RH (RH) 2003 Q4 法說會逐字稿

This is the Restoration Hardware quarterly earnings conference call. I would now like to turn the program over to your moderator, CFO of Restoration Hardware, Pat McKay. Go ahead, please.

Good afternoon, everyone, and welcome to Restoration Hardware's fourth quarter and fiscal year 2003 earnings release conference call. My name is Pat McKay, the Company's Chief Financial Officer.

I'd like to remind you that the call is being recorded and will be available for replay via webcast on our site at www.restorationhardware.com under company information, investor relations event calendar.

Leading our call today is Gary Friedman, the Company's President and Chief Executive Officer. At the end of our remarks we will open the call to questions. Before we begin, let me read our brief statement regarding forward-looking comments.

Certain statements and information on this call will constitute forward-looking statements within the meaning of the Federal Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve both known and unknown risks which may cause the actual results or performance to be materially different. These statements will include without limitations financial guidance and statements related to the implications of the Company's fourth quarter 2003 results on periods thereafter, statements regarding the Company's strategies and other statements regarding management's opinion and expectations regarding the business. Important factors that could cause such differences are contained in the Company's filings with the Securities and Exchange Commission.

Now let me turn the call over to Gary.

Good afternoon. I will begin today's call by commenting on our results this past quarter, give you an overview of our current initiatives and then turn the call back over to Pat for a more detailed financial review and Q&A. Let me start with the fourth quarter.

Clearly we were disappointed with the top-line performance in our retail division for the November/December holiday selling period, but we're also excited about the outstanding 51 percent increase generated in our direct channel. As communicated, in our retail stores the accessories and gift giving component of our business under-performed, creating the most significant shortfall to our bottom-line expectations. This component of our business has the most dramatic spike during the nine week holiday selling period and becomes the largest percentage of our total sales during that time period.

The question is why did this part of our business under-perform and how do we fix it. I believe the under-performance was due to a few key factors. One, over the past two years the organization has been focused on building the core businesses that are essential to developing a sustainable retail concept. Those businesses are hardware, bath ware, lighting, textiles and furniture. As it relates to the holiday performance, none of these core businesses have a significant lift during the key nine week gift giving period. In contrast, the accessories component of our business, which has been tremendously over-assorted with discovery items that cluttered and unfocused where we spent the last couple years editing and focusing the entire assortment, has the most dramatic holiday spike. Compounding the issue was the fact that this area was under-resourced from a product development, product design, merchandising and sourcing point of view. We have the vast majority of our resources focused on building the core categories. And on top of it all, during the most important time in our merchandising and product development calendar our company was going through a restatement of its financial results last year, which took my focus off the merchandising effort during that critical time.

So the next question is what are we doing differently to insure positive results this holiday. We have several initiatives in place. One, we've made investments in product development, product design, merchandising and sourcing, all focused on the accessories and gift component of our business. We have doubled the amount of time spent on product development, merchandising and marketing for holidays 2004 versus a year ago. We're also not restating our earnings this year, and Pat McKay has promised me that we will not be doing so in the future, enabling me to dedicate 80 percent of my time on the merchandising and marketing efforts for this fall and holiday versus being entwined in a restatement process. Our percent of new products for this holiday is targeted to be double that of holiday 2003.

Another important investment and structural change is the promotion of Marta Benson to Senior Vice President of Merchandising and Marketing for the Restoration Hardware brand. Marta was previously the Vice President of our Direct Division in charge our catalog and Internet business where she led efforts to increase our revenue by 52 percent this year while substantially improving profitability in that division. Marta will now have responsibility for coordinating and driving our business across all three channels of distribution.

We've also added two additional vice presidents of merchandising to our retail division. Where we previously had two vice president divisional merchandise managers -- one in charge hardware, bath ware and accessories and seasonal and one in charge of furniture, lighting and textiles -- we have now moved to what we call a core business excellence approach with a divisional merchandising manager in charge of hardware, bath ware and lighting, one in charge of accessories and seasonal, one in charge of furniture and one in charge of textiles. This structure is supported with team members in product development, design, sourcing and inventory management, creating vertical teams focused on the major core businesses, allowing us to build expertise and improve execution in each category.

Despite our fourth quarter disappointment, I would point out that the company's comp store sales has lead its home furnishings peer group in every quarter excluding the fourth quarter since we launched the first phase of our repositioning strategy in April 2002. Included in that peer group is Williams Sonoma, Pottery Barn, Cost Plus, Pier One, Home Depot, Lowe's, Linens and Things, Bed, Bath and Beyond and Ethan Allen.

Looking forward, our core businesses continue to perform well and the transformation of the Restoration Hardware brand is scheduled to be completed in the fall of this year. The final phase of our remerchandising effort includes furniture and accessories. This fall you'll see significant newness across all categories of furniture including bedroom, occasional, dining and upholstery. Approximately 65 percent of the assortment will be new versus last fall in this category. While the positioning and sensibility of the furniture will remain classic, it will reflect an updated on-trend point of view with a physical quality differentiation from our competitors. We believe the fresh look of our furniture assortment will create a significant perception of change and overall freshness of brand. We've also re-engineered our entire accessories category where you'll see 70 percent newness this fall. We feel we have created a compelling and stylistically unique assortment that will synergize with the rest of our overall assortment in all other categories. All of this, combined with the continuing honing on our efforts in hardware, bath ware, lighting and textiles completes merchandising overhaul of the brand this fall.

We also plan to launch a new redesigned catalog this fall with the objective of clearly communicating our authority and the quality differentiation inherent in our new strategy.

As you know, we experienced difficulties in our supply chain this past fall. We currently are conducting a search for a senior vice president of our supply chain. This is in lieu of replacing the chief operating officer position. We believe having a specialist versus a generalist in this area is the right approach. In addition, we've promoted Jason Camp, our Vice President of Stores, to Senior Vice President of Retail Operations. In his new position Jason will assume responsibility for stores, store operations, real estate and store development. These moves plus the addition of Pat McKay's leadership in finance and systems will give us the operational leadership that will enable us to deliver the bottom line results we expect.

Lastly, our new prototype stores continue to perform above our expectations from both a top and bottom-line point of view. This year we plan to open one to two new stores and expand and remodel one store. We also plan to close two to three under-performing stores in 2004.

Now let me turn the call over to Pat.

Thanks Gary. First I will take you through our financial performance for the fourth quarter and fiscal year 2003 and then I will provide guidance with respect to our expectations for the current fiscal year, with some specific detail on the first quarter. At the end I will open the call up for questions.

First quarter net revenues were up 6 percent to 165 million versus 155.2 million in the fourth quarter last year. Comparable store sales for the quarter were up 0.7 percent compared to a 3 percent increase in the fourth quarter 2002. The comp sales performance resulted from a 3.5 percent decline in holiday comp sales, offset by a strong 23 percent comp sales growth in January. In the direct channel, which includes sales from both the catalog and Internet, revenue was up 51 percent to $26.6 million on top of a 26 percent increase in last year's fourth quarter. Our new core businesses -- textiles, lighting and hardware, including bath hardware -- continued to perform well throughout the quarter.

Catalog circulation for the fourth quarter grew 13 percent with pages circulated up 48 percent. Our catalog continues to be a growth catalyst for our direct channel and also provides significant product and overall brand exposure in our retail trade areas. Catalog revenue grew 33 percent in the quarter to 15.1 million and Web revenue grew 84 percent to 11.4 million for the fourth quarter of 2003.

Demand from orders not yet delivered -- which includes deliveries in transit, back-orders and special orders -- declined in the quarter and created a positive effect on reported revenues as fulfillment caught up with the orders outstanding at end of the third quarter. However, we do continue to experience higher levels of unfilled demand, which we will experience as sell-throughs and which will positively affect revenues in both Q1 and Q2 of fiscal 2004. The guidance that we will provide later in this call regarding the first quarter of 2004 will take into consideration the effect on revenue for the order (ph).

Gross profit grew 4 percent in the fourth quarter of 2003 to 59 million from 57 million in the fourth quarter of the prior year. This was the result of increased revenue, partially offset by a 90 basis point decline in gross margins expressed as a percent of revenue to 35.8 percent versus 36.7 percent last year. The lower gross margin rate was due to increased markdowns in order to clear holiday merchandise and lower than anticipated holiday sales. In addition, the gross margin rate was adversely affected by the increased cost of distribution which we have been experiencing.

SG&A expenses were 45.2 million in the fourth quarter of 2003 or 27.4 percent of revenues, compared to 41.3 million or 26.6 percent in the prior year's fourth quarter. During the quarter we incurred higher costs of advertising, including the cost to catalog circulated and Web marketing, higher variable costs of sales fulfillment, costs incurred relating to the implementation of a customer order system, as well as severance costs of a senior executive and higher workers comp costs.

Our net income for the quarter was 7.9 million or 21 cents per diluted share versus 9.7 million or 26 cents per diluted share in the fourth quarter of 2002, using a weighted average share count in the 2003 fourth quarter of 37,943,000 shares.

We also experienced a higher effective tax rate of 40.7 percent in the fourth quarter of fiscal 2003 versus 2002's effective tax rate of 35 percent. The higher rate in the fourth quarter of 2003 had an impact of an incremental tax provision of approximately $800,000, as compared to using the effective tax rate in effect for the fourth quarter of 2002.

For the fiscal year 2003 our revenues were 438.5 million, up 10 percent versus fiscal 2002. Comp store sales were up 5.2 percent on top of a 6.2 percent increase last year. The direct to customer channel posted sales increases of 52 percent to $67.9 million on top of a 33 percent increase in fiscal 2002.

Catalog circulation for the year was up 9 percent and pages circulated up 40 percent. Catalog revenue was up 39 percent for the year to 40.9 million and Web sales grew 77 percent to 26.9 million for the year.

Gross profit for fiscal 2003 increased 13 percent to 132.5 million from 117.3 million last year. The increase was due to revenue growth and to an 80 basis point improvement in gross margin expressed as a percent of revenues. The 80 basis point improvement resulted from the leveraging of fixed occupancy costs included in cost of sales, as well as improved merchandise margins which were somewhat offset by higher distribution costs.

SG&A expenses were 135.1 million at fiscal 2003 or 30.8 percent of revenues compared to 126.3 million or 31.5 percent of revenues in fiscal 2002. The primary areas of expense increase were in advertising, as well as higher variable costs of sales fulfillment, costs associated with the implementation of a new customer order system and certain onetime costs of severance and professional fees. The full year percentage was impacted by the exponential growth of the direct business, which model will fundamentally deleverage SG&A expenses. However, the dollars of the increased spending still was more than offset by the leveraging effect of increased revenue reported in both channels.

Our net loss improved for fiscal 2003 to 2.9 million or 10 cents per share as compared to last year when we reported a loss of 4 million or 13 cents per share. Note also that last year's results were favorably impacted by a $4 million or 13 cents per share onetime income tax benefit resulting from the Economic Stimulus Package enacted in March of 2002. Excluding the effect of that income tax benefit in the prior year, the net loss would have been $8 million or 27 cents per share versus the 2.9 million reported in fiscal 2003.

Turning to the balance sheet, we ended the quarter with 102.9 million of inventory, up 9 percent compared to levels at the close of 2002 and in line with our sales growth plans for the fourth quarter of 2004. Bank debt was down 3.9 million to 10.3 at the end of fiscal 2003 as compared to 13.9 million at end of fiscal 2002, reflecting our positive cash flow for the year.

Our balance sheet also reflects the reclassification of debt necessary in accordance with the provisions of EITF 95-22 which technically requires our debt to be classified as a current obligation. However, I would stress that none of the terms or conditions of our agreement have changed, and there are no intentions or requests by our bank that would require payment of this obligation in the upcoming year. Our debt agreement has a maturity date of June 2006.

Gross capital expenditures for the year were $9.8 million, with the majority of the spending for two new stores and the expansion and remodeling of another store. In connection with these projects we received $1.7 million of tenant improvement allowances which offset some of these expenditures from a cash flow perspective and which then resulted in a net capital expenditure for the Company of $8.1 million.

In line with our ongoing effort to hone our store portfolio we closed four under-performing stores during fiscal 2003. These closures were accomplished with minimal cash flow and income statement effect.

Common shares outstanding grew over the year due to the conversion of preferred shares to common and the exercise of stock options. During the year approximately 4,800 preferred shares were converted, which resulted in 2.4 million additional common shares outstanding. We also saw option exercises of approximately 300,000 for the year. We finished the year with 32.7 million common shares outstanding and 8,600 shares of preferred shares which are convertible into 4.4 million shares of common stock.

Turning now to guidance for fiscal 2004, we expect comp store sales for fiscal 2004 to be in the low to mid single digit range. We expect to see fiscal 2004 revenues increase -- direct to customer revenues increase from 30 to 40 percent. Operating margins for fiscal 2004 are targeted at one to two percent of net revenue. We will open one to two new stores and expand or remodel an existing store during fiscal 2004. Two to three under-performing stores are expected to be closed. One of these stores, in Richland (ph), Mississippi, was in fact closed last week. Capital expenditures for fiscal 2004 are expected to be in the 10 to $12 million range and offset by a certain amount of tenant allowances totaling approximately $2 million. Depreciation expense is projected to be in the 14 to $15 million range in fiscal 2004. We expect to be cash flow positive again in fiscal 2004 and to finish the year with little or no debt on our balance sheet.

With respect to guidance for the first quarter of 2004, we expect comparable store sales to increase in the mid single digit range. We expect our net loss for the quarter to be between 13 and 16 cents per share on a basic share count of approximately 32.8 million shares outstanding.

Now I will open the call up to questions. Operator?

(OPERATOR INSTRUCTIONS) Mike Naplitana (ph), JPM Securities.

I wonder if you could give color on how much you spent on advertising in 2003 in total?

We have not historically disclosed that. We were trying to provide some color in terms of around what implications were for year-over-year (multiple speakers) quarter-over-quarter.

With respect to -- maybe can you give any color with respect to circulation on a year-over-year basis -- the growth to support the 34 to 40 percent revenue assumption in the direct channel?

The pages circulated that we provided?

Books, pages, yes.

The catalog circulation was up nine percent for the quarter.

Nine percent for Q4?

Thirteen percent for Q4, with pages increased forty-eight percent.

And then for '04? Can you give a little bit more color on the 30 to 40 percent growth -- how much is circulation or page counts going to be up; and what are some of the drivers there?

Circulation growth will probably be in the 15 percent range with page count continuing to grow in the book.

With respect to some of the costs inherent with the issues regarding the distribution center, should we expect to see gross margin be a little bit constrained in the first half of the year as you kind of unwind those issues and get that up and running for the second half?

There will be an impact on gross margin. We still planned gross margin to grow year-over-year through both occupancy leverage and through merchandise margin enhancements.

Has most of that been in the second half?

We see it growing both in the first and the second half, but it will be somewhat constrained in the first half due to our efforts to kind of improve our supply chain logistics.

Thanks.

Christine Corver (ph), WR Hambrecht.

A couple of questions. Can you tell us the number of catalogs that you mailed in '03 -- the actual number?

Let me get that for you.

And then, Gary, maybe you could give us a little more color on the distribution supply issues that you were faced with? You talk about how you were out there looking to hire someone on. Do you think the person will be brought on in the first half of the year? Is it second half of the year? And where do you stand with fulfilling orders at this point?

We have made significant progress since we started to experience difficulties in the third quarter. The difficulties we experienced were compounded by our furniture event that happened in September of last year. At that point, as you remember, we had -- significant demand for the furniture event caused a backup in our supply chain. At the same time we had difficulties in our Baltimore distribution center, primarily where the majority of our problems were coming from.

Currently, just to give you a sense, we have a team in place in our Baltimore distribution center working through, upgrading the management, putting the necessary processes in place and upgrading the overall logistical processes in that organization. We have a third party outside logistics expert who is currently working inside that facility and managing the facility for us.

At the same time we have an outside search for a senior vice president of supply chain logistics. We would expect to hopefully fill that position in the next 60 days or so, I would anticipate. But in the meantime we have plans to improve our processes and improve our logistics between now and then with some outside help in resources. And that is some of the additional costs that we're going to incur that will put a little pressure on margins here and there, a quarter or two (ph).

With respect to the catalogs we circulated, actually it was 32.4 million books last year, in 2003.

In 2003. And the new store openings for '04, where will those stores be located? And store closures -- the store closures that you have planned for '04, is that the end of the closures or are there more?

We're just about at the tail end. We will consistently look at our portfolio each year. When we started this process we said we had somewhere between six and ten under-performing stores that we wanted to target close. I think with the stores this year we will have closed ten stores. And as I said, we will consistently look at -- year by year we have some stores that are under-performing; we will take the appropriate action.

As it relates to the new stores, the one new store that we have on the books today is in South Coast Plaza in Costa Mesa, California and the expanded and remodeled store is targeted to be our Newport Beach store, which is an existing store and one of our top performing stores in Southern California. As it relates to the next new store, we've got a couple of opportunities on the books.

I think what's important to note from a new store point of view, we are only openings new stores today if we feel we have what I call slam-dunk economics where the rent deal is right, the tenant improvement deal is right and where at very conservative sales results we can guarantee ourselves a first year four wall of about 18 percent. By taking that approach all of our new stores (indiscernible) last year are targeted to perform in the 17 to 23 percent range in their first full year. So any new stores here should not be a drag on operating earnings; it should only be a benefit and it shouldn't have a major cash impact on the Company.

Finally, are you still considering entering the tabletop area?

Right now we've hired a director of product development for tabletop. We're working on a strategy. What we've decided to do for this year is to focus that person's efforts on the entertaining aspect of the business, that is the giftable component for the third and fourth quarter, and specifically the fourth quarter to ensure that we have a very good holiday, and then really look at '05 as kind of the year we probably -- in the third quarter of '05 made a decision to enter the broader tabletop category.

Thank you.

Rex Henderson (ph), Raymond James Associates.

A quick question about the severance and impact of that -- how much relief we get from that in the fourth quarter next year. Can you give me any feel for what impact that had and how much relief we get next year?

You can put into your model for $500,000.

Okay. And in the fourth quarter and into the first quarter so far what are you seeing in terms of traffic and transactions and tickets so far this year? How does that compare to what happened in the fourth quarter?

You saw business bounce back. November/December was -3.5 comps and you saw our business back in January to a 23 comp. And really what that reflected was in January we returned to kind of the model of the performance of our core businesses. We did have slightly more clearance that we had to move through because of the under-performance in November/December. And then we had some of the overhang starting to come in from our supply chain backup. If you just look at general sales results, traffic results and ticket results, they're all positive so far in Q1.

Okay. Finally, Gary, you went through these initiatives in your merchandising area quickly. Could you do a quick overview again to make sure I understood exactly what's going on there?

Any specific ones you wanted me to focus on?

Yes, the personnel changes. What's going on there in terms of -- I guess the structure of it is what I was interested in.

The structure is -- we had two vice presidents in merchandising in the retail -- divisional merchandise managers in the retail business. We've made a change and we're going from two to four. The reasoning there is to get our best people closer to the product and closer to the strategies and align our people to be able to -- senior merchandising folks to be able to focus on the most important core businesses. So we've got one vice president of merchandising focused clearly on our hardware, bath hardware and lighting business and a vice president of merchandising focused on our accessories, garden and seasonal business. One person used to oversee both of those; now it's split into two vice president divisional merchandise managers. And then where we have furniture, lighting and textiles, we split that into a furniture divisional and then a textiles divisional. So that way in each of these kind of big core categories we can develop the authority and expertise to really become experts in each of those categories and we are supporting each of those categories with product development, inventory management and sourcing support. We create vertical teams that become experts in their fields, if you will.

I think that will be an important move also as it relates to holiday. Last fall we spent a lot of time and effort upgrading our hardware business. Also launching our whole soffits (ph) and fittings business in multiple finishes and everything -- the whole plumbing part of our hardware business. That was under the responsibility of the same person that was merchandising accessories and seasonal and holiday. And what we believe is the added investment of having four divisionals will allow us to focus appropriately on the business and on each aspect of the business.

And then Marta Benson, who was promoted to Senior Vice President of Merchandising and Marketing for the brand, who was previously our Vice President of our Direct Division, is going to oversee the merchandising and marketing efforts across all three channels to better coordinate the businesses that we're going to grow, the businesses we're going to pull back on, the businesses we're going to expand in the catalog and the Web, and how we're going to market across all three channels. We think she is really our strongest leader and strongest merchandising executive in the organization and will make a great impact in the business. She has been highly successful at really taking our direct business in the last few years for 20 million to the 70 million level it is at today.

Thank you very much.

Janet Cloppenburg (ph), JJK Research.

A few questions. When you look at the holiday and the couple years where it has been under-performing, can you talk a little bit about what you didn't do, what you think now in hindsight, what categories of holiday were good and where the areas (indiscernible) so I can get a better idea of what direction you would be going in?

I think fundamentally it's two or three big things. One, if you think about where we edited the business, we edited the business around all the items and discovery items at Restoration Hardware which had expanded to the point where they polluted the core businesses and if anything were the overwhelming core business in and of itself except that there was not necessarily a real reason for being in the first three quarters of the year, but probably where that business performed the best was in the fourth quarter. So to edit and focus that over assortment of items and discovery items to make room for the textiles business, expanded bath hardware business, expanded hardware business, lighting, etc., etc., that's where we edited about 3,500 SKUs in the first phase of the remerchandising of the brand.

Secondarily, everybody is focused. When you're in a turnaround situation like we are operating with a pretty tight balance sheet, we had to decide where to focus our efforts. We focused our efforts on repositioning and remerchandising the core business that we thought were going to be essential to positioning Restoration Hardware for the long-term, that being the hardware business, the bath hardware business, the textiles business which included bath textiles, bedroom textiles, window treatments, board coverings, and lighting business. And then we did a little bit with the upholstered furniture business last year, but we didn't really focus too much on the furniture business because we not could change too many things at one time, and then contracted aggressively that discovery items part of the business that had kind of gotten a little bit tired and over-assorted.

But the efforts and energy and focus in the organization were really not focused on that accessories side of the business. And I think that the lack of resources and lack of focus on that part of the business, when you get into Q4 all these other core businesses which had been performing well all throughout the year carrying the comps, we got into November/December, those businesses don't ramp; the accessories and items business does ramp. And that part of the business where we had under-funded it and under resourced it and scaled it way back is what really hurt us.

I think compounding that, the last couple of years I gave played CEO and GMM. And the last couple of years we have restated our earnings at the end of the year. Well, when you're merchandising and marketing a retail business, everything you're doing from January through April is when you're finalizing the product and finalizing the assortments and booking the orders and placing the bets. And during that period of time, quite frankly, for the last two years I've kind had to play a hybrid CEO-GMM-CFO. And I'd say during that period of time probably 80 percent of my time was focused on working through a restatement process with our auditors, with our lawyers, with outside consultants and so on and so forth and it was extremely distracting to me, who happened to be the GMM, if you will, at the time.

This year in contrast, with Pat here I have spent 80 -- one, we're not restating for the first time in the last two years, thank God. Two, I have spent 80 percent of my time since January really on the merchandising and marketing efforts. That, in combination with the added resources we put in last year and this year, and the amount of time we have engineered the calendar for holiday, creates a completely different paradigm from a merchandising and marketing point of view for holiday. So where we under-perform in accessories and kind of in the gift giving component and kind of the holiday trim component of the business, I think you'll see us be focused, powerful and explosive this year. So I'm highly confident about what we've got loaded in the gun because we've spent the last three and a half months working on it.

Thanks. On the promotional events that you held last year, particularly the fall events -- lighting and furniture, etc., the upholstery furniture event -- will you be doing those events in the same sequence and the same timing this year?

There will be a little bit of a different change. The lighting event the Company has been doing for 20 years, and so there will be no change to that. Last year we added -- we added in January of this year our first annual bath ware event. That was highly successful and drove a lot of top and bottom-line performance. And what we've done is we've re-evaluated the furniture event, which is in September.

The furniture event that we had last year was completely focused on the furniture category, across all areas of furniture -- all case goods areas of furniture, not upholstery; but it include our bedroom, our occasional and our dining businesses. This year what we decided to do is focus it to be more of a bedroom event. And the reason for that is to, one, to minimize the amount of furniture. So we're cutting in half the amount of -- not quite half -- probably 40 percent the amount of furniture that we will be driving. But we're adding the softer side of the business -- the textiles part of the business -- which is also cash an carry and much higher margin.

So we think the overall balance is going to do a couple of things. One, it will reduce the furniture penetration, which will reduce the margin impact and also reduce the pressure on the back end supply chain. Two, it will raise the overall margins because the cash and carry component and the margins inherent in the textiles business are greater and will not create the additional back end expense, whether it's through our call centers or distribution centers or home delivery networks. So we think the approach we're going to take has the potential to drive as much or more top-line sales, but at a much higher profitability level.

Pat, on the supply chain pressure and the distribution pressure (indiscernible) what moves have been taken to (indiscernible) --

Can you speak up a bit?

We're having a hard time hearing you.

I was talking about the supply chain and distribution pressure from last fall and what measures Pat and the team have taken to help minimize those problems this year.

A lot of what needed to be accomplished was some leadership and focus there, and we've put in a number of things just to establish some disciplines day in and day out in terms of just monitoring and measuring how our DCs and the whole distribution channel is performing. I think importantly in recent days we have incrementally added somebody on the ground that's very talented, a senior executive on a temporary basis to actually improve our most challenged distribution center, to actually get that thing going while we concurrently search for a Senior VP of supply chain. So those couple of things give us a lot of confidence in terms of where we're headed in that effort.

Eighty percent of our problems were being serviced out of our eastern distribution center.

I understand that. Thanks very much.

Rusty Hoss, Roth Capital Partners.

The catalog -- it seems that that part of the business has been strong. What's the thinking behind re-designing the catalog?

Just making it better.

Okay. The furniture -- 64 percent of furniture and accessories will be fresh in the fall. Can you comment maybe on sort of focusing everything in the fall? And then obviously fourth quarter is a huge quarter for you anyway. Is that -- what's your thinking going into that?

What's our thinking? Specifically, we think there's a lot of opportunities with all the freshness. I think there is going to be a lot of excitement about the fact that if you look at our core furniture store assortment it's really been in rest mode (ph) for many, many years. I think the Company's been known for kind of the mission furniture look and kind that American craft look. That part of our furniture business has been down-trending for almost four years. But at the same time it is a pretty big component of our business and is one part we didn't want to really fuss with while we were changing so many other things. But we think there's a huge opportunity to freshen up that component of our business. So while we will keep kind of the best of the best and the best sellers in that area, you'll see two-thirds of it kind of new and fresh versus last fall. Not all of it will come in just in fall; you'll see some of it this spring. For instance, if you look in our catalog you'll see our Laurent collection, kind of handmade furniture made in France, beautiful hand distressed dining tables, bedroom sets etc., etc. And so we have some of it that is coming for the spring, but most of it -- 80 percent of it -- is coming in this fall. So when you look at year-over-year it will be about two-thirds new in furniture.

In accessories we really put the team and started to put the product development focus in that area towards the middle to end of last year. So really you are going to see that team's efforts kind of come alive this fall, and that where you'll see the re-engineering and newness happen in that part of the business.

And then there's a whole layer of newness that comes in on top of that for holiday. Our thinking is -- if you think about the components and what we've changed, those are the last two areas where -- when these two areas of the business change, I think you'll see kind of the completed transformation of Restoration Hardware. And I think what you're going to see is a very synergistic and focused brand point of view, where the quality and the styling and sensibility is consistent throughout every category in the business.

The promotional calendar -- can we expect anything in the second and I guess the third quarters as well?

It's just a typical spring floor sets that you see in our stores today, a summer floor set that happens in April, and then a Mother's Day emphasis and then a Father's Day focus. And so this is really the major drivers.

So we're not going to see -- in other words I am getting at is we're not going to see another like you had the bath hardware event?

We're only doing three major events. So you'll see -- it is the bath event, the bedroom event and the lighting event. And really what those -- what we hope to do with those -- as everybody understands from a strategic point of view, when you're trying to build the brand and get people to know who you are and what we're doing and what businesses we stand for, it makes it hard when you are in a turnaround position like we are with a tight balance sheet, deciding to make some major investments in advertising and just take that risk. So one of the ways to afford ourselves to take the risk is to coordinate that with an event that will allow us to increase our circulation, have a better sense of how the customer will respond and then allow more people to kind of know Restoration Hardware is headquarters for the bath. And the hope is you get people into your bath hardware, into your bath towels, and then the next time they need bath towels they are thinking of you, and when they have friends or guests over they're talking about the great bath towels they bought at Restoration Hardware. And so far the strategy is working quite well.

For example, in January we did our big bath ware event. In the month of February and March we thought our bath towel business would be off versus a year ago because of the significant borrowing we did in January. But that's not what happened. Our bath towel business continued to run at double-digit comps. And I think it is the phenomenon of all of a sudden people knowing about your business.

My last question is regarding guidance -- operating margins of 1 2 percent. That is what was said last year, yet two-thirds of the store -- maybe more than two-thirds -- I would say that the merchandise is greatly enhanced. Are you just being conservative? What's behind that?

I think as a practical matter I guess you could make your own assumptions relative to our conservatism given our guidance last year and coming short. So we are trying to ensure that we have a number out there that we're very comfortable with and that is the margin that we established.

Thank you.

Rob Wilson, Tiburon Research Group.

Pat, could you talk about the depreciation expense that you're expecting this year? I think you said 14 to 15, and I just want to check if I heard that correctly.

You did hear that correctly. One of the things, candidly, that I observed coming on board here is that we had assets that had been falling off in terms of being fully depreciated. So the number I think probably is maybe perhaps embedded in your question is it lower than 2003 levels. And we would expect to see that for a while until we actually get to a pace of where we're actually spending at a higher level and increasing our depreciation expense. Right now, again, we've got a lot of fully depreciated assets which is driving that reduction.

So that is a good number. And the tax rate you're expecting for this year is what?

Thirty-eight percent.

Okay, thank you.

Todd Kirkover (ph), UBS Financial Services.

Basic question -- relates to the growth story here long-term. Obviously you have basically saved the Company and are re-engineering the brand and the operations, and it is very clear from the conference call. I'm kind of interested in sort of the five-year lookout -- the growth story, if you will. I think most investors know the plight that Restoration Hardware was in and are probably going to look forward to what could happen.

You had commentary on one to two new stores this year. Could you comment on sort of a five-year plan on that, what you would see going out further? Secondly, with respect to financial flexibility, now that you have come out of this sort of bad phase, any thoughts on credit lines or terms with vendors, if those changed or have improved. And lastly, any thoughts on raising additional capital, whether equity or -- maybe not right now -- but debt at some point to fuel a flight plan for growth? Thank you.

Maybe let's look backwards on that one. One, we don't have any plans to raise additional capital. And as far as our terms and things with vendors, nothing has really changed. We're really current in how we handle the vendor community and run our business.

As it relates to growth and where we can go long-term, I think we've always believed that we think Restoration Hardware could be $1 billion plus brand, and that there's a huge void in the marketplace above the current lifestyle retailers and below the interior design trade. And when you look at the largest segment of the population being 45 to 60-year-old aging baby boomers that are the most home-centered, wealthiest segment out there, there really is no top of mind to go. When you've grown up and graduated from Pottery Barn and Z Gallery or any of these places and you want a higher level of quality and more of a sense of permanence in your purchases and kind of timeless classic design, you've got to kind of find the mom-and-pop's and the one offs, so we think that there's a huge void to fill, not only because the void exists today, but only because complemented by the fact that the void is going to get bigger.

Our goal here is to really take our time and we build a sustainable model. We like to say that a retail mall is like a graveyard for short-lived ideas in that if we were all in a mall today and looked around at the retailers that were in there and went through a time tunnel and went back 10 to 15 years and looked at the same wall, there's a 60 to 70 percent change. That is because there is a lot retailers that are interesting, but they're not necessarily relevant and they're not relevant because they were not built on a base of strong and sustainable core businesses that create a predictable promise for the customer.

So we're trying to do that and we're trying to engineer really strong core businesses that create a predictable promise, that drive consumer behavior into our stores each and every day; to have a clearly positioned and differentiated assortment. And once we build that and we've proven that, then we will start to pick up our store openings. And we think clearly there can be a lot more of then 103 or 4 Restoration Hardware stores.

But the other big opportunity here is we have stores that when we kind of started this journey were doing about 3.1 million a store and the others we doing 3.6 million store million store. We really believe they ought to be doing 4.5 to 5 million store. So there's inherent huge growth in the existing store base. We think that the direct business we've always believed to be 2 to 300 million. And we think long-term there's $1 billion plus opportunity in the brand in its current phase. And that doesn't include other ideas that we have to grow the business and extend the brand.

So we're all here for the long-term. I spent 11 years at the Gap and then 14 years at Williams Sonoma Inc. This is going to be my last stop. So I will be here for a long time. And this will become a really great company long-term. That's all our hopes and goals.

Dawn Stoner, Pacific Growth.

Thanks for taking my question. I just want to follow on to the earlier question about changes you're making in the furniture category. It sounds like we're going to start seeing more collections. I'm wondering if you could also comment on whether there will be any pricing changes and if we will start to see newness flow into the stores more frequently and how your changes will affected the overall SKU count and floor space devoted to that category.

The floor space will remain pretty consistent. The furniture kind of lives in a pad (ph) in rooms throughout the store. So there really won't be much of then incremental SKU count. There will be SKU count growth in the catalog and on the Web when we have the ability to expand categories. But in our stores where we have X number of furniture pads for couches, occasional tables and X number of pads for dining and X number of pads for bedroom, you really can't -- you are constrained by the space you have. So it's really refreshing, merchandising and using the space much more effectively to drive business through newness and also targeting categories more appropriately where (indiscernible) severely under merchandise the occasional part of our business, we severely merchandise the dining category. And last year throughout our operational problems, not only on the supply chain point of view but also just from an executional point of view, we had a few sofas on the floor last year that our vendor couldn't acquire enough fabric for and we lost business. We think there is a lot of upside in the furniture side of our business.

And also just because the furniture tends to be kind of the canvas for the rest of the goods -- the background to the rest of the good -- because the furniture hasn't necessarily changed or been freshened up and it looks somewhat dated, I think it's kind of held back overall look and feel of the brand. And I think when the furniture is updated and fresh; I think everything is going to look updated and fresh. I think a lot of people who may not have noticed us yet are going to notice us this fall. Furniture is a key component from that perspective. And we have spent a lot of time now -- we have spent (indiscernible) time thinking about it, and designing it, and tweaking it, and sourcing it.

The other thing we're excited about is we're excited about improving our furniture margins in that category through just better sourcing.

And would that entail a big shakeup in your vendor base?

I don't know if I can call it a shakeup, but maybe an expansion of our vendor base and where appropriate taking some components of our furniture business offshore.

That's helpful, thanks.

We have no further questions. I'd like to turn the program back to management for closing comments.

Thank you everyone for joining our call today. We look forward to talking to you in the next quarter. Thanks so much.