ~~associated~~incurred in a hosting arrangement that is a service contract with the ~~Company’s Source Books. Under Topic 606,~~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 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~~effects 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 operations. 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,~~this new ~~memberships were recorded as deferred revenue when collected from customers and recognized as revenue~~accounting standard will have 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 theits 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~~.financial statements.

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.

NOTE 3—PREPAID EXPENSE AND OTHER ASSETS

~~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 prepaidPrepaid expense and other current assets ~~(“right~~consist of ~~return asset~~the following (in thousands):


	May 4,		February 2,
	2019		2019

Insurance recovery receivable (1)	$	60,073	$	50,000
Capitalized catalog costs		17,948		16,178
Vendor deposits		13,873		11,836
Right of return asset for merchandise		6,063		5,883
Federal and state tax receivable		—		4,862
Prepaid expense and other current assets		20,691		15,439
Total prepaid expense and other current assets	$	118,648	$	104,198

(1)

Refer to Note 15—Commitments and Contingencies.

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


	May 4,		February 2,
	2019		2019

Landlord assets under construction	$	74,110	$	63,159
Promissory note receivable, including interest		5,167		5,104
Deferred financing fees		3,432		3,415
Other deposits		5,170		5,068
Other non-current assets		3,411		2,840
Total other non-current assets	$	91,290	$	79,586

NOTE 4—GOODWILL, TRADENAMES, TRADEMARKS AND DOMAIN NAMES

The following sets forth the goodwill, tradenames, trademarks and domain names activity for ~~merchandise”), with a corresponding increase to other current liabilities on~~ the ~~consolidated balance sheets,~~RH Segment and ~~did not impact~~Waterworks for the ~~consolidated statements of operations. As of~~three months ended May ~~5, 2018, the right of return asset for merchandise was $5.3~~4, 2019 (in thousands):


			Foreign
	February 2,		Currency		May 4,
	2019		Translation		2019
RH Segment
Goodwill	$	124,379	$	(30)	$	124,349
Tradenames, trademarks and domain names		48,563		—		48,563

Waterworks (1)
Tradename (2)		37,459		—		37,459

(1)

Waterworks reporting unit goodwill of $51.1 million recognized upon acquisition in fiscal 2016 was fully impaired as of February 2, 2019, with $17.4 million and $33.7 million impairment recorded in fiscal 2018 and fiscal 2017, respectively.

(2)

The Waterworks reporting unit tradename is presented net of an impairment charge of $14.6 million recorded in fiscal 2018.

NOTE 5—ACCOUNTS PAYABLE, ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES

~~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~~Accounts payable and accrued expenses onconsist of the ~~consolidated balance sheets as it is ultimately remitted to governmental authorities.~~following (in thousands):


	May 4,		February 2,
	2019		2019

Accounts payable	$	176,069	$	183,039
Accrued compensation		35,688		64,192
Accrued freight and duty		19,948		20,787
Accrued sales taxes		19,901		18,354
Accrued occupancy		10,786		10,839
Accrued catalog costs		8,546		10,276
Accrued professional fees		3,974		2,050
Other accrued expenses		14,234		10,960
Total accounts payable and accrued expenses	$	289,146	$	320,497

~~In connection with adoption~~

Table of ~~Topic 606,~~Contents

Other current liabilities consist of the ~~Company recorded a $6.6 million tax adjustment associated with the charges listed above to retained earnings on the consolidated balance sheets, resulting~~ following (in ~~an increase to the opening retained earnings balance~~thousands.):


	May 4,		February 2,
	2019		2019

Provision for legal settlement (1)	$	60,073	$	50,000
Allowance for sales returns		21,056		19,821
Unredeemed gift card and merchandise credit liability		17,582		17,192
Current portion of debt		19,351		892
Finance lease liabilities		7,716		9,184
Federal and state tax payable		7,827		—
Product recall reserve		5,819		7,767
Other current liabilities		4,269		4,600
Total other current liabilities	$	143,693	$	109,456

(1)

Refer to Note 15—Commitments and Contingencies.

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 May ~~5, 2018~~4, 2019 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 $17.7 million and $24.1 million as of May 5, 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 months ended May ~~5, 2018,~~4, 2019, the Company recognized ~~$4.9~~$4.7 million of revenue related to previous deferrals related to its gift cards and merchandise credits and recorded gift card breakage of $0.4 million. The Company expects that approximately 70% of the remaining gift card and merchandise credit liabilities as of May 4, 2019 will be recognized ~~when~~within the next twelve months as 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 May 5, 2018, net revenues recognized from the stores and direct sales channels were $314.5 million and $242.9 million, respectively.

~~Adoption Impact on Fiscal 2018 Results~~

~~The following table summarizes the impact of adopting Topic 606 on the Company’s condensed consolidated statements of operations (in thousands~~):

Three Months Ended May 5, 2018

As Reported

Adjustments

Balances without Adoption of Topic 606

Net revenues

$
557,406

$
(7,610
)

$
549,796

Cost of goods sold

345,371

(2,988
)

342,383

Gross profit

212,035

(4,622
)

207,413

Selling, general and administrative expenses

158,434

3,803

162,237

Income from operations

53,601

(8,425
)

45,176

Interest expense—net

17,035

—

17,035

Income before income taxes

36,566

(8,425
)

28,141

Income tax expense

8,507

(1,950
)

6,557

Net income

$
28,059

$
(6,475
)

$
21,584

~~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 May 5, 2018

As Reported

Adjustments

Balances without Adoption of Topic 606

Prepaid expense and other current assets

$
60,064

$
27,652

$
87,716

Deferred tax assets

30,014

(6,561
)

23,453

Accounts payable and accrued expenses

264,173

(638
)

263,535

Deferred revenue and customer deposits

172,379

9,463

181,842

Other current liabilities

59,944

(2,295
)

57,649

Retained earnings

159,417

14,561

173,978

~~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 and such adoption did not have a material impact on its consolidated financial statements.

~~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 for the three months ended April 29, 2017 of $28.0 million and $19.2 million, respectively, as well as resulted in an increase in capital expenditures for the three months ended April 29, 2017 of $7.7 million.

~~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. The ASU is effective for public companies for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. The Company is currently evaluating the effects that the adoption of ASU 2016-02 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.

~~NOTE 3—PREPAID EXPENSE AND OTHER ASSETS~~

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

May 5,

February 3,

2018

2018

Vendor deposits

$
20,896

$
9,701

Capitalized catalog costs

15,965

44,122

Right of return asset for merchandise

5,296

—

Prepaid expense and other current assets

17,907

14,762

Total prepaid expense and other current assets

$
60,064

$
68,585

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

May 5,

February 3,

2018

2018

Deferred financing fees

$
4,194

$
4,446

Construction related deposits

1,883

7,407

Other deposits

5,006

4,997

Other non-current assets

3,837

4,482

Total other non-current assets

$
14,920

$
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 three months ended May 5, 2018 (in thousands~~):

Foreign

February 3,

Currency

May 5,

2018

Translation

2018

RH Segment

Goodwill

$
124,448

$
(44
)

$
124,404

Trademarks and domain names

48,563

—

48,563

Waterworks

Goodwill ⁽¹⁾

17,445

—

17,445

Trademarks

52,100

—

52,100

~~(1)~~

T~~he Waterworks reporting unit goodwill is presented net of an impairment charge of $33.7 million, which was recorded in fiscal 2017~~.

~~NOTE 5—ACCOUNTS PAYABLE, ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES~~

~~Accounts payable and accrued expenses consist of the following (in thousands~~):

May 5,

February 3,

2018

2018

Accounts payable

$
166,044

$
195,313

Accrued compensation

31,250

47,534

Accrued freight and duty

18,219

23,757

Accrued sales taxes

17,674

19,525

Accrued occupancy

9,909

8,612

Accrued catalog costs

7,037

9,000

Accrued professional fees

2,960

3,555

Other accrued expenses

11,080

11,469

Total accounts payable and accrued expenses

$
264,173

$
318,765

~~Other current liabilities consist of the following (in thousands~~):

May 5,

February 3,

2018

2018

Allowance for sales returns

$
17,887

$
10,565

Unredeemed gift card and merchandise credit liability

17,673

24,138

Federal and state tax payable

13,478

5,391

Current portion of non-current debt

6,080

6,033

Product recall reserves

1,029

1,201

Other current liabilities

3,797

3,838

Total other current liabilities

$
59,944

$
51,166

NOTE 6—OTHER NON-CURRENT OBLIGATIONS

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


					May 4,		February 2,
	May 5,		February 3,		2019		2019
	2018		2018
Notes payable for share repurchases	$	19,633	$	19,390	$	18,741	$	18,741
Equipment security notes ⁽¹⁾		12,676		13,864
Promissory note ⁽²⁾		11,285		11,627
Lease loss liabilities		8,344		9,684
Capital lease obligations—non-current		7,389		7,509
Unrecognized tax benefits						3,089		2,992
Rollover units and profit interests (1)						2,744		2,637
Deferred contract incentive ⁽³⁾⁽²⁾		4,762		5,358		2,381		2,976
Unrecognized tax benefits		3,764		3,728
Rollover units and profit interests ⁽⁴⁾		2,317		2,211
Other non-current obligations		3,078		2,996		4,730		5,166
Total other non-current obligations	$	73,248	$	76,367	$	31,685	$	32,512

(1)

Represents rollover units and profit interests associated with the ~~non-current portion~~acquisition of ~~equipment security notes secured by certain of the Company’s distribution center property and equipment.~~Waterworks. Refer to Note 14—Stock-Based Compensation.

(2)

~~Represents the non-current portion of a promissory note secured by the Company’s aircraft.~~

~~(3)~~

Represents the non-current portion of an incentive payment received in relation to a ~~5-year~~5‑year service ~~agreement. The amount will be~~agreement, which is amortized over the term of the agreement.

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NOTE 7—LEASES

Accounting Policy

The Company leases nearly all of its retail and outlet store locations, corporate headquarters, distribution and home delivery facilities, as well as other storage and office space. The initial lease terms of the Company’s real estate leases generally range from ten to fifteen years, and certain leases contain renewal options for up to an additional 25 years, the exercise of which is at the Company’s sole discretion. In recognizing the lease right-of-use assets and lease liabilities, the Company utilizes the lease term for which it is reasonably certain to use the underlying asset, including consideration of options to extend or terminate the lease. The Company also leases certain equipment with lease terms generally ranging from three to seven years. The Company’s lease agreements generally do not contain any material residual value guarantees or material restrictions or covenants.

Leases, or lease extensions, with a term of twelve months or less are not recorded on the condensed consolidated balance sheets, and the Company recognizes lease expense for these leases on a straight-line basis over the lease term.

The Company accounts for lease and non-lease components as a single lease component for real estate leases, and for all other asset classes the Company accounts for the components separately. The Company determines the lease classification and begins to recognize lease and any related financing expenses upon the lease’s commencement, which for real estate leases is generally upon store opening or, to a lesser extent, when the Company takes possession or control of the asset.

As most of the Company’s leases do not include an implicit interest rate, the Company determines the discount rate for each lease based upon the incremental borrowing rate (“IBR”) in order to calculate the present value of lease payments at the commencement date. The IBR is computed as the rate of interest that the Company would have to pay to (i) borrow on a collateralized basis (ii) over a similar term (iii) an amount equal to the total lease payments and (iv) in a similar economic environment. The Company utilizes its asset based credit facility as the basis for determining the applicable IBR for each lease.

Certain of the Company’s lease agreements include rental payments based on a percentage of retail sales over contractual levels. Due to the variable and unpredictable nature of such payments, the Company does not recognize a lease right-of-use asset and lease liability related to such payments. Estimated variable rental payments are included in accounts payable and accrued expenses on the condensed consolidated balance sheets.

The Company has a small group of leases that include rental payments periodically adjusted for inflation (e.g., based on the consumer price index). The Company includes these variable payments in the initial measurement of the lease right-of-use asset and lease liability if such increases have a minimum rent escalation (e.g., floor). However, the Company excludes these variable payments from the initial measurement of the lease right-of-use asset and lease liability in the case of lease arrangements that do not specify a minimum rent escalation.

The Company rents or subleases certain real estate to third parties under operating leases and recognizes rental income received on a straight-line basis over the lease term, which is recorded as an offset to selling, general and administrative expenses on the condensed consolidated statements of income.

Lease arrangements may require the landlord to provide tenant allowances directly to the Company. Standard tenant allowances received from landlords, typically those received under operating lease agreements, are recorded as cash and cash equivalents with an offset recorded in lease right-of-use assets on the condensed consolidated balance sheets. In certain instances tenant allowances are provided for the Company to design and build the leased asset. Tenant allowances received from landlords during the construction phase of a leased asset and prior to lease commencement are recorded as cash and cash equivalents with an offset recorded in other non-current assets (to the extent the Company has incurred related capital expenditure for construction costs) or in other current liabilities (to the extent that payments are received prior to capital construction expenditures by the Company) on the condensed consolidated balance sheets. After the leased asset is constructed and the lease commences, the Company reclassifies the tenant allowance from other non-current assets or other current liabilities to lease right-of-use assets on the condensed consolidated balance sheets.

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Lease Classification

Certain of the Company’s real estate and property and equipment are held under finance leases. Lease related assets are included in finance lease right-of-use assets within property and equipment—net on the condensed consolidated balance sheets.

Leases that do not meet the definition of a finance lease are considered operating leases. Lease related assets are included in operating lease right-of-use assets on the condensed consolidated balance sheets.

Construction Related Activities

The Company is sometimes involved in the construction of leased stores for certain of its newer Design Galleries. Prior to construction commencement, the Company evaluates whether or not it, as lessee, controls the asset being constructed and, depending on the extent to which it is involved, the Company may be the “deemed owner” of the leased asset for accounting purposes during the construction period.

If the Company is not the “deemed owner” for accounting purposes during the construction period, such lease is classified as either an operating or finance lease upon lease commencement. During the construction period and prior to lease commencement, any capital amounts contributed by the Company toward the construction of the leased asset (excluding normal leasehold improvements, which are recorded within property and equipment—net) are recorded as “Landlord assets under construction” within other non-current assets on the condensed consolidated balance sheets (refer to Note 3—Prepaid Expense and Other Assets). Upon completion of the construction project, and upon lease commencement, the Company reclassifies amounts of the construction project determined to be the landlord asset to lease right-of-use assets on the condensed consolidated balance sheets. The construction costs determined not to be part of the leased asset are classified as property and equipment—net on the condensed consolidated balance sheets.

If the Company is the “deemed owner” for accounting purposes, upon commencement of the construction project, it is required to capitalize (i) costs incurred by the Company and (ii) the cash and non-cash assets contributed by the landlord for construction as property and equipment on its condensed consolidated balance sheets as build-to-suit assets, with an offsetting financing obligation under build-to-suit lease transactions. 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 the consolidated statements of cash flows. Over the lease term, these non-cash additions to property and equipment do not impact the Company’s cash outflows, nor do they impact net income within the consolidated statements of income.

Upon completion of the construction project, the Company performs a sale-leaseback analysis to determine if it can derecognize the build-to-suit asset and corresponding financing obligation. If the asset and liability cannot be derecognized, the Company accounts for the agreement as a debt-like arrangement.

As of May 4, 2019 and February 2, 2019, the Company did not have any build-to-suit lease transactions recorded on its condensed consolidated balance sheets.

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Lease Disclosures

Lease costs consist of the following (in thousands):


	Three Months Ended
	May 4,			May 5,
	2019			2018
Operating lease cost (1)(2)	$	19,117	$	21,346

Finance lease costs
Amortization of leased assets (1)		8,852		5,899
Interest on lease liabilities (3)		5,514		3,092

Sublease income (4)		(3,282)		(1,010)
Total lease costs—net	$	30,201	$	29,327

(1)

Operating lease costs and amortization of finance lease right-of-use assets are included in cost of goods sold or selling, general and administrative expenses on the condensed consolidated statements of income based on the Company’s policy. Refer to Note 3—Significant Accounting Policies in the 2018 Form 10-K.

(2)

Includes short-term leases and variable lease costs.

(3)

Included in interest expense—net on the condensed consolidated statements of income.

(4)

~~Represents rollover units~~

Included in selling, general and ~~profit interests associated with~~administrative expenses on the ~~acquisition~~condensed consolidated statements of ~~Waterworks. Refer to Note 13~~—income~~Stock-Based Compensation~~..

Lease right-of-use assets and lease liabilities consist of the following (in thousands):


		May 4,		February 2,
		2019		2019
	Balance Sheet Classification
Assets
Operating leases	Operating lease right-of-use assets	$	432,212	$	440,504
Finance leases (1)(2)	Property and equipment—net		658,077		646,875
Total lease right-of-use assets			1,090,289		1,087,379

Liabilities
Current
Operating leases	Operating lease liabilities	$	56,601	$	66,249
Finance leases	Other current liabilities		7,716		9,184
Total lease liabilities—current			64,317		75,433

Non-current
Operating leases	Non-current operating lease liabilities	$	427,961	$	437,557
Finance leases	Non-current finance lease liabilities		436,228		421,245
Total lease liabilities—non-current			864,189		858,802
Total lease liabilities		$	928,506	$	934,235

(1)

Finance lease right-of-use assets include capitalized amounts related to the Company’s construction activities to design and build leased assets, as well as rent payments made to landlords for which the respective Galleries are not yet opened.

(2)

Finance lease right-of-use assets are recorded net of accumulated amortization of $64.1 million and $55.5 million as of May 4, 2019 and February 2, 2019, respectively.

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The maturities of lease liabilities are as follows as of May 4, 2019 (in thousands):


Fiscal year	Operating Leases		Finance Leases		Total
Remainder of fiscal 2019	$	54,016	$	22,058	$	76,074
2020		76,683		33,426		110,109
2021		63,728		33,880		97,608
2022		56,804		34,388		91,192
2023		53,453		35,138		88,591
2024		49,688		35,680		85,368
Thereafter		228,008		548,155		776,163
Total lease payments (1)		582,380		742,725		1,325,105
Less—imputed interest (2)		(97,818)		(298,781)		(396,599)
Present value of lease liabilities (3)	$	484,562	$	443,944	$	928,506

(1)

Total lease payments exclude $211.3 million of legally binding payments for leases signed but not yet commenced as of May 4, 2019.

(2)

Calculated using the incremental borrowing rate for each lease at lease commencement.

(3)

Excludes future commitments under short-term lease agreements of $6.4 million as of May 4, 2019.

Supplemental information related to leases consists of the following:


	Three Months Ended
	May 4,		May 5,
	2019		2018
Weighted-average remaining lease term (years)
Operating leases		9.1	9.7
Finance leases		19.1	18.2

Weighted-average discount rate
Operating leases		3.80%	3.71%
Finance leases		5.26%	4.82%

Other information related to leases consists of the following (in thousands):


	Three Months Ended
	May 4,			May 5,
	2019			2018
Cash paid for amounts included in the measurement of lease liabilities
Operating cash flows from operating leases	$	(31,780)	$	(23,026)
Operating cash flows from finance leases		(5,514)		(3,092)
Financing cash flows from finance leases		(2,129)		(1,776)
Total cash outflows from leases	$	(39,423)	$	(27,894)

Lease right-of-use assets obtained in exchange for lease obligations (non-cash)
Finance leases	$	17,984	$	5,023
Operating leases		8,173		4,666

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NOTE 7—8—CONVERTIBLE SENIOR NOTES

0.00% Convertible Senior Notes due 2023

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 as part of the offering (collectively, the “2023 Notes”). The 2023 Notes are governed by the terms of an indenture between the Company and U.S. Bank National Association, as the Trustee. The 2023 Notes will mature on June 15, 2023, unless earlier purchased by the Company 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 the failure of the Company to perform certain of its 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 the Company or any of its 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, the Company 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 the Company’s 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 the Company’s common stock and the applicable conversion rate on such trading day; or (3) upon the occurrence of specified corporate transactions. As of May 4, 2019, none of these conditions have occurred and, as a result, the 2023 Notes were not convertible as of May 4, 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 the Company’s election, in cash, shares of the Company’s common stock, or a combination of cash and shares of the Company’s common stock. If the Company has not delivered a notice of its election of settlement method prior to the final conversion period it will be deemed to have elected combination settlement with a dollar amount per note to be received upon conversion of $1,000.

The Company 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 the Company 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.

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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, the Company 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 are recorded as a contra-liability and are presented net against the convertible senior notes due 2023 balance on the condensed consolidated balance sheets. During the three months ended May 4, 2019, the Company recorded $0.2 million related to the amortization of debt issuance costs.

The carrying values of the 2023 Notes, excluding the discounts upon original issuance and third party offering costs, are as follows (in thousands):


	May 4,		February 2,
	2019		2019
Liability component
Principal	$	335,000	$	335,000
Less: Debt discount		(77,264)		(81,311)
Net carrying amount	$	257,736	$	253,689
Equity component (1)	$	90,990	$	90,990

(1)

Included in additional paid-in capital on the condensed consolidated balance sheets.

The Company recorded interest expense of $4.1 million for the amortization of the debt discount related to the 2023 Notes during the three months ended May 4, 2019.

2023 Notes—Convertible Bond Hedge and Warrant Transactions

In connection with the offering of the 2023 Notes and exercise of the overallotment option in June 2018, the Company entered into convertible note hedge transactions whereby the Company has the option to purchase a total of approximately 1.7 million shares of its 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, the Company sold warrants whereby the holders of the warrants have the option to purchase a total of approximately 1.7 million shares of the Company’s 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). The Company 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 the Company’s 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, 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 condensed consolidated balance sheets.

The Company 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 condensed consolidated balance sheets.

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0.00% Convertible Senior Notes due 2020

In June 2015, the Company issued in a private offering $250 million principal amount of 0.00% convertible senior notes due 2020 and, in July 2015, the Company issued an additional $50 million principal amount pursuant to the exercise of the overallotment option granted to the initial purchasers as part of its June 2015 offering (collectively, the “2020 Notes”). The 2020 Notes are governed by the terms of an indenture between the Company and U.S. Bank National Association, as the Trustee. The 2020 Notes will mature on July 15, 2020, unless earlier purchased by the Company 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 the failure of the Company to perform certain of its 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 the Company or any of its 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 the Company’s 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, the Company 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 ~~fiscal~~calendar quarter, the last reported sale price of the Company’s 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 the Company’s common stock and the applicable conversion rate on such trading day; or (3) upon the occurrence of specified corporate transactions. As of May ~~5, 2018,~~4, 2019, none of these conditions have occurred and, as a result, the 2020 Notes ~~are~~were not convertible as of May ~~5, 2018.~~4, 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 the Company’s election, in cash, shares of the Company’s common stock, or a combination of cash and shares of the Company’s common stock. If the Company has not delivered a notice of its election of settlement method prior to the final conversion period it will be deemed to have elected combination settlement with a dollar amount per note to be received upon conversion of $1,000.

The Company 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 the Company 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.

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issuance of the 2020 Notes and the fair value of the liability component of the 2020 Notes. The ~~excess of the principal amount of the liability component over its carrying amount (“~~debt ~~discount”)~~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, the Company 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.~~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 are recorded as a contra-liability and are presented net against the convertible senior notes due 2020 balance on the condensed consolidated balance sheets. During both the three months ended May 4, 2019 and May 5, 2018, ~~and April 29, 2017,~~ the Company recorded $0.3 million related to the amortization of debt issuance costs.

The carrying values of the 2020 Notes, excluding the discounts upon original issuance and third party offering costs, are as follows (in thousands):


	May 5,			February 3,			May 4,		February 2,
	2018			2018			2019		2019
Liability component
Principal	$	300,000		$	300,000		$	300,000	$	300,000
Less: Debt discount		(39,974	)		(44,135	)		(22,642)		(27,081)
Net carrying amount	$	260,026		$	255,865		$	277,358	$	272,919
Equity component ⁽¹⁾	$	84,003		$	84,003		$	84,003	$	84,003

(1)

Included in additional paid-in capital on the condensed consolidated balance sheets.

The Company recorded interest expense of ~~$4.2~~$4.4 million and ~~$3.9~~$4.2 million for the amortization of the debt discount related to the 2020 Notes during the three months ended May 4, 2019 and May 5, 2018, ~~and April 29, 2017,~~ respectively.

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, the Company entered into convertible note hedge transactions whereby the Company has the option to purchase a total of approximately 2.5 million shares of its 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, the Company sold warrants whereby the holders of the warrants have the option to purchase a total of approximately 2.5 million shares of the Company’s 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). The Company 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 the Company’s 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, 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 condensed consolidated balance sheets.

The Company 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 condensed consolidated balance sheets.

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0.00% Convertible Senior Notes due 2019

In June 2014, the Company issued $350 million 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 the Company and U.S. Bank National Association, as the Trustee. The 2019 Notes will mature on June 15, 2019, unless earlier purchased by the Company 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 the failure of the Company to perform certain of its 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 the Company or any of its 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,” the Company 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 ~~fiscal~~calendar quarter, the last reported sale price of the Company’s 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 the Company’s common stock and the applicable conversion rate on such trading day; or (3) upon the occurrence of specified corporate transactions. As of May ~~5, 2018,~~4, 2019, none of these conditions have occurred and, as a result, the 2019 Notes ~~are~~were not convertible as of May ~~5, 2018.~~4, 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 the earlier of conversion and maturity of the 2019 Notes, ~~will be settled, at~~ the ~~Company’s election, in cash, shares of~~Company intends to settle the ~~Company’s common stock, or a combination of~~principal value with existing cash and shares of the Company’s common stock. If the Company has not delivered a notice of its election of settlement method prior to the final conversion period it will be deemed to have elected combination settlement with a dollar amount per note to be received upon conversion of $1,000.cash equivalents and restricted cash, as well as borrowings under our currently undrawn asset based credit facility.

The Company 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 the Company 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, the Company 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 ~~excess of the principal amount of the liability component over its carrying amount (“~~debt ~~discount”)~~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, the Company 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

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2019 Notes, and debt issuance costs attributable to the equity component are netted with the equity component in stockholders’ ~~equity.~~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 are recorded as a contra-liability and are presented net against the convertible senior notes due 2019 balance on the condensed consolidated balance sheets. During both the three months ended May 4, 2019 and May 5, 2018, ~~and April 29, 2017,~~ the Company recorded $0.2 million related to the amortization of debt issuance costs.

The carrying values of the 2019 Notes, excluding the discounts and commissions payable to the initial purchasers and third party offering costs, are as follows (in thousands):


	May 5,			February 3,			May 4,		February 2,
	2018			2018			2019		2019
Liability component
Principal	$	350,000		$	350,000		$	350,000	$	350,000
Less: Debt discount		(17,268	)		(20,988	)		(1,963)		(5,854)
Net carrying amount	$	332,732		$	329,012		$	348,037	$	344,146
Equity component ⁽¹⁾	$	70,482		$	70,482		$	70,482	$	70,482

(1)

Included in additional paid-in capital on the condensed consolidated balance sheets.

The Company recorded interest expense of ~~$3.7~~$3.9 million and ~~$3.6~~$3.7 million for the amortization of the debt discount related to the 2019 Notes during the three months ended May 4, 2019 and May 5, 2018, ~~and April 29, 2017,~~ respectively.

2019 Notes—Convertible Bond Hedge and Warrant Transactions

In connection with the offering of the 2019 Notes, the Company entered into convertible note hedge transactions whereby the Company has the option to purchase a total of approximately 3.0 million shares of its 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, the Company sold warrants whereby the holders of the warrants have the option to purchase a total of approximately 3.0 million shares of the Company’s 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). The Company 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, 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 condensed consolidated balance sheets.

The Company 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 assets are included in deferred tax assets on the condensed consolidated balance sheets.

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NOTE 8—9—CREDIT FACILITIES

The outstanding balances under the Company’s ~~outstanding~~ credit facilities were as follows (in thousands):


	May 5,							February 3,							May 4,						February 2,
	2018							2018							2019						2019
	Outstanding		Unamortized Debt			Net Carrying		Outstanding		Unamortized Debt			Net Carrying		Outstanding		Unamortized Debt		Net Carrying		Outstanding		Unamortized Debt		Net Carrying
	Amount		Issuance Costs			Amount		Amount		Issuance Costs			Amount		Amount		Issuance Costs		Amount		Amount		Issuance Costs		Amount
Asset based credit facility	$	219,000	$	—		$	219,000	$	199,970	$	—		$	199,970	$	—	$	—	$	—	$	57,500	$	—	$	57,500
LILO term loan		80,000		(472	)		79,528		80,000		(501	)		79,499
FILO term loan																120,000		(935)		119,065		—		—		—
Second lien term loan																200,000		(2,860)		197,140		—		—		—
Equipment promissory notes (1)																59,016		(350)		58,666		—		—		—
Total credit facilities	$	299,000	$	(472	)	$	298,528	$	279,970	$	(501	)	$	279,469	$	379,016	$	(4,145)	$	374,871	$	57,500	$	—	$	57,500

(1)

Represents total equipment security notes secured by certain of the Company’s property and equipment, of which $18.4 million was included in other current liabilities and $40.6 million was included in other non-current obligations on the condensed consolidated balance sheets.

Asset Based Credit Facility & ~~LILO~~FILO Term Loan

On June 28, 2017, Restoration Hardware, Inc. entered into an eleventh amended and restated credit agreement (the “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”~~“First Lien Administrative Agent”). The ~~credit agreement~~Credit Agreement has a revolving line of credit with initial 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~~$800.0 million if and to the extent the lenders, ~~revise~~whether existing lenders or new lenders, agree to increase their credit ~~commitments to encompass a larger facility.~~commitments. In addition, the ~~credit agreement establishes~~Credit Agreement established an $80.0 million ~~LILO~~last in, last out (“LILO”) term loan ~~facility.~~facility, which was repaid in full in June 2018. The ~~credit agreement~~Credit Agreement has a maturity date of June 28, 2022.

On April 4, 2019, Restoration Hardware, Inc., entered into a third amendment to the Credit Agreement (the “Third Amendment”). The Third Amendment, among other things, (a) established a $120.0 million first in, last out (“FILO”) term loan facility, which amount was fully borrowed as of April 4, 2019 and which incurs interest at a rate that is 1.25% greater than the interest rate applicable to the revolving loans provided for under the Credit Agreement at any time, (b) provided for additional permitted indebtedness, as defined in the Credit Agreement, that the loan parties can incur, and (c) modified the borrowing availability under the Credit Agreement in certain circumstances. The FILO term loan facility has a maturity date of June ~~12, 2018,~~28, 2022.

In addition, under the Credit Agreement, the Company is required to meet specified financial ratios in order to undertake certain actions, and the Company may be required to maintain certain levels of excess availability or meet a specified consolidated fixed-charge coverage ratio (“FCCR”). Subject to certain exceptions, 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 subject to certain exceptions to maintain an FCCR of at least one to one.

As of May 4, 2019, the Company had no outstanding borrowings under the revolving line of credit. The Credit Agreement provides for a borrowing amount based on the value of eligible collateral and a formula linked to certain

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borrowing percentages based on certain categories of collateral. Under the terms of such provisions, the amount under the revolving line of credit borrowing base that could be available pursuant to the Credit Agreement as of May 4, 2019 was $139.4 million, net of $285.0 million reserved for the upcoming repayment of the 2019 Notes, as well as $12.8 million in outstanding letters of credit.

As previously reported, on May 31, 2019, Restoration Hardware, Inc. entered into a ~~First~~fourth amendment to the Credit Agreement (the “Fourth Amendment”). The Fourth Amendment, ~~(the “Amendment”)~~among other things, amends the Credit Agreement to ~~credit agreement. The Amendment (i) changes~~(a) extend the ~~credit agreement’s definition~~time to deliver monthly financial statements to the lenders for the fiscal months ending February 2019 and March 2019 until June 19, 2019; (b) remove the requirement to deliver monthly financial statements to the lenders for the last fiscal month of ~~“Eligible In-Transit Inventory” to clarify the requirements to be fulfilled by the borrowers with respect to such in-transit inventory,~~any fiscal quarter; and ~~(ii) clarifies that no Default~~(c) waive any default or ~~Event~~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 Company’s borrowing base for eligible collateral for purposes of determining the amount of borrowing available to borrowersdefault under the ~~credit agreement.~~

~~Borrowings under~~Credit Agreement relating to the ~~revolving line~~delivery of ~~credit~~monthly financial statements or other information to lenders for the fiscal months ending February 2019 and LILO term loan facility 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.March 2019.

The ~~credit agreement~~Credit Agreement contains various restrictive and affirmative covenants, including, among others, required financial reporting, 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 a result of ~~May 5, 2018,~~ the Fourth Amendment, Restoration Hardware, Inc. was deemed to be in compliance as of May 4, 2019 with all applicable covenants of the Credit Agreement.

Second Lien Credit Agreement

On April 10, 2019, Restoration Hardware, Inc., entered into a credit agreement, dated as of April 9, 2019 and effective as of April 10, 2019 (the “Second Lien Credit Agreement”), among (i) Restoration Hardware, Inc., as lead borrower, (ii) the guarantors party thereto, (iii) the lenders party thereto, each of whom are funds and accounts managed or advised by either Benefit Street Partners L.L.C. and its affiliated investment managers or Apollo Capital Management, L.P. and its affiliated investment managers, as applicable, and (iv) BSP Agency, LLC, as administrative agent and collateral agent (the “Second Lien Administrative Agent”) with respect to a second lien term loan in an aggregate principal amount equal to $200.0 million with a maturity date of April 9, 2024 (the “Second Lien Term Loan”).

The Second Lien Term Loan bears interest at an annual rate generally based on the London Inter-bank Offered Rate (“LIBOR”) plus 6.50%. This rate is a floating rate that resets periodically based upon changes in LIBOR rates during the life of the Second Lien Term Loan. At the date of the initial borrowing, the rate was set at one-month LIBOR plus 6.50%.

All obligations under the Second Lien Term Loan are secured by a second lien security interest in substantially all of the assets of the loan parties, including inventory, receivables and certain types of intellectual property. The second lien security interest encumbers substantially the same collateral that secures the Credit Agreement. The second lien ranks junior in priority and is subordinated to the first lien in favor of the lenders with respect to the Credit Agreement.

The borrowings under the Second Lien Credit Agreement may be prepaid in whole or in part at any time, subject to certain minimum payment requirements, and including (i) a prepayment premium in the amount of 2.0% of the principal amount of the Second Lien Term Loan being prepaid during the first year after the effective date of the Second Lien Credit Agreement, (ii) 1.0% of the principal amount of the Second Lien Term Loan being prepaid during the second year after the effective date of the Second Lien Credit Agreement, and (iii) no prepayment premium after the second anniversary of the effective date of the Second Lien Credit Agreement.

The Second Lien Credit Agreement contains a financial ratio covenant not found in the Credit Agreement based upon a net senior secured leverage ratio of consolidated secured debt to consolidated EBITDA, as defined in The Credit Agreement, as follows:

The net senior secured leverage ratio test is based on the ratio of (i) the sum of (a) all obligations outstanding under the Second Lien Term Loan and the Credit Agreement plus (b) all other secured

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indebtedness of RH and certain of its subsidiaries that is (x) senior or pari passu to the lien on the Second Lien Term Loan collateral or (y) secured by property that does not constitute Second Lien Term Loan collateral under the Second Lien Term Loan, less (c) all unrestricted cash and cash equivalents of RH and certain of its subsidiaries subject to a blocked account control agreement, to (ii) consolidated EBITDA of RH and certain of its subsidiaries (the “Net Senior Secured Leverage Ratio”).

The Net Senior Secured Leverage Ratio may not exceed 3.50 to 1.00 as of the last day of any fiscal quarter. The Second Lien Credit Agreement also contains a consolidated fixed charge coverage ratio generally based on the same formulation set forth in the Credit Agreement such that the borrower may not make certain “restricted payments” in the event that the ratio of (i) consolidated EBITDA minus certain costs to the amount of (ii) debt service costs plus certain other costs is not less than 1.00 to 1.00 and the level of unused availability under the Credit Agreement meets certain levels.

The Second Lien Credit Agreement also contains certain events of default and other customary terms and conditions typical to a second lien credit agreement.

As of May ~~5, 2018,~~4, 2019, the Company had ~~$219.0~~$200.0 million in outstanding borrowings and ~~$138.8 million of~~no availability under the ~~revolving line~~Second Lien Credit Agreement.

As previously reported, on May 31, 2019, Restoration Hardware, Inc. entered into a first amendment to the Second Lien Credit Agreement (the “First Amendment”). The First Amendment, among other things, amends the Second Lien Credit Agreement to (a) remove the requirement to deliver monthly financial statements to the lenders for the last fiscal month of ~~credit, net~~any fiscal quarter and (b) waive any default or event of ~~$27.8 million in outstanding letters of credit. As of May 5, 2018, the Company had $80.0 million outstanding borrowings~~default under the ~~LILO term loan facility.~~Second Lien Credit Agreement relating to the delivery of monthly financial statements or other information to lenders for the fiscal months ending February 2019 and March 2019.

The Second Lien Credit Agreement contains various restrictive and affirmative covenants generally in line with the covenants and restrictions contained in the Credit Agreement, including required financial reporting, 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 a similar type and size. As a result of the ~~consolidated fixed-charge coverage ratio (“FCCR��) restriction that limits the last 10% of borrowing availability, actual incremental borrowing available~~First Amendment, Restoration Hardware, Inc. was deemed to ~~the Company and the other affiliated parties under the revolving line of credit was approximately $92.2 million~~be in compliance as of May 4, 2019 with all applicable covenants of the Second Lien Credit Agreement.

Intercreditor Agreement

On April 10, 2019, in connection with the Second Lien Credit Agreement, Restoration Hardware, Inc. entered into an Intercreditor Agreement (the “Intercreditor Agreement”), dated as of April 9, 2019 and effective as of April 10, 2019, with the First Lien Administrative Agent and the Second Lien Administrative Agent. The Intercreditor Agreement establishes 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.

Equipment Loan Facility

On September 5, ~~2018.~~2017, Restoration Hardware, Inc. entered into a Master Loan and Security Agreement with Banc of America Leasing & Capital, LLC (“BAL”) pursuant to which BAL and the Company agreed that BAL would finance certain equipment of the Company from time to time, with each such equipment financing to be evidenced by an equipment security note setting forth the terms for each particular equipment loan. Each equipment loan is secured by a purchase money security interest in the financed equipment. As of May 4, 2019, the Company had $59.0 million in aggregate amounts outstanding under the equipment security notes. The maturity dates of the equipment security notes vary, but generally have a maturity of three or four years. The Company is required to make monthly installment payments under the equipment security notes.

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NOTE 9—10—FAIR VALUE ~~OF FINANCIAL INSTRUMENTS~~MEASUREMENTS

Certain financial assets and liabilities are required to be carried at fair value. Fair value is the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. In determining the fair value, the Company utilizes market data or assumptions that it believes market participants would use in pricing the asset or liability, which would maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible, including assumptions about risk and the risks inherent in the inputs of the valuation technique.

The degree of judgment used in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Pricing observability is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction. Financial instruments with readily available active quoted prices for which fair value can be measured generally will have a higher degree of pricing observability and a lesser degree of judgment used in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have less, or no, pricing observability and a higher degree of judgment used in measuring fair value.

The Company’s financial assets and liabilities measured and reported at fair value are classified and disclosed in one of the following categories:

Level 1—Quoted prices are available in active markets for identical investments as of the reporting date.

Level 2—Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reporting date, and fair value is determined through the use of models or other valuation methodologies.

Level 3—Pricing inputs are unobservable for the investment and include situations where there is little, if any, market activity for the investment. The inputs used in the determination of fair value require significant management judgment or estimation.

A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

Fair Value Measurements—Recurring

Amounts reported as cash and equivalents, receivables, and accounts payable and accrued expenses approximate fair value due to the short-term nature of activity within these accounts. The estimated fair value and carrying value of the 2019 Notes, 2020 Notes and ~~2020~~2023 Notes were as follows (in thousands):


									May 4,				February 2,
	May 5,				February 3,				2019				2019
	2018				2018				Fair		Carrying		Fair		Carrying
	Fair Value		Carrying Value ⁽¹⁾		Fair Value		Carrying Value ⁽¹⁾		Value		Value (1)		Value		Value (1)
Convertible senior notes due 2019	$	327,352	$	332,732	$	324,866	$	329,012	$	347,211	$	348,037	$	334,756	$	344,146
Convertible senior notes due 2020	$	261,653	$	260,026	$	261,047	$	255,865		277,652		277,358		260,258		272,919
Convertible senior notes due 2023										257,639		257,736		230,684		253,689

(1)

Carrying value represents the principal amount less the equity component of the 2019 Notes, 2020 Notes and ~~2020~~2023 Notes classified in stockholders’ equity (deficit), and does not exclude the discounts upon original issuance, discounts and commissions payable to the initial purchasers and third party offering costs, as applicable.

The fair value of each of the 2019 Notes, 2020 Notes and ~~2020~~2023 Notes was determined based on inputs that are observable in the market or that could be derived from, or corroborated with, observable market data, including the

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trading price of the Company’s convertible

notes, when available, the Company’s stock price and interest rates based on similar debt issued by parties with credit ratings similar to the Company (Level 2).

Fair Value Measurements—Non-Recurring

The ~~estimated~~ fair ~~values~~value of the Waterworks reporting unit as of February 2, 2019 was determined based on unobservable (Level 3) inputs and valuation techniques, as discussed in “Impairment” within Note 3—Significant Accounting Policies in the 2018 Form 10-K. The fair value of the asset ~~based credit facility and LILO term loan were $219.0 million and $80.0 million, respectively, each of which approximates cost,~~held for sale as of ~~May 5, 2018. Fair value approximates cost for both the asset~~February 2, 2019 was determined based ~~credit facility~~on an appraisal prepared using unobservable (Level 3) inputs and ~~LILO term loan as the interest rate associated with each facility is variable and resets frequently.~~valuation techniques.

NOTE ~~10—~~11—INCOME TAXES

The Company recorded income tax expense of ~~$8.5~~$11.8 million and ~~an income tax benefit of $1.9~~$7.6 million in the three months ended May 4, 2019 and May 5, 2018, ~~and April 29, 2017,~~ respectively. The effective tax rate was ~~23.3%~~24.8% and ~~36.2%~~23.0% for the three months ended May 4, 2019 and May 5, 2018, ~~and April 29, 2017,~~ respectively. The ~~decrease~~increase in the effective tax rate is primarily due to ~~the reduction in the U.S. corporate income~~lower discrete tax ~~rate from 35% to 21% effective January 1, 2018 due to the passage of the Tax Cuts and Jobs Act (the “Tax Act”).~~

On December 22, 2017, the Tax Act was enacted in the United States. The Company recognized the income tax effects of the Tax Act in its fiscal 2017 financial statements in accordance with Staff Accounting Bulletin 118, which provides SEC staff guidance for the application of ASC Topic 740, Income Taxes, in the reporting period in which the Tax Act was signed into law. As noted in its fiscal 2017 consolidated financial statements, the Company was able to reasonably estimate certain effects and, therefore, recorded provisional amounts associated with the one-time transition tax on indefinitely reinvested foreign earnings and the adjustment to our deferred tax assets and liabilities for the reduction in the corporate income tax rate.

~~The Company has not made any additional measurement period adjustments~~benefits related to ~~these items during~~net excess tax windfalls from stock-based compensation in the three months ended May 5, 2018. As the Company continues its analysis of the Tax Act and interprets any additional guidance, it may make adjustments to the provisional amounts that have been recorded that may materially impact the Company's provision for income taxes.4, 2019.

As of both May ~~5, 2018~~4, 2019 and February ~~3, 2018,~~2, 2019, the Company had ~~$8.2~~$8.5 million of unrecognized tax benefits, of which ~~$6.5~~$7.3 million would reduce income tax expense and the effective tax rate, if recognized. The remaining unrecognized tax benefits would offset other deferred tax assets, if recognized. As of May ~~5, 2018,~~4, 2019, the Company had $0.4 million of exposures related to unrecognized tax benefits that are expected to decrease in the next 12 months.

NOTE ~~11—~~12—NET INCOME ~~(LOSS)~~ PER SHARE

The weighted-average shares used for net income ~~(loss)~~ per share ~~is presented in the table below. As the Company was in a net loss position for the three months ended April 29, 2017, the weighted-average shares outstanding for basic and diluted~~ are ~~the same.~~

as follows:


	Three Months Ended				Three Months Ended
	May 5,		April 29,		May 4,	May 5,
	2018		2017		2019	2018
Weighted-average shares—basic		21,545,025		37,609,516	19,976,858	21,545,025
Effect of dilutive stock-based awards		3,685,203		—	4,472,545	3,685,203
Effect of dilutive convertible senior notes⁽¹⁾		—		—	484,584	—
Weighted-average shares—diluted		25,230,228		37,609,516	24,933,987	25,230,228

(1)

The 2019 Notes, ~~and~~ 2020 Notes ~~will~~and 2023 Notes have an impact on the Company’s dilutive share count beginning at stock prices of $116.09 per share, $118.13 per share and ~~$118.13~~$193.65 per share, respectively.

The following number of options and restricted stock units were excluded from the calculation of diluted net income ~~(loss)~~ per share because their inclusion would have been anti-dilutive:


	Three Months Ended				Three Months Ended
	May 5,		April 29,		May 4,	May 5,
	2018		2017		2019	2018
Options		486,516		8,221,249	463,506	486,516
Restricted stock units		10,500		1,029,740	—	10,500
Total anti-dilutive stock-based awards		497,016		9,250,989	463,506	497,016

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NOTE ~~12—~~13—SHARE REPURCHASES

~~$300 Million~~ Share Repurchase Program

On ~~February 21, 2017,~~October 10, 2018, the Company’s Board of Directors authorized a ~~stock~~share repurchase program of up to ~~$300~~$700 million, ~~(the “$300 Million Repurchase Program”). Under~~of which $250.0 million in share repurchases were completed in fiscal 2018. The $700.0 million authorization amount was replenished by the ~~$300 Million Repurchase Program, the~~Board of Directors on March 25, 2019. The Company repurchased approximately ~~7.8~~2.2 million shares of its common stock at an average price of ~~$38.24~~$115.36 per share, for an aggregate repurchase amount of approximately ~~$300~~$250.0 million, during the three months ended ~~April 29, 2017. As the $300 Million Repurchase Program was completed during the three months ended April 29, 2017 there will be no repurchases in future periods~~May 4, 2019 under this share repurchase ~~authorization.~~program. As of May 4, 2019, there was $450.0 million remaining for future share repurchases under this program.

Share Repurchases Under Equity Plans

As of both May ~~5, 2018~~4, 2019 and February ~~3, 2018,~~2, 2019, the aggregate unpaid principal amount of the notes payable for share repurchases was $19.6 million, of which $0.9 million were included in other current liabilities and ~~$19.4~~$18.7 million ~~respectively, which is~~were included in other non-current obligations on the condensed consolidated balance sheets. During both the three months ended May 4, 2019 and May 5, 2018, ~~and April 29, 2017,~~ the Company recorded interest expense on the outstanding notes of $0.2 million.

Of the $19.6 million ~~and $19.4 million~~ notes payable for share repurchases outstanding as of both May ~~5, 2018~~4, 2019 and February ~~3, 2018, respectively,~~2, 2019, $15.5 million was due to a current board member of the Company.

NOTE ~~13—~~14—STOCK-BASED COMPENSATION

The Company estimates the value of equity grants based upon an option-pricing model (“OPM”) and recognizes this estimated value as compensation expense over the vesting periods. The Company recognizes expense associated with performance-based awards when it becomes probable that the performance condition will be met. Once it becomes probable that an award will vest, the Company recognizes compensation expense equal to the number of shares which are probable to vest multiplied by the fair value of the related shares measured at the grant date.

Stock-based compensation expense is included in selling, general and administrative expenses on the condensed consolidated statements of ~~operations.~~ income. The Company recorded stock-based compensation expense of ~~$8.0~~$5.7 million and ~~$5.3~~$8.0 million during the three months ended May 4, 2019 and May 5, 2018 ~~and April 29, 2017,~~, respectively. No stock-based compensation cost has been capitalized in the accompanying condensed consolidated financial statements.

2012 Stock Incentive Plan and 2012 Stock Option Plan

As of May ~~5, 2018, 8,564,739~~4, 2019, 7,761,127 options were outstanding with a weighted-average exercise price of ~~$50.66~~$55.87 per share and ~~6,295,895~~6,040,300 options were vested with a weighted-average exercise price of ~~$51.95~~$52.02 per share. The aggregate intrinsic value of options outstanding, options vested or expected to vest, and options exercisable as of May ~~5, 2018~~4, 2019 was ~~$429.8~~$413.6 million, ~~$388.2~~$397.5 million, and ~~$307.0~~$342.9 million, respectively. Stock options exercisable as of May ~~5, 2018~~4, 2019 had a weighted-average remaining contractual life of ~~5.90~~4.90 years. As of May ~~5, 2018,~~4, 2019, the total unrecognized compensation expense related to unvested options was ~~$23.4~~$37.9 million, which is expected to be recognized on a straight-line basis over a weighted-average period of ~~2.86~~3.30 years.

As of May ~~5, 2018,~~4, 2019, the Company had ~~768,463~~371,374 restricted stock units outstanding with a weighted-average grant date fair value of ~~$52.81~~$52.36 per share. During the three months ended May ~~5, 2018, 30,615~~4, 2019, 25,135 restricted stock units vested with a weighted-average grant date and vest date fair value of ~~$52.36~~$53.44 per ~~share and $97.09 per share, respectively.~~share. As of May ~~5, 2018,~~4, 2019, there was ~~$18.9~~$8.3 million of total unrecognized compensation expense related to unvested restricted stock and restricted stock units which is expected to be recognized over a weighted-average period of ~~2.81~~1.85 years.

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Rollover Units

In connection with the acquisition of Waterworks in May 2016, $1.5 million rollover units in the Waterworks subsidiary (the “Rollover Units”) were recorded as part of the transaction. The Rollover Units are subject to the terms of the Waterworks LLC agreement, including redemption rights at an amount equal to the greater of (i) the $1.5 million remitted as consideration in the business combination or (ii) an amount based on the percentage interest represented in the overall valuation of the Waterworks subsidiary (the “Appreciation Rights”). The Appreciation Rights are measured at fair value and are subject to fair value measurements during the expected life of the Rollover Units, with changes to fair value recorded in the condensed consolidated statements of ~~operations.~~income. The fair value of the Appreciation Rights is determined based on an ~~option pricing method (“OPM”).~~OPM. The Company did not record any expense related to the Appreciation Rights during the three months ended May 4, 2019 and May 5, ~~2018 or April 29, 2017.~~2018. As of both

May ~~5, 2018~~4, 2019 and February ~~3, 2018,~~2, 2019, the liability associated with the Rollover Units and related Appreciation Rights was $1.5 million, which is included in other non-current obligations on the condensed consolidated balance sheets.

Profit Interests

In connection with the acquisition of Waterworks in May 2016, profit interests units in the Waterworks subsidiary (the “Profit Interests”) were issued to certain Waterworks associates. The Profit Interests are measured at their grant date fair value and expensed on a straight-line basis over their expected life, or five years. The Profit Interests are subject to fair value measurements during their expected life, with changes to fair value recorded in the condensed consolidated statements of ~~operations.~~income. The fair value of the Profit Interests is determined based on an OPM. For both the three months ended May 4, 2019 and May 5, 2018, ~~and April 29, 2017,~~ the Company recorded $0.1 million related to the Profit Interests, which is included in selling, general and administrative expenses on the condensed consolidated statements of ~~operations.~~income. As of May ~~5, 2018~~4, 2019 and February ~~3, 2018,~~2, 2019, the liability associated with the Profit Interests was ~~$0.8~~$1.2 million and ~~$0.7~~$1.1 million, respectively, which is included in other non-current obligations on the condensed consolidated balance sheets.

NOTE ~~14—~~15—COMMITMENTS AND CONTINGENCIES

Commitments

The Company had no material off balance sheet commitments as of May ~~5, 2018.~~4, 2019.

Contingencies

The Company is involved in lawsuits, claims and proceedings incident to the ordinary course of its business. These disputes are increasing in number as the business expands and the Company grows larger. Litigation is inherently unpredictable. As a result, the outcome of matters in which the Company is involved could result in unexpected expenses and liability that could adversely affect the Company’s operations. In addition, any claims against the Company, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and result in the diversion of significant operational resources.

The Company reviews the need for any loss contingency reserves and establishes reserves when, in the opinion of management, it is probable that a matter would result in liability, and the amount of loss, if any, can be reasonably estimated. Generally, in view of the inherent difficulty of predicting the outcome of those matters, particularly in cases in which claimants seek substantial or indeterminate damages, it is not possible to determine whether a liability has been incurred or to reasonably estimate the ultimate or minimum amount of that liability until the case is close to resolution, in which case no reserve is established until that time. When and to the extent that the Company does establish a reserve, there can be no assurance that any such recorded liability for estimated losses will be for the appropriate amount, and actual losses could be higher or lower than what the Company accrues from time to time. The Company believes that the ultimate resolution of its current matters will not have a material adverse effect on its condensed consolidated financial statements.

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Securities Class Action

On February 2, 2017, City of Miami General Employees’ & Sanitation Employees’ Retirement Trust filed a class action complaint in the United States District Court, Northern District of California, against the Company, Gary Friedman, and Karen Boone. On March 16, 2017, Peter J. Errichiello, Jr. filed a similar class action complaint in the same forum and against the same parties. On April 26, 2017, the court consolidated the two actions. The consolidated action is captioned In re RH, Inc. Securities Litigation. An amended consolidated complaint was filed in June 2017 asserting claims under sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The complaint asserts claims purportedly on behalf of a class of purchasers of Company common stock from March 26, 2015 to June 8, 2016. The alleged misstatements relate to statements regarding the roll out of the RH Modern product line and the Company’s inventory levels. The complaint seeks class certification, monetary damages, and other appropriate relief, including an award of costs and attorneys’ fees. On ~~February 26, 2018, the Court filed an order denying the Company’s motion to dismiss the complaint. While the outcome of litigation is inherently uncertain,~~March 21, 2019, the Company and ~~its officers intend~~the individual defendants in the case entered into a binding memorandum of understanding to ~~vigorously defend~~settle the case. The settlement amount is $50 million, which amount is to our understanding covered in full by the Company's insurance policies. On May 6, 2019, the plaintiffs filed a motion for preliminary approval of the proposed settlement together with a settlement agreement executed by both parties. The settlement agreement is subject to customary conditions including court approval following notice to the Company's shareholders, and a hearing at which time the court will consider the fairness, reasonableness and adequacy of the settlement. If a settlement is finally approved by the court, it will resolve all of the claims that were or could have been brought in the action. A hearing for preliminary approval of the settlement is scheduled for June 18, 2019. As a result of signing the memorandum of understanding and ~~believe~~ the ~~complaint lacks merit~~.potential liability becoming probable and estimable, the Company has recorded a provision for legal settlement and unpaid legal fees for $60.1 million within other current liabilities on the condensed consolidated balance sheets as of May 4, 2019. Additionally, the Company has recorded a litigation insurance recovery receivable of $60.1 million as of May 4, 2019 within prepaid expense and other current assets on the condensed consolidated balance sheets, which represents the estimated insurance claims proceeds from the Company’s insurance carriers.

Shareholder Derivative Lawsuit

On April 24, 2018, purported Company shareholder David Magnani filed a purported shareholder derivative suit in the United States District Court, Northern District of California, captioned Magnani v. Friedman et al. (No. 18-cv-02452). ~~The suit~~On June 29, 2018, Hosrof Izmirliyan filed a similar purported shareholder derivative complaint in the same forum, captioned Izmirliyan v. Friedman et al. (No. 18-cv-03930). On July 29, 2018, the court consolidated both derivative actions, and the consolidated action is captioned In re RH Shareholder Derivative Litigation. On August 24, 2018, plaintiffs filed an amended complaint that names ~~the Company~~RH as a nominal defendant and ~~certain current~~Gary Friedman, Karen Boone, Carlos Alberini, Keith Belling, Eri Chaya, Mark Demilio, Katie Mitic, Ali Rowghani and ~~former directors and officers~~Leonard Schlesinger as ~~individual~~ defendants. The allegations ~~in the complaint~~ substantially track those in the securities class action described above. ~~The plaintiff brings~~Plaintiffs bring claims against all individual

defendants under Section 14(a) of the Exchange Act, as well as claims for breach of fiduciary duty, unjust enrichment, and waste of corporate assets. The ~~complaint~~plaintiffs also ~~includes~~allege insider trading and misappropriation of information claims against two of the individual defendants. The amended complaint seeks monetary damages, corporate governance changes, restitution, and an award of costs and attorneys’ fees. The Company believes that ~~the plaintiff lacks~~plaintiffs lack standing to bring this derivative action.

On September 28, 2018, the Company filed a motion to stay proceedings and a motion to dismiss the consolidated complaint. On January 23, 2019, the court granted the motion to stay the case.

NOTE ~~15—~~16—SEGMENT REPORTING

The Company defines reportable and operating segments on the same basis that it uses to evaluate performance internally by the Chief Operating Decision Maker (the “CODM”). The Company has determined that the Chief Executive Officer is its CODM. As of May ~~5, 2018,~~4, 2019, the Company had two operating segments: RH Segment and Waterworks. The two operating segments include all sales channels accessed by the Company’s customers, including sales through catalogs, sales through the Company’s websites, sales through stores, and sales through the commercial channel.

The Company’s two operating segments are strategic business units that offer products for the home furnishings customer. While RH Segment and Waterworks have a shared management team and customer base, the Company has

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determined that their results cannot be aggregated as they do not share similar economic characteristics, as well as due to other quantitative factors.

The Company uses operating income to evaluate segment profitability. Operating income is defined as net income ~~(loss)~~ before interest expense—net and income ~~taxes.~~tax expense.

Segment Information

The following table presents the statements of ~~operations~~income metrics reviewed by the CODM to evaluate performance internally or as required under ASC 280—Segment Reporting ~~(in thousands)~~(in thousands):


	Three Months Ended												Three Months Ended
	May 5,						April 29,						May 4,						May 5,
	2018						2017						2019						2018
	RH Segment		Waterworks		Total		RH Segment		Waterworks		Total		RH Segment		Waterworks		Total		RH Segment		Waterworks		Total
Net revenues	$	526,007	$	31,399	$	557,406	$	533,528	$	28,552	$	562,080	$	563,706	$	34,715	$	598,421	$	526,007	$	31,399	$	557,406
Gross profit		199,035		13,000		212,035		159,627		10,629		170,256		217,943		14,871		232,814		195,706		13,627		209,333
Depreciation and amortization		15,935		1,112		17,047		14,901		1,119		16,020		26,004		1,185		27,189		21,633		1,112		22,745

The following table presents the balance sheet metrics as required under ASC 280—Segment Reporting ~~(in thousands)~~(in thousands):


	May 5,						February 3,						May 4,						February 2,
	2018						2018						2019						2019
	RH Segment		Waterworks		Total		RH Segment		Waterworks		Total		RH Segment		Waterworks		Total		RH Segment		Waterworks		Total
Goodwill ⁽¹⁾	$	124,404	$	17,445	$	141,849	$	124,448	$	17,445	$	141,893	$	124,349	$	—	$	124,349	$	124,379	$	—	$	124,379
Trademarks and domain names		48,563		52,100		100,663		48,563		52,100		100,663
Tradenames, trademarks and domain names (2)														48,563		37,459		86,022		48,563		37,459		86,022
Total assets		1,621,817		127,144		1,748,961		1,608,290		124,576		1,732,866		2,397,748		148,084		2,545,832		2,273,951		149,067		2,423,018

(1)

The Waterworks reporting unit goodwill of $51.1 million recognized upon acquisition in fiscal 2016 was fully impaired as of February 2, 2019, with $17.4 million and $33.7 million impairment recorded in fiscal 2018 and fiscal 2017, respectively.

(2)

The Waterworks reporting unit tradename is presented net of an impairment charge of ~~$33.7~~$14.6 million ~~which was~~ recorded in fiscal ~~2017.~~2018.

The Company uses segment operating income to evaluate segment performance and allocate resources. Segment operating income excludes (i) ~~legal expenses incurred~~asset impairments and change in ~~connection with the final purchase price~~useful lives, (ii) product recall accruals and adjustments, (iii) reversal of ~~Waterworks, (ii)~~an estimated loss on disposal of asset, (iv) non-cash amortization of the inventory fair value adjustment recorded in connection with the acquisition of Waterworks ~~(iii) the lease loss liability adjustment associated~~and (v) costs incurred in connection with ~~the Dallas distribution center closure and (iv) product recall adjustments.~~a legal settlement. These items are excluded from segment operating income in order to provide better transparency of segment operating results. Accordingly, these items are not presented by segment because they are excluded from the segment profitability measure that management reviews.

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The following table presents segment operating income ~~(loss)~~ and income ~~(loss)~~ before ~~tax~~income taxes (in thousands):

	Three Months Ended
	May 5,			April 29,			Three Months Ended
	2018			2017			May 4,		May 5,
Operating income (loss):
							2019		2018
Operating income:
RH Segment	$	53,896		$	10,058		$	69,400	$	49,048
Waterworks		(516	)		(1,782	)		1,094		110
Distribution center closures		2,072			—
Asset impairments and change in useful lives								(3,476)		—
Recall accrual		254			—			1,615		254
Post-acquisition related legal costs		(1,915	)		—
Loss on asset disposal reversal								—		840
Impact of inventory step-up		(190	)		(1,380	)		—		(190)
Operating income		53,601			6,896
Legal costs								—		(1,915)
Income from operations								68,633		48,147
Interest expense—net		17,035			12,179			21,118		15,098
Income (loss) before tax	$	36,566		$	(5,283	)
Income before income taxes							$	47,515	$	33,049

The Company classifies its sales into furniture and non-furniture product lines. Furniture includes both indoor and outdoor furniture. Non-furniture includes lighting, textiles, fittings, fixtures, surfaces, accessories and home décor. Net revenues in each category were as follows (in thousands):


	Three Months Ended				Three Months Ended
	May 5,		April 29,		May 4,		May 5,
	2018		2017		2019		2018
Furniture	$	352,646	$	352,956	$	396,698	$	352,646
Non-furniture		204,760		209,124		201,723		204,760
Total net revenues	$	557,406	$	562,080	$	598,421	$	557,406

The Company is domiciled in the United States and primarily operates its retail and outlet stores in the United States. As of May ~~5, 2018,~~4, 2019, the Company operates 4 retail and 2 outlet stores in Canada and 1 retail store in the U.K. Revenues from Canadian and U.K. operations, and the long-lived assets in Canada and the U.K., are not material to the Company. Canada and U.K. geographic revenues are based upon revenues recognized at the retail store locations in the respective country.

No single customer accounted for more than 10% of the Company’s revenues in the three months ended May 4, 2019 or May 5, ~~2018~~2018.

NOTE 17—SUBSEQUENT EVENTS

Fourth Amendment to Eleventh Amended and Restated Credit Agreement

On May 31, 2019, Restoration Hardware, Inc., a wholly-owned subsidiary of RH, entered into a Fourth Amendment to the Credit Agreement, dated as of May 31, 2019 (the “Fourth Amendment”). The Fourth Amendment, among other things, amends that Credit Agreement to (a) extend the time to deliver monthly financial statements to the lenders for the fiscal months ending February 2019 and March 2019 until June 19, 2019; (b) remove the requirement to deliver monthly financial statements to the lenders for the last fiscal month of any fiscal quarter; and (c) waive any default or ~~April 29, 2017.~~event of default under the Credit Agreement relating to the delivery of monthly financial statements or other information to lenders for the fiscal months ending February 2019 and March 2019.

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First Amendment to Second Lien Credit Agreement

On May 31, 2019, Restoration Hardware, Inc., a wholly-owned subsidiary of RH, entered into a First Amendment to the Second Lien Credit Agreement, dated as of May 31, 2019 (the “First Amendment”). The First Amendment, among other things, (a) removes the requirement to deliver monthly financial statements to the lenders for the last fiscal month of any fiscal quarter; and (b) waives any default or event of default under the Second Lien Credit Agreement relating to the delivery of monthly financial statements or other information to lenders for the fiscal months ending February 2019 and March 2019.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of ~~the~~our financial condition and the results of our operations should be read together with our condensed consolidated financial statements and the related notes included in Item 1 of Part I of this Quarterly Report on Form ~~10-Q~~10‑Q and with our audited consolidated financial statements and the related notes included in our ~~2017~~2018 Form ~~10-K.~~10‑K.

FORWARD-LOOKING STATEMENTS AND MARKET DATA

This quarterly report contains forward-looking statements that are subject to risks and uncertainties. Forward-looking statements give our current expectations and projections relating to our financial condition, results of operations, plans, objectives, future performance and business. You can identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. These statements may include words such as “anticipate,” “estimate,” “expect,” “project,” “plan,” “intend,” “believe,” “may,” “will,” “short-term,” “non-recurring,” “one-time,” “unusual,” “should,” “likely” and other words and terms of similar meaning in connection with any discussion of the timing or nature of future operating or financial performance or other events.

Forward-looking statements are subject to risk and uncertainties that may cause actual results to differ materially from those that we expected. We derive many of our forward-looking statements from our operating budgets and forecasts, which are based upon many detailed assumptions. While we believe that our assumptions are reasonable, we caution that it is very difficult to predict the impact of known factors and it is impossible for us to anticipate all factors that could affect our actual results and matters that we identify as “short term,” “non-recurring,” “unusual,” “one-time,” or other words and terms of similar meaning may in fact recur in one or more future financial reporting periods. Important factors that could cause actual results to differ materially from our expectations, or cautionary statements, include those factors disclosed under the sections entitled Risk Factors in Part II of this quarterly report and in our Annual Report on Form ~~10-K~~10‑K for the fiscal year ended February 3, 2, 2019 (“2018 ~~(“2017~~ Form ~~10-K”~~10‑K”), and Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part I of this quarterly report and in our ~~2017~~2018 Form ~~10-K.~~10‑K. All forward-looking statements attributable to us, or persons acting on our behalf, are expressly qualified in their entirety by these cautionary statements, as well as other cautionary statements. You should evaluate all forward-looking statements made in this quarterly report in the context of these risks and uncertainties.

We cannot assure you that we will realize the results or developments we expect or anticipate or, even if substantially realized, that they will result in the consequences or affect us or our operations in the way we expect. The forward-looking statements included in this quarterly report are made only as of the date hereof. We undertake no obligation to publicly update or revise any forward-looking statement as a result of new information, future events or otherwise, except as otherwise required by law.

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, ~~tableware,~~ 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.

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As of May ~~5, 2018,~~4, 2019, we operated ~~a total~~the following number of 84 retail Galleries, ~~consisting~~outlets and showrooms:


RH
Design Galleries		20
Legacy Galleries		43
Modern Galleries		2
Baby & Child Galleries		5
Total RH Galleries		70
Outlets		40

Waterworks Showrooms		15

As of 17May 4, 2019, six of our RH Design Galleries ~~46 legacy~~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 ~~2 RH Modern Galleries and 4 RH Baby & Child Galleries throughout the United States and Canada, and 15 Waterworks showrooms~~that we open in the ~~United States and in the U.K. In addition, as of May 5, 2018, we operated 32 outlet stores throughout the United States and Canada.~~future.

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.

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, ~~including timing of legacy Gallery lease expiration,~~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 ~~the Company~~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 ~~increased cadence should support an increase in the~~

~~rate of our long-term revenue growth as new Design Gallery openings are one of the key drivers of our long-term revenue growth. 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. We expect to open two more~~2018, our Nashville Design ~~Galleries~~Gallery in ~~Nashville and New York in fiscal~~June 2018, as well as ~~one smaller~~our New York Design Gallery and our Design Gallery in Yountville, California in the Napa Valley, ~~all with~~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 ~~our~~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 ~~accelerate~~more quickly place our ~~new store opening cadence beginning in fiscal 2019.~~disruptive product assortment and immersive retail experience into the market. The new ~~prototype~~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 the integrated hospitality experience, and~~without. These new Galleries will represent our assortments from RH Interiors, RH Modern, RH Baby & Child, ~~RH TEEN~~Teen and ~~RH Outdoor.~~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, ~~we believe these~~this new ~~Galleries~~model will be more capital efficient with less time and ~~should have lower~~cost risk, ~~in the real estate development process both with respect to costs and time required for completion,~~ but yield similar productivity. We anticipate ~~these~~the new prototype Design Galleries will represent approximately two thirds of our target ~~markets~~markets. Future prototype location examples include Edina, MN, Corte Madera, CA, Columbus, OH and ~~enable us to ramp up from three to five new Galleries per year to a pace~~Charlotte, NC.

Table of ~~five to seven new Galleries per year beginning in fiscal 2019.~~Contents

WeSecond, 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, ~~Aspen,~~ Palm Beach, Yountville and ~~the Napa Valley,~~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 ~~also~~ believe ~~there is an opportunity~~our multi-tier market approach to ~~transition~~transforming our real estate ~~strategy~~will enable us to ramp our opening cadence from ~~a leasing model~~3 to 5 new Galleries per year, to a ~~development model, where~~pace of 5 to 7 new Galleries per year commencing in fiscal 2020.

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 ~~potentially buy~~have developed a multi-tier real estate strategy that is designed to significantly increase our unit level profitability and ~~develop our Design Galleries then~~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.

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 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.

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We anticipate that all of the ~~investments through a sale leaseback arrangement resulting in~~above deal structures should lead to lower capital ~~investment~~requirements, higher unit profitability, and ~~lower rent. We currently have two projects, RH Yountville, California, and Edina, Minnesota, under construction using this new model and have an additional five projects in the~~significantly higher return on invested capital versus our prior Gallery development ~~process.~~strategies.

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

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

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

transforming our real estate platform;

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

growing our merchandise assortment and introducing new products and categories;

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

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 and our advertising and public relations activities and events.

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 ~~have~~ 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~~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.

Grow Our Integrated 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.

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Business Initiatives

We are undertaking a large number of new business initiatives in support of our ~~move~~key value driving strategies. In particular, beginning in fiscal 2016 and continuing through fiscal 2019, 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.

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.~~model has also resulted lower rates of cancelled orders and returns.

~~Architect New Operating Platform.~~ Improved operational costs~~Our goal is to architect a new operating platform that we believe will simplify~~. The volume of sales, orders and shipments in our business ~~enhance~~under the prior promotional model was characterized by large spikes in customer ~~experience,~~orders based upon promotional events followed by lower orders and ~~amplify decision quality~~sales after the end of an event. This buying pattern also affected numerous other aspects of our business, including staffing and ~~speed. As part~~costs as we required elevated staffing levels to service the increased number of ~~architecting a new operating platform, we have focused on redesigning~~customers during peak sales events. Likewise, significant fluctuations in sales had downstream implications for our supply chain ~~network, rationalizing~~related to merchandise orders, manufacturing and production, shipment to our ~~product offerings,~~distribution centers and ~~transitioning inventory into fewer facilities, creating~~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 ~~capital efficient~~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 enhancing our approach to services in connection with in-home delivery. We are in the

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process of implementing a number of measures that are designed to increase our level of control and improve services levels over the delivery experience to the customer’s residence. We believe that we are well positioned to develop improved solutions for in-home delivery to the customer in the luxury market. We have already adopted a number of service improvements that are yielding improvements in the customer experience and reductions in product return and exchange rates. We expect to continue to optimize our service offering to customers in connection with the in-home delivery experience and are confident that our efforts in this regard will continue to achieve substantial results.

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 ~~food and beverage~~hospitality experience in a number of our new Galleries, will ~~will~~ further enhance~~enhance~~ our customers’ in-store experience, allowing us to further disrupt the highly fragmented home furnishings landscape and achieve market share gains.

•

~~Increase Operating Margins.~~ We anticipate improved operating margins through cycling our SKU rationalization and inventory reduction efforts, anniversarying the significant start-up costs from our integrated hospitality experience, neutralizing the earnings drag from Waterworks, benefitting from the continued cost savings of our new operating platform, and leveraging the gain we expect from our real estate transformation. In addition, we believe the operating

~~efficiencies of our membership model are helping to drive a number of efficiencies across our business that are contributing to our improving operating margins.~~

~~Optimize~~

In fiscal 2017, fiscal 2018 and continuing into fiscal 2019, we have focused on the ~~Allocation~~allocation of ~~Capital in the Business.~~capital. We believe that our operations and current initiatives ~~present~~are providing a significant opportunity to optimize the allocation of capital in our business, including generating free cash flow and optimizing our balance ~~sheet. Our focus on cash during fiscal 2017 resulted in the Company generating $412 million in free cash flow in fiscal 2017. We expect~~sheet, as well as deploying capital to ~~continue~~repay debt and repurchase shares of our common stock, which we believe creates a long term benefit to ~~focus on generating additional free cash flow during fiscal 2018.~~

~~Pursue International Expansion.~~ ~~We plan to strategically expand~~ our business into select countries outside of the United States and Canada in the future. We continue to explore opportunities to open our first RH Gallery in London. We believe that our luxury brand positioning and unique aesthetic will have strong international appeal.shareholders.

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, ~~and~~ 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.~~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 ~~of the Company~~ may create additional uncertainty with respect to our consolidated net revenues and profit in the near term.

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Basis of Presentation and Results of Operations

The following table sets forth our condensed consolidated statements of ~~operations~~income and other financial and operating data.

Three Months Ended

May 5,

April 29,

2018

2017

(dollars in thousands)

Condensed Consolidated Statements of Operations:

Net revenues

$
557,406

$
562,080

Cost of goods sold

345,371

391,824

Gross profit

212,035

170,256

Selling, general and administrative expenses

158,434

163,360

Income from operations

53,601

6,896

Interest expense—net

17,035

12,179

Income (loss) before income taxes

36,566

(5,283
)
Income tax expense (benefit)

8,507

(1,913
)
Net income (loss)

$
28,059

$
(3,370
)
Other Financial and Operating Data:

Net revenues:

Stores⁽¹⁾

$
314,517

$
316,724

Direct

$
242,889

$
245,356

Direct as a percentage of net revenues ⁽²⁾

44
%

44
%
Growth in net revenues:

Stores ⁽¹⁾

(1
)%

24
%
Direct

(1
)%

23
%
Total

(1
)%

23
%
Comparable brand revenue growth⁽³⁾

1
%

9
%
Adjusted net income ⁽⁴⁾

$
33,454

$
1,794

Adjusted EBITDA ⁽⁵⁾

$
78,424

$
29,585

Capital expenditures

$
27,121

$
21,173


	Three Months Ended
	May 4,		May 5,
	2019		2018

Condensed Consolidated Statements of Income:
Net revenues	$	598,421	$	557,406
Cost of goods sold		365,607		348,073
Gross profit		232,814		209,333
Selling, general and administrative expenses		164,181		161,186
Income from operations		68,633		48,147
Interest expense—net		21,118		15,098
Income before income taxes		47,515		33,049
Income tax expense		11,793		7,588
Net income	$	35,722	$	25,461
Other Financial and Operating Data:
Adjusted net income (1)	$	45,188	$	30,586
Adjusted EBITDA (2)	$	100,385	$	79,900

Capital expenditures	$	7,916	$	17,674
Landlord assets under construction—net of tenant allowances		4,542		18,648
Adjusted net capital expenditures (3)	$	12,458	$	36,322

(1)

Stores data represents sales originating in retail stores, including Waterworks showrooms, and outlet stores. Net revenues for outlet stores, which include warehouse sales, were $43.2 million and $56.1 million for the three months ended May 5, 2018 and April 29, 2017, respectively.

~~(2)~~

~~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.~~

~~(3)~~

Comparable brand revenue growth includes direct net revenues and retail comparable store sales, including RH Baby & Child, RH Modern Galleries and 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.

~~(4)~~

Adjusted net income is a supplemental measure of financial performance that is not required by, or presented in accordance with, generally accepted accounting principles (“GAAP”). We define adjusted net income as 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~~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. The following table presents a reconciliation of net income, ~~(loss),~~ the most directly comparable GAAP financial measure, to adjusted net income for the periods indicated below.


	Three Months Ended
	May 4,		May 5,
	2019		2018
	(in thousands)
Net income	$	35,722	$	25,461
Adjustments pre-tax:
Amortization of debt discount (a)		11,689		7,272
Asset impairments and change in useful lives (b)		3,476		—
Recall accrual (c)		(1,615)		(254)
Loss on asset disposal reversal (d)		—		(840)
Impact of inventory step-up (e)		—		190
Legal costs (f)		—		1,915
Subtotal adjusted items		13,550		8,283
Impact of income tax items (g)		(4,084)		(3,158)
Adjusted net income	$	45,188	$	30,586

Three Months Ended

May 5,

April 29,

2018

2017

(in thousands)

Net income (loss)

$
28,059

$
(3,370
)
Adjustments pre-tax:

Amortization of debt discount^(a)

7,272

6,715

Post-acquisition related legal costs ^(b)

1,915

—

Impact of inventory step-up^(c)

190

1,380

Distribution center closures^(d)

(2,072
)

—

Recall accrual ^(e)

(254
)

—

Subtotal adjusted items

7,051

8,095

Impact of income tax items ^(f)

(1,656
)

(2,931
)
Adjusted net income

$
33,454

$
1,794

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(a)

Under GAAP, certain convertible debt instruments that may be settled in cash on conversion are required to be separately accounted for as liability and equity components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate. Accordingly, in accounting for GAAP purposes for the $350 million aggregate principal amount of convertible senior notes that were issued in June 2014 (the “2019 Notes”) ~~and~~, 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 ~~2020~~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 ~~2020~~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 ~~2020~~2023 Notes and the fair value of the liability components of the 2019 Notes, 2020 Notes and ~~2020~~2023 Notes, respectively. Amounts are presented net of interest capitalized for capital projects of ~~$0.6~~$0.7 million and ~~$0.7~~$0.6 million during the three months ended May 4, 2019 and May 5, 2018, ~~and April 29, 2017,~~ respectively.

(b)

Represents ~~legal expenses incurred~~the acceleration of depreciation expense of $3.0 million due to a change in ~~connection~~the estimated useful lives of certain assets, as well as a $0.5 million charge related to the termination of a service agreement associated with ~~the final purchase price of Waterworks.~~such assets.

(c)

Represents an adjustment to net revenues, increase in cost of goods sold and inventory charges associated with product recalls, as well as accrual adjustments and vendor claims. The recall adjustments had the following effect on our income before taxes:


	Three Months Ended
	May 4,		May 5,
	2019		2018
	(in thousands)
Reduction of net revenues	$	413	$	—
Impact on cost of goods sold		(2,061)		(254)
Impact on gross profit		(1,648)		(254)
Incremental selling, general and administrative expenses		33		—
Impact on income before income taxes	$	(1,615)	$	(254)

(d)

Represents the reversal of an estimated loss on disposal of asset due to negotiations of the sales price being finalized.

(e)

Represents the non-cash amortization of the inventory fair value adjustment recorded in connection with our acquisition of Waterworks.

~~(d)~~(f)

R~~epresents an adjustment to the lease related liability associated~~

Represents costs incurred in connection with ~~the Dallas distribution center closure in fiscal 2017 primarily due to the remeasurement of the liability for lease losses resulting from~~ a ~~sublease agreement we entered into in April 2016 that resulted in an update to both the timing and the term of future lease-related cash inflows.~~legal settlement.

~~(e)~~(g)

~~Represents an~~ ~~adjustment~~ ~~related to certain product recalls initiated in prior years.~~

~~(f)~~

~~The adjustments~~Assumes a normalized tax rate of 26% for the three months ended May 4, 2019 and May 5, ~~2018 and April 29, 2017 represent the tax effect of the adjusted items based on our effective tax rates of 23.3% and 36.2%, respectively.~~2018.

~~(5)~~

(2)

EBITDA and Adjusted EBITDA are supplemental measures of financial performance that are not required by, or presented in accordance with, GAAP. We define EBITDA as consolidated net income ~~(loss)~~ before depreciation and amortization, interest expense, loss on extinguishment of debt and ~~provision for~~ income ~~taxes.~~tax expense. 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~~these non-GAAP financial ~~measure~~measures in order to have comparable financial results to analyze changes in our underlying business from quarter to quarter. Our measures of EBITDA and Adjusted EBITDA are not necessarily comparable to other similarly titled captions for other companies due to different methods of ~~calculation.~~ calculation. The following table

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presents a reconciliation of net income, ~~(loss),~~ the most directly comparable GAAP financial measure, to EBITDA and Adjusted EBITDA for the periods indicated below.

	Three Months Ended
	May 5,			April 29,			Three Months Ended
	2018			2017			May 4,		May 5,
	(in thousands)						2019		2018
Net income (loss)	$	28,059		$	(3,370	)
							(in thousands)
Net income							$	35,722	$	25,461
Depreciation and amortization		17,047			16,020			27,189		22,745
Interest expense—net		17,035			12,179			21,118		15,098
Income tax expense (benefit)		8,507			(1,913	)
Income tax expense								11,793		7,588
EBITDA		70,648			22,916			95,822		70,892
Non-cash compensation^(a)		7,997			5,289
Post-acquisition related legal costs ^(b)		1,915			—
Stock-based compensation (a)								5,695		7,997
Asset impairments and change in useful lives (b)								483		—
Recall accrual (b)								(1,615)		(254)
Loss on asset disposal reversal (b)								—		(840)
Impact of inventory step-up^(b)		190			1,380			—		190
Distribution center closures^(b)		(2,072	)		—
Recall accrual ^(b)		(254	)		—
Legal costs (b)								—		1,915
Adjusted EBITDA	$	78,424		$	29,585		$	100,385	$	79,900

(a)

Represents non-cash compensation related to equity awards granted to employees.

(b)

Refer to the reconciliation of net income ~~(loss)~~ to adjusted net income table above and the related footnotes for additional information.

(3)

We define adjusted net capital expenditures as (i) capital expenditures from investing activities and (ii) cash outflows of capital related to construction activities to design and build landlord-owned leased assets, net of tenant allowances received.

The following tables present ~~retail~~RH Gallery ~~metrics, which have been~~ ~~calculated based upon retail stores, which includes our RH Baby & Child, RH Modern Galleries~~ and Waterworks ~~Showrooms,~~showroom metrics and ~~excludes outlet stores.~~

exclude outlets:


											Three Months Ended
											May 4,			May 5,
	Three Months Ended										2019			2018
	May 5,						April 29,					Total Leased			Total Leased
	2018						2017					Selling Square			Selling Square
	Store Count			Total Leased Selling Square Footage⁽¹⁾			Store Count		Total Leased Selling Square Footage⁽¹⁾		Store Count	Footage (1)		Store Count	Footage (1)
				(in thousands)					(in thousands)				(in thousands)			(in thousands)
Beginning of period		83			981			85		912	86		1,089	83		981
Retail Galleries opened:
RH Galleries:
Dallas RH Modern Gallery (relocation)											—		(4.5)	—		—
Dallas RH Baby & Child Gallery											(1)		(3.7)	—		—
Dallas legacy Gallery (relocation)											—		(2.6)	—		—
Portland Design Gallery		1			26.0		—		—		—		—	1		26.0
RH Modern Dallas		1			8.2		—		—
Dallas RH Modern Gallery											—		—	1		8.2
Portland legacy Gallery											—		—	(1)		(4.7)
Waterworks Showrooms:
Waterworks Scottsdale Showroom		1			2.2		—		—		—		—	1		2.2
Retail Galleries closed:
Portland legacy Gallery		(1	)		(4.7	)	—		—
Waterworks Scottsdale Showroom		(1	)		(1.1	)	—		—		—		—	(1)		(1.1)
End of period		84			1,012			85		912	85		1,078	84		1,012

(1)

Leased selling square footage is retail space at our stores used to sell our products. Leased selling square footage excludes backrooms at retail stores used for storage, office space, food preparation, kitchen space or similar purpose, as well as exterior sales space located outside a store, such as courtyards, gardens and rooftops. Leased selling square footage for the three months ended May 4, 2019 includes approximately 11,600 square feet related

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to two owned store locations. Leased selling square footage for the three months ended May 5, 2018 includes approximately 4,800 square feet related to one owned store ~~location~~. ~~Leased selling~~location.


	Three Months Ended
	May 4,	May 5,
	2019	2018
	(in thousands)
Total leased square footage at end of period (1)	1,454	1,358
Weighted-average leased square footage (2)	1,461	1,323
Weighted-average leased selling square footage (2)	1,084	984

(1)

Total leased square footage ~~for the three months ended April 29, 2017~~as of May 4, 2019 includes approximately ~~13,000~~16,100 square feet related to two owned store locations.

Three Months Ended

May 5,

April 29,

2018

2017

(in thousands)

Total leased square footage at end of period⁽¹⁾

1,358

1,242

Weighted-average leased square footage⁽²⁾

1,323

1,242

Weighted-average leased selling square footage⁽²⁾

984

912

Retail sales per leased selling square foot (in dollars)⁽³⁾

$
275

$
284

~~(1)~~

Total leased square footage as of May 5, 2018 includes approximately 5,400 square feet related to one owned store ~~location.~~ ~~Total leased square footage as of April 29, 2017 includes approximately 24,000 square feet related to two owned store locations.~~location

(2)

Weighted-average leased square footage and leased selling square footage is calculated based on the number of days a Gallery location was opened during the period divided by the total number of days in the period.

~~(3)~~

Retail sales per leased selling square foot is calculated by dividing total net revenues for all retail stores, comparable and non-comparable, by the weighted-average leased selling square footage for the period.

The following table sets forth our condensed consolidated statements of ~~operations~~income as a percentage of total net revenues.

	Three Months Ended
	May 5,			April 29,			Three Months Ended
	2018			2017			May		May 5,
Condensed Consolidated Statements of Operations:
							2019		2018
Condensed Consolidated Statements of Income:
Net revenues		100.0	%		100.0	%	100.0	%	100.0	%
Cost of goods sold		62.0			69.7		61.1		62.4
Gross profit		38.0			30.3		38.9		37.6
Selling, general and administrative expenses		28.4			29.1		27.4		29.0
Income from operations		9.6			1.2		11.5		8.6
Interest expense—net		3.1			2.1		3.6		2.7
Income (loss) before income taxes		6.5			(0.9	)
Income tax expense (benefit)		1.5			(0.3	)
Net income (loss)		5.0	%		(0.6	)%
Income before income taxes							7.9		5.9
Income tax expense							1.9		1.3
Net income							6.0	%	4.6	%

Three Months Ended May ~~5, 2018~~4, 2019 Compared to Three Months Ended ~~April 29, 2017~~

May 5, 2018


	Three Months Ended														Three Months Ended
	May 5,							April 29,							May 4,						May 5,
	2018							2017							2019						2018
	RH Segment		Waterworks⁽¹⁾			Total		RH Segment		Waterworks⁽¹⁾			Total		RH Segment		Waterworks (1)		Total		RH Segment		Waterworks (1)		Total
	(in thousands)														(in thousands)
Net revenues	$	526,007	$	31,399		$	557,406	$	533,528	$	28,552		$	562,080	$	563,706	$	34,715	$	598,421	$	526,007	$	31,399	$	557,406
Cost of goods sold		326,972		18,399			345,371		373,901		17,923			391,824		345,763		19,844		365,607		330,301		17,772		348,073
Gross profit		199,035		13,000			212,035		159,627		10,629			170,256		217,943		14,871		232,814		195,706		13,627		209,333
Selling, general and administrative expenses		144,728		13,706			158,434		149,569		13,791			163,360		150,404		13,777		164,181		147,479		13,707		161,186
Income (loss) from operations	$	54,307	$	(706	)	$	53,601	$	10,058	$	(3,162	)	$	6,896	$	67,539	$	1,094	$	68,633	$	48,227	$	(80)	$	48,147

(1)

Waterworks results include non-cash amortization of $0.2 ~~million and $1.4~~ million related to the inventory fair value adjustment recorded in connection with our acquisition of Waterworks during the three months ended May 5, ~~2018 and April 29, 2017, respectively.~~2018. No amortization was recorded during the three months ended May 4, 2019.

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Net revenues

Consolidated net revenues ~~decreased $4.7~~increased $41.0 million, or ~~0.8%~~7.4%, to $598.4 million in the three months ended May 4, 2019 compared to $557.4 million in the three months ended May 5, ~~2018 compared to $562.1 million in the three months ended April 29, 2017. Stores~~2018.

RH Segment net revenues

RH Segment net revenues ~~decreased $2.2~~increased $37.7 million, or ~~0.7%~~7.2%, to ~~$314.5~~$563.7 million in the three months ended May ~~5, 2018~~4, 2019 compared to $316.7 million in the three months ended April 29, 2017. Direct net revenues decreased $2.5 million, or 1.0%, to $242.9 million in the three months ended May 5, 2018 compared to $245.4 million in the three months ended April 29, 2017. Comparable brand revenue was 1% for the three months ended May 5, 2018.

~~RH Segment net revenues~~

~~RH Segment net revenues decreased $7.5 million, or 1.4%,~~ to $526.0 million in the three months ended May 5, ~~2018 compared to $533.5 million in the three months ended April 29, 2017.~~ 2018. The below discussion highlights several significant factors that resulted in ~~decreased~~ increased RH Segment net revenues, which are listed in order of magnitude.

RH Segment core net revenues ~~decreased~~increased primarily due to additional discounts offered on discontinued merchandise related to the optimization of our inventory and SKU rationalization during the first quarter of fiscal 2017 that did not repeat in the first quarter of fiscal 2018. The overall decrease in RH Segment core net revenues was partially offset by an increase in retail weighted-average ~~leased~~ selling square footage related to new store openings, including New York, Nashville and Yountville, and, to a lesser extent, due to increased revenues from our RH Hospitality operations and Contract business.

RH Segment outlet sales increased $12.4 million to $55.6 million in ~~West Palm Beach, Toronto and Portland.~~

~~Outlet sales, which include sales via warehouse locations, decreased~~the three months ended May 4, 2019 compared to $43.2 million in the three months ended May 5, 2018 ~~compared~~primarily due to an increase of eight outlet locations year over year.

RH Segment net revenues for the three months ended ~~April 29, 2017 primarily as a result~~May 4, 2019 were negatively impacted by $0.4 million related to the reduction of revenue associated with product recalls. Product recalls and the establishment or adjustment of any related recall accruals can affect our results and cause quarterly fluctuations affecting the period-to-period comparisons of our ~~inventory optimization efforts during~~results. No assurance can be provided that any accruals will be for the ~~first quarter of fiscal 2017 as~~appropriate amount, and actual losses could be higher or lower than what we increased our outlet promotional activity and offered higher discounts. Similar promotions and discounts were not offered in the first quarter of fiscal 2018. We increased the number of outlet locations, adding four new locationsaccrue from ~~the prior period and increasing outlet selling square footage by approximately 28% compared~~time to ~~the prior period.~~

We had increases in net revenues during the first quarter of fiscal 2018 as compared to the first quarter of fiscal 2017 associated with our Contract business, Membership revenue and Hospitality operations.time, which could further affect results.

Waterworks net revenues

Waterworks net revenues increased ~~$2.8~~$3.3 million, or ~~10.0%~~10.6%, to $34.7 million in the three months ended May 4, 2019 compared to $31.4 million in the three months ended May 5, ~~2018 compared to $28.6 million in the three months ended April 29, 2017.~~2018.

Gross profit

Consolidated gross profit increased ~~$41.8~~$23.5 million, or ~~24.5%~~11.2%, to ~~$212.0~~$232.8 million in the three months ended May 4, 2019 from $209.3 million in the three months ended May 5, ~~2018 from $170.3 million in the three months ended April 29, 2017.~~2018. As a percentage of net revenues, consolidated gross margin increased ~~7.7%~~1.3% to ~~38.0%~~38.9% of net revenues in the three months ended May 4, 2019 from 37.6% of net revenues in the three months ended May 5, ~~2018 from 30.3% of net revenues in the three months ended April 29, 2017.~~2018.

RH Segment gross profit for the three months ended May 4, 2019 and May 5, 2018 was positively impacted by $1.6 million and $0.3 million, respectively, related to reserve adjustments associated with product recalls initiated in prior years, partially offset by the reduction of revenue and incremental costs associated with such product recalls. RH Segment gross profit for the three months ended May 4, 2019 was negatively impacted by $3.0 million related to ~~an adjustment associated with product recalls.~~ the acceleration of depreciation due to a change in the estimated useful lives of certain assets.

Waterworks gross profit for the three months ended May 5, 2018 ~~and April 29, 2017~~ was negatively impacted by $0.2 million ~~and $1.4 million, respectively,~~ of amortization related to the inventory fair value adjustment recorded in connection with the acquisition.

Excluding the product recall ~~adjustment~~adjustments and the impact of the amortization related to the inventory fair value adjustment mentioned above, consolidated gross margin would have increased ~~7.5%~~1.6% to ~~38.0%~~39.1% of net revenues in the three months ended May 4, 2019 from 37.5% of net revenues in the three months ended May 5, ~~2018 from 30.5% of net revenues in the three months ended April 29, 2017.~~2018.

RH Segment gross profit

RH Segment gross profit increased ~~$39.4~~$22.2 million, or ~~24.7%~~11.4%, to ~~$199.0~~$217.9 million in the three months ended May 4, 2019 from $195.7 million in the three months ended May 5, ~~2018 from $159.6 million in the three months ended April 29, 2017.~~2018. As a percentage of net revenues, RH Segment gross

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margin increased ~~7.9%~~1.5% to ~~37.8%~~38.7% of net revenues in the three months ended May 4, 2019 from 37.2% of net revenues in the three months ended May 5, ~~2018 from 29.9% of net revenues in the three months ended April 29, 2017.~~2018.

Excluding the product recall ~~adjustment~~and acceleration of depreciation adjustments mentioned above, RH Segment gross margin would have increased ~~7.9%~~1.7% to ~~37.8%~~38.9% of net revenues in the three months ended May 4, 2019 from 37.2% of net revenues in the three months ended May 5, ~~2018 from 29.9% of net revenues in the three months ended April 29, 2017.~~2018. The increase was related to ~~higher product margins due to higher outlet and warehouse sales driven by increased promotions and higher discounts during the first quarter of fiscal 2017 versus fiscal 2018,~~ 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, leverage in our occupancy costs primarily related to our distribution center network ~~redesign. In addition, we realized~~redesign, and leverage in ~~total shipping expense due to the initiatives implemented in fiscal 2017 to redesign~~ our ~~Outlet and reverse logistics business, which were~~delivery expense. The overall increase was partially offset by ~~higher expenses related~~lower outlet product margins due to ~~cost increases in~~increased promotional activity and discounts as compared to the ~~transportation industry.~~first quarter of fiscal 2018.

Waterworks gross profit

Waterworks gross profit increased ~~$2.4~~$1.2 million, or ~~22.3%~~9.1%, to ~~$13.0~~$14.9 million in the three months ended May 4, 2019 from $13.6 million in the three months ended May 5, ~~2018 from $10.6 million in the three months ended April 29, 2017.~~2018. As a percentage of net revenues, Waterworks gross margin ~~increased 4.2%~~decreased 0.6% to ~~41.4%~~42.8% of net revenues in the three months ended May 4, 2019 from 43.4% of net revenues in the three months ended May 5, ~~2018 from 37.2% of net revenues in the three months ended April 29, 2017.~~2018.

Excluding the impact of the amortization related to the inventory fair value adjustment mentioned above, Waterworks gross margin would have decreased ~~0.1%~~1.2% to ~~42.0%~~42.8% of net revenues in the three months ended May 4, 2019 from 44.0% of net revenues in the three months ended May 5, ~~2018 from 42.1% of net revenues in the three months ended April 29, 2017.~~2018.

Selling, general and administrative expenses

Consolidated selling, general and administrative expenses ~~decreased $4.9~~increased $3.0 million, or ~~3.0%~~1.9%, to ~~$158.4~~$164.2 million in the three months ended May 4, 2019 compared to $161.2 million in the three months ended May 5, ~~2018 compared to $163.4 million in the three months ended April 29, 2017.~~2018.

RH Segment selling, general and administrative expenses

RH Segment selling, general and administrative expenses ~~decreased $4.8~~increased $2.9 million, or ~~3.2%~~2.0%, to ~~$144.7~~$150.4 million in the three months ended May 4, 2019 compared $147.5 million in the three months ended May 5, ~~2018 compared $149.6 million in~~2018.

RH Segment selling, general and administrative expenses for the three months ended ~~April 29, 2017.~~May 4, 2019 included advertising and marketing costs which increased $4.8 million primarily due to an increase in circulation and pages of our Source Books. This was partially offset by a decrease in corporate expenses of $2.4 million, primarily due to reduced preopening expense associated with our Design Gallery openings and other corporate costs. Selling, general and administrative expenses also included a $0.5 million charge related to a loss on disposal of an asset.

RH Segment selling, general and administrative expenses for the three months ended May 5, 2018 included ~~a $2.0 million lease loss liability reversal associated with the Dallas distribution center closure completed in fiscal 2017 and~~ $1.9 million of costs ~~associated with legal expenses~~ incurred in connection with ~~the final purchase price of Waterworks.~~

Advertising and marketing costs decreased $12.5 million during the three months ended May 5, 2018 as compared to April 29, 2017, due to the adoption of Topic 606 in the first quarter of fiscal 2018 as well as the timing of our spring website launch. The decrease in advertising and marketing costs wasa legal settlement, partially offset by ~~increases in employment and employment related costs~~.a $0.8 million reversal of an estimated loss on disposal of asset.

RH Segment selling, general and administrative expenses were ~~27.5%~~26.6% and ~~28.0%~~27.8% of net revenues for the three months ended May 4, 2019 and May 5, 2018, ~~and April 29, 2017,~~ respectively, excluding the ~~adjustments related to the distribution center closure lease loss liability and the legal expenses~~costs incurred in connection with ~~the final purchase price~~a legal settlement and reversal of ~~Waterworks~~an estimated loss on disposal of asset mentioned above. The decrease in selling, general and administrative expenses as a percentage of net revenues was primarily driven by leverage in our employment and employment related costs as a result of our organization redesign and, to a lesser extent, leverage in our corporate expenses. This decrease was partially offset by an increase in advertising and marketing ~~costs primarily due to the adoption of Topic 606, partially offset by deleverage in employment and employment related~~ costs.

Waterworks selling, general and administrative expenses

Waterworks selling, general and administrative expenses ~~decreased~~increased $0.1 million, or ~~0.6%~~0.5%, to $13.8 million in the three months ended May 4, 2019 compared to $13.7 million in the three months ended May 5, ~~2018 compared to $13.8 million in the three months ended April 29, 2017.~~2018. Waterworks selling, general and administrative expenses were ~~43.7%~~39.7% and ~~48.3%~~43.7% of net revenues for the three months ended May 4, 2019 and May 5, 2018, ~~and April 29, 2017,~~ respectively.

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Interest ~~expense~~—expense—net

Interest ~~expense~~expense—net increased ~~$4.8~~$6.0 million to ~~$17.0~~$21.1 million for the three months ended May 4, 2019 compared to $15.1 million for the three months ended May 5, ~~2018 compared to $12.2 million for the three months ended April 29, 2017.~~2018. Interest ~~expense~~expense—net consisted of the following:


	Three Months Ended						Three Months Ended
	May 5,			April 29,			May 4,		May 5,
	2018			2017			2019		2018
	(in thousands)						(in thousands)
Amortization of convertible senior notes debt discount	$	7,881		$	7,457		$	12,377	$	7,881
Build-to-suit lease transactions		4,668			4,153
Asset based credit facility		2,811			431
Finance lease interest expense								5,514		3,092
Term loans		1,004			—			1,724		1,004
Amortization of debt issuance costs and deferred financing fees		787			647			1,090		787
Asset based credit facility								687		2,480
Promissory notes								432		576
Other interest expense		946			547			395		340
Capitalized interest for capital projects		(900	)		(742	)		(819)		(900)
Interest income		(162	)		(314	)		(282)		(162)
Total interest expense—net	$	17,035		$	12,179		$	21,118	$	15,098

Income tax expense ~~(benefit)~~

Income tax expense was ~~$8.5~~$11.8 million ~~in the three months May 5, 2018~~ and ~~a benefit of $1.9~~$7.6 million in the three months ended ~~April 29, 2017.~~May 4, 2019 and May 5, 2018, respectively. Our effective tax rate was ~~23.3%~~24.8% and ~~36.2%~~23.0% for the three months ended May 4, 2019 and May 5, 2018, ~~and April 29, 2017,~~ respectively. The ~~decrease~~increase in ~~the~~our effective tax rate is primarily due to 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 effective tax rate was also favorably impacted by $1.0 million oflower discrete tax benefits related to net excess tax windfalls from stock-based ~~compensation.~~compensation in the three months ended May 4, 2019.

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 (refer~~2017. In October 2018, our Board of Directors approved a new $700 million share repurchase program, of which $250 million in share repurchases were completed in fiscal 2018, and the $700 million authorization amount was replenished by the Board of Directors in March 2019. During the three months ended May 4, 2019, we repurchased approximately 2.2 million shares of our common stock for an aggregate repurchase amount of approximately $250 million, with $450 million still available under the $700 million repurchase program. Refer to “Share Repurchase Programs” ~~below).~~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 ~~$650~~$985 million in aggregate principal amount of convertible notes outstanding, of which $350 million mature in June 2019, ~~and~~ $300 million mature in June ~~2020.~~2020 and $335 million mature in June 2023. In addition, the $350 million principal amount of convertible senior notes that matures in June 2019 became convertible by the holders beginning on March 15, 2019 and remain convertible through the close of business on the second schedule trading day immediately preceding June 15, 2019. Upon the earlier of conversion and maturity of the 2019 Notes, we intend to settle the principal value with existing cash and cash equivalents and restricted cash, as well as borrowings under our currently undrawn asset based credit facility.

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Based on anticipated strong cash flow generation in 2019 and beyond, we expect to repay the outstanding principal of the remaining $635 million convertible notes at maturity in June 2020 and June 2023 in cash to minimize dilution. While we anticipate using excess cash, 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. Based on anticipated strong cash flow generation in 2018 and beyond, we expect to repay the outstanding principal of our $650 million convertible notes at maturity in June 2019 and June 2020 in cash to minimize dilution. We believe the strength of our business and the reduction in leverage we have achieved during the past ~~three quarters~~year puts us in a strong position to take advantage of the ~~positive conditions in the~~ capital ~~markets.~~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~~$600 million, of which ~~$10.0~~$10 million is available to Restoration Hardware Canada, Inc., and includes a ~~$200.0~~$200 million accordion feature under which the revolving line of credit may be expanded by agreement of the parties from ~~$600.0~~$600 million to up to ~~$800.0~~$800 million if and to the extent the lenders revise their credit commitments to encompass a larger facility. ~~In addition, we have an $80.0 million last out, delayed draw term loan (“LILO term loan”) facility.~~ The revolving line of credit ~~and LILO term loan facility have~~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 ~~revolving line of~~asset based credit ~~borrowings under our term loan~~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.

At May 5, 2018, we had approximately $928.7 million of net debt, excluding financing obligations under build-to-suit lease transactions, compared to approximately $1,052.2 million of net debt, excluding financing obligations under build-to-suit lease transactions, as of July 29, 2017. Over the last three quarters, we have substantially reduced our net debt to trailing twelve months Adjusted EBITDA from 5x at the end the second quarter fiscal 2017 to 3x at the end of the first quarter fiscal 2018. A reconciliation of our net income to EBITDA and Adjusted EBITDA is as follows:

Trailing Twelve Months

May 5,

July 29,

2018

2017

(in thousands)

Net income

$
33,609

$
721

Depreciation and amortization

71,162

63,606

Interest expense—net

67,426

49,626

Goodwill impairment^(a)

33,700

—

Loss on extinguishment of debt^(b)

4,880

—

Income tax expense

38,391

11,168

EBITDA^(m)

249,168

125,121

Non-cash compensation^(c)

53,417

51,296

Recall accrual ^(d)

7,453

9,348

Asset impairment and lease losses ^(e)

4,417

12,743

Distribution center closures^(f)

3,723

—

Post-acquisition related legal costs ^(g)

1,915

—

Impact of inventory step-up^(h)

1,337

5,294

Anti-dumping exposure⁽ⁱ⁾

(2,202
)

—

Gain on sale of building and land^(j)

(2,119
)

(1,300
)
Aircraft impairment ^(k)

—

4,767

Reorganization related costs ^(l)

—

974

Adjusted EBITDA ^(m)

$
317,109

$
208,243

~~(a)~~

~~Represents goodwill impairment related to the Waterworks reporting unit.~~

~~(b)~~

~~Represents the loss on extinguishment of debt related to the second lien term loan which was repaid in full in October 2017.~~

~~(c)~~

~~Represents non-cash compensation related to equity awards granted to employees, including the non-cash compensation charge related to a fully vested option grant made to Mr. Friedman in May 2017.~~

~~(d)~~

~~Represents an adjustment related to certain product recalls.~~

~~(e)~~

~~Represents the impairments associated with RH Contemporary Art and RH Kitchen.~~

~~(f)~~

Represents property and equipment disposals, lease related charges, inventory transfer costs, severance expense and other costs associated with two distribution center closures, which were completed in November 2017 and January 2018.

~~(g)~~

~~Represents legal expenses incurred in connection with the final purchase price of Waterworks.~~

~~(h)~~

~~Represents the non-cash amortization of the inventory fair value adjustment recorded in connection with our acquisition of Waterworks.~~

~~(i)~~

Represents the release of the remaining reserve for potential claims regarding anti-dumping duties which we believe have lapsed. The reserve related to potential tariff obligations of one of our foreign suppliers following the U.S. Department of Commerce’s review on the anti-dumping duty order on wooden bedroom furniture from China for the period from January 1, 2011 through December 31, 2011.

~~(j)~~

~~Represents the gain on the sale of building and land of one of our owned retail Galleries.~~

~~(k)~~

~~Represents the impairment recorded upon reclassification of aircraft as asset held for sale.~~

~~(l)~~

Represents costs associated with a reorganization, which include severance costs and related taxes, partially offset by a reversal of stock-based compensation expense related to unvested equity awards.

~~(m)~~

~~Refer to footnote (5) of the operating results table within “Basis of Presentation and Results of Operations” above.~~

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 pursue strategies 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.

Our adjusted net capital expenditures include (i) capital expenditures from investing activities and (ii) cash outflows of capital related to construction activities to design and build landlord leased assets, net of tenant allowances received. We anticipate our ~~gross~~adjusted net capital expenditures to be ~~approximately $125~~$165 million to ~~$135~~$185 million in fiscal ~~2018,~~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 ~~2018~~2019 adjusted net capital expenditures will be partially offset by proceeds from sales of assets of ~~approximately~~ $50 million to $60 million. During the three months ended May ~~5, 2018, our investments in~~4, 2019, adjusted net capital expenditures ~~totaled $27.1~~were $12.5 million, inclusive of cash received related to landlord tenant allowances of $10.8 million.

~~The majority~~Certain lease arrangements require the landlord to fund a portion of the ~~current~~construction related costs through payments directly to us. Other lease arrangements for our new Design Galleries require the landlord to fund a portion of

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the construction related costs directly to third parties, rather than through traditional construction allowances and accordingly, under these arrangements we do not expect to receive ~~significant~~ contributions directly from our landlords related to the building of our Design ~~Galleries in fiscal 2018.~~Galleries. As we develop new Galleries, as well as other potential strategic initiatives in the future like our integrated hospitality experience, we may explore other models for our real estate, which could include longer lease terms or further purchases of, or joint ventures or other forms of equity ownership in, real estate interests associated with new sites and buildings. These approaches might require 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 ~~$650~~$985 million at maturity of such senior convertible ~~notes or our term loan at the maturity date of such term loan.~~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

A summary of operating, investing, and financing activities is set forth in the following table:

Three Months Ended

May 5,

April 29,

2018

2017

(in thousands)

Provided by operating activities

$
7,756

$
123,948

Provided by (used in) investing activities

$
(27,121
)

$
159,528

Provided by (used in) financing activities

$
16,792

$
(299,087
)
Decrease in cash and cash equivalents and restricted cash equivalents

$
(2,635
)

$
(15,697
)
Cash and cash equivalents and restricted cash equivalents at end of period

$
22,679

$
99,370


	Three Months Ended
	May 4,		May 5,
	2019		2018
	(in thousands)
Provided by (used in) operating activities	$	38,824	$	(3,234)
Used in investing activities		(7,916)		(17,674)
Provided by financing activities		65,833		18,335
Increase (decrease) in cash and cash equivalents, restricted cash and restricted cash equivalents		96,747		(2,635)
Cash and cash equivalents, restricted cash and restricted cash equivalents at end of period		102,550		22,679

Net Cash Provided By (Used In) Operating Activities

Operating activities consist primarily of net income ~~(loss)~~ adjusted for non-cash items including depreciation and amortization, stock-based compensation, amortization of debt discount and the effect of changes in working capital and other activities.

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For the three months ended May ~~5, 2018,~~4, 2019, net cash provided by operating activities was ~~$7.8~~$38.8 million and consisted of net income of $35.7 million and non-cash items of ~~$32.9 million and net income of $28.1~~$66.4 million, partially offset by a decrease in cash used for working capital and other activities of ~~$53.2~~$63.3 million. Working capital and other activities consisted primarily of decreases in accounts payable and accrued expense of ~~$57.2~~$38.6 million related to timing of payments, decreases in operating lease liabilities of $27.1 million primarily due to payments made under the agreements, as well as increases in prepaid expenses and other ~~current~~ assets of ~~$26.2~~$17.8 million ~~primarily due to vendor deposits~~ and ~~capitalized catalog costs, as well as increases in accounts receivable~~landlord assets under construction of ~~$7.2~~$4.5 million. These decreases to working capital were partially offset by increases in deferred revenue and customer deposits of ~~$28.2 million and increases in other current liabilities of $13.8~~$21.6 million.

For the three months ended ~~April 29, 2017,~~May 5, 2018, net cash ~~provided by~~used in operating activities was ~~$123.9~~$3.2 million and consisted of a decrease in ~~uses of~~cash provided by working capital and other activities of ~~$96.3~~$88.4 million ~~and~~partially offset by non-cash items of ~~$31.0~~$59.7 million ~~offset by~~and net ~~loss~~income of ~~$3.4~~$25.5 million. Working capital and other activities consisted primarily of decreases in ~~inventory~~accounts payable and accrued expense of ~~$66.1~~$46.7 million related to timing of payments, increases in prepaid expenses and other assets of $31.5 million, increase in landlord assets under construction of $18.6 million, as well as decreases in operating lease liabilities of $16.6 million primarily due to lower inventory receipts and higher sales, including through our outlet and warehouse sales channels, in part as a result of our SKU rationalization initiative and our outlet inventory optimization efforts,payments made under the agreements. These decreases to working capital were partially offset by increases in deferred revenue and customer deposits of ~~$22.2 million and decreases in prepaid expense and other current assets of $7.5~~$28.2 million.

Net Cash ~~Provided By (Used In)~~Used In Investing Activities

Investing activities consist primarily of investments in capital expenditures related to ~~new Gallery openings,~~ investments in ~~supply chain~~information technology and systems infrastructure, and supply chain investments, as well as ~~activities associated with investing in available-for-sale securities.~~retail stores.

For the three months ended May 4, 2019 and May 5, 2018, net cash used in investing activities was ~~$27.1~~$7.9 million and $17.7 million, respectively, due to investments in ~~new Galleries, information technology and systems infrastructure, and supply chain investments.~~

For the three months ended April 29, 2017, net cash provided by investing activities was $159.5 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 $300 Million Repurchase Program. In addition, we had net proceeds from the sale of an aircraft of $4.9 million. These increases to cash were partially offset by purchases of investments in available-for-sale securities of $16.1 million and investments in new Galleries, information technology and systems infrastructure, supply chain investments, and ~~other corporate assets of $21.2 million.~~retail stores.

Net Cash Provided By ~~(Used In)~~ Financing Activities

Financing activities consist primarily of borrowings related to credit facilities and other financing arrangements, as well as share repurchases, principal payments under finance lease agreements and other equity related transactions.

For the three months ended May 4, 2019, net cash provided by financing activities was $65.8 million primarily due to net borrowings of debt of $321.5 million, including the issuance of a $200.0 million second lien term loan, a $120.0 million FILO term loan and $60.0 million of promissory notes secured by certain equipment, partially offset by net repayments of $57.5 million under the asset based credit facility and repayments of $1.0 million on our promissory notes. We incurred costs of $4.5 million related to the debt issuances. We repurchased approximately 2.2 million shares of our common stock for an aggregate repurchase amount of $250.0 million. Principal payments under finance lease agreements totaled $2.1 million.

For the three months ended May 5, 2018, net cash provided by financing activities was ~~$16.8~~$18.3 million primarily due to net borrowings under the asset based credit facility of $19.0 million and proceeds from exercise of employee stock options of $2.9 million. ~~The cash provided by these financing activities was partially offset by $3.2~~Principal payments under finance lease agreements totaled $1.8 million ofand we made payments on ~~build-to-suit lease transactions.~~our promissory notes of $1.5 million.

~~For the three months ended April 29, 2017, net cash used~~Convertible Senior Notes

0.00% Convertible Senior Notes due 2023

In June 2018, we issued in ~~financing activities was $299.1 million primarily due to~~a private offering $300 million principal amount of ~~share repurchases made~~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

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obligations under the ~~$300 Million Repurchase Program.~~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.

~~Non-Cash Transactions~~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.

~~Non-cash transactions consist~~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 ~~non-cash additions~~the immediately preceding calendar quarter, the last reported sale price of ~~property~~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 ~~equipment~~the applicable conversion rate on such trading day; or (3) upon the occurrence of specified corporate transactions. As of May 4, 2019, none of these conditions have occurred and, as a result, the 2023 Notes were not convertible as of May 4, 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 ~~notes payable~~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 ~~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~~issuance of the ~~accounting requirements of Accounting Standards Codification (“ASC”) 840—Leases~~ ~~(“ASC 840”) for those construction projects for which~~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 ~~“deemed owner”~~effective interest method over the expected life of the ~~construction project given~~2023 Notes, and debt issuance costs attributable to the ~~extent~~equity component are netted with the equity component in stockholders’ equity (deficit).

Debt issuance costs related to ~~which we~~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 are ~~involved in constructing~~recorded as a contra-liability and are presented net against the ~~leased asset. If we are~~convertible senior notes due 2023 balance on 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 condensed consolidated balance sheets. ~~The contributions by~~

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2023 Notes—Convertible Bond Hedge and Warrant Transactions

In connection with the ~~landlord toward construction, including~~offering of the ~~building, existing site improvements at construction commencement~~2023 Notes and ~~any amounts paid by~~ the ~~landlord~~exercise of the overallotment option in June 2018, we entered into convertible note hedge transactions whereby we have the option to ~~those responsible for construction, are included as property and equipment additions due to build-to-suit lease transactions within the non-cash section~~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 condensed consolidated ~~statements~~balance sheets.

We recorded a deferred tax liability of ~~cash flows.~~

~~Over~~$22.3 million in connection with the ~~lease term, these non-cash additions to property~~debt discount associated with the 2023 Notes and ~~equipment due to build-to-suit lease transactions do not impact our cash outflows, nor do they impact net income within our~~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 condensed consolidated ~~statements of operations.~~

~~Convertible Senior Notes~~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 ~~fiscal~~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

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of May ~~5, 2018,~~4, 2019, none of these conditions have occurred and, as a result, the 2020 Notes ~~are~~were not convertible as of May ~~5, 2018.~~4, 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 ~~excess of the principal amount of the liability component over its carrying amount (“~~debt ~~discount”)~~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.~~equity (deficit).

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 condensed 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 condensed consolidated balance sheets.

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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 ~~fiscal~~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 May ~~5, 2018,~~4, 2019, none of these conditions have occurred and, as a result, the 2019 Notes ~~are~~were not convertible as of May ~~5, 2018.~~4, 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 the earlier of conversion and maturity of the 2019 Notes, ~~will be settled, at our election, in cash, shares of our common stock, or a combination of~~we intend to settle the principal value with existing cash and ~~shares of~~cash equivalents and restricted cash, as well as borrowings under our ~~common stock.~~currently undrawn asset based credit facility.

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.

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.~~equity (deficit).

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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 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 condensed 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 condensed consolidated balance sheets.

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 (the “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”~~(“First Lien Administrative Agent”). The ~~credit agreement~~Credit Agreement has a revolving line of credit with initial 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~~whether existing lenders or new lenders, agree to increase their credit ~~commitments to encompass a larger facility.~~commitments. In addition, the ~~credit agreement establishes~~Credit Agreement established an $80.0 million ~~LILO~~last in, last out (“LILO”) term loan ~~facility.~~facility which was repaid in full in June 2018. The Credit Agreement has a maturity date of June 28, 2022.

On June 12, 2018, Restoration Hardware, Inc. entered into a First Amendment ~~(the “Amendment”)~~ to the ~~credit agreement.~~Credit Agreement (the “First Amendment”). The First Amendment (i) ~~changes~~changed the ~~credit agreement’s~~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~~clarified that no ~~Default~~default or ~~Event~~event of ~~Default~~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.~~Credit Agreement.

On November 23, 2018, Restoration Hardware, Inc. entered into a Consent and Second Amendment to the Credit Agreement (the “Second Amendment”). The Second Amendment included 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

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payment to allow the lead borrower to make annual restricted payments of up to $3.0 million per fiscal year to cover payments of certain administrative and other obligations of RH in the ordinary course of business.

On April 4, 2019, Restoration Hardware, Inc., entered into a Third Amendment to the Credit Agreement (the “Third Amendment”). The Third Amendment, among other things, (a) established a $120.0 million first in, last out (“FILO”) term loan facility, which amount was fully borrowed as of April 4, 2019 and which incurs interest at a rate that is 1.25% greater than the interest rate applicable to the revolving loans under the Credit Agreement, (b) provided for additional Permitted Indebtedness, as defined in the Credit Agreement, that the loan parties can incur, and (c) modified the borrowing availability under the Credit Agreement in certain circumstances. The FILO term loan facility has a maturity date of June 28, 2022.

The availability of credit at any given time under the ~~credit agreement~~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~~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 ~~and LILO term loan facility~~ are subject to interest, at the borrowers’ option, at either the bank’s reference rate or ~~LIBOR~~London Inter-bank Offered Rate (“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,~~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.

In addition, under ~~our credit agreement,~~the 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~~Subject to certain exceptions, 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~~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~~Credit Agreement is less than the foregoing amount, then Restoration Hardware, Inc. is required subject to certain exceptions to maintain an FCCR of at least one to one. ~~As of May 5, 2018, Restoration Hardware, Inc. was in compliance with all applicable covenants of the credit agreement.~~

The ~~credit agreement~~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 May ~~5, 2018,~~4, 2019, Restoration Hardware, Inc. had ~~$219.0 million in~~no outstanding borrowings under the revolving line of credit. The Credit Agreement provides for a borrowing amount based on the value of eligible collateral and ~~$138.8 million~~a formula linked to certain borrowing percentages based on certain categories of ~~availability~~collateral. Under the terms of such provisions, the amount under the revolving line of credit borrowing base that could be available pursuant to the Credit Agreement as of May 4, 2019 was $139.4 million, net of ~~$27.8~~$285.0 million reserved for the upcoming repayment of the 2019 Notes, as well as $12.8 million in outstanding letters of credit.

As previously reported, on May 31, 2019, Restoration Hardware, Inc. entered into a fourth amendment to the Credit Agreement (the “Fourth Amendment”). The Fourth Amendment, among other things, amends the Credit Agreement to (a) extend the time to deliver monthly financial statements to the lenders for the fiscal months ending February 2019 and March 2019 until June 19, 2019; (b) remove the requirement to deliver monthly financial statements to the lenders for the last fiscal month of ~~May 5, 2018, the Company had $80.0 million outstanding borrowings~~any fiscal quarter; and (c) waive any default or event of default under the ~~LILO term loan facility.~~Credit

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Agreement relating to the delivery of monthly financial statements or other information to lenders for the fiscal months ending February 2019 and March 2019.

The Credit Agreement contains various restrictive and affirmative covenants, including, among others, required financial reporting, 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 a result of the ~~consolidated FCCR restriction that limits the last 10% of borrowing availability, actual incremental borrowing available~~Fourth Amendment, Restoration Hardware, Inc. was deemed to ~~the Company and the other affiliated parties under the revolving line of credit would~~ be ~~approximately $92.2 million~~in compliance as of May 4, 2019 with all applicable covenants of the Credit Agreement.

Second Lien Credit Agreement

The Second Lien Term Loan bears interest at an annual rate generally based on LIBOR plus 6.50%. This rate is a floating rate that resets periodically based upon changes in LIBOR rates during the life of the Second Lien Term Loan. At the date of the initial borrowing, the rate was set at one month LIBOR plus 6.50%.

All obligations under the Second Lien Term Loan are secured by a second lien security interest in substantially all of the assets of the loan parties, including inventory, receivables and certain types of intellectual property. The second lien security interest encumbers substantially the same collateral that secures the credit. The second lien ranks junior in priority and is subordinated to the first lien in favor of the lenders with respect to the Credit Agreement.

The net senior secured leverage ratio test is based on the ratio of (i) the sum of (a) all obligations outstanding under the Second Lien Term Loan and the Credit Agreement plus (b) all other secured indebtedness of RH and certain of its subsidiaries that is (x) senior or pari passu to the lien on the Second Lien Term Loan collateral or (y) secured by property that does not constitute Second Lien Term Loan collateral under the Second Lien Term Loan, less (c) all unrestricted cash and cash equivalents of RH and certain of its subsidiaries subject to a blocked account control agreement, to (ii) consolidated EBITDA of RH and certain of its subsidiaries (the “Net Senior Secured Leverage Ratio”).

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costs to the amount of (ii) debt service costs plus certain other costs is not less than 1.00 to 1.00 and the level of unused availability under the Credit Agreement meets certain levels.

The Second Lien Credit Agreement also contains certain events of default and other customary terms and conditions typical to a second lien credit agreement.

As of May 4, 2019, the Company had $200.0 million in outstanding borrowings and no availability under the Second Lien Credit Agreement.

As previously reported, on May 31, 2019, Restoration Hardware, Inc. entered into a first amendment to the Second Lien Credit Agreement (the “First Amendment”). The First Amendment, among other things, amends the Second Lien Credit Agreement to (a) remove the requirement to deliver monthly financial statements to the lenders for the last fiscal month of any fiscal quarter and (b) waive any default or event of default under the Second Lien Credit Agreement relating to the delivery of monthly financial statements or other information to lenders for the fiscal months ending February 2019 and March 2019.

The Second Lien Credit Agreement contains various restrictive and affirmative covenants generally in line with the covenants and restrictions contained in the Credit Agreement, including required financial reporting, 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 a similar type and size. As a result of the First Amendment, Restoration Hardware, Inc. was deemed to be in compliance as of May 4, 2019 with all applicable covenants of the Second Lien Credit Agreement.

Intercreditor Agreement

Equipment Loan Facility

On September 5, ~~2018.~~2017, Restoration Hardware, Inc. entered into a Master Loan and Security Agreement with Banc of America Leasing & Capital, LLC (“BAL”) pursuant to which BAL and we agreed that BAL would finance certain equipment of ours from time to time, with each such equipment financing to be evidenced by an equipment security note setting forth the terms for each particular equipment loan. Each equipment loan is secured by a purchase money security interest in the financed equipment. As of May 4, 2019, we had $59.0 million in aggregate amounts outstanding under the equipment security notes, of which $18.4 million was included in other current liabilities and $40.6 million was included in other non-current obligations on the condensed consolidated balance sheets. The maturity dates of the equipment security notes vary, but generally have a maturity of three or four years. We are required to make monthly installment payments under the equipment security notes.

Share Repurchase Programs

~~During fiscal 2017, we repurchased approximately 20.2 million shares~~We regularly review share repurchase activity and consider various factors in determining whether and when to execute share repurchases, including, among others, current cash needs, capacity for leverage, cost of borrowings, results of operations and the market price of the our common ~~stock under two separate repurchase programs for an aggregate repurchase amount of approximately $1 billion, which represented 49.5% of the shares outstanding as of the end of fiscal 2016.~~ ~~We generated $412 million in free cash flow in fiscal 2017 which supported our share repurchase programs.~~stock. We believe that these share repurchase programs will continue to be an excellent allocation of capital for the ~~long term~~long-term benefit of our shareholders. We may undertake other repurchase programs in the future with respect to our securities.

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$300 Million ~~Share~~ Repurchase Program (Completed)

On February 21, 2017, our ~~board~~Board of ~~directors~~Directors authorized a ~~stock~~share repurchase program of up to $300 million (the “$300 Million Repurchase Program”) through open market purchases, privately negotiated transactions or other means, including through Rule 10b18 open market repurchases, Rule ~~10b5-1~~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 $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 $300 Million Repurchase Program.

$700 Million ~~Share~~ Repurchase Program (Completed)

Following completion of the $300 Million Repurchase Program, our ~~board~~Board of ~~directors~~Directors authorized on May 2, 2017 an additional ~~stock~~share repurchase program of up to $700 million (the “$700 Million Repurchase Program”) through open market purchases, privately negotiated transactions or other means, including through Rule 10b18 open market repurchases, Rule ~~10b5-1~~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 $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 $700 Million Repurchase Program.

~~Contractual Obligations~~$950 Million Repurchase Program (Existing)

On October 10, 2018, our Board of Directors authorized a share repurchase program of up to $700 million 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, of which $250.0 million in share repurchases were completed in fiscal 2018. The $700.0 million authorization amount was replenished by the Board of Directors on March 25, 2019 (as replenished, the “$950 Million Repurchase Program”). During the three months ended May 4, 2019, we repurchased approximately 2.2 million shares of our common stock under the $950 Million Repurchase Program at an average price of $115.36 per share, for an aggregate repurchase amount of approximately $250.0 million. As of May ~~5, 2018,~~4, 2019, there was $450 million remaining for future share repurchases under this program.

Contractual Obligations

As of May 4, 2019, there were no material changes to our contractual obligations described in the Management’s Discussion and Analysis of Financial Condition and Results of Operations—Contractual Obligationsin the ~~2017~~2018 Form 10-K.

Off Balance Sheet Arrangements

We have no material off balance sheet arrangements as of May ~~5, 2018.~~4, 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

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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.

Management evaluated the development and selection of its critical accounting policies and estimates and believes that the following involve a higher degree of judgment or complexity and are most significant to reporting our consolidated results of operations and financial position, and are therefore discussed as critical:

~~Revenue Recognition~~

Revenue Recognition

~~Merchandise Inventories~~

Merchandise Inventories

~~Advertising Expenses~~

Impairment

~~Impairment of Goodwill and Long-Lived Assets~~

Lease Accounting

~~Lease Accounting~~

Stock-Based Compensation

~~Stock-Based Compensation~~

~~Income Taxes~~

Income Taxes

In the first quarter of fiscal ~~2018,~~2019, we adopted Accounting Standards Update ~~2014-09—Revenue from Contracts with Customers (Topic 606)~~2016‑02—Leases. The adoption of ~~Topic 606~~this standard resulted in a material change to the ~~“Revenue Recognition” and “Advertising Expenses”~~“Lease Accounting” critical accounting ~~policies~~policy in fiscal ~~2018.~~2019. Please refer below for our updated ~~“Revenue Recognition” and “Advertising Expenses”~~“Lease Accounting” critical accounting ~~policies.~~ policy. There have been no material changes to the other critical accounting policies and estimates listed above from the disclosures included in the ~~2017~~2018 Form ~~10-K.~~10‑K. For further discussion regarding these policies, refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates in the ~~2017~~2018 Form ~~10-K.~~10‑K.

~~Revenue Recognition~~Lease Accounting

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~~lease nearly all of our retail and outlet store locations, corporate headquarters, distribution ~~channels.~~and home delivery facilities, as well as other storage and office space. The initial lease terms of our real estate leases generally range from ten to fifteen years, and certain leases contain renewal options for up to an additional 25 years, the exercise of which is at our sole discretion. In ~~instances where revenue is recognized~~recognizing the lease right-of-use assets and lease liabilities, we utilize the lease term for which we are reasonably certain to use the ~~related merchandise prior~~underlying asset, including consideration of options to ~~delivery~~extend or terminate the lease. We also lease certain equipment with lease terms generally ranging from three to ~~customers (i.e., revenue recognized upon shipment), the related costs~~seven years. Our lease agreements generally do not contain any material residual value guarantees or material restrictions or covenants.

Leases, or lease extensions, with a term of ~~shipping and handling activities will be accrued for in the same period. Costs of shipping and handling~~twelve months or less 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~~not recorded on the condensed 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 revenuewe recognize lease expense for these leases on a straight-line basis over the ~~membership period,~~lease term.

We account for lease and non-lease components as a single lease component for real estate leases, and for all other asset classes we account for the components separately. We determine the lease classification and begin to recognize lease and any related financing expenses upon the lease’s commencement, which for real estate leases is generally upon store opening or, ~~one year.~~to a lesser extent, when we take possession or control of the asset.

~~Sales tax collected~~As most of our leases do not include an implicit interest rate, we determine the discount rate for each lease based upon the incremental borrowing rate (“IBR”) in order to calculate the present value of lease payments at the commencement date. The IBR is computed as the rate of interest that we would have to pay to (i) borrow on a collateralized basis (ii) over a similar term (iii) an amount equal to the total lease payments and (iv) in a similar economic environment. We utilize our asset based credit facility as the basis for determining the applicable IBR for each lease.

Certain of our lease agreements include rental payments based on a percentage of retail sales over contractual levels. Due to the variable and unpredictable nature of such payments, we do not ~~recognized as revenue but is~~recognize a lease right-of-use asset and lease liability related to such payments. Estimated variable rental payments are included in accounts payable and accrued expenses on the condensed consolidated balance sheets.

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We have a small group of leases that include rental payments periodically adjusted for inflation (e.g., based on the consumer price index). We include these variable payments in the initial measurement of the lease right-of-use asset and lease liability if such increases have a minimum rent escalation (e.g., floor). However, we exclude these variable payments from the initial measurement of the lease right-of-use asset and lease liability in the case of lease arrangements that do not specify a minimum rent escalation.

We rent or sublease certain real estate to third parties under operating leases and recognize rental income received on a straight-line basis over the lease term, which is included in selling, general and administrative expenses on the condensed consolidated statements of income.

Lease arrangements may require the landlord to provide tenant allowances directly to us. Standard tenant allowances received from landlords, typically those received under operating lease agreements, are recorded as cash and cash equivalents with an offset recorded in lease right-of-use assets on the condensed consolidated balance sheets. In certain instances tenant allowances are provided for us to design and build the leased asset. Tenant allowances received from landlords during the construction phase of a leased asset and prior to lease commencement are recorded as cash and cash equivalents with an offset recorded in other non-current assets (to the extent we have incurred related capital expenditure for construction costs) or in other current liabilities (to the extent that payments are received prior to capital construction expenditures by us) on the condensed consolidated balance sheets. After the leased asset is constructed and the lease commences, we reclassify the tenant allowance from other non-current assets or other current liabilities to lease right-of-use assets on the condensed consolidated balance sheets.

Lease Classification

Certain of our real estate and property and equipment are held under finance leases. Lease related assets are included in finance lease right-of-use assets within property and equipment—net on the condensed consolidated balance sheets.

Construction Related Activities

We are sometimes involved in the construction of leased stores for certain of our newer Design Galleries. Prior to construction commencement, we evaluate whether or not we, as lessee, control the asset being constructed and, depending on the extent to which we are involved, may be the “deemed owner” of the leased asset for accounting purposes during the construction period.

If we are not the “deemed owner” for accounting purposes during the construction period, such lease is classified as either an operating or finance lease upon lease commencement. During the construction period and prior to lease commencement, any capital amounts contributed by us toward the construction of the leased asset (excluding normal leasehold improvements, which are recorded within property and equipment—net) are recorded as “Landlord assets under construction” within other non-current assets on the condensed consolidated balance sheets (refer to Note 3—Prepaid Expense and Other Assets). Upon completion of the construction project, and upon lease commencement, we reclassify amounts of the construction project determined to be the landlord asset to lease right-of-use assets on the condensed consolidated balance sheets. The construction costs determined not to be part of the leased asset are classified as property and equipment—net on the condensed consolidated balance sheets.

If we are the “deemed owner” for accounting purposes, upon commencement of the construction project, we are required to capitalize (i) costs incurred by us and (ii) the cash and non-cash assets contributed by the landlord for construction as property and equipment on its condensed consolidated balance sheets as ~~it is ultimately remitted~~build-to-suit assets, with an offsetting financing obligation for the amount funded by the landlord. The contributions by the landlord toward construction, including the building, existing site improvements at construction commencement and any amounts paid by the landlord to ~~governmental authorities.~~

~~We reserve~~those responsible for ~~projected merchandise returns. Merchandise returns~~construction, are ~~often resalable merchandise~~included as property and ~~are refunded by issuing~~equipment additions due to build-to-suit lease transactions within the ~~same payment tender~~non-cash section of the ~~original purchase. Merchandise exchanges~~consolidated statements of cash flows. Over the lease term,

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these non-cash additions to property and equipment do not impact our cash outflows, nor do they impact net income within the consolidated statements of income.

Upon completion of the ~~same product~~construction project, we perform a sale-leaseback analysis to determine if we can derecognize the build-to-suit asset and ~~price are not considered merchandise returns~~corresponding financing obligation. If the asset and ~~therefore, are excluded when calculating~~liability cannot be derecognized, we account for the ~~sales returns reserve.~~agreement as a debt-like arrangement.

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.

~~Advertising Expenses~~

~~Advertising expenses primarily represent the costs associated with our catalog mailings, as well as print and website marketing.~~

~~Capitalized Catalog Costs~~

Capitalized catalog costs consist primarily of third-party incremental direct costs to prepare, print and distribute Source Books. Such costs are capitalized and recognized as expense 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.

~~Website and Print Advertising~~

Website and print advertising expenses, which include e-commerce advertising, web creative content and direct marketing activities such as print media, radio and other media advertising, are expensed as incurred or upon the release of the content or the initial advertisement.

Recent Accounting Pronouncements

Refer to Note 2—Recently Issued Accounting Standards in our condensed consolidated financial statements for a description of recently proposed accounting standards which may impact our consolidated financial statements in future reporting periods.

Item 3. 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. As of May ~~5, 2018, $219.0 million was~~4, 2019, no amounts were outstanding under the revolving line of credit. AsThe Credit Agreement provides for a borrowing amount based on the value of ~~May 5, 2018,~~eligible collateral and a formula linked to certain borrowing percentages based on certain categories of collateral. Under the ~~undrawn borrowing availability~~terms of such provisions, the amount under the revolving line of credit borrowing base that could be available pursuant to the Credit Agreement as of May 4, 2019 was ~~$138.8~~$139.4 million, net of ~~$27.8~~$285.0 million reserved for the upcoming repayment of the 2019 Notes, as well as $12.8 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 was approximately $92.2 million as of May 5, 2018. Based on the average interest rate on the revolving line of credit during the three months ended May ~~5, 2018,~~4, 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.

We are subject to interest rate risk in connection with borrowings under our LILO term loan, which bears interest at variable rates. As of May 5, 2018, $80.0 million was outstanding under the LILO term loan. Based on the average interest rates on the LILO term loan during the three months ended May 5, 2018, 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.

As of May ~~5, 2018,~~4, 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 May ~~5, 2018,~~4, 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 May 4, 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

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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. Refer to Note 7—8—Convertible Senior Notes in our condensed consolidated financial statements.

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. Refer to Note 7—8—Convertible Senior Notes in our condensed consolidated financial statements.

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. Refer to Note 8—Convertible Senior Notes in our condensed consolidated financial statements.

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.

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Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules ~~13a-15(e)~~13a‑15(e) and ~~15d-15(e)~~15d‑15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this quarterly report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that as of the end of the period covered by this report our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and include controls and procedures designed to ensure that the information required to be disclosed by us in such reports is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.

Changes in Internal Control Over Financial Reporting

During fiscal year 2018 and the first fiscal quarter of 2019, we implemented key system functionality and modified our internal controls to ensure we adequately assessed the impact of the new accounting standard related to leases, which standard was effective for us in the first fiscal quarter of 2019. There were no other changes in our internal control over financial reporting that occurred during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II~~PART~~ II

Item 1. Legal Proceedings

From time to time, we and/or our management are involved in litigation, claims and other proceedings relating to the conduct of our business, including purported class action litigation, as well as securities class action litigation. Such legal proceedings may include claims related to our employment practices, wage and hour claims, claims of intellectual property infringement, including with respect to trademarks and trade dress, claims asserting unfair competition and unfair business practices, claims with respect to our collection and sale of reproduction products, and consumer class action claims relating to our consumer practices including the collection of zip code or other information from customers. In addition, from time to time, we are subject to product liability and personal injury claims for the products that we sell and the stores we operate. Subject to certain exceptions, our purchase orders generally require the vendor to indemnify us against any product liability claims; however, if the vendor does not have insurance or becomes insolvent, we may not be indemnified. In addition, we could face a wide variety of employee claims against us, including general discrimination, privacy, labor and employment, ERISA and disability claims. Any claims could result in litigation against us and could also result in regulatory proceedings being brought against us by various federal and state agencies that regulate our business, including the U.S. Equal Employment Opportunity Commission. Often these cases raise complex factual and legal issues, which are subject to risks and uncertainties and which could require significant management time. Litigation and other claims and regulatory proceedings against us could result in unexpected expenses and liability and could also materially adversely affect our operations and our reputation.

For additional information regarding certain pending securities litigation, refer to Note ~~14—~~15—Commitments and Contingencies in our condensed consolidated financial statements within Part I of this Quarterly Report on Form ~~10-Q.~~10‑Q.

Item 1A. Risk Factors

We operate in a rapidly changing environment that involves a number of risks that could materially and adversely affect our business, financial condition, prospects, operating results or cash flows. For a detailed discussion of certain risks that affect our business, refer to the section entitled “Risk Factors” in our Annual Report on Form ~~10-K~~10‑K for the fiscal year ended February 3, 2, 2019 (“2018 ~~(“2017~~ Form ~~10-K”~~10‑K”). ~~There have been no material changes to the risk factors disclosed in our 2017 Form 10-K.~~

The risks described herein and those described in our ~~2017~~2018 Form 10-K are not the only risks we face. We describe in Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part I of this quarterly report certain known trends and uncertainties that affect our business. Additional risks and uncertainties that we are unaware of, or that we currently believe are not material, may also become important factors that adversely affect our business, operating results and financial condition. We have identified additional material changes to our risk factors set forth below.

We are subject to risks associated with our dependence on foreign manufacturing and imports for our merchandise.

Based on total dollar volume of purchases, in fiscal 2018 we sourced approximately 85% of our merchandise from outside the United States, including 73% from Asia, with approximately 39% of our products sourced from China and approximately 3% of our products sourced from Mexico and in fiscal 2017 we sourced approximately 85% of our merchandise from outside the United States, including 76% from Asia, with approximately 42% of our products sourced from China and approximately 3% of our products sourced from Mexico. We expect the amount of products that we source from China will be lower in fiscal 2019 compared to fiscal 2018, but the exact product mix in terms of vendor factory locations is subject to a range of different factors and is inherently difficult to predict with accuracy. In addition, some of the merchandise we purchase from vendors in the United States also depends, in whole or in part, on vendors located outside the United States. As a result, our business highly depends on global trade, as well as any trade and or other factors that impact the specific countries where our vendors’ production facilities are located. Our future success will depend in large part upon our ability to maintain our existing foreign vendor relationships and to develop new ones based on the requirements of our business and any changes in trade dynamics that might dictate changes in the locations for sourcing of products. In addition, we face risks related to the ability of our vendors to scale their operations whether

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in connection with new products we introduce or new production manufacturing locations that may be added to our supply chain, which in some cases would require substantial ongoing investments to support additional capacity. In addition, we have previously encountered difficulties in the ability of our vendors to scale production commensurate with demand from our customers. While we rely on long-term relationships with many of our vendors, we do not rely on long-term contracts with our vendors and generally transact business with them on an order-by-order basis.

Many of our imported products are subject to existing duties, tariffs, anti-dumping duties, quotas and other similar trade restrictions that may limit the quantity or affect the price of some types of goods that we import into the United States. In addition, substantial regulatory uncertainty exists regarding international trade relations and trade policy, both in the United States and abroad. An introduction of new duties, tariffs, quotas or other similar trade restrictions, or increases in existing duties or tariff rates, on products imported into the United States, whether actual, pending or threatened, may have a negative impact on our results of operations. Additionally, such uncertainties, even if not directly applicable to our imported products, may have a negative influence on the domestic and international economy generally and indirectly reduce market demand for our products.

A significant subset of our furniture and lighting sourced from China has been affected by the tariffs on such products which became effective (i) as a 10 per cent ad valorem duty as of September 24, 2018, and (ii) as a 25 per cent ad valorem duty for all goods shipped on or after May 10, 2019. While we have been working with our vendor partners on mitigation strategies to seek to address the impact of such tariffs on our product pricing and costs, such efforts may not be fully sufficient to remediate the impact of the 25 per cent ad valorem duty on certain products imported from China. In addition, such mitigation efforts may not be successful with respect to other pending or future increases in tariffs. There is substantial uncertainty regarding the possible application of additional tariffs with respect to additional countries other than China. Recently, the President proposed the possible imposition of tariffs. We may not able to anticipate the exact contours of tariffs and other burdens on global trade that may become applicable and our efforts to respond to these circumstances may be inadequate. In particular, we may not be able to receive or sustain adequate pricing concessions from our vendors with respect to applicable tariffs and any applicable pricing increases that we seek to pass through to our customers may not be successful in achieving our objectives. Our sales may fall in response to any price increases and our vendors may not be able to support the level of pricing concessions that we seek.

In addition, we are undertaking ongoing efforts to examine our sourcing strategy in a comprehensive way in order to achieve the best possible outcomes for our business. Such efforts include addressing among other factors the country of origin and the current and potential future imposition of tariffs with respect to particular countries of origin. These efforts to optimize our supply chain may not be successful and we may encounter various obstacles to these and other related initiatives. Although we have moved some of our merchandise sourcing away from China to other countries, these efforts may not achieve the desired outcomes. For example, we may not be able to move sufficient quantities of our product manufacturing to new locations outside of China and the quality of products manufactured in new factories may not meet the requirements of our business. In addition, we may encounter logistics and other challenges in moving manufacturing to new jurisdictions including the potential imposition of new tariffs on products sourced from other jurisdictions such as the proposed tariffs with respect to Mexico.

In addition, there can be no assurance that tariffs that are imposed or proposed will not become effective on a longer term basis. In the event that any tariffs applicable to our business become applicable on a longer term basis, there can be no assurance that our efforts to mitigate the impact of such longer term tariffs will be successful.

There can be no assurance that we will not experience disruption in our business related to tariffs or other changes in trade practices and applicable rules or as a result of our efforts to respond to these matters. Tariffs and other similar trade actions are inherently unpredictable and can change quickly based on political or economic pressures or policy changes. Any changes to tariffs or other rules and practices related to cross border trade, including the possible implementation of additional tariffs, could materially increase our cost of goods sold with respect to merchandise that we purchase from vendors who manufacture products in China, Mexico or other countries outside the United States, which could in turn require us to increase our prices and, in the event consumer demand declines as a result, negatively impact our financial performance. While we may seek to adopt mitigation measures and changes to our business practices to seek to counteract the effect of such tariffs on our business and results of operations, due to multiple factors that can occur in the context of trade disputes and the inherent unpredictability of how customers and market participants may

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respond, any mitigation measures we adopt may be not achieve their intended purpose. Certain of our competitors may be better positioned than us to withstand or react to these kinds of changes including border taxes, tariffs or other restrictions on global trade and as a result we may lose market share to such competitors. In addition, to the extent that our competitors, our vendors or companies in other industries that manufacture products in China or Mexico respond to the tariffs imposed to date or the possibility of future tariffs by shifting production to other countries in Asia or to other regions, the costs of production in such countries may increase, which may increase our costs or otherwise have an adverse impact on our product supply chain. Similarly, to the extent that we or our vendors respond to the tariffs imposed to date or the possibility of future tariffs by shifting merchandise purchases or production to other countries in Asia or to other regions, we may face delays or costs associated with developing new vendor relationships and our vendors may face delays or costs associated with bringing online new manufacturing facilities, which may increase the cost of our products or cause delays in the shipment of our merchandise that result in the cancellation of orders by our customers. An interruption or delay in supply from our foreign sources, or the imposition of additional duties, taxes or other charges on these imports, could have a material adverse effect on our business, financial condition and results of operations unless and until alternative supply arrangements are secured. Due to broad uncertainty regarding the timing, content and extent of any regulatory changes in the U.S. or abroad, we cannot predict the impact, if any, that these changes could have to our business, financial condition and results of operations.

Our dependence on foreign imports also makes us vulnerable to risks associated with products manufactured abroad, including, among other things, risks of damage, destruction or confiscation of products while in transit to our distribution centers located in the United States, product quality control charges on or assessment of additional import duties, tariffs, anti-dumping duties and quotas, loss of “most favored nation” trading status by the United States in relation to a particular foreign country, work stoppages, including without limitation as a result of events such as longshoremen strikes, transportation and other delays in shipments, including without limitation as a result of heightened security screening and inspection processes or other port-of-entry limitations or restrictions in the United States, freight cost increases, political unrest, economic uncertainties, including inflation, foreign government regulations, trade restrictions, increased labor costs and other similar factors that might affect the operations of our vendors in specific countries such as China or Mexico.

In addition, there is a risk of compliance violations by our vendors, which could lead to adverse consequences related to the failure of our vendors to adhere to applicable manufacturing requirements or other applicable rules. Any such noncompliance could have an adverse impact on our business and may result in product recalls, regulatory action, product liabilities, investigation by governmental agencies and other similar adverse consequences. Any failure by our vendors outside the United States to adhere to applicable legal requirements or our global compliance standards such as fair labor standards, prohibitions on child labor and other product safety or manufacturing safety standards could give rise to a range of adverse consequences including the disruption of our supply chain as well as potential liability to us and harm our reputation and brand and could subject us to other adverse consequences including boycotts by our consumer or special interest groups including activists, any of which actions could negatively affect our business and results of operations.

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Item 2. Unregistered Sales of ~~Equi~~tyEquity Securities and Use of Proceeds

Repurchases of Common Stock during the Three Months Ended May ~~5, 2018~~4, 2019

During the three months ended May ~~5, 2018,~~4, 2019, we repurchased the following shares of our common stock:

Number of
Shares

Average
Purchase
Price Per
Share

Total Number of shares Repurchased as Part of Publicly Announced Plans or Programs

Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plans or Programs

(in millions)

February 4, 2018 to March 3, 2018

—

$
—

—

$
—

March 4, 2018 to April 7, 2018 ⁽¹⁾

3,584

$
95.28

—

$
—

April 8, 2018 to May 5, 2018 ^{(1) (2)}

9,721

$
96.62

—

$
—

Total

13,305

$
96.26

—


				Total Number of	Approximate Dollar
		Average		Shares Repurchased	Value of Shares That
		Purchase		as Part of Publicly	May Yet Be
	Number of	Price Per		Announced Plans or	Purchased Under the
	Shares (1)	Share		Programs (2)	Plans or Programs
					(in millions)
February 3, 2019 to March 2, 2019	—	$	—	—	$	700
March 3, 2019 to April 6, 2019	2,305	$	102.95	—	$	700
April 7, 2019 to May 4, 2019	2,168,985	$	115.36	2,167,396	$	450
Total	2,171,290			2,167,396

(1)

Includes shares withheld from delivery to satisfy exercise price and tax withholding obligations of employee recipients that occur upon the exercise of stock options and vesting of restricted stock units granted under the Company’s 2012 Stock Incentive Plan.There were 3,894 shares surrendered for this purpose during the three months ended May 4, 2019.

(2)

~~Includes 2,800~~

Reflects shares ~~of common stock~~ repurchased ~~from a former employee~~as part of the ~~Company in connection with certain options granted under~~$950 Million Repurchase Program authorized by the ~~Company’s 2012 Stock Incentive Plan that contain a repurchase right in favor~~Board of ~~the Company. For additional information, refer to Note 12~~—~~Share Repurchases~~ ~~to our condensed consolidated financial statements within Part I of this Quarterly Report~~Directors on ~~Form 10-Q.~~October 10, 2018 and replenished on March 25, 2019.

Item 3. Defaults Upon Senior Securities

Not applicable.

Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Other Information

~~First Amendment to the Eleventh Amended and Restated Credit Agreement~~Not applicable.

~~On June 12, 2018, Restoration Hardware, Inc. entered into a First Amendment (the “Amendment”) to the Eleventh Amended and Restated Credit Agreement, dated as~~

Table of June 28, 2017, among Restoration Hardware, Inc. as lead borrower, various other subsidiaries of RH named therein as borrowers, the guarantors party thereto, the lenders party thereto and Bank of America, N.A. as administrative agent and collateral agent (the “Credit Agreement”). The 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 Company’s borrowing base for eligible collateral for purposes of determining the amount of borrowing available to borrowers under the Credit Agreement.Contents

~~This description of the Amendment is qualified in its entirety by reference to the Amendment, which is filed with this Quarterly Report as Exhibit 10.1 and incorporated herein by reference.~~

Item 6. Exhibits

Incorporated by Reference

Exhibit
Number

Exhibit Description

Form

File
Number

Date of
First Filing

Exhibit
Number

Filed
Herewith

10.1

First Amendment to Eleventh Amended and Restated Credit Agreement, dated June 12, 2018, among Restoration Hardware, Inc., as lead borrower, various other subsidiaries of RH named therein as borrowers, the guarantors party thereto, the lenders party thereto and Bank of America, N.A., as administrative agent and collateral agent.

—

—

—

—

X

10.2

Form of Compensation Protection Agreement for Section 16 Presidents.

10-K

001-35720

March 29, 2018

10.11

31.1

Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.

—

—

—

—

X

31.2

Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.

—

—

—

—

X

32.1

Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

—

—

—

—

X

32.2

Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

—

—

—

—

X

101.INS

XBRL Instance Document

—

—

—

—

X

101.SCH

XBRL Taxonomy Extension Schema Document

—

—

—

—

X

101.CAL

XBRL Taxonomy Extension Calculation Linkbase Document

—

—

—

—

X

101.DEF

XBRL Taxonomy Extension Definition Linkbase Document

—

—

—

—

X

101.LAB

XBRL Taxonomy Extension Label Linkbase Document

—

—

—

—

X

101.PRE

XBRL Taxonomy Extension Presentation Linkbase Document

—

—

—

—

X


			Incorporated by Reference
Exhibit Number	Exhibit Description	Form	File Number	Date of First Filing	Exhibit Number	Filed Herewith

10.1	Third Amendment to Eleventh Amended and Restated Credit Agreement, dated April 4, 2019, among Restoration Hardware, Inc., as lead borrower, various other subsidiaries of RH named therein as borrowers, the guarantors party thereto, the lenders party thereto and Bank of America, N.A. as administrative agent and collateral agent.	8-K	001‑35720	April 5, 2019	10.1

10.2	Credit Agreement, dated as of April 9, 2019, and effective as of April 10, 2019, among Restoration Hardware, Inc., as lead borrower, various other subsidiaries of RH named therein as borrowers, the guarantors party thereto, the lenders party thereto and BSP Agency, LLC, as administrative agent and collateral agent.	8‑K	001‑35720	April 16, 2019	10.1

10.3	Intercreditor Agreement, dated as of April 9, 2019 and effective April 10, 2019, among Restoration Hardware, Inc., Bank of America, N.A. and BSP Agency, LLC.	8‑K	001‑35720	April 16, 2019	10.2

31.1	Certification of Chief Executive Officer pursuant to Rule 13a‑14(a) of the Securities Exchange Act of 1934, as amended.	—	—	—	—	X

31.2	Certification of Chief Financial Officer pursuant to Rule 13a‑14(a) of the Securities Exchange Act of 1934, as amended.	—	—	—	—	X

32.1	Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.	—	—	—	—	X

32.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.	—	—	—	—	X

101.INS	XBRL Instance Document	—	—	—	—	X

101.SCH	XBRL Taxonomy Extension Schema Document	—	—	—	—	X

101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document	—	—	—	—	X

101.DEF	XBRL Taxonomy Extension Definition Linkbase Document	—	—	—	—	X

101.LAB	XBRL Taxonomy Extension Label Linkbase Document	—	—	—	—	X

101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document	—	—	—	—	X

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SIGNATURES~~SIGNATURES~~

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

		RH


Date: June ~~12, 2018~~13, 2019		By:		/s/ Gary Friedman
					Gary Friedman
				Chairman and Chief Executive Officer
					(Principal Executive Officer)


Date: June ~~12, 2018~~13, 2019		By:	/s/ Jack Preston
	~~/s/ Karen Boone~~	Jack Preston
		Chief Financial Officer
		(Principal Financial Officer)
					~~Karen Boone~~

Date: June 13, 2019		~~President,~~By:	/s/ Glenda Citragno
		Glenda Citragno
		SVP, Chief ~~Financial and Administrative~~Accounting Officer
					(~~Principal Financial Officer and~~ Principal Accounting Officer)

4671

	Three Months Ended May 5, 2018
	As Reported		Adjustments			Balances without Adoption of Topic 606
Net revenues	$	557,406	$	(7,610	)	$	549,796
Cost of goods sold		345,371		(2,988	)		342,383
Gross profit		212,035		(4,622	)		207,413
Selling, general and administrative expenses		158,434		3,803			162,237
Income from operations		53,601		(8,425	)		45,176
Interest expense—net		17,035		—			17,035
Income before income taxes		36,566		(8,425	)		28,141
Income tax expense		8,507		(1,950	)		6,557
Net income	$	28,059	$	(6,475	)	$	21,584

	As of May 5, 2018
	As Reported		Adjustments			Balances without Adoption of Topic 606
Prepaid expense and other current assets	$	60,064	$	27,652		$	87,716
Deferred tax assets		30,014		(6,561	)		23,453
Accounts payable and accrued expenses		264,173		(638	)		263,535
Deferred revenue and customer deposits		172,379		9,463			181,842
Other current liabilities		59,944		(2,295	)		57,649
Retained earnings		159,417		14,561			173,978

	Trailing Twelve Months
	May 5,			July 29,
	2018			2017
	(in thousands)
Net income	$	33,609		$	721
Depreciation and amortization		71,162			63,606
Interest expense—net		67,426			49,626
Goodwill impairment^(a)		33,700			—
Loss on extinguishment of debt^(b)		4,880			—
Income tax expense		38,391			11,168
EBITDA^(m)		249,168			125,121
Non-cash compensation^(c)		53,417			51,296
Recall accrual ^(d)		7,453			9,348
Asset impairment and lease losses ^(e)		4,417			12,743
Distribution center closures^(f)		3,723			—
Post-acquisition related legal costs ^(g)		1,915			—
Impact of inventory step-up^(h)		1,337			5,294
Anti-dumping exposure⁽ⁱ⁾		(2,202	)		—
Gain on sale of building and land^(j)		(2,119	)		(1,300	)
Aircraft impairment ^(k)		—			4,767
Reorganization related costs ^(l)		—			974
Adjusted EBITDA ^(m)	$	317,109		$	208,243

	Number of Shares		Average Purchase Price Per Share		Total Number of shares Repurchased as Part of Publicly Announced Plans or Programs		Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plans or Programs
							(in millions)
February 4, 2018 to March 3, 2018		—	$	—		—	$	—
March 4, 2018 to April 7, 2018 ⁽¹⁾		3,584	$	95.28		—	$	—
April 8, 2018 to May 5, 2018 ^{(1) (2)}		9,721	$	96.62		—	$	—
Total		13,305	$	96.26		—

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