RH (RH) 2004 Q2 法說會逐字稿

Good day, everyone, and welcome to Restoration Hardware's second-quarter earnings conference call.

At this time, all sites have been placed into the program in a listen-only mode.

There will be an opportunity for questions later in the program.

Instructions for submitting a question will be given at that time. (OPERATOR INSTRUCTIONS) I would now like to turn the conference over to your moderator, Ms. Pat McKay, CFO of Restoration Hardware.

Good afternoon, everyone, and welcome to Restoration Hardware's second-quarter 2004 earnings release conference call.

My name is Pat McKay, the Company's Chief Financial Officer.

I would 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," or by dial-in at 888-566-0148.

Leading our call today is Gary Friedman, the Company's President and Chief Executive Officer.

At the end of our remarks, we will open up 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 limitation, financial guidance and statements related to the implications of the Company's second-quarter 2004 results on periods thereafter and statements regarding management's opinion and expectations regarding the business.

Important factors that could cause differences are contained in the Company's filings with the SEC.

And now let me turn the call over to Gary.

Thank you, Pat.

Good afternoon and thank you for joining us.

I will begin today's call by reviewing the highlights of our second-quarter results.

Then I will give you an update of our progress as it relates to repositioning of the Restoration Hardware brand, and I'll end a few comments regarding the hiring of John Tate as our Chief Operating Officer and the investments we are making to build the management team and infrastructure for long-term profitable growth.

We are pleased to report continued strong top-line performance in both our retail and direct channels.

Total Company revenues were up 26 percent on the quarter over last year.

Comparable store sales increased 9.4 percent in the quarter on top of a 9.9 percent increase in the second quarter last year and a 8.9 percent increase in the second quarter of 2002.

This reflects a compounded growth of 31 percent in our comparable store sales since the initial launch of the first phase of our new merchandising strategy (ph) in April of 2002.

Sales in our direct channel increased 103 percent on top of a 46 percent increase in the second quarter of last year.

Our direct business is now tracking to comfortably exceed 100 million in sales this fiscal year.

Clearly, these results demonstrate the customers' positive response to our strategy and the growing strength of our brand.

We were able to reduce our loss per share in the quarter to 6 cents from a loss of 9 cents per share last year.

This was despite investments we have made to improve our supply chain and distribution network and margin pressure due to a midyear warehouse sale to clear unproductive inventory.

As a note, the warehouse sales' revenues are not included in the comp store sales results.

Let me now talk about our progress as it relates to the repositioning of the Restoration Hardware brand.

We have articulated from the beginning our goal is to position Restoration Hardware as the premium home lifestyle brand in the marketplace, above the current lifestyle retailers and below the interior design trade.

Our objective has been to target the aging baby boom population, the largest, wealthiest and most home-entered consumer segment.

This fall completes the remerchandising transformation of the Restoration Hardware from an items-driven discovery store to a premium home furnishings brand that fills a predictable promise, built on a foundation of dominant core businesses of hardware, bathware, furniture, lighting, textiles and accessories.

The final phase of our remerchandising effort includes the introduction of new collections across furniture and accessories, where we have 50 (ph) to 70 percent new assortments versus last fall.

The overhaul of our furniture and accessories, combined with the refining of our efforts in hardware, bath, lighting and textiles, communicates a clear and focused point of view, representing a sense of style and quality that is unique in the marketplace.

To market our new positioning, we've developed a multilevel marketing campaign.

First, we have completely redesigned our catalog to communicate the authority and quality differentiation inherent in our new strategy.

Second, we are running a national advertising campaign this fall in three upscale home magazines -- Architectural Digest, Elle Decor, and Traditional Home.

Third, we have launched an effort to "tip Resto."

Based on the marketing book, "The Tipping Point," we have developed a campaign targeted to the highly influential opinion makers in key markets.

We have mailed this group a leather portfolio enclosed with our new catalog, a Friends of Restoration Hardware discount card and a letter from me inviting them to peruse our new catalog Website and visit our stores, and enjoy a 20 percent discount through the end of the year.

We believe getting these highly-connected folks experiencing our new products and talking about Restoration Hardware will help us create the momentum and buzz that has the potential to tip the brand.

In addition, we continue to invest in our online business.

We have introduced a new Website design and email campaign for this fall.

You will also notice we are the first retailer to devote the back of our catalog to marketing our Website.

Another noteworthy point to consider this fall is we will not repeat our fall furniture sale that we held in September of last year.

That event created considerable pressure and expense in the back end of our business.

We believe it will be more profitable for us not to anniversary the event, but do anticipate it will create some top-line pressure in the quarter.

As you know, this week, we announced the hiring of John Tate as our Chief Operating Officer.

John brings a wealth of operating and financial experience with him to Restoration Hardware.

He has been a member of our Board for the past year and a half, and I have also had the pleasure of working with John in his role as CFO of Williams Sonoma.

John's understanding of the multichannel specialty retail environment, Board experience at Resto, plus his prior working experience with both myself and Pat McKay, will enable him to make immediate contributions to the Company.

John will have responsibility for our supply chain, IT, direct-to-customer operations, human resources and the Michaels Furniture Company.

We will continue our search for a Senior Vice President for the supply chain, and that position will report directly to John.

I think the hiring of John Tate, combined with a strong Senior Vice President of Supply Chain, our recent hire of Jeff Turner (ph) as CIO, an ex-Gap and Levi Strauss IT executive, and Pat McKay as CFO, demonstrates the Company's commitment to building the management team that will allow us to execute at a high level and build an infrastructure for long-term profitable growth.

As communicated, we continue to make investments in our supply chain and distribution center operations.

We successfully relocated and opened a new West Coast furniture distribution center in Tracy, California in the quarter.

We have also expanded our East Coast distribution center in Baltimore by 30 percent in anticipation of continued revenue growth.

As you know, we have hired a supply chain consultant team to manage our operations and improve the distribution processing systems.

While these investments create short-term expense pressure, we believe they are necessary to ensure the Company executes at high level this fall and holiday.

Now I will turn the call back over to Pat for a more detailed financial review.

Thanks, Gary.

First, I will take you through our financial performance for the second quarter of 2004 and year-to-date, and then I will provide guidance with respect to our expectations for the third quarter and the current fiscal year.

At the end, I will open the call up to questions.

Second-quarter net revenue was up 26 percent to 120.9 million versus 96 million in the second quarter last year.

Comparable store sales for the quarter were up 9.4 percent on top of a 9.9 percent increase in the second-quarter fiscal 2003 and an 8.9 percent increase in the second quarter of 2002.

These increases reflect a compounded growth of 31 percent in our comparable store sales since the initial launch of our new merchandising strategy in the second quarter of 2002, as customers continue to respond positively to our core product offering.

Retail net revenue includes a $3.6 million worth of sales related to a July warehouse sales event, and that revenue is not included in comparable store sales.

We used the warehouse sale event to clear out returned, damage or discontinued products until such time that we have other channels for their disposition, like an outlet store strategy.

In the direct channel, which include sales from both the catalog and the Internet, revenue was up 103 percent to $28.6 million on top of a 46 percent increase in last year's second quarter.

Catalog revenue grew 83 percent in the quarter to $16.1 million, and Internet sales grew 135 percent to $12.5 million for the second quarter.

The Internet continues to react (ph) exceedingly favorably with our customers.

Catalog circulation for the second quarter grew 35 percent to $5.6 million books, with pages circulated up 64 percent.

Our catalog continues to provide significant product and overall brand exposure in our retail trade areas as well.

Gross profit grew 30 percent in the second quarter of 2004 to $32.3 million from 24.8 million in the second quarter of the prior year.

This was the result of increased revenues, coupled with an 80-basis point improvement in gross margins expressed as a percentage of revenue to 26.7 percent from 25.9 percent in the same period last year.

The improvement in gross margin rate is attributable to the leverage achieved on store occupancy expense on the higher sales levels and the expansion of product margins, which benefits were largely offset by higher levels of customer shipping and distribution costs.

Distribution costs have continued to be impacted by the improvement efforts underway within our distribution network, including the cost of consultants to oversee this activity.

Selling, general and administrative expense was 35.2 million in the second quarter of 2004, or 29.1 percent of net revenue, compared with 28.9 million, or 30.1 percent, in the prior year's second quarter.

During the quarter we were able to achieve expense leverage on higher sales as well as benefits from a continued focus on cost reduction and management efforts around store payroll and supply costs.

As expected, we incurred higher cost of advertising, including the cost of catalogs circulated and Web marketing, in support of the dramatic growth of our direct-to-customer channel.

We also continue to incur incremental costs associated with the execution of improvements in the customer order process and professional fees associated the implementation of the requirement of the Sarbanes-Oxley Act, particularly section 404.

Our operating loss for the quarter improved to 2.9 million as compared to 4.0 million in the prior year.

Our net loss for the second quarter of fiscal 2004 improved to 2.0 million, or 6 cents per share, from 2.8 million, or 9 cents per share, in the prior year's second quarter, using a weighted average share count of 32.9 million shares.

On a year-to-date basis, net revenue was $219.8 million, a 24 percent increase over the same six-month period in the prior year, with an average of two fewer stores open during the same period.

Comparable store sales for the six-month period increased 9.2 percent on top of a 10.8 percent increase in the six months last year, with our new core product offerings contributing to the retail sales growth.

Direct-to-customer net revenue increased 99 percent to 50.5 million in addition to a 57 percent increase from the same period a year ago.

Within our direct-to-customer division, net revenue grew 78 percent within catalog and 134 percent from sales on the Internet.

On a year-to-date basis, circulation of our catalog grew 29 percent and pages circulated expanded by 67 percent.

The Company's net loss for the six months ended July 31, 2004 was $6 million, or 18 cents per share, which showed significant improvement over the six-month period a year ago, when the net loss was $8 million, or 27 cents per share.

Higher revenues coupled with expanded gross profits and a leveraging of our selling, general and administrative expense all had a positive influence on the year-to-date results.

Turning to our balance sheet, our line of credit was 37.9 million at the end of the second quarter, up seasonally from the 10.3 million that we had outstanding at the end of the year and up from the prior year's second quarter of 25.9 million.

The increase in borrowing levels reflects the increase in our inventory, up 16.8 million, or 16 percent, from the year-end, and 27.2 million, or 29 percent, from the second quarter in the prior year.

The increase in inventory levels is in support of our continuing sales growth, which was 26 percent in the second quarter.

Capital expenditures for the second quarter were 3.8 million, with the largest portion of spend occurring for our new store in Southern California, as well as store remodels, as well as the spending for our distribution centers for both relocation and expansion activities.

Depreciation and amortization expense for the second quarter of fiscal 2004 was 3.8 million, with depreciation representing 3.6 million of that amount.

During the quarter, we closed one underperforming store in Florida, with minimal cash flow, margin, and income statement effect.

We also temporarily closed one store for expansion in a remodeling and opened one store in Southern California.

Common shares outstanding were 33 million at the end of the quarter.

We finished the quarter with 8500 shares of preferred stock, which is convertible into 4.3 million shares of common.

Turning now to guidance for the third quarter and the full year.

We expect comparable store sales for the third quarter to be in the mid-single digits on top of a 2.9 percent increase in the prior year's third quarter.

We expect to see third-quarter direct-to-customer revenue increase 70 to 80 percent on top of a 46 percent increase in the same quarter last year.

We expect our net loss for the quarter to be in the range of 4 to 7 cents per share versus a loss of 9 cents in the prior year's third quarter on a share count of 33 million shares.

On a full-year basis, we are modifying the guidance to reflect the favorable sales performance in the first half of 2004, as articulated further.

All further year guidance remains unchanged.

Comparable store sales are expected to increase in the mid-single digit range for the full year.

Direct-to-customer growth will increase by range of 60 to 70 percent.

Operating margins are still expected at 1 to 2 percent of net revenue.

Now I will turn the call over to questions.

(OPERATOR INSTRUCTIONS) Kristine Koerber, WR Hambrecht.

Congratulations on a good quarter.

A couple of questions.

First of all, can you quantify the impact of the furniture sale in the third quarter?

To quantify the effect of the furniture sale (multiple speakers) --.

How much did that affect top line last year?

What kind of impact?

We will have to probably get back to you specifically on that.

We don't have that number right our fingertips.

Okay.

Gary, can you talk about the repositioning, where you are?

Is the repositioning complete now and what will be the strategy over the next 9 to 12 months?

Sure, yes.

I think with the merchandise overhaul of the furniture business, which is the last piece that we really touched here, and the remerchandising accessories, I think if you look at our catalog today, if you go into our stores, you go online, I think the brand really represents a single and complete point of view, and looks like the brand that we aspire to merchandise it to be.

The efforts from here forward will really be focused on continuing to become more dominant and more complete and more authoritative in each of the core businesses that we compete in.

As you know, previously we have discussed that we have brought on a person to head up the development of the tabletop business internally.

We are still reviewing that and might possibly look to bring in an additional business in tabletop business in the future.

Short-term, you will see us over the next couple years -- while we have completed the transformation, we are always unfinished here and always on the move, so you'll see us get better and better and better in each of these core businesses and there will be a lot of innovations within these categories.

Okay.

And then can you also talk about holiday -- what your plans are for a successful holiday season and what you have done to avoid the mishaps last year?

Sure.

I think the shortfall that we have had, at least the expectation from a holiday point of view, has really been around the fact that most of our efforts here have been focused on building the core businesses that we are in, drive predictable consumer behavior year-round at Restoration Hardware.

And where we have edited the assortment the most over the last couple of years has been in the accessories and discovery items part of the business, where we edited out about 3500 SKUs in that part of the business.

That part of the business, obviously, was the most relevant business during the nine-week holiday period, but prevented us from being a really clear business year-round.

I think our issue there was twofold.

One, we edited a lot of that out.

And two, because of our limited resources, we really had almost all of our resources exclusively focused on the core businesses.

And what we did a year ago is we brought in additional resources and built up the product development and design team focused on the accessories part of the business.

And so we have the resources behind that part of the business.

We expanded our merchandising team to support that business.

We have more focus on it from an inventory management point of view.

And we think we have got that part of the business appropriately merchandised for the fourth quarter this year, and we think we will see positive results as we go into the holiday season.

We feel quite confident and quite prepared from a holiday perspective, and we think we have some hit items out there.

If anybody has seen our catalog or been in our stores pricing the New Yorker collection, it is a set of dessert plates/cheese plates that we did an exclusive agreement with the New Yorker magazine and have the rights to their wine cartoons.

So we did a series of six dessert plates, beautifully packaged, with New Yorker wine cartoons.

We did coasters; we did wine bags.

We did cocktail napkins.

We think is going to be one of those huge hits, highly giftable items at the holiday time.

Plus they did an exclusive book for us, with all of their wine cartoons.

And to follow that up for holiday, we have a New Yorker holiday collection of dessert plates and mugs that you will see come in for the holiday period that have Santa scenes and holiday scenes and cartoons on them.

Kristine, to follow up on your question earlier, we expect in the furniture area to be down about 10 percent relative to sales levels last year.

And obviously, with our comp store sales guidance, expecting to see that other merchandise is more than filling the gap, and that would be the plan in terms of just making sure that the Q3 moving parts were minimized.

And furniture is a similar complicated piece of the business to plan for and to execute.

Okay, great.

Just lastly, can you talk about your advertising plans, the catalog circ plans, rather, for the second half of the year and any change from the prior year?

Okay, if we look at the circ plans for the full year, we expect overall books to be up somewhere in the neighborhood of probably 35 plus percent circulated, which is about a 19 percent growth rate over the prior year.

So we will continue to experience -- we have had an experience this quarter of about 35 percent growth, so over the full year, we will end up with a 19 percent increase.

As well as page has expanded, which has been some of the story over the last little bit in terms of the growth.

If you look at our recent fall book that was launched, it has obviously got quite a few more pages than where we had been trending in the past, so the growth rate and the actual pages circulated will be up about 50 some odd percent.

Thank you.

Rex Henderson, Raymond James.

Thank you very much.

I wanted to focus a little bit on the inventories, which were up a little bit more than your sales levels were, it appears.

Can you give me some idea of -- because your inventories include both inventories for catalog, sales and for stores, can you give me a sense of how the inventory on the store floors has changed year-over-year?

We had quite a dramatic floor change that started -- to start this floor set.

But just to put the inventories in perspective, this is probably the best we have ever done in delivering a season on time.

So historically, we have not executed very well as far as landing the season and being in stock at the beginning of a book drop or from a retail point of view.

Just to give you a point of comparison, last year we started the fall book at about 65 percent in stock.

This year, we started at around 90, 92 percent in stock.

So there is some timing with the inventory.

The inventory gotten here a little earlier.

That should put us in a position to capitalize on sales, where historically we have not landed the goods and been in stock to start the fall season.

Okay.

The second thing is SG&A was up about 6.3 or so million dollars year-over-year.

I assume a lot of that was catalog expense.

Could you break down what the increase in SG&A was year-over-year?

We have not actually, as you know, gone through and provided that level of detail, but your thought process is spot-on in terms of what drove the overall increase year-over-year.

And in addition -- in overall order of magnitude (ph).

And in addition to that is I spelled out earlier we also had some incremental spend in terms of professional fees on our favorite subject, which is the compliance with Sarbanes-Oxley Rule 404.

So that had a little bit of an increase as will.

Can you quantify for me how much Sarbanes-Oxley cost you this year?

I think we're easily on a year-to-date basis in the $0.5 million range.

Okay, and finally, the direct-to-consumer channel.

Is it at operating breakeven at this point or close to it?

I think, as you'll remember, in our segment information in our footnotes, we provide the breakdown in terms of the retail versus the direct contribution, and for this quarter we are at 15 percent.

Now, that doesn't fully allocate back all the corporate overhead, etc., but if we look on a consistent basis as we look at our retail channel, that would be the contribution that you would assign to the direct-to-customer piece.

Okay, thank you very much.

Kevin Foll (ph), Next Generation Equities.

Hi.

Can you maybe break out some of the components of the gross margin increase?

I know you broke out some of the -- maybe quantify some of the components; maybe how much did markdown margins affect from the warehouse sale and whatnot?

I guess in overall order of magnitude, the warehouse sale probably cost us about 30 basis points in margin compression for the quarter.

Overall markdowns, I'd look at it this way.

I guess if we look at total product margins, we actually had an improvement year-over-year, inclusive of any markdowns.

But if we were to take it on a quarter-by-quarter or Q1 to Q2 seasonally, this ends up being the quarter that we traditionally will have a little bit of higher levels of markdowns.

And then the transitioning of the fall furniture also created an opportunity or an event that we need to make sure that we're cleanly transitioned out of our furniture lines and into our next line of furniture that was coming out.

This was the largest furniture transition we have ever made for a floor set, so we had the highest rate of floor samples sell off in markdowns than we have had historically.

So we did create higher than normal pressure on the margins to get the floors cleaned and transitioned for the beginning of the fall floor set.

And those are pretty much transitioned by now then?

They are.

And looking at your thought process for gross margin and SG&A for the back half of the year, what are your thought there?

Do we still have this carryover from Sarbanes-Oxley and how much added costs are related to the gross margin for the added infrastructure in the back half of the year as well?

I think from the Sarbanes-Oxley point of view, I think we will continue to see spend there.

I think all companies are moving through that and continuing to expend in that arena.

On the investment spending, I think was your other part of your question?

Right.

On DC, I think that will moderate a bit as we look at Q3, so you'll see opportunities as we look at, I think, for our gross margins to expand in Q3, as we move into the new fall furniture have less of an impact on the transition that we just spoke about of the seasonal goods and the moving the furniture to the new furniture line.

And that will create, again, some opportunities for us to be able to see some expanded gross margin percentage over Q2 levels.

Okay.

And lastly, any early reads on the new fall catalog and the furniture line that you've seen so far in the stores?

So far, the early response has been positive, and we're tracking right on our plan.

Great, thanks.

Paula Kalandiak, Roth Capital.

Great quarter.

I wanted to know how this year's bath event compared to last year.

Were you pleased with how it went?

We were very pleased with the bath event this year, and we picked up considerable ground from a year ago.

We were better in stock than we were a year ago.

A year ago last year was the first time we did the bath event.

And the bath products are pretty much year-round types of things, where you could keep a tremendous amount of stock on hand and it is not going to get stale.

That is true. 90 percent of that product is all core product, so there is very little risk of us making inventory investments based on that.

Our real strategy there, especially in the bath area, is how do we get market share and build (indiscernible) mind awareness around that category.

We remerchandised that area of the business.

Particularly in our textiles, we've had some notable competitors.

We have our 802 (ph) graham weight towels and they came out with their copycat 820 graham weight towels.

And we thought before they start to get any of our market share, we were going to do get our customers invested into that product and invested into that category.

With us, I think it's no different than buying wine glasses or anything else.

Once you buy into a wine glass suite, you break glasses, you go back and you buy the same wine glasses.

Once you buy into somebody's towels with a certain (indiscernible) and color palette, when you need new towels, you are going to go back to that store.

So part of our strategy there was to build market share and get the customer thinking about us as a destination for that category.

Okay.

And since you brought up competitors, can you talk a little bit about some changes going on in the competitive landscape?

Particularly which changes?

New entrants into your space.

Particularly (indiscernible) Home?

Is that what you're asking?

Yes, that's where I'm going.

Do you have a question about them?

Well, no.

I was just wondering what you are anticipating their positioning is going to be versus your positioning, how similar might they be?

Those guys don't talk to me much anymore.

We feel pretty good about our positioning.

I think some of the advantages I think that we have is we already have 100 and so locations out there.

We have built a catalog-direct business that will be in excess of 100 million already, and we think we're starting to pretty firmly position ourselves in the marketplace in the core categories that we are competing in.

I don't know what they're going to come out with.

Rumors have it they're going higher end than we are.

I am not sure.

You probably know more rumors than I do.

We're kind of focused on what we do and do it well, and I think competition's always good.

It makes you -- it gives you an edge.

So believe me, when their catalogs are out (ph), we will completely square root it and craft a competitive response.

Sounds good, thank you.

Chris Krueger, Miller Johnson.

Good quarter here.

Most of my questions have been answered, but I just want to make sure I understand the comments on the third quarter, the coming third quarter.

Your guidance for mid-single digit increases and same-store sales does assume the top-line pressure that was mentioned in your comments on the call?

Yes.

Okay.

Furniture should be a smaller percent of sales we should look for -- just based on that, we should look for improvements in gross margin as well.

Is that correct to assume too, versus the prior year?

That is a good assumption.

As well as the other elements that I mentioned earlier, in terms of the seasonal transition pressure (indiscernible).

Yes, that's actually all I had.

I might call you back off-line if I have anything else.

Thank you.

Rob Wilson, Tiburon Research.

Pat, could you talk about the distribution costs that were incurred in the second quarter and how that impacted cost of goods sold?

And do those costs continue going forward?

I think, as you know, the cost of our distribution of our goods is included in cost of goods sold.

So all of the costs of our DCs, etc., are all included there.

So to the extent that we have incremental spend in investments, whether it is in the consultants that we have hired to help, as we have mentioned before, to help to shore up the distribution center execution, as well as some other incremental efforts, whether it's with incremental labor that we have put in that DC -- and particularly in Baltimore, I'm talking about -- help to shore up the efforts and clean up the execution there -- those costs are going in there.

And so as we look at Q3, we see that some of those costs will moderate to some degree.

And we also have included in the distribution centers the cost of the move of our Tracy DC, so that was incremental as well in Q2.

And that again should moderate a bit in Q3.

We have also made some investments in beefing up our home delivery team and that kind of network of representatives that help us manage the direct-to-customer home delivery furniture.

Okay.

So the impact in basis points, Pat, would have been approximately how many in Q2, and maybe an impact that you would estimate for Q3 and Q4?

I am talking about the distribution center costs that you referenced.

As we look at it, I think we probably are still a good 50 to 100 basis points higher than what we would like to be relative to our overall distribution costs.

You had referenced earlier, Pat, a 15 percent direct-to-customer operating margin in the direct division.

Right.

And that is materially higher than last year.

Is that correct?

I think last year's was about 12 or 13 percent.

Do you expect that trend to continue?

We expect 15 percent is a pretty solid number.

Marginally, it will move up and down a little bit, but I would not consider that we will have expansion of that materially as we go through the balance of the year.

Do you have the retail division number for Q2?

The retail division contribution, as we look at from that, again, that segment footnote that we provide, was 9.1 percent in the quarter.

And that was higher than last year.

That is correct.

We've heard from your stores that you plan on opening outlet stores.

Is that true?

One of the things that we're looking at is clearly warehouse sales are probably not the best way of us being able to move through unproductive inventory.

And we have done one, as I think you'll recall, in January and then executed one actually in three different locations in July.

So that is one area that we are looking in terms of being able to have much more of a thoughtful and seamless process, if you will, for being able to handle some of those goods.

When you get down to the onesie-twosies in your goods that you need to actually liquidate through, an outlet strategy would certainly be more efficient from our point of view than doing it via a warehouse sale.

So that would be a yes?

That would be a long-winded yes.

Lastly, do you plan on closing any more stores this year?

We have no plan to close more stores this year.

One more question, Gary.

Chinese furniture sourcing, do you do any of that, and has the anti-dumping stuff that has hit recently impacted you at all?

We have.

This is our first year that we have focused on it.

A couple of our dining collections in the stores and many of our occasional groups we sourced from China this year.

We had an effort about 18 months ago to research China and find the appropriate factories that could make our level of quality.

Brad Hammond (ph), who headed up that effort, who is our Vice President of Global Sourcing, identified some very high-quality factories that make goods for Henredon, Drexel, Ethan Allen, and so on and forth.

And we began testing sourcing there about a year ago and decided to bring in collections this year.

So if you looked at our feather (ph) dining table that is on our floor, our Mason (ph) occasional table collection, our better occasional table collection, our Camden dining table collection, are sourced out of China.

We decided not to pursue bedroom furniture out of China for a couple of reasons.

One, there is the anti-dumping issues that were looming when we were looking at this strategy.

But probably more importantly, as we looked at the cost differences to source and bring big case goods, we (indiscernible) in serious bedroom furniture, the cost difference, by the time you add the freight and get those goods here, was not as substantial as when you looked at dining tables and occasional furniture, where things could pack flatter and ship more efficiently.

As well as we have a real competency in our own furniture factory, the Michaels furniture factory in Sacramento, of really making the larger case goods and the bedroom furniture.

So at this time, we're going to keep our furniture factory solely focused on the bedroom furniture category while we look at other opportunities to source offshore in occasional and dining furniture.

Thank you.

I will come back as you cycle through the questions.

William (indiscernible), (indiscernible) Capital Management.

I have one general question and one quick specific question.

Generally speaking, your direct-to-customer sales only represented about 6 percent of your sales about four years ago and now it is pushing 25 percent.

I think it was 24 percent this most recent quarter.

Is there an optimum level that you see between the stores versus the catalog and Internet as a balance that is either a goal or something you think is reasonable down the road?

I think that I would've said it was probably about a 60/40 split, but I think that is going to be changing as the consumer changes and becomes more familiar with shopping online.

And long-term, I think we look at it somewhere probably between 35 and 50 percent.

I think the consumer's going to make that decision, long-term, where they decide to shop.

But clearly, the Internet and the Web site of our business is accelerating at a much faster pace -- faster than we anticipated.

And I think the consumer can become more and more confident shopping brands that they can trust online, I believe.

And with high-speed Internet, especially when you look at high-speed Internet access and the consumer groups that are kind of the first movers there, I think that most of our customers and the premium positioned customers are probably the first ones to get high-speed access that makes shopping online a lot more -- a much better experience than it is on dial-up. but we think it is going to be a changing landscape.

The consumer will probably be the one to determine what the balance is.

Thank you.

More specifically, I was curious.

This Costa Mesa store you opened in the quarter here.

I presume that is reflective of your new prototype store concept, meaning it is -- I haven't been in it.

But is that a 6500, 7000 square foot store?

I think in total, I think it is 11,000 square feet gross, with probably about 6500 selling.

Got you.

Okay.

Pretty typical model for us as far as size.

Could you identify a little bit of the cost to open a unit like that and break it out between inventory and fixtures and improvements?

Yes.

I think that we have not gone out with our model in terms of how the store openings (multiple speakers).

Typically, we would spend somewhere around 1.2 to 1.6 million, depending on how big and complex the space is to build out in furniture and fixtures.

And then we have inventory investment of probably $400,000 to $500,000 it costs.

Got you.

Thank you.

A follow-up question from Rob Wilson.

Gary, your decision not to run the fall furniture sale, does that have anything to do with an early reaction, maybe positive reaction, to your furniture line?

I think the decision was made before we got to see -- the decision was made before we got to see the early reads on the furniture line.

And really came down to the fact that we put a considerable amount of pressure on the back end in a short amount time last year.

It caused us to not execute well and it caused a lot of expense on the back end up.

And we just thought we had had enough excitement in the overall assortment, whether it's furniture and other categories, that we didn't necessarily need it to obtain a reasonable comp store sales performance.

And long-term, we really want to build this brand as a full price brand long-term, and we wanted to get over the hump of some of the promotions that have been inherent in the business over the last four to five years.

One of the reasons we went into the furniture event last year is we had been doing quiet events every year.

Prior to when I got here -- I think the two years before I got here, there was always some kind of a knee-jerk sale going on in furniture and that created a blip.

We could never get over that blip, and so I said last year, let's be intentional.

If we're going to wind up doing this furniture sale anyway, let's be intentional about it.

And I think because we had a somewhat stale furniture assortment, you needed to promote it to get the revenue going.

So we feel more confident in this year's assortment.

We think it's fresh, it's new, it's exciting.

And if there is a year to get over that hump and to get a promotional needle and pull it out, it's really this year, with the exciting new catalog and the marketing behind the business.

Plus we feel very confident about the growth in other categories to offset any negative sales pressure from not doing the furniture event.

And then it allows us to take the most difficult part of our business to execute and not create any more complexity to it.

All right.

And finally, do you incentivize your store people to push catalog sales?

I say this in a good way, because we seem recently to be encouraged to go to the catalog or the Internet, and you don't see a lot of multichannel retailers out there doing that.

I'm just curious if there is something internally you are doing different this year?

We try to do two things.

One, we want to make sure that everybody focuses on making the customer happy, no matter where they buy.

So if we are out of stock or there is a catalog-only product -- one, if we are out of stock, the store gets shadow sales credit for that on their incentive.

So they will get an incentive, while on a P&L basis, the sale hits our direct channel.

Internally, we have a kind of a shadow booking of that sale that helps them make their incentive, so they are incentivized to do the right thing.

And then from a catalog-only point of view, we try to develop a culture where we try to help the customer no matter where they want to buy and no matter who gets the credit.

But on a catalog-only sale, the store does not get credit for that sale in any way, whether it be shadow or non shadow.

A follow-up question from Kevin Foll, Next Generation.

Can you give us the transactions and revenue per transaction for the retail and direct channels in the quarter?

And looking in the back half of the year, what are some of the drivers?

How do you see overall inventory and on a per-square-foot basis for the stores for the back half of the year?

The transactions for the quarter were actually off 1 percent, but the average order was actually up about 13 percent.

And we have been very breakeven, if you will, in terms of transaction count as we look back over the last several quarters.

So that's pretty consistent with where we've been; and the average order continuing to go up as we reposition the goods.

And I would think that's the same kind of thinking that you should put around the back half of the year as well.

Okay.

And thoughts on the inventory levels then in terms of units and dollars for the back half of the year?

Pretty similar?

Again, I think what the guidance that we provided before and where we have actually been aiming at is to make sure that our inventories are pretty much in line with what our overall sales growth is.

So that should be the way I would suggest that you think about that.

Thanks.

Mickey Strauss (ph), Strauss Asset Management.

It seems like you are being awfully conservative in your comp guidance for the third and fourth quarters (technical difficulty).

And I was expecting (indiscernible) and then the fourth quarter was (indiscernible) that you had last year.

Could you go into your thinking as to why you think we'll only hit mid-single digit comps?

You weren't real clear.

We couldn't hear you that well here, but I think -- let me just we try to paraphrase that.

I think you were saying that we were being somewhat conservative from your point of view regarding our third-quarter comps, because we are up against tougher comps last year.

Third and fourth quarter, yes.

Third and fourth quarter.

Probably part of our conservatism that is baked into the third quarter particularly is the fact that we're not going to anniversary the furniture event, so we think that there is -- it probably creates downward pressure on sales, but we should have some upward lift in merchandise margins.

So even with the furniture sales, you're confident only 2-plus percent in the third quarter of last year.

I think it is a fair call out and point you're making.

I think we feel today it is appropriate to give the guidance that we're giving, so --.

And then as a practical matter, the furniture transactions themselves are by nature higher per transaction.

So the comps sales, by having a lesser percentage, just naturally put some pressure on the comp store sale number from a mix perspective.

And the fourth quarter last year, you had some disappointment because of -- (indiscernible) the comps for the fourth quarter.

The tough thing about giving a lot of guidance on the fourth quarter is we have such a big part of the mix of the product mix is new and seasonal, related around all the holiday gift-giving product and all of the Christmas trim and ornaments and so on and so forth.

And so until we get some kind of reads on those, I think our guidance today is appropriate.

Would we hope to be more optimistic?

Sure, but it wouldn't be prudent until we see how the customer responds early on to a lot of new products that will be flowing into the fourth quarter.

Okay, thanks.

Todd Hawthorne (ph), RS Investments.

I was curious.

It seemed that revenues were running about $13 million ahead of plan, and yet it didn't really drop down to the bottom line.

Was that spending on the DCs or where do you think that disconnect is?

Certainly in part, the spending on the DCs and just our overall higher distribution and shipping costs were a contributor in the quarter.

We also had some of the incremental spend came in a little bit higher than what we expected -- we talk about the professional fees in the quarter.

And I think importantly is we calibrated through -- whether it's the warehouse sale -- the warehouse sale provides about $3.6 million of revenue.

But as a practical matter, we really end up with a breakeven situation as we sell those goods through, so there's not a lot of bottom-line profit that results from the sale of those items.

So if you peel back all of those elements on top of the seasonal transition that occurred, that is really what happened versus our expectations from our guidance perspective.

(multiple speakers) down a little further, how much of that really was shipping cost and what effect did that have on margins?

I think what I commented earlier is that we probably expect about 50 to 100 basis points in terms of we are a little bit heavier than what we would have expected on distribution costs.

And it will take us some time to normalize that back down.

But you expect it to normalize?

Over time.

Okay, great.

Thanks.

(OPERATOR INSTRUCTIONS) John Pinto (ph), (indiscernible) Partners.

Just following on margin side, is there any way you can give us just a little bit of help on the merchandise margins expectations for the next couple of quarters, given the mix in the product categories, and then also the fact that you're not going to have the furniture sale Q3?

I think earlier on, you said something that your Q3 gross margins should be better than Q2.

I'm assuming that Q3 will be better than last year Q3 as well?

Yes.

Okay.

And on the merchandise margin, what has been the impact of product mix and obviously cleaner inventory and lower markdowns?

Can we expect merchandise margin to be also improving over Q3 and Q4?

Yes, we do expect that as we continue forth with our increased foreign-sourced product that it gives us an opportunity to expand merchandise margins.

And again, Q3, if you look at it sequentially, Q3 has a less transitional nature, last seasonal transition to it and it's more of the fresh goods that are coming -- core product offerings that are coming in for the season.

So there should be less pressure on margins for markdowns, if you will, as a consequence of that.

So those two items are probably a big opportunity for us.

Our highest markdown quarters are Q2, because we transition out of spring/summer product in July; and then Q4, as we transition out of fall/holiday product in January.

Okay.

And so just to clarify, for this Q2 just released, you had better merchandise margins than last year?

Yes.

Okay.

And was that significant -- that was then hurt by something else?

I'm assuming you had distribution -- or improvement to the gross margin from distribution this quarter.

No, no at all.

That was what pressured the margins.

Okay.

All right, understood.

And anything on the initial markup?

You said there's initial markup or better costing.

When did that phase in?

Did you receive some of those benefits this quarter or when will that phase in -- next quarter?

No.

I think we have had an ongoing strategy to edge up the initial merchandise margins.

So it has been a continuous thought process as we've been expanding, again, our foreign-sourced goods over the domestic goods.

So taking those opportunities as we are being able to get cost reductions in the sourcing to be able to transition that and translate that into higher IMUs.

Okay.

And so you are expecting for Q3, Q4, is it a combination of both better IMUs and lower markdowns, or is one area more -- more opportunity in one area than the other?

I would characterize it as equal.

All rights.

Terrific.

Thank you.

Kevin Foll, Next Generation.

Just a quick follow-up.

Tax rate, did that change a little bit in the quarter?

Do you expect the same rate to carry forward to the back of the year?

Yes, we do. 39.5.

We have no further questions in the queue.

I will turn the program back to the presenters for closing comments.

Thank you all for attending and participating in our Q2 conference call and look forward to sharing with you our Q3 results in November.

Thank you, everyone.