RH (RH) 2005 Q1 法說會逐字稿

Good day. (OPERATOR INSTRUCTIONS).

At this time I would like to turn the conference over to Pat McKay, the Company's Chief Financial Officer.

Go ahead please.

Good afternoon everyone and welcome to Restoration Hardware's first quarter 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 website at www.RestorationHardware.com under Company Information, Investor Relations event calendar, or by dial-in at 800-283-4593.

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

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

At 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.

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.

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

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

These statements will include, without limitations, financial guidance and statements related to the implications of the Company's first quarter 2005 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 in our most recently filed Form 10-K and our earnings release posted on the company's Website.

Any guidance we 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.

And now let me turn the call over to Gary.

Good afternoon.

I'm going to review the highlights of our first quarter results, comment on our outlook for the second quarter, and review some of the important initiatives planned for the second half of this year.

Let me start with a review of our first quarter.

Comp store sales increased 5%, on top of a 9% increase last year and a 12% increase in the first quarter of 2003.

This equates to a 28% comparable store sales increase in the first quarter over the past three years.

We experienced strong growth in outdoor furniture, textiles, hardware, bathware and lighting, while strategically contracting our non-core discovery items in fringe accessories categories.

Merchandise margins were up substantially in the quarter, as we are seeing the benefits as shifting to a higher margin mix of products.

We are also experiencing a lower cost of goods as a result of the benefits we have realized from the creation of the vertically integrated product design merchandising and sourcing organization.

We expect merchandise margins will continue to be up in every quarter of this year.

Our merchandise margins increased despite the fact we're transitioning out of and marking down the last of our non-core categories like games, electronics, discovery items and a good portion of our garden business.

The elimination of these categories will make room for the expansion of our core businesses this fall.

In addition, we're also planning to launch an entirely new accessories strategy that will position Restoration Hardware as a destination for aspirational accessories and gifts.

You'll also note a majority of our lighting assortment is currently marked down as we prepare for the launch of a new lighting strategy this fall.

Given the many comments made by other retailers regarding outdoor furniture, I also want to comment on the timing of markdowns versus a year ago.

We have accelerated markdowns versus last year by approximately four weeks on one outdoor collection, which was planned up significantly over last year and has performed slightly below our expectations.

With this adjustment we expect inventories to be clean at the end of the season, and still have realized strong margins given the higher initial mark-ups achieved from our sourcing strategies.

Our direct business continues to post the most impressive gains in the industry, as revenues increased 50% on and top of a 94% increase in last year's fourth quarter -- first quarter, excuse me.

We continue to see positive trends in average order, sales per book and sales per page circulated.

Our Web business continues to grow at an exponential rate, and now represents 45% of our direct sales.

As we look forward, we expect continued positive comparable store sales in the mid to high single digits in the second quarter, on top of a 9.4% increase last year.

We expect merchandise margins will continue to improve versus last year despite aggressive markdowns that will be required to clear the non-core categories, transition the lighting assortment, an end the quarter clean of seasonal inventory.

We expect our direct business to continue to post an impressive gain in the range of 45% to 50% above last year, versus an increase of 103% in last year's second quarter.

As we mentioned in the press release, we plan to invest approximately $15 million into the remodeling and refixturing of all of our stores, allowing us to expand and improve the presentation of certain core businesses this fall.

We're launching meaningful merchandising initiatives in furniture, lighting, textiles, accessories and bath.

In total, these initiatives will represent the single largest merchandising evolution at any one time, including the initial launch of our new merchandising strategy in the spring of 2002.

We will also be introducing a new lighting strategy this fall, which we believe will further establish Restoration Hardware as an authority in this category.

We're also excited to re-launch our custom upholstery strategy -- Our Sofa, Your Style -- which, as many of you may remember, was successfully introduced in the fall of 2003 but scaled back due to our inability to execute on the supply chain side.

This fall we'll reintroduce the program with over 60 custom fabrics, delivered in 45 days or less in every major market in the country.

We will also have enhanced delivery times for stock furniture and be able to deliver in one week in most major markets.

We believe this eliminates the previous competitive advantage that existed and was enjoyed by one of our core competitors.

We have once again enhanced the design of our catalog, and you'll see marked improvement in our presentation and organization of the book.

We have upgraded the styling and photography to represent the products in a more aspirational manner, positioning Restoration Hardware as an interior design resource.

We have also expanded and redesigned core businesses to communicate our category dominance and authority, and believe this will be the most exciting home catalog in the marketplace is fall.

A major re-architecture of our website is currently underway which will greatly enhance our presentation and usability.

The first phase of the new website, which will launch this fall, will follow with continued enhancements.

As previously communicated, we're moving to purify the concept and positioning of Restoration Hardware as the premium home lifestyle brand in the marketplace by continuing to strengthen our core businesses, and editing all non-core legacy discovery items.

While historically fun and interesting, three years ago these products accounted for 47% of our total sales and were not relevant to building authority in core categories and, if anything, diffused the overall presentation and credibility in our important businesses.

Today, accessories and discovery items represent approximately 20% of our total sales.

We have made a decision to move even more rapidly toward concept clarity and expect to further edit this category.

We anticipate that this will result in a negative effect on the Company's fourth quarter top line and expect comps to be flat to slightly negative.

On the flipside, these products have historically had the lowest merchandise margins.

So we expect merchandise margins to increase significantly in the fourth quarter and earnings to be significantly over last year.

Also, as mentioned in the press release, the Company has announced the hiring of Lisa Versacio, Senior Vice President of New Business Development.

Lisa will begin working on developing a new brand and growth vehicle for the Company.

We expect to test the new concept with the introduction of a new catalog in the fall of 2006, or spring of 2007.

Lisa spent the last five years at Williams-Sonoma, Inc. where she developed and launched the West Elm catalog in stores.

I would like to also comment on the progress we're making on the supply chain side of our business.

Under the leadership of John Tate and his team, we're operating as a completely new Company versus a year ago.

We're seeing an improvement our service and cost monthly, and now have the confidence that we can build the supply chain into a long-term competitive advantage.

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

Good afternoon everyone.

I would like to take a few minutes and share several of the accomplishment and areas of focus for the operations team.

Because we believe everything starts with the right people, I will often talk to you about the operations staff on these calls.

We have essentially completed the re-staffing of the senior team.

The CIO, SVP Supply Chain and SVP Human Resources are now on board and well assimilated into the Company.

This group is beginning to generate significant change, which I will tell you about in a moment.

The Vice President of Global Sourcing, now a part of the operations group, continues to extend the reach and capabilities of her organization as we increase our sourcing directly from manufacturers abroad.

Additionally, we expect to announce the appointment of a Senior Vice President of inventory planning and allocation within the next week or two.

This position has been vacant for some time.

The arrival of this senior leader will create substantial opportunity for better management of inventories and improved gross margin through allocating more effectively to our stores.

The supply chain continues to evolve and improve.

You may remember that in September 2003 a majority of our hourly associates in our Baltimore distribution center voted to be represented by a labor union.

As of April 2005, the union local representing our employees in that facility was officially decertified as a result of a petition for decertification signed by a majority of our associates.

I am proud of the managers who led the facility in a way which now recognizes the importance of our associates, and of our associates themselves, who decided to take responsibility for their own individual destinies.

This change allows us to run the facility more flexibly and innovatively, and in a way which recognizes and rewards superior individual contribution.

More importantly, it is symbolic of the changes underway across the entire operations function.

Productivity in each of our warehouses is increasing.

We have substantially upgraded the leadership in Baltimore.

We have completely reengineered the way we flow and stage product through the warehouse.

As a result, we were able to eliminate 120 temporary workers, a workforce larger than our permanent staff.

Our full-time associates are more engaged and busier.

Productivity is up significantly.

As we have begun measuring performance, execution issues are decreasing quickly in the warehouses on both coasts.

We're reengineering several aspects of our transportation network.

We have improved a rate structure, streamlined DC to store replenishment, and nearly eliminated duplicate shipments through better DC execution.

We're beginning to build a service culture.

For example, we're migrating from four-hour delivery windows for replenishment freight to arrive at stores to firm appointment times.

As we reengineered each market's delivery schedule and process, a member of management from the DC was physically present in the market to assure smooth execution and understanding of our customers' problems.

It may seem like a small thing, but last month in some markets the drivers started delivering cookies or bagels to the store team along with their freight.

It is symbolic of an attitude.

As a result of the things above, and many more, we have reversed a negative cost trend.

Supply chains cost as a percent of sales in Q1 were lower than both budget and prior year.

While Pat won't let me be any more specific than that at this early date, I can say that you will see this trend continue and intensify.

A special note, I would like to reiterate what Gary told you.

I'm pleased to be able to say that as a result of systems and transportation redesign, as well as the careful planning of our merchant partners, we will be positioned to offer 45-day special order furniture delivery in major markets to our customers beginning this fall.

Finally, we began to work in earnest during the first quarter to architect a completely new systems platform.

Our systems are a good news/bad news situation.

The bad news is that while we can accomplish our mission with current systems, most, if not all, need to be replaced if we expect to be truly excellent.

The good news is we're still small enough to make this multi-year effort very achievable without financial penalties often associated with discarding existing systems.

We approach this path carefully.

We are fully aware of the risks and difficulty.

We will focus on one major application at a time, starting the next only after successful completion of the last.

I will be speaking more about this in the coming quarters.

In summary, the end of Q1 finds the operations team improving service, reducing cost, and ahead of schedule on our major initiatives.

Though I'm pleased with our progress so far, we have lots of work ahead of us.

Now I'll turn it over to Pat.

First I would like to take you through our financial performance for the first quarter of 2005.

And then I will provide guidance with respect to our expectations for the second quarter.

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

First quarter net revenue was up 19% to 117.5 million, versus 98.9 million in the first quarter last year, with comparable store sales for the quarter up 5% and direct-to-customer revenue up 50% from that of the prior year's first quarter.

Along with the increases in revenue, we experienced substantial expansion in our gross margin of 250 basis points, driven by a combination of higher product margins, occupancy leverage, and to a lesser extent initial results from distribution and supply chain improvements from the leadership changes that we made late last year.

Selling, general and administrative expense in the quarter expressed as a percentage of sales were slightly higher than the prior year by 10 basis points.

Consequently, we experienced a 240 basis point improvement in our operating results for the quarter as compared to the prior year.

We ended the quarter with inventory levels up 22% compared to the prior year's first quarter, which is up in relation to our higher level of sales.

I'll touch on each of these areas in a moment as I review our performance in more detail with you.

Results for the first quarter was a loss of $0.09, improved from last year's first quarter results of $0.12 per share and the first quarter fiscal 2003's loss of $0.17 per share.

Operating results improved an impressive 27% for the first quarter as compared to the prior year.

Turning to retail sales performance, as mentioned, we experienced in 5% increase in comp store sales on top of a 9% increase in the first quarter of fiscal 2004, and an 11.9% increase in the first quarter of fiscal 2003.

These increases reflect our customers' positive response to our continued merchandise repositioning and our seasonal spring and summer product offerings.

During the first quarter we experienced a lift in the average retail dollars per transaction of 7%.

Total retail transactions were flat.

We believe that will continue to experience this kind of transactional result with the changes that we have made in our merchandise offering.

The simplification of our operations, whereby we sell less units but generate higher sales, will afford us increased opportunities for cost savings throughout our stores, distribution centers and supply chains.

In the first quarter of 2005 we opened our second outlet store and we held warehouse sale events.

Sales generated from our two outlet stores, coupled with revenue from warehouse sale events, totaled 2.9 million in the first quarter of 2005.

We did not hold any warehouse sale events in the first quarter of 2004, and no outlet stores had yet been opened.

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

As we open additional outlet stores, and four more are planned in the balance of this year, we expect to eliminate the need to hold separate warehouse sale events which tend to be less productive.

Sales of these goods will tend to be at a lower product margin, and in fact in the first quarter had a 90 basis point negative effect on our overall gross margin as compared to the prior year.

I should remind you that while this revenue has been reflected in the retail segment, it is not considered in the calculation of comp store sales.

For the first quarter of fiscal 2005, our retail segment realized a $7.1 million four wall contribution after cost of district management, or an 8.4% contribution margin as stated as a percent of segment revenue.

This compares with a $4.9 million contribution at 6.4% of net retail revenue reported in the first quarter of the prior year.

Gross margin for retail was favorably impacted by store occupancy leverage on higher sales, and product margin expansion in the initial improvements we are realizing in our supply chain and distribution costs as compared to the prior year's first quarter.

Our selling, general administrative expenses segment also benefited from favorable benefits of lower payroll and other store expenses.

In the direct channel, which includes sales from both the catalog and Internet, revenue was up 50% to 32.8 million, on top of a 94% increase in last year's first quarter.

Catalog revenues grew 45% in the quarter to 18.1 million.

And Internet sales grew 57% to 14.7 million for the first quarter.

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

Catalog circulation for the first quarter was up 20%, with pages circulated up 45%, and remarkably with resulting net revenue up 50%.

A key point to note is the fact that while we have been growing the pages circulated at a very rapid pace, the productivity per page has also been expanding.

We'll continue to reassess the appropriate circulation strategy for the balance of 2005 as we see opportunities to leverage productivity successes in our catalog mailings.

Segment profitability for the direct-to-customer segment was 14% in the first quarter as compared to 13.8% in the prior year, with higher profit margins driving improved performance.

At the total Company level, we continue to see expansion in our gross profit dollars in the first quarter to 35.6 million, a 29% increase versus the first quarter of the prior year.

This was the result of increased revenue coupled with the 250 basis point improvement in gross margin, expressed as a percentage of revenue, to 30.3% from 27.8% in the same period last year.

The improvement in gross margin rate is attributable to leverage achieved on store occupancy expenses on the higher sales levels, expansion of product margins, as well as initial improvements in our supply chain and distribution costs.

The improvements we realized in our supply chain and distribution costs is meaningful, as it marks the reversal of a negative cost trend that we have been experiencing for many quarters.

Selling, general and administrative expense was 40 million in the first quarter of 2005, or 34% of net revenue, compared with 33.5 million or 33.9% in the prior year.

Cost of advertising, primarily those costs associated with the catalog, production, and mailing, were as expected higher in the first quarter when expressed as a percentage of net revenue.

As our direct-to-customer business grew at a more rapid pace than retail, excluding advertising costs, selling, general administrative costs actually realized leverage of 100 basis points in the quarter compared to the prior year, notably in payroll.

Our operating results for the quarter improved by 27% to a loss of 4.3 million, compared to the operating loss reported in the prior year of 6 million.

Our effective tax rate was approximately 40% for the quarter.

Our net loss for the quarter of fiscal 2005 was 3.1 million or $0.09 per share, as compared to a loss of 3.9 million or $0.12 per basic share a year ago using a weighted average share count of 33.1 million shares for the current fiscal quarter.

Turning to our balance sheet.

Our outstanding balance on our line of credit was 52.4 million at the end of the first quarter, and up 18.6 million as compared to year-end.

As we discussed at year-end, we had a substantial amount of inventory in transit for which payment was made during the first quarter.

Inventory at the end of the first quarter was 144.2 million, up 22% compared to the prior year's first quarter, and is up in relation to our higher level of sales.

Capital expenditures for the quarter was 2.3 million, with the largest portion of spending occurring for IT in support of Internet business, as well as spending for newly opened outlet stores and other distribution and supply chain expenditures.

Depreciation and amortization expense for the first quarter was $4.1 million.

Our current plans for the second quarter include the remodeling of a majority of our retail stores in support of the expansion of certain of our core businesses.

The capital spend associated with this remodeling effort is approximately $15 million and will be substantially completed in advance of the fall selling season.

It will also require the removal of certain fixtures in our stores.

The remaining depreciative cost of those fixtures is estimated at $1.2 to $1.6 million and will be fully expensed in the second quarter, resulting in a non-cash charge of $0.02 to $0.03 per share.

Common shares outstanding were 33.2 million at the end of the first quarter, and we finished the quarter with approximately 8500 shares of preferred stock, which is convertible into 4.3 million shares of common.

Now turning to guidance for the second quarter of 2005.

We expect comp store sales to be in the mid to high single digits for the second quarter, on top of comp store sales of 9.4% in the prior year.

Comp store guidance for the second quarter considers any disruption that we might experience during the store remodeling effort.

We expect to see second quarter direct-to-customer revenue increase 45% to 50% on top of an increase of 103% in the prior year.

We expect to see results for the second quarter of a loss of $0.03 to $0.04 per share, with a share count of 33.2 million common shares.

This earnings per share guidance excludes the impact of the non-cash charge of approximately 1.2 to 1.6 million, $0.02 to $0.03 per share associated with the store remodeling effort previously described.

Inventory for the second quarter is expected to increase by 20%, and again will be in line with our year-over-year projected sales growth.

Now I would like to open the call up to questions.

Operator?

(OPERATOR INSTRUCTIONS).

Rex Henderson with Raymond James.

Congratulations on a good quarter.

A couple of quick questions.

First of all on the gross margin line, it is pretty impressive gross margin expansion.

You talked about the three elements that went into it.

Can you quantify it for us, or give us a proportional ranking of how much each of those three things contributed to the gross margin expansion?

This is Pat.

I would describe it this way.

Occupancy leverage was at the head of that contribution, but followed very closely by product margins.

And then to a lesser degree, distribution supply chain costs, because we're getting traction there.

But it is just starting to really kick into high gear.

Okay.

I'm interested in the traction you can get on supply chain, because that has been a problem for you in the past.

Can you give me any sense for how much opportunity you think there is for that this year or next year?

I don't think we can quantify that yet.

We're trying to understand what our base is.

We're trying to do a much better job of statistical measurement of the actual work performed.

At this time next year I would be in a much better position to make predictions.

But I would not want to at this point.

I asked that question last quarter, and I will ask it again this quarter, and you can expect me to probably ask it again next quarter.

Sooner or later I will answer you.

On the -- you hired someone new to develop a new concept, which kind of raises the question of where you think your core concept is going.

You haven't talked much recently about what you think the store opportunity and the total revenue opportunity for the core Restoration Hardware concept is.

I wonder if you could kind of refresh us on that and give us an idea of when you think you're going to restart store growth in a meaningful way?

Sure.

This is Gary.

I will take that.

We believe that the core Restoration Hardware concept as it is positioned today can probably be somewhere between 1.2 billion to 1.5 billion long-term.

That would include a store count of somewhere between, I would say, 150 to 200 stores and a direct business in excess of 300 million.

In that, you think that you can get sales per square foot -- or selling square foot in the Restoration stores to what, 650 or so?

Is that right?

We believe we could perform at $1 per square foot equal to the highest performing mall-based target competitors in the market today.

I will let others ask some questions right now.

Thank you.

Kristine Koerber, JMP Securities.

Congratulations on a great quarter.

A couple of questions.

John, you talked about the system upgrades.

Can you tell us when you might begin any system upgrades?

Would it be this year or are we looking out to '06 at this point?

We began working on one particular one, which I will probably describe later in the year.

It is a significant application and we would need to -- we have begun to scope out the requirements now in anticipation of a mid '07 rollout.

What --.

I'm sorry, '06.

'06.

This time next year.

Gary, can you remind me on the remodels when you're going to start the remodel process and how long it is going to take?

Is the work done at night?

And when will the stores be completely set with new fall product?

Sure.

The process starts in the next couple of weeks and will continue through the end of July.

The stores will remain open during the remodel process.

Some of our best stores get a more extensive remodel.

Then our lower volume stores -- we're going to touch I think in total almost 90% of our stores in some way, shape or form from a fixturing point of view.

And we expect the project to be complete when we launch our Fall catalog on -- the end of July.

With regard to the Fall catalog launch, I believe it is going to be a bigger book than a year ago.

Can you tell us with the page count is going to be in the circ?

Yes, we plan the page count will increase to 188 pages, up from -- what was last year's count? 150? 160 pages.

We will have an additional 28 pages in this year's fall book.

And circulation I believe is different by drop.

It's actually up 14% for the quarter, and probably the overall pages circulated would be up 50%.

For Q3?

Q2.

Q2.

I think you're asking for Q3, right?

Q2 actually. (multiple speakers).

(multiple speakers) -- the fall book will be 188 pages.

But the fall launch of the fall book is at the end of July, so it will be Q3?

Yes.

It is the very last week of July.

It is really Q3 mailing.

It will drop one week earlier than a year ago.

And then as far as the direct business, looking at the direct business, you had some unbelievable growth there, 40, 50% range.

Going forward, where do you see it leveling off?

Is this a 20%, 25% grower longer-term?

Obviously, we're not going to be able to continue compounding at the rate we have with 50% increases on top of 100% a year ago.

If you would have asked me a year ago would I have thought that the increases would be as high as they are today, I would have probably said no.

So we're still learning as we mail each season, as we improve the merchandise and the presentation of the merchandise.

But I would expect that this book at some point will start to level off.

With that said, I believe there is any more opportunities for Restoration Hardware to explore subcategories within the direct-to-customer business.

Just lastly, any more color on the new brand you're thinking about developing?

No color at this time.

Paula Kalandiak, Roth Capital.

Great quarter.

First question is, you had done a national ad campaign a couple of quarters ago, I believe, and I was wondering if you're going to be doing any more of that, or if you currently are doing that?

That was in the fall of last year.

And we do not plan to repeat that ad campaign.

We plan to focus our marketing expenditures on our catalogs.

And can you update us on how your home cleaning products are doing?

We're very happy with the response of the customers to our private-label cleaning and chemicals collection.

You'll see us expand that assortment as we go forward.

And then finally, with regards to the custom upholstery program, can you comment on how the margins on custom upholstery compare to the margins on something that is already upholstered?

The margins are slightly higher on custom upholstery.

Rob Wilson, Tiburon Research.

Pat, could you talk about credit concerns that may arise in Q3 and maybe alleviate some of my fears at least?

Can you give me a sense for where the line of credit will be at the end of Q3?

Obviously, as we have looked at our plans as we came into the year, which included the consideration of remodeling that we described to you, as well as any other CapEx, we have obviously factored in our thinking as to what our credit facilities will enable.

But at the end of Q1, as I talked about, we're about in the 53, 54-ish level.

At the end of Q2, we see it probably being at about the same level in terms of absolute dollars outstanding, which will be up about $14 million over the prior year.

And then leveling off as we get into Q3 and then lowering into Q4 as we move through the selling season and the holiday selling season.

But we're perfectly comfortable that we have adequate liquidity and availability on our credit facility to be able to accomplish our goals and objectives for the year.

So you see it declining in Q3?

The line of credit?

No, it won't be declining.

We will have less of a gap vis-à-vis the comparison with the prior year.

We will still be lifting in terms of the absolute dollars outstanding on the debt.

But it won't be as much of a gap as we have had in the earlier part of the year.

I would just say, as sales are increasing at 20%, obviously we have got to buy inventory to support that.

So that will, at today's operating performance of the Company, increase debt levels.

Inventory at the end of Q3 would probably approximate the increase in sales level?

Actually I think we'll probably moderate that a bit if we get to the end of Q3.

We will see it up only modestly year-over-year.

Okay.

Gary, you talked about the supply chain being a strategic competitive advantage.

How -- could you go further on that topic?

Sure.

John just said don't say too much.

I would echo John's point.

One of the -- the bad news/good news about how we have been operating over the last several years, this Company has been cash starved since 1999, 2000, and has not had the resources to put in any kind of significant systems upgrades since then.

So the bad news is, as one vendor came in and told as that they were trying to help us figure out how to launch a gift card, we are one of the few retailers in America without a gift card.

Can you believe that?

You're the only ones that your systems are so old we can't figure out how to launch a gift card.

And that is really bad news.

The good news is we're fully depreciated here on the systems base.

So as we think about how we want to run this business strategically over the long run, we have an ability here to kind of whiteboard the operation.

And we have a very clear vision of -- what is (sic) the processes we want to put in place in how we want to run this business.

That, coupled within supporting those processes with really state-of-the-art technology to enhance overall productivity and efficiencies in the Company, is probably an opportunity that not a lot of companies have.

Because as companies grow they have to strategically keep pasting on a new system or a new piece of infrastructure, because you have legacy systems that are fully depreciated and you have to kind of paste it together.

So we're very excited about the fact that we're small enough and we do not have a significant investment into the current systems that we can really architect from -- a complete vision how we're going to run this Company over the next five to ten years.

And not a lot of retailers have that opportunity.

So we're very excited about that.

We've got, I think, a stronger team, a lot of smart people here that have a strong point of view about how we can do it better than anybody else in our space today.

Just two more questions.

The merchandise margin, your IMUs on outdoor furniture this year versus last year, is it materially higher?

It is.

Can you refresh -- if you go back three years, let's say to Q1 2002, how much higher are your merchandise margins overall?

Significantly.

Throw out a number?

No.

That's a good try.

Finally, your friends across the Bay had mentioned that sales productivity per catalog page is going down.

Why would yours be going up?

I will let you make your own deductions or conclusions on that.

I would say it is unfortunate that that is happening across the Bay.

But what are you doing that you think is improving your sales productivity?

We're doing a lot of things that, again, is probably information that is not appropriate to share in a conference call.

Fair enough.

Thank you.

Andy Graves, Pacific Growth.

Great quarter, particularly on the top line, and so congratulations.

It sounds as if both on the DT side and a little bit also on retail at the store level, that sales are running at least above expectations that we had in our model and I think most folks had in their models.

Yet there is not much change on the bottom line.

Where are the additional expenses coming from?

Or should we expect some diminution of gross margins in Q2 or maybe also in Q3 as you clear inventory?

Good question.

Yes, I am not familiar with your model, but based on our expectations we felt like the additional improvement in earnings we generated was commensurate with the revenue increases.

We hit, actually, the guidance that we established in terms of top line performance, and came in improved over what our bottom line guidance was, so --.

Q1 I think was fine.

I am thinking more going into Q2 it appears as if the top line is going to be materially better than what most people were expecting, which is great news.

And wondering what is it in either the cost of goods sold or other cost items -- cost lines that would cause a lack of additional leverage on the bottom line?

Let me add a little color to that.

I would say that based on my comments, the fact that we are continuing to contract non-core businesses, we have probably higher projections for higher markdowns than we originally anticipated in our current projections, as we will aggressively push to clear those product categories by the beginning of the third quarter.

Where historically we may have let some of the markdowns run into the third quarter, our goal is to be really whistle clean for the drop of that catalog.

That is going to put some pressure on merchandise margins if you compared Q1 to Q2.

Got it.

And for the year, given that we have seen both Q1 and the guidance for Q2 sales essentially above where most people were thinking, should we expect the guidance for the year sales to also be commensurate and to be better than what some of us were thinking?

I think not at this time.

We have a lot of changes that are going to be happening in the third quarter.

We would like to see the results of the many merchandise initiatives, the remodels, the changes in our catalog, so on and so forth.

We would like to get a month under a belt and see what those new trends are.

But today we think it is appropriate to remain conservative, based on the amount of change that will happen in the business in the third quarter.

Michael McTighe, Brean Murray.

Can you discuss where you are in terms of fulfillment rates at the end of Q1?

I think we have ended up in both of our -- on our direct side as we enter into the summer program, 90% plus in terms of fulfillment rates.

And on the retail side, probably a little bit slightly below that.

And then kind of following up on the last question, anything -- any change in terms of the guidance on the operating margin?

Are you still looking for that 2% to 3% operating margin for the year?

Yes.

Lastly, do you guys think that given how the subtle (ph) changes in working capital, what you are seeing now with CapEx, and those types of things, that you're going to achieve free cash flow positive levels this year?

We expect we should still be able to realize that.

Janet Kloppenberg, JJK Research.

Congratulations.

Pat, just a couple of questions on the remodel.

How many stores will be remodeled in the second quarter?

Probably 90% of our stores, so 90 stores (multiple speakers) will be touched.

You are going to keep the stores open during the renovation and you don't think -- I think you said something about comp stores being disrupted.

Can you talk a little bit about that?

The way the program will work is certain rooms and parts of the store will be (indiscernible) cleaned (ph) off as construction teams work throughout the day and in the evening.

And then they will remove the (indiscernible) and move to a different part of the store.

I would anticipate in many of our stores, 20% of the sales square footage maybe corridored off during different times of the month of July and/or August.

The stores will happen in groups starting in the June period and moved through the last week of July, with all stories being completed about I think July 20.

How long will the individual store renovation take?

It all depends on the scope.

There are very different scopes of work happening.

We are investing more significantly in our highest volume stores.

Gary, who did you say -- how many stores you thought the brand could hold but I didn't -- maybe I missed your answer about when you would begin again to open new stores?

I would think if we have the kind of year we expect to have this year, we will, as we look forward, start to think about opening 5 new stores in '06 and possibly going back and remodeling and expanding 5 or (ph) 15 stores.

The way we think about Restoration Hardware today is, if you think about our current real estate that we have, the majority of that real estate was not designed for our current concept, the current core businesses that we merchandise to our customers.

So we have had to back into this real estate strategy and we have had to go through now two significant rounds of refixturing, one in 2002 when we spent about $15 million.

And again, we'll spend another $15 million trying to take the existing physical plants and making them present the goods in the most appropriate way.

As we think through the future here, if you think about us over the next five years, we are working on what we call a quantum leap Restoration Hardware prototype store that will, from the get go, be designed to present these core businesses in a way that is superior to others in the marketplace in every category we compete.

The design of the store, you'll redesign (multiple speakers).

Yes, completely redesign the stores based on the current assortment.

So the idea, and I might think about this much in the way maybe people thought about the Williams-Sonoma Grande Cuisine store several years back, when there was an existing basic store and the company started to open the Grande Cuisine stores.

And as the company rolled out the concept, they would open a certain amount of new stores and remodel and refixture existing stores.

So I think about this -- I think about five new stores, six and five remodels.

And as we go out, you might see 10 and 10.

And it all depends in what the real estate availability is and what the landlord's enthusiasm is based on wanting to have the new concept, the new prototype as opposed the old prototype.

But we would think in five years you might think about us having 150 stores out there, maybe more, with 60% to 70% the stores in an entirely new format.

I was also interested in your -- these -- I think you're going to have a quick ship furniture delivery program and then a 45 day custom program?

Right.

Those will be launched in what, July, Gary?

In the fall.

Yes.

So they will be launched both in-store and in the catalogs?

They will.

Can you just talk to us about the executional complexities involved in these programs, and what challenges you face to make sure that you don't have delivery issues and lose customers and that kind of backorder problem (multiple speakers) past?

Sure.

Let me make one point and I will turn it over to John.

If you look at our in-stock furniture programs today, we are in many major markets today and now executing at a one to two week delivery time period in most of the major markets, and believe confidently we can deliver in one week.

The special order program is one where today -- we have been at anywhere 8 to 12 weeks on special order upholstered furniture in the past.

We have been able to re-engineer that supply chain part of the business and believe we can execute in 45 days in all the major markets.

But let me turn it over to John for more color.

I think about it in three ways.

I think first of all, we have to have confidence in our vendors to support it.

And we have a new furniture merchant team in place, and have had almost since I have been here -- has really got (indiscernible) place.

I have high confidence in that.

Secondly, we have to have systems that will support it.

And we have not previously had systems that would support it at retail we will have by the fall.

And then thirdly, we have to be -- we have to execute well enough in the DCs that we can be confident scheduling appointments at the appropriate time.

We have not historically had that.

I believe that we have reached the point where we have confidence in our ability to ship out of both DCs in a way that allows us to optimize scheduling.

So those are -- I could talk about a lot of different things, but those are 3Q legs of the program that we feel very good about.

Gary, I just wanted to ask another question on the outdoor furniture.

Not just with the guys across the Bay, but a lot of people have talked about the weather issues negatively affecting that business.

I know you said the margins were better.

And I think you said one line underperformed slightly.

Would you say the category performed to your expectations both in terms of sales and margins?

Yes.

The category -- we had very high expectations.

But I would say in general, the category had significant comp store sales increases and huge growth on the direct side.

And you only -- (multiple speakers) have one group marked down right now?

Right.

We had only have one of the three groups marked down.

We have three major groups in the store.

We have the Montauk Wood collection.

We have our Classic Garden metal collection.

And we have our All-Weather Wicker collection.

We have taken the Wood collection down; historically, we have run out of that.

We bought it probably too aggressively in hindsight, and were too optimistic.

But our overall outdoor sales are significantly above last year in all channels.

We were just probably a bit optimistic.

And then my last question in the DTC side of the business, are you seeing that driven by furniture?

Furniture has always been the largest category in our direct-to-customer business, but all categories are performing very well.

You wouldn't say that the largest contributed to the gain in sales is coming from furniture?

Furniture sales are consistent year-over-year in terms of proportionately to total sales and direct.

They didn't get bigger as a percentage?

No.

Thanks very much.

Congratulations.

Rex Henderson, Raymond James.

One question.

I want to ask about the second quarter guidance.

You said that the mid single comp guidance included expected disruptions.

Can you quantify a little bit about how much disruption or how you think about the disruption and how much -- I'm trying to get a handle on how much risk there is due to the store remodel?

That one -- we have a little bit of history, because in 2002 we remodeled by stores over the course of about the same amount of weeks.

And we touched about as is many stores in about the same amount of significance.

So we think we have that factored in.

We hope we're conservative.

There may be a little risk.

There may not be -- there may be a little upside.

That is really one that is very hard to forecast.

We're going to be as efficient as possible and try to have as little disruption as possible in our stores.

And we believe our sales numbers are -- we feel confident in them today.

I was looking back at the transcript from a quarter ago.

It appears that you accelerated the remodel somewhat, and that more stores will be touched and the CapEx involved has gone down.

Can you explain a little bit about why that program has shifted some?

No, I think the specific remodel spend is pretty consistent.

I think what we may have described is total store spending was higher.

But that would have included other things like new store openings and outlet stores, and just normal types of CapEx things that we do incrementally beyond the specific projects.

But the remodel is actually -- was embedded in those numbers last time.

That's helpful.

Thank you.

Bill Tische (ph), Fideau Capital Management. (ph)

How about Sarbanes-Oxley?

I know -- I think that cost you about close to $0.05 a share or something like that last year.

What is the ongoing effect of those costs?

I think what -- just make sure we are in the same page, I think to be correct we talked about 1.6 million in total last year, the cost.

I said it would be a couple -- $0.02, $0.03.

But in any event, Sarbanes-Oxley for everybody was a dramatic cost expenditure first go-around, and it has come down dramatically this year.

But we really had not started to rev that up until really Q2 and Q3 last year.

So not much spending in the first quarter of last year.

As far as the store openings, it looks like you finally, after a lot of struggling, have got it right with respect to your store base.

Assuming the remodels go according to expectations, and the gross margins are coming along fine, do you think a realistic target might be to get to a -- say your former employers have about a 40% gross margin.

You are at about -- I think you were 31.6 last year.

Do you think a 38% gross margin is a doable number in say three or four years from now?

I am not sure the reporting relationship on their externally reported numbers and ours are exactly the same.

And we would have to look at that.

We have UCAP calculation in our externally reported numbers that they do not.

So there is -- it's not quite apples-to-apples looking at the numbers.

I would say -- I would think about it this way.

I would say from an operating margin point of view, we don't think that there is any reason to why our Company over the long-term should not perform at the level of Williams-Sonoma.

Thank you.

Rob Wilson, Tiburon Research.

What are you expecting for interest expense in Q2?

We would expect to see about -- we had about $800,000 in interest expense this first quarter.

It will be up a bit in Q2.

There are no further questions at this time.

Okay, everyone.

Thank you for your interest and we will talk to you next quarter.

That concludes today's conference.

Thank you for joining.

You may now disconnect.