RH (RH) 2005 Q2 法說會逐字稿

All sites are now on the conference line in a listen-only mode. I would now like to turn the conference over to your moderator, Ms. Pat McKay, Chief Financial Adviser. Go ahead, please.

Good afternoon and welcome to Restoration Hardware's second-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 Web-cast on our Website at www.RestorationHardware.com, under company information/investor relations/event calendar, or by dial-in at 1-800-362-0571.

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 meeting 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 in circumstances. Actual results or performance may vary materially from those expressed or implied in such statements. These statements will include, without limitation, financial guidance and statements related to implications about the Company's second 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-Q and Form 10-K, and on our earnings release posted on the Company's Website. Any guidance we offer represents a point-in-time estimate. We expressly declaim 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.

Thank you, Pat. Good afternoon. We were pleased with our overall performance in the second quarter, particularly in light of the significant remerchandising and remodeling efforts that took place in our stores. Total company revenues increased 20% while operating results improved 42% in the quarter, excluding the one-time non-cash charge due to the disposition of fixtures replaced during our remodel.

Retail comparable store sales were up a solid 5.6% on top of a 9.4% increase last year, and a 9.9% increase in the second quarter of 2003. This was accomplished despite the disruption caused due to our remodeling efforts and with flat merchandise margins versus a year ago. This is an important point, considering we marked down and eliminated several merchandising categories, including garden, electronics, games, and the majority of our accessories offering.

In addition, we marked down and transitioned 85% of our lighting to introduce the new upgraded assortment you see in our stores today, as well as a good portion of our furniture offering. We believe this illustrates the underlying margin strength in our core businesses and positions the Company for meaningful merchandise margin expansion as we anniversary these numbers next year.

Our direct-to-customer revenues increased an impressive 50% on top of a 103% increase in last year's second quarter. We have been able to accomplish this growth while achieving positive margin leverage in this segment. The emergence of our outlet division is beginning to have a positive impact on our ability to move through out-of-season and slightly distressed products in a more timely fashion, and will allow us to improve inventory productivity going forward. We plan to open two additional outlet stores in the second half of this year, bringing our total to five stores.

We are also pleased with the progress being made in our supply chain as we continue to lower our distribution costs while improving service to our stores and customers. We achieved almost 200 basis points of leverage versus a year ago in this quarter. We are also in the early stages of developing a multichannel supply chain strategy designed to support each of our unique core businesses and provide significant service and cost advantages over the next several years. John will provide more color on this topic later in the call.

As you know, we have just completed a major remerchandising effort in our retail stores, Website and catalog. This fall represents the single largest one-time change since we began transforming Restoration Hardware from a store that sold mission furniture and retro discovery items to what you see today, a premium home furnishings brand built on a foundation of dominant core businesses. We believe that we have developed the most comprehensive and authoritative assortments and presentation in furniture, lighting, bed and bath linens, window treatments, bath and cabinet hardware of all upscale mall-based specialty retailers.

In addition, we have created an integrated color merchandising approach that stimulates our customers to purchase across categories, from bedding to bath linens, window treatments to wall paint, clearly differentiating Restoration Hardware from our competitors.

We also believe that the investments we have made in redesigning and upgrading our Website supports that positioning. If you have not visited our site lately, I would encourage you to check out our design-your-own lighting section, which enables you to customize your lamp with our offering of six lampshade styles in six sizes and eight colors. All of our lampshades are color matched to our window treatments and textile selection.

We also reintroduced Our Sofa, Your Style, where we offer 55 custom fabrics plus eight leather choices, all with 45-day delivery. In-stock upholstery is now available for delivery in one to two weeks to all major markets. To build on Our Sofa, Your Style, we introduced Our Drapery, Your Style, offering our most popular window fabrications, Thai silks, Belgian linen, and other fabrics in French pleat, inverted pleat and flat-panel construction. We believe we offer the most compelling assortment in this category outside the interior design trade. These latest efforts and investments now position Restoration Hardware as the destination for our core categories and will enable us to continue to gain market share, increase store productivity and improve merchandise margins with a less seasonal, higher-margin assortment.

While still early in the season, we are pleased with the early response to our fall offering and expect our business to build throughout the quarter and into next year as we become the top-of-line destination for premium home furnishings. As we think about our business going forward, we are confident that we can build a predictable, high-margin merchandise model that will allow us to achieve mid to high single-digit operating margins.

In the short-term we are forecasting solid comparable store growth with meaningful merchandise margin improvement in Q3, but still remain cautious about the fourth quarter, as we have significantly reduced our offering of non-core fringe categories that did perform well during the five-week peak holiday season. Thus, we continue to forecast comparable store sales flat to slightly negative in the fourth quarter, with substantial merchandise margin improvement.

The decision to edit and focus the assortment and sacrifice some of the fourth-quarter upside will result in a clearly positioned and more profitable year-round Restoration Hardware business. Our efforts will also have meaningful long-term benefits in regard to simplifying execution throughout our supply chain and in our stores. We will be handling fewer categories, generating higher sales on lower units and reduced transactions as a result of higher average unit retails and average transaction size.

As announced earlier today, Pat McKay will be leaving Restoration Hardware to join Office Depot as their chief financial officer, where she has served on the board and audit committee for the past 16 months. While we will miss having Pat on our leadership team, we want to thank her for the important contributions she has made to our organization, including building a strong and capable finance team. She has restaffed the majority of the finance and FT&A (ph) team with seasoned professionals and implemented disciplined financial processes that have greatly improved our ability to execute our business strategies. We wish Pat and her family all the best as they return to Florida, which was their home before she joined Restoration Hardware.

We also announced today that Murray Jukes, the Company's Vice President, Corporate Controller, has been appointed Acting Chief Financial Officer. Murray has been an important leader in rebuilding the finance organization, including his role in raising the Company's financial standards and controls to be Sarb-Ox compliant. In his new role, Murray will report directly to me.

In addition, the Company announced the appointment of Robert Hamer to our Board of Directors. Bob is currently Chief Executive Officer and Chairman of Primitive Logic, a San Francisco-based technology services firm he founded in 1997. Bob's extensive IT background will serve us well as we began to design and build an entirely new system platform for our company.

Now let me turn the call over to John Tate, our Chief Operating Officer.

Thanks, Gary. Good afternoon, everyone. I will start with an organizational update, highlight some of the progress we have made against our initiatives, and give you a glimpse into some of the longer-term priorities we're working on.

In the last 12 months we have completely rebuilt the operations organization to support Restoration Hardware's long-term growth plans. We now have in place a new senior vice president of our supply chain, vice president of distribution, vice president of transportation, senior vice president of inventory planning, senior vice president of human resources, and senior director of customer service and call center operations. These executives join our senior vice president and chief information officer, whom Pat hired before I arrived, and our vice president of sourcing, who joined Gary from Williams-Sonoma. We now have a fully staffed senior operational leadership team to support the vertically-integrated merchandising organization that Gary has built over the past several years.

Let me update you on some of our most recent hires. I told you last quarter we were close to announcing a senior inventory leader. Several weeks later, Michael Berry (ph) started at Restoration Hardware as Senior Vice President of Inventory Planning and Allocation. Michael is a 17-year veteran of Gap, Inc. and has performed in virtually every aspect of planning and allocation at the Gap. He is, additionally, very experienced in systems implementation across the enterprise and will be a key resource here at Resto as we focus on the broad replacement of our technology business applications over the next several years. As I said last quarter, we believe we have opportunities in both reduced inventories through more systematic management and margin improvement opportunities as we refine the allocation process across store types and sizes.

At the same time, I'm pleased to share that we have also recruited a senior transportation leader. Glenn Berger (ph) has joined us as Vice President of Transportation. Glenn was most recently Vice President of Global Transportation for Williams-Sonoma, Inc. Glenn has deep supply chain and specific transportation experience after a career with companies known for their supply chain excellence, including Frito-Lay and Compaq. Glenn will continue to focus on improving the service and reducing the cost of our transportation modes, including the elimination of use of cooling services wherever possible, improving truck cube utilization of DC-to-store shipments and optimizing our small package delivery. Glenn will also oversee the home delivery network and will intensify our reengineering efforts of the current network, which includes too many providers and a need for improved measurement and management of those providers.

Finally, Karen Barker has recently joined us as Senior Director of Customer Service and Call Center Operations. Karen joins us most recently from Moviebeam, a Disney Company joint venture, after a career managing multiple call centers and customer service operations for companies such as Disney and Sprint. This new role marks the first time that Restoration Hardware has identified a senior executive to manage tri-channel customer service from a single perspective. In Karen's early days we are already seeing significant benefits from this single-focus, multichannel approach to our customers.

Now let me update you on our progress against our initiatives. Our transportation initiatives continue to progress. We are nearly complete with the process of eliminating unnecessary transportation cooling services. By the end of September we will have eliminated cooling across approximately 80% of our store network, compared with 27% when we started this effort earlier this year. The economic benefit provided to the last three quarters of this year will increase next year as we enjoy a full year of benefit across the system.

Additionally, we continue to progress with our initiative to convert our replenishment process from pallet loading of trucks to floor loading, when and where appropriate. While this initiative will provide some benefit later this year, we are still in a learning phase. I expect the benefits from this to be much more significant next year.

We continue to refine and improve our distribution process. During this quarter we completed modifications to our existing warehouse management system, which will improve picking and shipping accuracy and labor effectiveness. As Gary mentioned, this quarter we experienced probably the largest scale change in merchandise offering since he and his merchant team began recrafting the business. I am very proud of the supply chain performance during the second quarter in support of this effort. In a quarter when we dealt with an unprecedented newness of SKUs, sizes, colors, category changes and floorset requirements, the team managed to deliver total distribution center costs which were reduced 13% from the prior year in absolute dollars.

Gary also mentioned our early efforts on developing individually engineered supply chains for unique product categories. During this quarter we completed the first of these from an outbound standpoint. We now ship to customer and replenish to stores most of our high-value textiles out of a single distribution center -- Baltimore, in this case. This will allow us to consolidate and reduce inventories. Because freight cost as a percent of retail is so low for these categories, the small incremental freight to replenish by ground service to the West Coast stores is more than outweighed by the benefits of significant inventory reduction. We are now working to complete the returns processing segment of this supply chain, which is also quite unique. Our long-term vision is to intentionally operate each of our core businesses in a unique manner appropriate to inherent product qualities and customer needs.

The planning stages for our systems initiatives and long-term supply chain physical network are progressing as planned. While most of the efforts will actually begin in earnest early next year, the detailed planning necessary to success is fully underway.

In summary, the operations group performed well in the second quarter. Our focus across every group in operations is an obsession with improved customer service. In this case, doing good also translates to doing well. While reengineering our network and improving our service to internal and external customers alike, our supply chain costs were significantly lower than prior year as a percent of sales across all major transportation categories. In the case of distribution costs, as I said earlier, absolute dollars actually decreased during a quarter in which total revenues increased nearly 20%.

While proud of the progress we are making, we are only in the beginning stages of building a world-class operational infrastructure and culture that will deliver first-class service to our organization and our customers and make a significant contribution to the bottom-line results of Restoration Hardware.

Now I will turn it over to Pat.

Thanks, John. First I will take you through our financial performance for the second quarter of 2005 and then I will provide guidance with respect to our expectations for the third quarter. At the end I will open the call up for questions.

The results for the second quarter of 2005 include a pre-tax non-cash charge of 1.6 million, or $0.03 per share, associated with the cost of certain store fixtures which were removed as part of our second-quarter store remodel efforts. The discussion of the Company results that follow will exclude the effect of this non-cash charge.

Second-quarter net revenue was up 20% to $144.8 million, versus 120.9 million in the second quarter last year, with comp store sales for the quarter up 5.6% and direct-to-customer revenue up 50% from that of the prior year's second quarter. Along with the increases in revenue, we experienced substantial expansion in our gross margin of 300 basis points, driven primarily by a combination of continuing improvements in our supply chain and distribution costs of 190 basis points and, to a lesser degree, leverage on store occupancy cost of 120 basis points.

Product margins were down 10 basis points, reflecting the impact of heavier markdowns in the second quarter of 2005 due to the repositioning of our merchandise assortment for the fall and the effect of lower margin outlet and warehouse selling events. We expect to continue to see these favorable trends in our supply chain and distribution costs as well as leverage of our store occupancy costs. Product margins have rebounded and should also provide gross margin expansion opportunities in future quarters.

Selling, general and administrative expense in the quarter expressed as a percentage of sales was higher than the prior year by approximately 190 basis points, driven primarily by higher catalog circulation costs of 165 basis points. SG&A will continue to reflect some deleverage in future quarters, in part due to higher catalog circulation costs which tend to rise at a higher rate than total company revenue, reflecting the continuing dynamic growth of our direct-to-customer business.

For the quarter we experienced a 110 basis point improvement in our operating results as compared to the prior year and a 42% reduction in our operating loss to 1.5 million, compared to the operating loss reported in the prior year of 2.7 million. Our effective tax rate was 38% for the quarter and 39% for the first half of fiscal 2005. Results for the second quarter, excluding the non-cash charge of $0.03 per share, was a loss of $0.04, improved from last year's second-quarter results of $0.06 per share.

We ended the quarter with inventory levels up 14% compared to the prior year's second quarter, which is lower than what we had expected as receipts for the fall season were delayed, particularly in lighting and decorative accessories.

Turning to retail sales performance, as mentioned, we experienced a 5.6% increase in comp store sales on top of a 9.4% increase in the second quarter of fiscal 2004 and a 9.9% increase in the second quarter of fiscal 2003. These increases reflect our customers' positive response to our continued merchandise repositioning, and the comps for the second quarter of 2005 reflect sales performance that was achieved despite disruption caused by remodeling efforts.

During the second quarter we experienced a significant lift in the average retail dollars per transaction of 15%, and total retail transactions were lower by approximately 6%. We believe that we 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 chain.

Sales generated from our outlet stores, the third of which was open at the end of July, coupled with revenue from warehouse sale events, totaled 6.1 million in the second quarter of 2005 as compared to 3.6 million in the prior year. These are sales of products that have been returned by customers, damaged or discontinued, and tend to result in lower product margins. 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 second quarter of fiscal 2005 our retail segment realized a $10.2 million four-wall contribution after the cost of district management, or a 10% contribution margin as stated as a percent of segment revenue. This compares with an 8.2 million contribution at 8.8% of net retail revenue reported in the second quarter of the prior year.

Gross margin improved by 20 basis points from a combination of the following -- supply chain and distribution cost savings of 100 basis points; leverage achieved on floor occupancy of 30 basis points, which were offset by product margin pressure of 110 basis points from heavy transitional activities in our full (ph) retail stores, as well as the impact on the retail segment of lower-margin selling in our outlets and warehouse events.

Selling, general and administrative expense for the segment improved by 100 basis points from the favorable effects of various store expenses offset by higher advertising costs. In the direct channel, which include sales from both the catalog and Internet, revenue was up 50% to 42.9 million on top of a 103% increase in last year's second quarter. Catalog revenue grew 41% in the quarter to 22.7 million and Internet sales grew 62% to 20.2 million for the second quarter.

Our catalog continues to provide significant product and overall brand exposure in our retail trade areas as well. Catalog circulation for the second quarter was up 14%, with pages circulated up 50%. A key point to note is the fact that while we have been growing the number of pages circulated at a very rapid pace, the productivity per page has also been maintained, and on a year-to-date basis has grown. For the full year, circulation is currently planned to increase by approximately 3% with pages circulated planned up by approximately 25%.

Segment profitability for the direct-to-customer segment was 15% in the second quarter, as compared to 14.1% in the prior year, with improvements in supply chain and distribution costs of 330 basis points driving the majority of the improvement, somewhat offset by higher costs of catalog circulation of 140 basis points.

Turning to our balance sheet, our outstanding balance on our line of credit was 48.6 million at the end of the second quarter and up 14.8 million as compared to year end. Inventory at the end of the second quarter was 137 million, up 14% compared to the prior year's second quarter.

We amended our credit facility with our bank group, which increased our line by 50% to 150 million, reduced our borrowing rate, and increased our availability on our borrowing base. The agreement also was amended to eliminate the lockbox arrangement except under certain conditions, such as the occurrence of an event of default.

At the end of the quarter all of the preferred stock outstanding was converted into 4.3 million shares of common. We had 37.5 million common shares outstanding at the end of the second quarter, including the just-converted preferred stock.

Capital expenditures for the quarter was 9.6 million, with the largest portion of the spend occurring for the store remodel effort. 7.9 million of the expected $15 million spending for the store remodels was reflected in the quarter. Depreciation and amortization expense was 4.1 million for the second quarter, excluding the non-cash charge associated with the store remodel effort of 1.6 million.

Turning now to guidance for the third quarter of 2005 and the full year. We expect comp store sales to be in the mid single digits for the third quarter on top of comp store sales of 8.7% in the prior year. We expect to see third-quarter direct-to-customer revenue increase 25 to 30% on top of an increase of 78% in the prior year. We expect to see results in the third quarter of a loss of $0.03 to $0.05 per share with a share count of 38 million common shares.

Inventory for the third quarter is expected to increase by approximately 10%, and we reconfirm our full-year guidance of a range of 2 to the 3% operating margin.

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

(OPERATOR INSTRUCTIONS). Kristine Koerber with JMP Securities.

A couple of questions. First of all, can you talk about the store remodels? I'm assuming all the stores are now completed. And kind of where in-stock levels are right now? And then, Pat, can you tell us where you expect the line of credit to be at year end? And then lastly, as far as Q3 guidance, am I correct in saying that prior guidance called for a low to mid single digit comp, and now it's just mid single digit comp?

This is Gary. First, let me address the store remodels. We are, except for a couple of stores, basically complete with our remodels. There were a couple of stores where we had some permit issues or landlord issues, so we have yet to remodel our Vancouver store or our Boston store. Those stores will be remodeled, hopefully, in the next several weeks.

And then we have kind of a phase two in a couple of stores. Our New York store, Flatiron store, was substantially remodeled. There is another phase of remodel that will happen in a couple weeks in that store, as well as one other store. But for the most part we are basically done.

As far as in-stock -- this is John -- with all the SKU change, we were a little slower than we had anticipated, primarily in the lighting and, as Pat said, the decorative accessories. That in the last couple of weeks has come up. We are projecting to end this week at about 75% in stock on lighting, about the same on dec acc, next week up to 80%, and then the following week up to about 90%. So over the next three weeks we will get pretty close to 100% as the final receipts come in. In all the other categories we are in a pretty good stock position.

As it relates to where we think the line is going to be at the end of the year, it will probably be somewhere -- you know, considering the guidance of 2 to 3% operating margins -- will be somewhere the 27 million to $30 million in terms of debt outstanding at the end of the year. And as it relates to Q3 comp guidance, we have not provided that previously. What we have provided is full year in the past, as well as the current quarter that we were attending to. And then, for example, toward the end of Q1 we had guided mid to high-digit single comps for Q2, but had not been conversant about Q3 at all. So this is the first time we are talking about Q3.

Gary, with regard to your upholstery sale that you have going on through the third week of September, I believe that you did not have that last year, and you resumed the sale this year. Is that correct?

Right. We had it the year before. We did not execute well on the supply chain side, and so we pulled it last year. And then with the confidence of what is going on in the back end of our business, we decided to resume the upholstery event. It does kind of make us competitive with one of our other biggest competitors out there in the marketplace; Crate & Barrel holds a major upholstery event this time of year in all of their stores across the country. And we had felt historically that our upholstery business was negatively impacted across all the centers because of Crate & Barrel's position. So we decided to resume that event and be competitive during this early fall season.

Paula Kalandiak with Roth Capital.

I have a couple of questions. One is, if you end this current fiscal year with five outlet stores, will that eliminate the need to hold any warehouse sales in '06?

I would think we would still have the need to maybe have some warehouse sales. It would probably be smaller and less frequent, and more targeted categories. But the goal is to have outlet stores do a couple things. One, be able to move through the distressed and returned goods in a much more productive way. Also, we have targeted the outlet stores to be close to the major metropolitan markets where we have a substantial amount of our volume. So we can, hopefully, bypass -- not having to spend all furniture returns all the way back to the distribution centers and reallocate them in the future. We'd hope that we can consolidate the returns by market in the outlet stores and save ourselves a lot of transportation and handling costs.

Approximately how many warehouse sales do you hold each year currently?

We have held from two to four.

And with regard to the catalog, I have noticed that mine keeps getting fatter. And I was thinking there's got to be a point where you get diminishing returns, but it sounds like you haven't seen that yet. How fat can the catalog get?

That's a good question.

That's not the way we think about that.

Exactly, not the way -- we don't exactly think of it that way. Right now this is the highest page count of a home furnishing catalog I've been involved with. And we believe that there could be more room to increase page count. I think a better way to think about is once the catalog gets to a certain size, do you start to segment and focus categories through more focused books, whether we take a category out of the current assortment like bed and bath or outdoor furniture, so on and so forth, and just have separate books targeted to the appropriate customers that allow us to continue to grow the direct business but not have to have the book get up to 2 or 300 pages.

And then just finally, have you successfully delivered any custom upholstered furniture in 45 days yet, or is it still too soon?

John, how many orders?

We are just crossing that threshold, but we do have several that we have delivered on time and none right now that are late.

Andrew Graves with Pacific Growth.

Congratulations, everyone. And Pat, especially to you; I know we are going to miss you as you go to Office Depot, because Restoration -- we need you.

I think a lot of great progress has been made here, but thank you for those congrats.

Potentially -- this is just a side note -- would there be a possibility of you remaining on the board of Restoration to sort of add your insights and the like, despite you moving to a different company?

That's an interesting thought. I think I'm going to have my hands full for awhile as well. But it's an interesting concept.

Well, let me ask -- I don't really know how to -- it's a broad question. Merchandise margins year-to-date continue to surprise our models on the upside, and at the same time it looks like SG&A continues to be slightly higher than what we had anticipated as well. When are we going to be able to get a transition where we'll continue to see leverage on margins, but begin to see some leverage on SG&A? And maybe several of you can tackle that.

Pat and I can both kind of add some perspective to this. One thing that's important to think about, Andy; when you have got a business dynamic that we have had over the last couple of years here, where you have got a direct business which carries a big SG&A component -- the biggest number in the direct business is ad cost. And ad cost is all in G&A. So if you're growing the direct business exponentially -- and that is growing at 100% or 50%, and that's growing much faster than the retail segment of the business, which, if you think about the biggest piece in retail is generally your occupancy cost, and that's in margin -- you're going to wind up seeing the dynamic happen where the SG&A grows somewhat faster because you're growing the channel that is SG&A heavy. So when you add them all together, it kind of creates a different picture.

And if I could just kind of talk about that. In fact, I think you may remember I mentioned that we were up about 155 basis points for the total company. The lion's share of that is attributable to that higher percentage of direct revenue growth in the quarter. So for example, if I did my math (indiscernible) probably about 40 basis points would be the effect (indiscernible) kind of year-over-year or quarter-over-quarter the same percentage of direct revenue in the quarter as we had in the prior year. It's a little bit costlier book, but not -- net net, we ended up with most of it being attributable to higher direct-to-customer growth.

I would say if you look out -- obviously, we're not going to be able to continue 1500% kind of gains in the direct channel. And we are now guiding to what we think is a more normalized growth rate going forward in the 25 to 30% range. That will relieve some of the pressure on the G&A, just because of the dynamic of the growth of the channel.

And is there any reason to believe that margins couldn't be even greater in Q3 and Q4 than the 300 basis points that you saw, since we did see merchandise, direct merchandise margins negative in the period? Could we see overall margins improve more in the 4 to 500 basis points area?

Well, I don't know that I want to be specific in terms of what -- because you guys will work your models appropriately. But I think what we have tried to share with you is we saw significant supply chain improvements in Q2, and didn't have that luxury in product margins. So I'll let you discern where that might go.

Congratulations, by the way, John; you've done a great job in making that happen.

Thanks, Andy. I'm having a good day talking with you.

Finally, any need for financing of any sort as you get near the end of the year and into next year, as you may roll out some new stores? Would there be an opportunity for the Company to secure some maybe fixed financing on the debt side, or potentially some equity-type financing?

I don't think you ever say never, but I think -- what we have tried to do, and our banks have been very supportive of Restoration Hardware and our needs. So I think what we have been able to do is size up the facility where it feels pretty comfortable for us in terms of what our needs are going forward, and then we will just have to kind of continue to evaluate that as we progress. But it feels that we are very comfortable from a liquidity perspective where we are today.

I would also just add to that, we have now spent two rounds at $15 million each round to kind of back into the real estate we have and transform it into a store box that would present the current core businesses appropriately. We don't see that kind of level of spending going forward. So if you think about capital expenditures, that will put us in a better position to target capital expenditures towards building our infrastructure and growing our store base.

And CapEx -- we probably have a pretty good idea for that for '05. What does that look like at this point?

That's a good question. We had guided that would be at $20 million for the year. I think that number is probably nudging up from that, probably at about a 22 to $25 million spend.

And then by the next year would we see that go down by about 10 to 12?

I don't know if it will go down by 10 to 12. It should move down. But as Gary alluded to both on this call and prior calls, we have got some pretty heavy infrastructure things we've got to do on the system side. So we'll see some of that spend have to be kind of fulfilled in that area, as well as potentially from store openings.

Molly Hessel (ph) with Friedman Billings.

I was wondering if you guys could give a little bit more color on what is driving the not-as-high-as-we-expected growth in the inventory. I know you had said that there were some delays there, and if you could just talk a little bit about what's causing the delays.

I would say, in general -- Gary alluded to the fact that we had 85% newness in our lighting. And as we designed all in that and placed the orders, some of that was late in the cycle. So some of our lighting arrived a little later than we expected and just kind of flopped over the quarterly line. So for instance, in August of week two we were about 50% in stock in our lighting. In week one we were probably about 30%, meaning a lot of those SKUs had not arrived yet. Now, we are getting close to the 80% level at this point, so we feel good about our stock levels now. But it was largely just a shift across the quarter in receipts of lighting and, to a lesser extent, decorative accessories, which were also quite new.

And then you said within the next three weeks you should be pretty close to 100% in stock on these?

Well, you always wish to be 100% and you never are. I expect to end this week at 80%. And I expect a week and a half after that we'll be in the close to 90% range, which is a pretty decent target for an in-stock level.

And then on the catalog and the increase in the circulation cost that you saw -- is that a function of just the book being bigger, or is it being driven by higher paper prices? Can you just give us a little more color on that as well?

Paper costs certainly are affecting everybody that's in the catalog circulation business, so that certainly was kind of a larger driver of that. The book sizing up had, candidly, not as much impact as you might think. Because what we used to do when we produced our catalogs previously with the smaller pages, we actually had throwaway of paper. So there was some waste that we were actually able to utilize and just mail it, if you will, as opposed (indiscernible) put more goods, if you will, on that page. So moreover, the base cost of the paper was what drove some of those cost increases so far year-over-year. And then will see a little bit of a -- we'll see some pressure on pricing of paper that everybody is experiencing in the latter part of the year.

So are you assuming that the higher paper prices are going to continue?

We have arrangements with some of our suppliers that has a level at which we will be able to experience and control for the balance of the year, so we kind of know what that impact will be. And that's reflected in our forecast.

And in terms of the product margin, can we assume that it'll start making a positive contribution in the third quarter or do you think it will be a little bit later than that?

We'll see. As I mentioned, our margins, our product margins have already rebounded. So we definitely expect to see that in Q3.

Really, one of the major objectives in this latest round of repositioning the businesses was to eliminate lower-margin categories and build our highest-margin core categories. So what we have tried to do with the repositioning of the categories, the expansion of certain core businesses, was to really form a different merchant model, merchandise model going forward. So we feel very confident that the Company will now operate at a higher merchandise margin level than it has in the past.

Budd Bugatch with Raymond James.

Can you give us any guidance or feeling on the profitability of direct-to-customer/consumer in terms of operating margin?

Yes, sure. I think what I had articulated during the quarter -- we had a -- the direct-to-customer business experienced a 15% contribution margin, and that was up 90 basis points over that of the prior year's second quarter.

I guess I didn't get that. I didn't hear that.

There's a lot of numbers in there, so --

Well, I've got a lot of numbers written down, but I just didn't -- can you give us also -- where do you think the tax rate goes going forward?

I would expect putting a 39% model rate in for the year, which is consistent with our year-to-date number, would be a good tax rate to use.

And the end of the quarter prepaid catalog asset -- is that the entire amount of the prepaid assets, or how do you account for that?

No, there's quite a number, as you can imagine. We have rent, etcetera, that is in that prepaid and other current assets line item on the balance sheet. So as with any company who, again, is circulating catalogs, we do have a certain element of costs that get deferred or prepaid, if you will, at the end of each of the quarters. And that number was probably about up 60 (ph) prior year, which is pretty much in line with what our total page count circulation increase has been, and then some cost increases on the paper.

And you are doing that under a 93-7? Is that the accounting rule that you're doing that under? I think that's the right rule, isn't it?

That's a good one, but I've never -- I've been in the catalog business for 20 years and never heard anybody use that.

I'll get back to you on the code number that we are using, but we haven't changed any of our accounting methodologies. It's very straightforward in terms of how we amortize those costs.

And would you disclose that number, what the prepaid catalog number is?

The prepaid catalog number was $8 million at the end of the second quarter.

Thanks and congratulations. Keep it up, Gary. Let's sell some more product.

Crystal Lanigan with D.A. Davidson.

Congratulations to everyone. And, Pat, you will definitely be missed, but it sounds like a wonderful career opportunity for you.

Just a few questions, I guess. Pat, we'll start with you since you're on the line. Looking at stock options going into '06, there has been a fair amount of talk from various companies as far as how they are going to address perhaps changing the compensation structure. And before you leave, is that something that you think you will be talking about? Is that something you considered as a company to help offset some of the dilution when you report in 2006?

Well, I think, as you know, most of the effect of how, if you will, the impact of expensing stock options are already kind of set in stone, with respect to kind of your history in terms of what options you have issued. We have looked at it, and John mentioned that we had hired in last fall a senior VP of human resources who has been looking at that very issue in terms of what is the right compensation structure for our associates of Restoration Hardware. And that continues to be something that -- and we will always kind of re-look at that.

We operate in a very competitive retail pool here in the Bay Area, and so we are keeping a close eye on our competitors and what it takes to be competitive in this market. So far we haven't seen a lot of change.

Yes. That's really the driving force here, is to make sure we are competitive and we can attract and retain the best talent. And so there's a pool of fixed local companies here, probably, that compete for the talent.

Pat, do you have an idea yet of where you think the year-end cash levels might end?

Well, cash doesn't end up being a number that moves much on us because, effectively, with kind of just procedurally we make sure that to the extent that we have excess cash it goes to kind of pay down our debt levels. So what I described a little while ago is we'd expect debt to be probably 27 to $30 million, depending on what end of the range of the 2 to 3% operating margin we end up on, and where our CapEx normalizes out at.

John, you went through this quickly, and I just want to make sure I got this accurately. Did you say distribution costs were down 13%?

I did.

Great. And you are expecting that to continue to accelerate moving forward with all the (technical difficulty) that are going on?

I expect to continue showing those kinds of favorabilities.

And then just for Gary, Q4 is going to be very different than what you have experienced as a company in a while, with the decline in the discovery and the gifts. And I guess the question for you is, if it plays out the way you hope it to, what would be the ideal sales mix for Q4?

From what perspective?

I guess, clearly there's been a pretty long-range strategy for you to move into the higher ticket. It sounds like your gift assortment and number of SKUs is going to be significantly lower. You said it's going to be more aspirational. So I guess I wonder, when you look at that, are you anticipating a shift into more textiles, more furniture?

Yes. I think you would think about the quarter this way. You've got a November-December-January quarter. We would expect to kind of bookend the quarter in November and January, and have really pretty solid performance from the core businesses because those are really important months in all of our core categories. And then the pressure this year really becomes in the five-week kind of holiday season in December, where kind of the accessories and related items, kind of discovery item categories, would have their greatest lifts and giftability. And that would be where the compression is in the business. And we just feel long-term that it's important to kind of -- in any retail business it's just as important what you don't sell as what you do sell. And I can remember the story and share it with a lot of people around here -- when we first introduced bath faucets a couple years ago, and we were opening a new story in Raleigh. I was traveling with our Vice President of Stores, Jason Camp, and I was asking him -- so, what is the feedback from the stores? What are the customers saying about our bath faucets? And he said to me -- well, I am hearing that people want to know who makes your bath faucets. And I said, well, why do they want to know who makes our bath faucets? Nobody asks who makes Waterworks' bath faucets; I mean, Restoration Hardware -- we make our bath faucets. And he goes -- well, Waterworks doesn't sell Halloween eyeball nightlights, either.

And I remember that comment; it hit me right between the eyes. And as I've always thought about kind of taking this business from almost 50% of the sales three years ago, where discovery items and kind of knickknacks, and things that nobody was waking up in the morning coming to us for. And as we now have transitioned this business over the years, and transitioned to real estate; if you think about that -- perimeter walls in Restoration Hardware in 2001 -- 80% of the perimeter walls did not represent a core business. You had one room that had cabinet hardware, and then you had all the rest of the perimeter walls had (indiscernible). And they shifted all the time, depending on what kind of items and what kind of seasonality was in the business.

Today, if you walk into our stores, 100% of the perimeter walls are now core businesses. They represent cabinet hardware, bath hardware, window treatments, bed and bath textiles and lighting. And so we used to have all this perimeter space that was highly, what I would say -- goods that were terrific during a four to five-week period of holiday, but not terrific the other 11 months of the year. And so what we have done, if you've seen our comp store sales -- if you look at our comp store sales over three years, we're up about 30% in the first three quarters over a three-year period. And in the fourth quarter we are up 10%. And I think some people have thought that has been relatively disappointing. Well, not necessarily, considering we have taken the perimeter wall space that was all somewhat giftable and basically almost eliminated it.

So this business really becomes a very different model. I think this becomes kind of, as I think about it and communicate to investors, and think about it myself as an investor in the Company, this is the last unpredictable quarter, in my mind, as far as where the sales are going to be because we have so much change. Beyond this, this will be a very predictable business with, I think, a very robust margin structure, and could be really one of the best businesses I've ever been involved in running.

One of the things I used to love about the Williams-Sonoma business was cookware, cook's tools, and electrics and tabletop. And it was almost all core business in specialty foods, except for a small seasonal layer. So the business was -- it was really hard to get that business off the tracks. I don't even think we had a negative comp quarter in the 14 years I was there. And Resto is going to look a lot like that. The only difference is, in the Williams-Sonoma mix you were selling Calphalon cookware and KitchenAid mixers and things that were 50 and 40 points of margin. This is all proprietary goods, uniquely positioned in the marketplace with a very high margin structure. So as we look at this long-term, we're very excited about how this model looks. Short-term, holiday has got some question marks. We think we've got a good assortment, but there is a big fundamental change that -- we'll see how it plays out during those five weeks.

So does it make sense for you to be in the gift business?

Yes. I think, absolutely. We should be in the relevant gift business; what is relevant to our core businesses? We shouldn't be selling record players and things that have nothing to do with the core businesses we are in. You'll still see us have an assortment of holiday trim and decor. We'll have Christmas ornaments; we'll have home decor that's holiday relevant. And then we will still have somewhat of a stocking stuffer business that's been kind of historically relevant to Resto. We have edited that down by about 40% and tried to make it a little less chotske (ph).

But long-term what you'll see is we will next year explode the bath accessory business. And within bath accessories there's a lot of very giftable things you can do there. You'll see us expand high-end frames and entertaining and candlelight -- things that really resonate with our high-end positioning of our goods. So we think, if anything, this holiday is probably the low watermark, if you can call it that. And we will only get better building on the holiday assortment going forward in a way that's relevant to the core businesses that Restoration stands for.

And then just finally, I know the stores have been converted only for a short timeframe. So far in the timeframe, what has been the most surprising result that's come over the past few weeks?

The most surprising result? I think that there has been a bigger shift than anticipated to special order upholstered furniture. So we've had a terrific response to our 55 fabrics and eight leather choices. So that sort of business response point of view. Everything else is really building the way we anticipated. I think the thing that surprised me the most personally is we have a lot of stores here that, from a layout perspective, I sat there and I thought could they ever look good? You know, were some of them even worth spending a dime in to try to remodel, because the layouts were so odd, I didn't know if we could really make the store businesses read. I was in six cities last week and saw quite a few of our stores over the last three weeks, and I've got to tell you I think this remodel has completely transformed the concept. I think today if you go see our stores that have been remodeled, any of the (indiscernible) stores that have been remodeled, I think we look as powerful and well-positioned as any retail store in the center. And I think we look better than any home furnishing store. I think in each of our core businesses, I think, you would say we have leapfrogged the competition in the categories that we want to be famous for.

So over the long-term I think now we have a concept here that is going to continue to gain market share. And I think we have put ourselves a year or two ahead of the competition in every one of our core categories. That's going to allow us to gain market share, increase margins, etcetera, etcetera.

Great. Well, we have certainly seen an increase in the traffic in the northwest area, so the initiatives look great. And thank you very much.

I haven't been up there. Which stores have you been in?

We have been in the Portland store, which is about to have one of the very first Williams-Sonoma home stores across the street open up. But your store was absolutely packed over the past few weeks, not only on the weekend but in the middle of the afternoon, etcetera. So it looks wonderful.

Janet Kloppenburg with JJK Research.

Congratulations. Pat, I'm going to miss you, but congratulations to you as well.

Thanks, Janet.

(technical difficulty) segment information (technical difficulty)

You are cutting in and out.

I didn't get the segment profitability for the retail business. Can you give that to me?

You bet. For retail, the contribution margin was 10% this year, or $10.2 million, versus 8.8%, or $8.2 million last year.

And on the inventory situation, John or Gary, I think you are having a lighting sale in early October. And I'm wondering if you think you'll be in an okay position in terms of inventory for the event?

Yes, we do. Actually, our new inventory leader couldn't have come at a better time. And I think in combination with our supply chain guy and (indiscernible) our sourcer, we have really got it dialed. I expect by the second week in September actually on the initial lighting to be up above 95% in stock. And we've got a really good plan to say in stock through the balance of the event.

The other thing that is really working for us is we are really getting product for our DCs. You can see them get observably better month by month in terms of their execution. So the short answer to your question is we feel very good about that.

And do you think you'll only get to 90% in stock, John, or do you think you can get it to be higher than that?

Any inventory planner will tell you that if they can run in the upper 80s in stock in retail or catalog, they'd feel great. I've got some projections that on paper are above 95%. That's pretty lofty air up there.

We'll start the event in the mid-90s. What level we will maintain it and what runaways we'll have -- but I guess, again, just to reinforce John's point, we will be all caught up in the next couple of weeks here and we'll be in great position for the lighting sale.

And what about on the decorative accessories? Is that the same, Gary?

Yes. Over the next, I'd say, two to four weeks, it will build. We changed so much there. We added a new home accessories category. So some of the ideas were just late developed ideas, and so (indiscernible) not necessarily, I'd say -- the late goods are more focused on lighting in some of the decorative accessories, but a good part of the decorative accessories were just planned to flow later in the season.

And the inventory plan for being up 10% going into the fourth quarter -- is that an adjusted number given the level you are at now, or is that where you wanted to be?

That's where we wanted to be.

And that's based on the costs being down slightly in the fourth quarter, Gary?

Yes.

And with respect to the lighting business, (technical difficulty) revamp there on the assortment. Can you give as any idea of what you think the customer response looks like?

We think it's terrific. And again, I don't think anybody has a presentation that rivals ours or an assortment that rivals our today. Initial response -- customers are reacting favorably to the assortment, love the fact that they can mix and match any of the six shade styles and eight color ways and sizes. So we just think that as word-of-mouth builds that that business is going to continue to build and build and build. So we feel terrific about it. I don't know if you've seen many stores with the new fixturing.

No, I have. I told you last week I thought they look fabulous. The other question is on the custom upholstery business getting a better response to it, Gary, than you had expected. Can you give us an idea of the margin on that business versus the margin on the in-stock upholstery (indiscernible)?

It's comparable. I think in some cases we take a slightly higher margin on some of the special order.

John, do you feel good about being able to deliver as promised to the customer on that product?

Yes, I do. From a supply chain standpoint I feel really good. It's clear that we have a path, and we are heavily focused. We have actually added some staff to make sure that we manage our vendors carefully.

And lastly, John, you added a lot of senior vice presidents and vice presidents. Is that cost fully reflected in the SG&A rate we saw for the second quarter? Or do you think that (multiple speakers) adjust next quarter?

It won't materially affect it. Almost all of those positions I described are replacements, not adds.

Gary, just lastly, if you could talk a little bit about where your sales per square foot are right now in the retail stores, and where you would like them to be and how you get there?

I think -- one of the presentations I've given to investors who have visited us showed if you looked at externally-reported numbers -- if you take the benchmark company, Williams-Sonoma, sales per selling square foot, which is reported in our sales per selling square foot, and you look at where we started this journey in 2001, we were 37% behind their productivity per square foot in 2001. I think we ended last year about 12% behind. We project by the end of this year we'll be about 6% behind them, and by next year we'll perform at the dollars-per-square-foot level that Williams-Sonoma, Inc. does.

That's the combined Pottery Barn and Williams-Sonoma stores together?

That's true.

And do you think you'll be able to throw off the same level of profitability, Gary, as they do?

We do, over time. Yes, sure. We do, over time. I think as we get efficiencies on our back end of our business, I feel very good about the merchandise margin structure we can build here, and the fact that we have, I think, differentiated ourselves in the marketplace in a way where you can't really buy our goods somewhere else. So I think we've got more room to -- whether it's raise prices and increase margins, source better, buy better with better leverage as our orders go up. And then I think we have tremendous opportunity, as John has alluded to, to really engineer core business excellence throughout our supply chain and look at each of our categories as a unique supply chain, and how do we run them in the most efficient way. So all indications -- we are very motivated that we can build a business here that's highly profitable.

Thanks very much and congratulations again.

I would now like to turn the conference back over to our moderators.

Okay, everyone. Well, thank you for your interest in the Company and we will talk to you next quarter. Thanks so much.

That concludes today's teleconference.