RH (RH) 2004 Q4 法說會逐字稿

Good day.

All sites are now on the conference line in a listen only mode.

At this time, I would like to turn the program over to Pat McCay.

Good afternoon everyone and welcome to Restoration Hardware's fourth quarter and full year 2004 earnings release conference call.

My name is Pat McCay, 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 web site at www.RestorationHardware.com under Company information, investor relations event calendar, or by dialing at 888-566-0148 until March 31, 2006.

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

John Tate, our Chief Operating Officer, will also provide comments regarding certain operating matters.

And the end of our remarks, we will open the call up to questions.

Before we begin, let me address a few preliminary items starting with a brief statement regarding forward-looking statements.

Current statements and information on this call will constitute forward-looking statements within the meaning of the federal Private Securities Litigation Reform Act of 1995.

These statements are based on management's current expectations and are subject to certain assumptions, risks, uncertainties and changes of circumstances.

Actual results or performance may vary materially from those expressed or implied in such statements.

These statement will include without limitations financial guidance and statements related to the implications of the Company's fourth quarter and full year 2004 earnings 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 Securities and Exchange Commission, including the MD&A section of our most recently filed Form 10-Q and our earnings release posted on the Company's web site.

Any guidance whose offer represents a point in time estimate.

We expressly disclaim any obligation to revise or update any guidance or other forward-looking statements to reflect events or circumstances that may arise after the date of this call.

As previously announced, the Company along with many other retailers, will restate prior period financial statements to give effect to a correction in the Company's lease accounting practices and all references to financial results made during the call today give effect to the anticipated impact of the restatement which the Company expects to complete as part of the filing of its 10-K.

Now let me turn the call over to Gary.

Good afternoon, thank you Pat.

We are pleased to report our first profitable year since the company went public in 1998.

Now while a small operating profit of $4 million may not be a reason for investors to break out the champagne, it is a far cry from the $42 million operating loss or 24 million net of onetime write-offs when we started this journey.

What we're most proud of is Restoration Hardware is fundamentally a different brand and company than it was when we launched the first phase of our repositioning strategy three years ago.

This has been much more than a financial repositioning, but rather a total reconceptualization of the brand and business model.

We have evolved from a store that fit (ph) for Mission furniture and retro discovery items to vertically integrated premium home furnishings brand built on a foundation of dominant and predictable core businesses.

We have posted the strongest compounded comparable store sales increases amongst the specialty home retailers in our peer group over the past three years, including the 5.7% increase this past fourth quarter and a 7.8% increase for fiscal 2004.

During that period, we have increased our average store sales from 3.1 million per store to 3.9 million per store.

We have also grown our direct business from 22.6 million to 119 million this year, including a 75% increase for fiscal year 2004 on top of the 52% increase last year.

We've built a direct model that produces total direct dollars per book among the highest in specialty home retailing.

Restoration Hardware now operates as a fully vertically integrated retailer, controlling our product from concept to customer.

Additionally, we increased our direct imports from 15% to over 60%, enabling us to improve our merchandise margins year-over-year.

While there was some negative impact to this year's financial performance due to problems in our supply chain plus costs related to the implementation of Sarb-Ox 404, we believe that we have put in place a passionate operations leadership team that will position Restoration Hardware to be a predictably profitable retailer in the very near future.

Looking forward, we are focused on continuing to strengthen our leadership position in our core businesses.

This fall, we will remodel and refixture approximately 80% of our stores.

You will see innovative ideas as they relate to merchandising of all of our core businesses with the most dramatic efforts in furniture, lighting and textiles.

While we won't offer specifics for competitive reasons, let me say the effort this fall is every bit as dramatic as the first phase of our repositioning in 2002.

This next evolution of our brand will also create a higher merchandise margin model as we edit lower margin, non-synergistic categories and items.

These moves have the greatest impact in quarters 1 through 3, greatest positive impact in quarters 1 through 3, and we're currently forecasting the fourth quarter comps to be flat to slightly negative.

We do plan on achieving a significant increase in profitability in Q4 due to less seasonal markdowns and a much higher merchandise margins.

We are also excited and confident about our prospects to drive higher sales and margins at our stores, catalogs and online as we position the Restoration Hardware brand to stand the test of time.

We are equally excited about the short-term improvements and longer-term plan to build operational excellence throughout our supply chain.

And with that, I would like to turn the call over to John Tate, our Chief Operating Officer.

Thanks, Gary, and good afternoon everyone.

I would like to share a few key events of the fourth quarter from an operations perspective.

As you know, a critical focus over the last two quarters has been identifying and recruiting key leaders in critical parts of the operations organization.

I'm pleased to report significant progress in the fourth quarter.

Bob Hessan (ph) joined us as Senior Vice President of Supply Chain as the fourth quarter began and is already making big changes in the supply chain.

In December, we restaffed both the General Manager and Human Resource Manager positions in Baltimore.

At the same time, we eliminated the consulting services which we had engaged to sustain Baltimore as we began its turnaround.

The new management and several leaders who were already there have gelled as a team to create an entirely new dynamic in Baltimore.

In the last few months, we have eliminated temporary labor, which numbered as high as 120 people at points in the past year; avoided the necessity of renting an additional 100,000 square feet of warehouse space; reorganized and reduced management layers; created a reverse logistics warehouse and an effective process to flow damaged to returned furniture and other goods from this warehouse to our outlets and successfully launched our summer furniture program, which as you know, was hampered by some executional issues last year.

Our distribution centers in Tracy and Hayward, California continued in this quarter to provide strong operational execution as they have in the past.

We also launched programs in the fourth quarter aimed at, among other things, lowering the cost of delivering small packages, reducing our surface transportation costs, improving our home delivery experience and improving our reverse logistics process.

While it is still too early to quantify the results of these efforts, I'm confident that each of these initiatives led by an energized and passionate leadership team will provide an improved customer experience at reduced cost.

As you know, we have now completed the senior leadership tame in operations, having filled the Chief Operating Officer, Chief Information Officer, Senior Human Resources and Senior Supply Chain positions.

Importantly, this prepares us for the even more important endeavor of engineering long-term plans for our technology platform, supply chain configuration, human resource development initiatives and evolution of our sourcing capabilities into a long-term competitive advantage.

Looking forward, I would like you to know that our efforts are equally balanced between two broad efforts.

The first is optimizing customer service and cost using our current tools in the short and medium-term.

Happily as we have increased our bench strength and knowledge base, we have found that many of our existing systems have functionalities that are easily enabled that have not been capitalized on previously.

As an example, we have learned that our current transportation systems provide considerably more visibility in tracking customer furniture orders than was previously thought.

We have also found that as we rationalize and simplify processes, often we actually need fewer resources, human and material, than previously thought.

An example here would be the significant reductions I previously described in the management, material handling equipment and space requirements in Baltimore, combined with rapidly improving service to our stores.

These opportunities are purely and simply the results of the right leaders in the right seats.

The second broad focus will be capitalizing on the knowledge and experience of these leaders to look farther out and prepare to create an infrastructure to support a rapidly growing and much larger Restoration Hardware over the next several years.

We have actively engaged in that effort and I expect we will begin to see material benefits in the second half of next year.

I look forward to talking to all you over the coming quarters about our progress on both these short and longer-term initiatives.

With that, I'll turn it back to Pat.

Thanks, John.

First, I'll take you through our financial performance for the fourth quarter of 2004 and full year, and then I will provide guidance with respect to our expectations for the first quarter and full year of fiscal 2005.

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

Fourth quarter net revenue was up 14% to 187.9 million versus 165 million in the fourth quarter last year with comparable store sales for the quarter up 5.7% and direct to customer revenue up 51% from the prior year’s fourth quarter.

Along with the increases in revenue, we experienced expansion in our gross margin driven by higher product margins and occupancy leverage and a reduction in our selling, general and administrative expense in the quarter expressed as a percentage of sales.

We also had a lower effective tax rate.

I will touch on each of these areas in a moment as I review our performance with you.

Earnings-per-share for the fourth quarter was $0.28 cents compared to $0.21 in the prior year, up 33%.

Importantly, our full-year results reflect positive net income of 1.7 million or $.04 a share, which is the first time we've posted net income for the full year since fiscal 1998 when we went public.

Turning to retail sales performance, as mentioned, we experienced 5.7% increase in comparable store sales.

The comp sales performance reflects a 3.1% comp store sales results for the holiday sales period as well as a 20.7% increase in comp store sales in January.

These increases reflect our customers' positive response to our product offerings for both the holiday and January sales period when we anniversaried our now annual bath event.

During the fourth quarter, we experienced a lift in both the average retail dollars per transaction of 7% and an increase in total retail transactions of approximately 1%.

In the fourth quarter of 2004, we opened our first outlet store and we held in warehouse sales events that generated revenue totaling 2.9 million compared to 2.7 million in the fourth quarter of fiscal 2003.

The outlet and the warehouse events have been designed to liquidate returned, damaged or discontinued goods.

As we open additional outlet stores, we expect to eliminate the need to hold separate warehouse sale events which tend to be less productive.

This revenue has been reflected in the retail segment but is not considered in the calculation of our comp store sales.

For the fourth quarter of fiscal 2004, our retail segment realized a $30.6 million four-wall contribution after cost to district management, or a 20.7% contribution margin as stated as a percent of segment revenue.

This compares with the 25.1 million contribution at 18.1% of net retail revenue reported in the fourth quarter of the prior year.

Gross margin for retail was favorably impacted by store occupancy leverage on higher sales and product margin expansion, but slightly offset by higher distribution costs as compared to the prior year's fourth quarter.

Our selling, general and administrative expense for the segment benefited from the favorable effects of payroll and other store expenses.

In the direct channel, which includes sales from both the catalog and the Internet, revenue was up 51% to 40.1 million on top of a 51% increase from last year’s fourth quarter.

Catalog revenue grew 41% in the quarter to 21.4 million and Internet sales grew 64% to 18.7 million for the fourth quarter.

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

Catalog circulation for the fourth quarter was up 16% with pages circulated up 42%.

Segment profitability rebounded to 12.1% for the fourth quarter on more normalized levels of advertising cost as compared to the third quarter when we experienced deleveraging of advertising costs from one of the fall book mailings which resulted in a reduction of segment profitability to 6.6%.

At the total company level, we continue to see expansion in our gross profit in the fourth quarter to 67.9 million or 15% up versus the fourth quarter of the prior year.

This was the result of increased revenue coupled with a 40 basis point improvement in gross margin expressed as a percentage of revenue to 36.2% from 35.8% in the same period the prior year.

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

Selling, general administrative expense was 50.7 million in the fourth quarter of 2004 or 27% of revenue compared with 45.2 million or 27.3% in the prior year’s fourth quarter.

As I've shared with you previously, in periods like this where we experienced rapid growth in the direct to customer channel advertising, which is the most significant cost driver, will have the effect of deleveraging SG&A administrative costs for the Company.

During Q4 of fiscal 2004, this was the case but offset by other favorable leverage that I commented on within the individual segments.

We also continued to incur higher cost of compliance for professional fees associated with the implementation of Rule 404 of Sarbanes-Oxley as of 2002.

Our operating earnings for the quarter were 17.2 million, which was 23% higher than the amount reported in the prior year of 13.9 million.

Our effective tax rate was 35.5% for the quarter as we appropriately adjusted our tax account balances at year-end.

This included a reversal of our deferred tax valuation allowance which is deemed to be no longer necessary, somewhat offset by the accrual of reserves for certain tax contingent fees.

This had a net effect of a reduction of 850,000 of our tax provision for the fourth quarter.

Our net income for the fourth quarter of fiscal 2004 was 10.6 million or $0.28 per diluted share as compared to 8 million or $0.21 per diluted share in the prior year's fourth quarter using a weighted average share count of 38.1 million shares for the current fiscal year.

EBITDA for the fourth quarter of fiscal 2004 was 21.4 million as compared to 17.8 million in the same period in fiscal 2003.

On a year-to-date basis, our total revenue was 525.8 million, a 20% increase over the prior year with an average of one less store opened in the year.

Comparable store sales for the full year increased 7.8% on top of a 5.2% increase last year with our core product offerings contributing to the retail sales growth.

Direct to customer net revenue increased 75% to 119 million in addition to a 52% increase a year ago.

Within our direct to customer division, net revenue grew 60% within catalog and 98% from sales on the Internet.

For the year, circulation of our catalog grew 15% and pages circulated expanded by 48%.

The Company's net income for the year ended January 29, 2005 was 1.7 million, $.04 per share and again is the first year of profitability for us since 1998.

The net loss last year was 2.5 million or $.08 per share.

EBITDA for fiscal 2004 for the full year was 20 million as compared to 16 million in the prior year.

Turning to our balance sheet, our outstanding balance on our line of credit at the end of the year was 33.8 million, up from 10.3 million at last year end.

The increase in borrowing levels reflects the increase in inventory up 41 million or 40% from the prior year.

The increase in inventory levels is in support of our continuing sales growth and also the earlier timing of receipts for our outdoor furniture program which also included shipments in transit.

Inventory related to seasonal holiday merchandise represented a very small portion of the inventory balance as we cleared through the majority of this merchandise either through discounted sales early in calendar 2005 in either the retail to direct to customer channels.

Capital expenditures for the year were 13.4 million with the largest portion of the spend occurring for new and remodeled stores, as well as spending for our distribution centers for both relocation and expansion activities.

Depreciation and amortization expense for the fiscal 2004 was 15.9 million.

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

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

Turning now to guidance for the first quarter and the full-year of 2005.

We expect comp store sales to be in the low- to mid-single digits for the full year.

We expect to see full year direct to customer revenue increase 25% to 35% on top of the 75% increase in 2004.

We expect our operating income margins for the year to be in the range of 2% to 3%.

We expect capital expenditures to be approximately 20 million as we remodel stores to support modifications of our merchandise assortment and open one new retail and five outlet stores.

We expect inventory to end the year relatively flat compared to fiscal 2004 year-end levels.

We will be able to take advantage of the outlet channel as we more efficiently move through nonproductive inventory.

Depreciation and amortization is expected to be approximately $17 million.

We expect first quarter fiscal 2005 results to be in the range of $.10 to $.11 per share and a basic share count of 34.2 million -- excuse me -- 33.2 million shares.

And with that, I will open the call up to questions.

(Operator Instructions).

Christine Kerber (ph), JMP Securities.

Hi, congratulations on a good quarter.

Can you talk about -- first of all Pat, can you tell me what the share count you are forecasting for the full-year?

It's going to be 34 million shares and 38.4 on a fully diluted basis.

38.4 fully diluted?

Right.

And could you talk about catalog circulation plans for '05, what page count increase you're looking for and how many books you actually mailed in '04?

And I know that we're seeing rising paper costs, and is that factored into the guidance?

Yes, it is.

How many books did you mail in '04?

We mailed -- well, what we have actually been talking about lately, Christine, is actually what our list is in overall circulation.

So the pages circulated went up to 48% with the book circulation going up 15%.

Is that the '05 guidance?

I'm sorry, that's '04.

'05, what the guidance is for '05?

Sorry.

For '05, we're expecting overall pages circulated to be up in the neighborhood of about 13% to 15%.

You mentioned distribution costs higher in the quarter.

Can you explain why DC costs were higher?

And any insight on what we expect distribution costs to be, kind of the savings on a go-forward basis, with Bob on board?

In the fourth quarter, we ramped up our consulting arrangements, which -- the invoices of which carried it through early January.

At the same time, we brought on our new management and they began the effort to reduce temporaries.

But you did not see the results of most of that and it actually got accomplished fairly late in the fourth quarter.

So year-over-year, you're looking at increased distribution costs associated with volume.

We do expect to see distribution costs be lowered next year.

We are still working through the details of exactly what that will look like and what staffing will look like.

Okay.

Thank you.

Janet Kloppenberg, JJK Research.

A couple of questions.

Pat, your inventory on a comparable store basis or a comparable square footage basis -- how much was that at?

We really have not had much movement.

So overall, it's still going to be at about the 40% level.

Can you talk about why it's at that level?

Are you comfortable with it there?

Yes.

As I mentioned in my comments, we had a significant amount of outdoor furniture that we actually brought in in advance of the selling season, earlier than what we had done in the prior year.

And that drove a lot of the increase.

As we look at the Q1 close, we expect to be back in more of a normalized range, about 15% to 20% up, in terms of year-over-year inventory growth.

It is in balance with overall (MULTIPLE SPEAKERS).

If you look at the first 30 pages or so of our catalog, we've made a major statement in outdoor furniture.

Last year, we began the season not in very good in-stock shape within the program, so we've brought the outdoor furniture in early to support both the catalog and the retail floor sets.

Both the catalog and retail had expanded assortments versus a year ago and we brought the inventory in early to support it, to make sure our DCs were set, our stores were set.

So you see a timing issue there.

And by the end of Q1, you should see inventory levels in the 15% to 20% increase.

But not on a store basis, Gary.

No, I'm talking total.

Would the store inventory growth at the end of the first quarter be more in line with the --?

What our stores are holding today?

I'm just trying to get an idea.

You're looking for comps to be up low- to mid-single digits, I think.

I'm wondering if you can -- if you're going to do that on inventory up low- to mid-single digits, or if you need more inventory.

How do you look at that?

I think certainly, you get a little bit disproportionate because of the growth of the direct channel.

So if you were to carve out the direct (multiple speakers) inventory, certainly, it's having a bit of a higher push in terms of moving the inventory levels up.

And if you looked at the retail-only, we would expect that to mirror and be perhaps slightly a little bit higher than what our overall sales level growth are in support of making sure that we have strong in-stock positions for a lot of our core merchandise programs as we look at opportunities to not miss sales opportunities as they represent themselves in our stores.

Okay.

And on the direct sourcing front, how do you see that moving forward?

To what level do you think you will get to this year, and what effect do you think that will have on gross margins?

We think we'll probably be somewhere in the 65% to 70% range this year.

And what is your goal, Gary?

It's somewhere around 75, 80%.

We do own our own furniture factory in Sacramento that's still producing furniture for the Company and will continue to.

And much of our upholstery still is manufactured in the United States.

We have made some significant moves in major categories obviously like textiles, lighting over the next 18 months is significantly moving offshore to direct imports.

So we probably have another 5 to maybe 10 points more to go, but not too much further than that.

And we should see a direct benefit in the gross margin line as you ease out of that?

You will just continue to see gross margin benefits I think over the next several years as we just get better stores same.

The other things you're going to see is, as we get better at running the businesses we are running, over the last several years has been a significant change in movement of core businesses, expansion of businesses, introduction to the new businesses.

And when you're early in the game, you are right sometimes, you are wrong sometimes.

And we are a lot smarter than we used to be as far as how to size businesses, how to buy for the businesses, seasonal factors in each of the core categories and seasonal layer to the business.

As well as you are seeing us, we will continue to contract what I call the last of the legacy businesses and the items and discovery items at some of the accessories parts of the business where we've historically had our lowest gross margin performance and trade that space and real estate for a higher productive core businesses that draw higher margins.

My question on that is, some of that contraction, does that have to do with your what I would call less than aggressive outlook for comp store sales growth?

I know the fourth quarter will dampen your comp performance for the year.

But, given your expansion of the lighting area and the textile area and the improvements in the furniture assortments, do you think that's just a cautious outlook?

Did you want to be conservative?

I think of course, we are taking a cautious outlook at the end of the year and I think there has been a lot of rumbling out there about interest rates and (multiple speakers) sales and other people reporting less than stellar comps.

We are pleased with our comp store performance and our direct road to the fourth quarter.

I think this month was the highest out there.

I think we are just taking a cautious approach to the year.

It forces the Company also to manage expenses tightly and not get ahead of ourselves.

So I think like everyone, we hope to overperform.

But we should not look for a straight-line low- to mid-single comp for the whole year?

We should factor in your outlook for the fourth quarter and then putting something higher for the first three quarters?

Yes.

I think you ought to look at the low- to mid-single digit comps in the first three quarters and flattish comps in the fourth quarter.

And really the reason there is, again, we are going to contract the items and discovery business.

And then the real reason, it's kind of, it looks disconnected to the rest of the store and the brand strategy.

I think it's holding us back from looking as high-quality and inspirational as we want to look and it's some of our lowest performing businesses from a gross margin point of view and a gross margin return on investment point of view.

So we're going to make some last big moves that we think are important to kind of fortify the model here on an ongoing basis.

I would not see us continuing to think we're going to run flat comps in the fourth quarter.

We're taking a pretty big whack out of the last of that stuff.

And so I think from there forward, we will comp the fourth quarter like we will in all cases.

It was interesting, we just got done with a board meeting here in the last couple of days.

And if you looked at our comp store sales over the last three years since we launched our strategy, we have been up near the high 20s to 30% in Q1, Q2, Q3, a compounded basis over a three-year period and we were about 10.5% I think the number was for Q4.

And out of that seven or so comparable companies, we benchmarked ourselves against, we had the third best comp store performance.

I think we were just behind Bed, Bath & Beyond and Linens N' Things -- is that right? (indiscernible) we are number two.

But we were ahead of just about everybody else.

And so I think there's a perception that Resto has not really performed in the fourth quarter.

I don't know if we haven't performed.

We have contracted significantly the discovery item and accessories business.

It used to be 46%, 47% of the total revenue of the Company which was the fundamental problem.

No one was waking up in the morning saying hey, honey, I need a Moon Pie or I need something I'm not looking for.

And generally what happens is that kind of store is really exciting for browsers but the only problem with browsers and the only thing they have to spend is the day.

And so we -- standing back and looking at it, now quite frankly, it's looking at the numbers saying it's not so bad in that fourth quarter.

We've actually gained market share versus our key competitors and we significantly gained market share in Q1 through Q3 and we continue to believe we will continue to gain market share in the first three quarters.

And except for this year where we're saying hey, you know what, let's now let go of the last piece and kind of finally clean up the model here and build on the future, because I think you basically have a completely transformed company once we come out of this year in every way, shape or form.

Just for John.

I was wondering, John, when you look at what's going on in Baltimore and the changes you have made there in the management staff, do you think you have to invest a bit more in that before you start to see greater efficiencies, or do you think we will start to see some leverage in the first half of this year?

No, I think we will start to see leverage in the first half of this year definitely, Janet.

I think there is lots more out there to get with greater investment, but we're going to take that in digestible chunks.

Okay.

So we won't necessarily see a cost center going forward or a higher cost?

We'll never have revenue in Baltimore, but you will see it be a savings generator.

I think as we look at it, it gets better every quarter here.

Thank you.

Rex Henderson, Raymond James.

Good afternoon.

A couple of quick housekeeping items first.

First of all, I know that you had a tax rate adjustment in this quarter.

What kind of tax rate are you assuming for next year?

40%.

Okay.

Okay, does the guidance for next year contemplate any new store openings?

We have one new store opening for next year.

Do you have any idea what quarter that will be in?

Third quarter.

Okay.

And any closures?

Not expected.

Okay.

It's the merchandising.

Rex, if I may, the share count, which should be about 39 million shares for next year.

I can correct that comment.

All right.

To merchandise.

I know that you had a cleaning product sale in Q1.

I was wondering about how that performed for you and how it performed relative to your expectations?

We did not have a cleaning products sale.

We introduced our new private label cleaning collection, so we launched with that full price.

You may have seen some of the old goods, the transitional goods that we were editing out to introduce that collection on sale.

But we introduced a comprehensive cleaning collection line of products that very excited about, performed very well.

We have always been in that category.

It has been a good category for Restoration Hardware.

But historically, we have been selling branded goods.

And what happens is we make an item famous and other people were buying it and copying it and merchandising it and we couldn't protect our brand.

And we thought our brand had the kind of authority in that category that would lend us to do our own collection and we just spent about 1.5 years developing it and launched it we're very happy.

Well it's certainly much more prominent in the stores than it was.

Well it's merchandising colorized to merchandise cross-category with our bed and bath, textiles, etc.

And the margins on those products, those would be in general above your corporate average?

Yes.

Looking at new categories for next year, you said you are going to expand textiles, expand furniture and expand lighting.

Any other new categories that you're contemplating?

No new categories.

In fact, one thing I probably should just add clarity to is I think a year, 1.5 years ago, we had talked about that we had brought somebody on to work on developing a tabletop business for Restoration Hardware and thought that could be an important category for us.

And probably added some of our frustrations of not seeing the big comps we saw in Q1, Q2, Q3 happening Q4.

And quite frankly, as we did our strategic work, competitive assessments of ourselves and our competitors, we decided that the right path for Restoration Hardware was to become more dominant and have more authority in the categories that we're in, to spend our time, money, investments, dedicate the real estate to those categories where we could be famous.

And so we're conceding the tabletop category except for some seasonal dessert plates and other things and interesting gift items.

We will be in the entertaining and bar business.

But as we go forward and as a company has always kind of had that kind of layer to it, but no new categories and I don't really see any for awhile.

Okay.

So you feel like the merchandising in the stores is -- with the exception of some adjustments to existing categories, it's fairly complete at this point?

I think this fall, it will be fairly complete.

The retail business you're kind of always unfinished, always on the move.

So you never really say complete because there is always a new and better idea.

But I think I will tell you from my point of view, I think the business that we have planned, I think the model we have planned from a core category point of view and the hand we're going to play this fall I think is good and well-positioned a brand that's going to be out there.

So I think the businesses that we're in, we believe that we're going to have the number one ranking in probably six out of eight categories we compete and the number-two ranking in the other two categories if you put us up against the five or six people you compare us to.

To some logistics questions.

Do you measure stockouts in the stores and in-stock position?

And how to you rank yourself?

Do you have any feel for any lost sales from those things?

Sure.

We look at that stuff every day and we're okay, we're not great, we get better every month here.

And whether it's upgrading leadership or our processes and John and his team have an effort to relook at rebuilding our merchandising systems.

But I think that again, as we now have more of a stable brand and more of a focus on the businesses that we're in and not as much dislocation, we will get better and better and better.

We have an internal mantra here that we're focused on called core business excellence.

And we have aligned our company around the core businesses and categories that we want to win in.

And we have dedicated teams for merchandising, product development, sourcing, we have inventory management and so on and so forth, all the way through the Company.

And we are trying to engineer core business excellence from the very inception of the product all the way through the supply chain to the delivery and customer experience.

And then once you do that, once you have a model and a blueprint of a retail business to run and you have to stabilize to where this business is and kind of it's going by this fall, you get better and better all the time.

Okay.

Do you have any metrics that you can articulate, where you are in terms of in-stock and where you would like to be?

I can tell you, last year in the direct channel, we were running the business at 75% to 85% fulfillment rates on initial fills, and this year, we're targeting 85% to 95%.

We have internal measures on store in-stocks, in-stock percent when a catalog drops, in-stock percents in a season for floor set -- we have all kinds of things.

We can talk all day and show you all kinds of (indiscernible).

But we have all of the things that everybody else has.

We look at all of the same reports and all of the same kind of metrics.

Finally, John talked a lot about a number of initiatives in the supply chain to take some cost out.

He went through them rather rapidly.

They're in my notes, but I'm not sure I have them right here.

But do you have any quantification of how much savings in terms of basis points or in dollars that those initiatives can save?

No.

In fact, I said in the comments that it's a little too early to quantify the results of those efforts.

Many of them are still in test.

What I think that you can assume to Janet's earlier point is they will facilitate the distribution centers being positive contributors to operating income as a percent of sales for the next several years, over and above the normal leverage benefits that you would get.

Okay.

Thank you very much.

Paula Kalandiak, Roth Capital Partners.

Good afternoon.

Nice quarter.

A couple of questions.

One is -- I don't if you would give us the actual percentages, but can you at least tell us directionally which product categories grew during the year and which ones got a little smaller?

From a competitive point of view, we just like to say as little as possible.

I think we probably get too enthusiastic on these calls and talk too much, I feel like I already have.

So I think it's a good question, but we're taking the fifth on that.

We are in a competitive environment.

Innovation and ideas don't have as long of a shelf life as they used to in the past.

Paula, you're killing Gary here.

He's aching to say something.

Okay.

I my last question just relates to your outlet strategy.

Can you tell us to where those outlets would be?

And is there going to be any special made product, or is it purely for appearance at this point?

Paula, let me give you some general information, because I don't think we specifically know where all of them will be.

We've opened the one in Vacaville, California, a suburb of Sacramento.

We'll open one in Virginia very soon, suburban DC.

As a general rule, you will see us open them in large population centers where we would expect lots of customer furniture returns from both channels of our business.

And we expect to use those by integrating them with the distribution centers and our home delivery providers so that we get a smooth flow of furniture.

We will try to deluxe and rebox all of the active programs that we have that we can return to a new condition and get those back in the DC.

But, across the nation where we have either furniture that we're still selling but the line is discontinued, our furniture which is nicked and dented, too bad to bring to a like-new condition, we want a smooth flow that bypasses a DC and goes straight to those outlets.

And for the next couple of years, that will be the primary purpose of those outlets.

It's hard to see beyond that what the merchandise mix is.

But for the next couple of years, there will be a big focus on perfecting the reverse logistics flow that moves our return to furniture effectively from time to time excess merchandise inventories that we have.

Paula, one thing we do know too, just to follow onto that, is that the outlets thus far that we have opened have actually been much more effective, much more productive from even just a margin realization.

So I think it's going to be a real efficient vehicle for us just month-in, month-out versus the couple of times a year that we've had them before.

So it's a great opportunity for us.

Thank you.

Kevin Foll, Next Generation Equity Research.

Thanks a lot and great quarter.

A lot of my questions were answered, but just a couple of clarifications and a few additional.

Going back to the decline in the impulse items that you're going to be talking about this fourth quarter, I just want to clarify -- does that mean that you're going to be less giftable?

Because I know that was a problem that you identified in the fourth quarter of '03 that kind of hurt traffic.

And I just want to clarify that that's going to be the case.

I think we will be a different kind of giftable.

You're going to see us elevate the quality and styling of all of our accessories as we go forward with -- you will see a different kind of offering, much more aspirational and probably synergistic with our positioning in furniture and textiles.

And then in terms of the opportunity in furniture delivery and the cost savings there, is there still a big opportunity to improve the efficiency of the furniture delivery?

And what steps are you going to be taking to do that?

You mentioned the outlet strategies already.

There is, Kevin, and our first priority because we're in the existing contracts, our first priority is to get out there and manage our existing providers better than we have in the past, and we're into that effort.

So the first improvement that we're already seeing is a significant improvement in the delivery experience and presumably a lower return rate.

The actual reduced cost is something that we will look at as we identify providers that we want to move out and make those opportunities available to our existing superior providers.

I would say in that one particular area, reducing the cost of the delivery is not our highest priority.

Customers buying a $4500 Lancaster couch -- we want them to have a great delivery experience.

We want the couch delivered in perfect condition and we don't want to see it come back.

And if we can do that, it's a total win.

Cost savings (multiple speakers).

The cost to save is really from not doing it right the first time.

Just a rehandling cost (multiple speakers).

And then you commented a little bit about spring, and I have seen the cleaning product line.

I think it's great and I think it's very well coordinated with the rest of the store.

Just a little more detail on that.

It seems like that is kind of in-line with your textile program that kind of once people get hooked on it, they keep coming back and it kind of generates more traffic.

Is that something that you're experiencing as well?

And what is the feedback you're getting from your consumers on that?

That would be true.

We're very happy with the performance of the line.

And we have more innovations in that whole utility category that we will be unveiling as the year unfolds.

Okay.

And a follow-up to the spring.

Your decision to bring in the outdoor furniture a little early, are you getting any reads on how the customer's reacting to that product?

We're very happy with our early numbers in the outdoor furniture category.

That's all I should say.

Any difference in circulation by quarter, or should we just kind of assume a similar run rate by quarter in '05?

You know, there are slight variances.

But I think from an overarcing point of view, I think you're okay with using kind of the overall 15%, say a 20% less than a full year in terms of total pages circulated.

Great, thanks a lot.

Rob Wilson, Tiburon Research.

Thank you.

Gary, can you talk about the traffic at the store level, given that you have greatly increased catalog circulation?

You guys have a national advertising campaign in magazines.

Why would the traffic still be flat?

It's really, Rob, more of a function of what we're selling than if you're looking at transactions.

We are continuing to pare and move away from selling smaller, lower ticket items.

And whether it's the number of items that are around the cash wrap and the small $5, $10, $15 items that we've sold historically that have been merchandised around the store and transitioning to a higher transaction type business.

That's really -- it's fundamentally, the evolution of the merchandising assortment and model.

Alright.

And also, your catalog, I guess it's 168 pages now.

I mean, can it get any bigger?

Is the extent of the size of the catalog?

It's going to get bigger for fall.

Wow.

It there -- help me understand the catalogs business.

Is there an opportunity to do a smaller catalog for prospecting, or are you going to come up with different versions, like your friends across the Bay are suggesting for '05?

I don't know.

Are my friends across the Bay listening into the call?

It's interesting and to give you my quick view on this, and you don't hold me to it, because things always change.

But I had been associated with catalog businesses now for almost 20 years.

And about every three or four years, somebody joins the Company with a new idea and thinks that they have a smaller book because that's cheaper to prospect with.

And I have never yet seen it work.

And I think is -- who is the most recent disaster that reported with it -- Jay, Jill (ph) or somebody -- who came out there and said we're going to circ (ph) a book in the store area and it's smaller and this and that.

Next thing you know, kaboom, it didn't work.

And generally, what you find out in the catalog business is your best customers want a bigger offer.

If you send out a bigger net, you have a better chance of catching somebody.

And sending out a smaller net, even though it's a little less expensive, isn't necessarily something that works.

So it will be interesting, but whatever I see new leadership in a Company, that is an idea that pops up about every time leadership changes or somebody new comes in.

I have not seen it work yet.

Pat, you mentioned the direct channel.

You went through the metrics kind of fast, but the operating margin and direct channel in Q4 -- was that 12.1%?

That's right.

And what was that compared to last year?

I think it was slightly higher actually last year, 15.6% last year.

So why the drop off?

There has been a little bit of deleveraging in terms of some of the ad costs in Q4 this year.

In Q3, we imploded on the second drop in the third quarter, right?

Of Q4 yes.

I thought you were talking about the full year.

And a little bit higher fulfillment cost.

And I remember Pat last quarter, you said that you expected to achieve 1ml of cost savings at the DC or in distribution cost overall in Q4.

Yes.

Did you achieve that?

Yes, we did.

Good for you.

And also, finally, Gary, the Corda Madera (ph) store is being remodel.

Is this similar to what you're going to do in the fall to the other stores?

Maybe.

Alright, well I appreciate you taking my call.

Andy Graves, Pacific Growth Equities.

Nice quarter, thank you very much.

Some additional sort of housekeeping items.

If I run the three quarters or the four quarters, should we be using about 34 million shares for Q1, 2 and 3, and then 39 million in Q4?

Yes.

It would be 34 for the first three quarters and -- 33.2 for the first three quarters and about 40 for the fourth quarter.

40.

That of course assumes that Q's 2 and 3 are breakeven, or thereabouts, instead of adding profits?

That's what that would assume.

And with same store sales, if we assume 0% in Q4, would that then suggest in sort of round numbers as Gary, your team edits out some of these discovery items, maybe same-store sales start off in the upper mid-single digit range and then sort of slope down towards Q4?

What we're saying today is we think comps in the first three quarters will be in the low- to mid-single digits, kind of mid-single digit range, and Q4 will flatten out.

Okay.

I thought that's what that meant.

And as we see Q4, just maybe to get a little clarity on that, we really see the dip just in the December period when real estate that was devoted to things like games and toys and other stuff will be just much less real estate devoted to items like that.

And the real estate would be devoted to other more core businesses.

So the presumption, though, is that you essentially are going to have negative 50, 200% (ph) same-store sales on certain categories, but are you assuming sort of similar mid-single digit comps for the remaining categories?

We have some categories that are growing significantly higher than others.

So we are trading out the real estate and trading out the sales for much more productive sales and some significantly higher margins.

Is there any chance that some of the items that you're replacing, or the items that you're replacing, these discovery items, could have fairly robust sales anyway?

That's a good chance.

I mean we will have different kind and different level of giftable items for Q4 because it's different than -- there's some unknown when you look at the products and the price points could work better than we think.

We're taking a very conservative view.

Okay, makes sense to me.

And then on the direct side, overall 25 to 35% on top of this past year's very large 75%, will that also sort of scale down as the year goes, or you'd start off with a much bigger percentage growth and then it would scale down until we get to Q4?

That would be right.

Okay, that makes sense as well.

And of the $41 of additional inventory, can you give us some sense of how much was this commitment to the outdoor furniture?

Was it 10 million, was it 20 million, some number like that?

In terms of the incremental on the outdoor furniture, it was probably about half of the increase.

It looks great, by the way.

Nice job on that.

Thank you for.

Sarbanes-Oxley cost you quite a bit of money in 2004.

Would you mind quantifying that for us if you could?

And when do you expect to sort of round the bend there and have that actually get some leverage on Sarbanes-Oxley in '05?

I think in the next couple of weeks, we will file our K and I think we will have rounded the bend.

So I think for all intents and purposes, I think we have those Herculean efforts from first-year done.

So it's probably about 1.6 million to $2 million for full year costs for Sarbanes.

In '04, then in '05, will it be something like half that?

Probably -- I think everybody is still trying to figure that one out, but probably 50% or 60$, what we think is recurring.

Okay, great.

And leverage on all of the logistics expenses and renovations that John, you're putting together and some of your team.

When should we begin to see some of that leverage on either cost of goods sold or SG&A during 2005?

From the first quarter, Andy, you will start to see improvements.

We are not making a lot of big investments right now.

What we're doing is letting the leadership team sink their teeth into the business and understand it well and decide how they want to change process.

But you will see a steady stream of improvements throughout the year.

And we are two months into Q1.

Any sense that you could give us on where sales are running quarter to date?

Not earnings, but sales?

I think it would be premature just because of the shift of Easter this year, the significant shift of Easter, so you really have to look at the March-April timeframe combined.

So I had rather not at this point.

With such a large commitment, upwards almost 20% of your inventory committed to outdoor-related items, have you seen any clear differentiation between warm-weather markets, a-la Florida, Texas, Southern California, Arizona; versus say New York, Boston, Chicago?

We sure have.

And is it material enough where the hope is whether it gets warmer like it has been the last week, should take you through a pretty good April time period?

I think it's fair to say we would anticipate that.

I think the extreme cold weather this spring in many eastern markets and also in the central, I think it probably slowed down demand on spring goods for all retailers.

So we are pretty happy though all the way through with our trip.

So while we see differences in different markets, in aggregate, we are pleased at our own plan.

CapEx in 2004 -- what was the final number on that?

And I apologize if you have already said it.

$20 million.

So we are flat CapEx year-over-year?

No.

We spent $13 million this year.

13 in '04, okay, and 20 million in '05?

Correct.

And D&A this year -- what was the number?

$14 million.

And in terms of growth margins and SG&A percentage for the year, what is the sort of specific or at least general guidance that you can give to all of us as to what sort of leverage you'd like to see on both of those lines?

I'm sorry Andy, would you repeat the question?

On gross margins, you're obviously going from essentially a 0% operating margin to a guidance of 200 to 300 basis points positive.

What should be the mix of the leverage between say gross margins and SG&A in terms of the percentage or the basis point improvement?

I think maybe you can think of it this way.

I think as we look at our operating margin going from 2% to 3%, and you heard from John talking about what the opportunities were within distribution as well as within the product margin's expansion from some of the things that we're doing there, I think suffice it to say, you can assume that there's a fair amount that is going to come out of the gross margin line.

Okay.

So by the end of the year, would you like to try to keep SG&A sort of flat year-over-year and try to generate most of that improvement off GM's?

We probably don't want to get into that specific a detail at this point right now in guidance.

Thank you all very much.

Nicky Strauss, Strauss Asset Management.

I wanted to ask about your extension plans.

It seems to me that -- it's (indiscernible) disappointing to me that you're going to only open one store this year.

It would've thought by now you would have the formula down to the point you would be opening more stores.

Could you elaborate on that and when you might expect to see square footage growing in the (multiple speakers) range?

Sure.

As we look at our investments for this year, I think the biggest leverage for us still is driving performance in our current store base.

So as we sit here and talk about where we want to place our bets, I think the investments we're going to make to continue to refine the model in our current stores, refixture and position our core businesses in a more dominant way and leverage the current fixed occupancy costs that we have, we think it's the right investment to make.

And we're being very selective about new stores.

And if we hone the model and we feel better about how the thing's performing, we'll step on the pedal a bit.

But I think the wise decision for us is to take the markets that we are in, which are basically all of the key markets and strengthen our position in those markets.

And I think it's important for the brand to kind of do that because we have to protect marketshare where we're at and build marketshare where we are at.

And if we kind of divert too much capital to growth in new stores, we could be picking up marketshare in some markets and then losing market share in current markets.

I think a lot of things that we're doing today, you are seeing a lot of our ideas and innovations pop up in other peoples' catalogs 12 to 18 months later in other stores.

So we think we have to keep fortifying our position.

And then once we fine-tune this thing, we will speed things up.

So do you anticipate a greater store growth next year than, or --?

I think that's fair to say, we would anticipate greater store growth next year, yes.

I don't mean going from one to two, I mean going from one to 10 or one to eight or something --.

I think it's probably safe to say if we perform at the levels we expect this year, we would go from 1 to 5 to 10, somewhere between the 5 and 10 range.

And other question.

Design within reach seems to have captured a certain portion of your market and brags about that.

Where do you see them in your portfolio?

A portion of our market?

They did the same customer demographic, but a different clearly different taste levels and stylistic point of view.

So I don't think there's a true competing customer.

I don't think somebody's thinking about buying a sofa at Design Within Reach is probably not thinking about buying a sofa from Restoration Hardware or vice versa.

There's very different stylistic positioning and a different point of view to the business.

And I think what they do is fantastic.

I think they run a great business and it has had a terrific job.

And they have really captured that kind of modern aesthetic at the high end.

But I think they could open right next door to us in every location and I don't think they would take any business from us.

I remember you were trying to get into the high-end design in between high-end and let's say.

They are a very, very modern aesthetic though, a highly contemporary aesthetic.

That's not the aesthetic.

We're more timeless updated classics, timeless classic point of view with updated with a twist.

It's -- I don't think there is a piece of furniture that's on their floor that we would put on our floor and then there's probably not a piece of furniture that's on our floor that they would put on their floor, or catalog, vice versa.

Thank you.

We have no further questions at this time.

I'd like to turn the call back over to management.

Okay, everyone, thank you for your time and interest and we will talk to you next quarter.

That does conclude today's conference.

You may not disconnect your lines and thank you for participating.