RH (RH) 2005 Q3 法說會逐字稿

Good day. (OPERATOR INSTRUCTIONS).

Please note this call may be recorded.

At this time I will turn it over to our moderator, Mr. Murray Jukes.

Go ahead sir.

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

My name is Murray Jukes, the Company's acting 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 dialing at 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 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, 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 with respect to the Company's anticipated earnings for future periods, statements regarding product margin and store occupancy costs, trends for future quarters, statements relating to the rate of special order, future sales, and the impact thereof on the deferral of revenues into future quarters, statements relating to the implications of the Company's third quarter 2005 earnings on periods thereafter, statements regarding our cost savings in future quarters as a result of the simplification of our operations, and other 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 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.

Now let me turn the call over to Gary.

Good afternoon.

I'm going to take a few minutes to review the issues that affected our results for the third quarter, comment on our outlook for the fourth quarter, and share our perspective on the evolution of the Restoration Hardware brand, and some of the initiatives we are focused on to continue to grow the business and improve our performance.

Net revenues for the quarter increased 9%, with direct-to-customer revenues up 27% on top of a 78% increase last year, and comparable store sales decreasing 2.1% versus an 8.7% increase a year ago.

As I mentioned in our pre-release last month, there were two factors that negatively affected our results versus our original guidance for the third quarter.

First a higher deferral of furniture revenues than planned into future quarters due to the higher than planned shift of business to special order furniture, which has a 45 day delivery cycle vs. our in-stock furniture which is delivered in one to two weeks.

The shift was driven by a higher than planned response to our fall furniture event, which advertised 45 day delivery on 55 fabrics and 8 leathers.

The shift to a higher than planned percentage of special order furniture has continued post event, and will create a higher than planned ongoing deferral in future quarters.

We had estimated in our pre-release that the negative impact to our comparable store sales for the quarter would be approximately 4%, and the final number was a 3.6% impact to the quarter versus our original guidance.

Once again, I want to stress that this was not a supply chain issue, but simply a revenue timing issue.

The second factor contributing to our under performance for the quarter was below planned sales during our Fall Lighting Sale.

As discussed, we made investments in new fixturing and expanded the space dedicated to lighting at the beginning of the quarter.

We also introduced an entirely new assortment in custom shade programs.

While we experienced low double-digit comp growth in lighting for the quarter, we had planned the business much higher.

In retrospect, we believe that we put -- we believe we planned the initial response too aggressively.

The amount of new product introduced, in addition to a completely new shopping experience, did not play to our advantage during the sale, as the decision-making process was complicated and time-consuming for customers as they decided what shade would look best with what lamp and in what color.

We do believe our assortment and presentation strategy is the right one going forward, as we are now beginning to see the lighting sales build to the planned increased we previously anticipated.

The new assortment also carries significantly higher merchandise margins than our old assortment.

Due to the fact that lighting is a nonseasonal core business, we do not anticipate having to take higher than planned markdowns.

While lighting inventory is higher than planned, we're comfortable with the current inventory levels, and have canceled or adjusted on order quantities, and lighting inventories should be back on plan early next year.

As communicated, our product margins improved significantly versus the prior year, consistent with our strategy to expand our higher margin core businesses and the editing of noncore lower margin discovery items and accessories.

While the initial results in customer response from our remodels and major category shifts was a more difficult transition than planned, we are confident that our strategy of building Restoration Hardware on a foundation of dominant, high margin and uniquely positioned core businesses has differentiated the concept in the marketplace, and will allow us to continue to gain market share, simplify our operations, and improve our future operating results.

We have now transformed ourselves from a concept that was mostly domestic market goods comprised of almost 50% discovery items and accessories to a concept that is primarily exclusive direct sourced products with discovery items and accessories representing only 15 to 20% of the mix.

We've accomplished that while increasing our average store volumes from 3.1 million per store to a projected 4 million per store this year, with a significantly higher merchandise margins going forward.

As discussed, we had planned the fourth quarter conservatively, as it represents the final major transition of the brand as we continue to edit noncore accessories and discovery items from the assortment that did perform well in the holiday period.

This will create greater pressure on the fourth quarter comps as these products no longer have the dedicated perimeter wall space they previously once had, as the space has been remodeled and allocated to the expansion of core textiles and lighting.

We have an exciting January bath event planned to kick off the day after Christmas, one week earlier than last year, with a fresh new assortment and color palette merchandised in all three channels.

We believe there is an opportunity to capitalize on the heavy post Christmas traffic with fresh product while most retailers are pushing markdowns.

Looking beyond this fourth quarter, we anticipate a return to positive comparable store sales with significantly improved product margins versus a year ago.

We are also planning to launch a new separate outdoor living catalog in March of 2006, building on the success of our outdoor furniture programs this past year.

We believe there's a significant opportunity to gain market share and expand our business in this rapidly growing category.

The book will mail multiple times from March through September.

This will represent the first step towards continuing to grow our direct business beyond our current core catalog.

At this point I will turn the call over to John Tate, our Chief Operating Officer.

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 longer-term priorities that we're working on.

I told you last quarter that we had completed our operations senior management restaffing initiatives.

To reiterate, over the last 18 months we have hired a Chief Information Officer, a Senior Vice President of the Supply Chain, a Senior Vice President of Inventory Planning, a Senior Vice President of Human Resources, a Vice President of Distribution, a Vice President of Transportation, and a Senior Director of Customer Service and Call Center Operations.

Along with our Vice President of Sourcing, who has been with us since 2001, 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.

For these leaders the process of learning the business and assessing and reengineering their individual functions is progressing rapidly.

These efforts are are farthest advanced in the areas of sourcing, distribution, human resources and information technology.

Our transportation, inventory planning, and customer service leaders have begun to redefine the processes within their organizations.

And we're already beginning to see some early benefits.

Now let me update you on our progress against initiatives.

Our transportation initiatives continue to progress.

We have completed the process of eliminating unnecessary transportation pooling services.

We eliminated pooling across approximately 85% 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 continue into next year, as we enjoy a full year of benefit across the system.

Additionally, we continue to progress with our initiatives to convert our replenishment process from palette loading of trucks to floor loading, when and where appropriate.

We expect to see the first significant benefit from this initiative in the fourth quarter.

During the quarter we also converted our small package delivery service to UPS.

The Excel Home Delivery conversion serving the Chicago market has been completed, and we're already seeing substantial improvements in execution and service in that market.

This is just the first of a significant number of home delivery network restructurings.

Likewise, we have made early changes in our surface transportation network, improving service to our store network and reducing costs.

Our 45 day special order initiative continues to progress well.

We are currently delivering on time to our customers over 80% of the time, with the vendor delays mentioned last quarter constituting the largest factor in late deliveries.

Late in the quarter we made substantial progress in reducing order backlog with this vendor.

As a result we expect our on-time delivery percentage to increase significantly in the fourth quarter.

We continue to invest in our sourcing organization in the areas of production scheduling, and production management.

This is substantially improving our ability to manage both international and domestic vendors.

The distribution centers executed well in the third quarter.

As we have continued to refine our operations, absolute dollar spending at our distribution centers continues to run significantly below last year's levels.

The reengineering of both processes and systems is now well underway in the inventory planning area.

I'm confident we will see significant benefits next year in inventory turns, in-stock percentages, and gross margin performance, as we improve the way we manage inventory and allocate it to our stores.

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 continued to perform effectively in the third quarter.

While reengineering our network and improving our service to internal and external customers, 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 once again decreased during a quarter in which total revenues increased nearly 10%.

We continue to make careful and measured progress in the beginning stages of building a world-class operational infrastructure and culture that will deliver first-class service to our organization and customers, and make a significant contribution to the bottom line results of Restoration Hardware.

Now I will turn the call over to Murray.

First I will take you through our financial performance for the third quarter of 2005.

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

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

Third quarter net revenue was up 9% to $128.4 million versus $118.2 million in the third quarter last year.

Retail revenues were up 3% for the quarter, with comparable store sales for the quarter down 2.1%.

The comparable store sales results includes a 3.6%, or $3.2 million, negative impact for the increase in the revenue deferral year-on-year, primarily due to the timing of furniture sales from the Upholstered Furniture Event.

Direct-to-customer revenue was up 27% to $36.1 million, on top of a 78% increase in last year's third quarter.

For our free guidance call on October 28, we anticipated that the furniture shipments in the final few days of the quarter would have been proportionate to each channel.

In fact, most of the shipments occurred in the retail channel, so while comparable store sales were slightly favorable in retail by 1 to 2%, direct sales were unfavorable by 2 to 3%.

Along with the increases in revenue, we experienced substantial expansion in our gross margin of 240 basis points, primarily driven by a combination of continuing improvements in our supply chain, and distribution costs of 140 basis points, and improved product margins of 120 basis points, offset by a slight deleverage in occupancy of 20 basis points.

The improved product margins are consistent with the expansion in our retail and direct core businesses, and the editing of lower margin discovery items and accessories, offset by 90 basis points due to the growth of our outlet business.

We expect to continue to see these favorable trends in our product margin and supply chain and distribution costs.

Store occupancy costs are also expected to deleverage slightly in the fourth quarter due to lower comparable store sales from the change in our merchandise offerings.

Selling, general and administrative expense in the quarter, expressed as a percentage of sales, was higher than the prior year by approximately 320 basis points.

As in prior quarters, the rapid growth of the direct business as a percentage of the total business, resulted in a mix deleverage of 140 basis points related to higher catalog circulation costs, and 60 basis points for higher call center and fulfillment costs.

The impact of the increase in revenue deferral of $3.2 million from the Upholstered Furniture Event deleveraged SG&A in the third quarter by approximately 100 basis points.

SG&A will continue to reflect some deleveraging in future quarters in part due to the rapid growth of the direct business and its associated higher catalog costs.

For the quarter we experienced an 80 basis point reduction in our operating results, or a loss of $5.9 million, as compared to an operating loss reported in the prior year of $4.5 million.

Our effective tax rate was 41% for the quarter, and 40% for the first nine months of fiscal 2005.

The results for the third quarter were a net loss per share of $0.11, an increase in our net loss from last year's third quarter net loss of $0.09 per share.

We ended the quarter with inventory levels up 4% compared to the prior year's third quarter, which is slightly below anticipated levels, but generally in line with our sales growth.

We also experienced a $4.4 million increase in our deferred revenue balance to $11.8 million compared to 7.4 million in the prior year's third quarter.

This includes the shift in furniture sales due to the Company's new special order program that was implemented and promoted in the third quarter.

These special order sales typically have longer production lead times.

We anticipate that this shift will continue to be seen in future quarters, as the special order penetration of total furniture sales grow.

The change does not include the impact of sales orders of approximately $2 million that were taken but unshipped as of the quarter end.

Turning to retail sales performance, as mentioned we experienced a 2.1% decrease in comparable store sales as compared to a 8.7% increase in the third quarter of fiscal 2004, and a 2.9% increase in the third quarter of fiscal 2003.

Overall retail revenues grew 3%, reflecting the impact of the new outlet stores, and positive impact on a noncomparable store.

The reduction in comparable store sales of 2.1% includes a 3.6%, or $3.2 million, negative impact from revenue deferral, primarily related to furniture sales from the Upholstered Furniture Event, which will move into future quarters rather than being recognized in the third quarter.

During the third quarter we continued to experience a significant lift in the average retail dollars per transaction of 34%, with total retail transactions being lower by approximately 24%.

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

The simplification of our operations, whereby we sell fewer units to 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 fourth and fifth of which were opened in the quarter, totaled $3.9 million in the third quarter of 2005.

We did not have any outlet stores 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 compilation of comparable store sales.

For the third quarter of fiscal 2005 our retail segments realized a $7.6 million for wall contribution, after cost of district management, or an 8.3% contribution margin as stated as a percent of segment revenue.

This compares with an $8.2 million contribution after cost of district management, or 9.1% contribution margin as stated as a percent of segment revenue reported for the third quarter of the prior year.

Segment gross margin improved by 100 basis points from a combination of the following, continued supply chain and distribution costs savings of 160 basis points, product margin expansion of 60 basis points reflecting the shift from lower margin accessories and discovery items into our core businesses, offset by deleverage on store occupancy of 120 basis points.

Note, the product margins were negatively impacted by 110 basis points from sales in the outlet stores.

The deleverage in occupancy was due to the lower than anticipated comparable store sales, and the increased depreciation from the store remodel, which impacted results by 40 basis points.

Overall, selling, general and administrative expense for the segment deleveraged by 180 basis points, primarily due to the impact of higher advertising costs of 70 basis points from the increased page ad to drive the lighting and Upholstered Furniture Event, and 50 basis points from store payroll as a result of lower than anticipated sales from the lighting event, and the impact of furniture sales and orders falling into future quarters.

Other expenses deleveraged by approximately 60 basis points as a result of the decrease in comparable store sales.

In the direct channel, which includes sales from both the catalog and Internet, revenue was up 27% to $36.1 million, on top of a 78% increase in last year's third quarter.

Catalog revenue grew 24% in the quarter to $19.2 million, and Internet sales grew 31% to $16.9 million for the third quarter.

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

While catalog circulation for the third quarter was relatively flat, pages circulated were up 19%.

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 being maintained, and on a year-to-date basis has grown.

Based on our change in merchandise offerings, we have refined our circulation to focus on optimizing productivity per page and maximizing the page count to our best customers in the important fourth quarter, thus reducing our circulation in the fourth quarter by 16%, but increasing our page count per book by 10%.

We anticipate that full year circulation will be flat to prior year, and pages will be up approximately 18% year-on-year.

Segment profitability for the direct-to-customer segment was 7.4%, or $2.7 million, in the third quarter, as compared to 5.3%, or $1.5 million, in the prior year's third quarter.

The 210 overall basis point improvement was driven by a 310 basis point increase in gross profit due to product margin expansion of 200 basis points, and continued improvements in supply chain and distribution costs of 110 basis points, offset by increases in call center and fulfillment costs of 120 basis points due to price increases at our third-party provider.

Turning to our balance sheet.

The outstanding balance on our line of credit was $79.6 million at the end of the third quarter, and up $15.4 million as compared to prior year's third quarter.

The increase is primarily due to 12 million in additional capital expenditure year-on-year, principally for the store remodeling effort.

Inventory at the end of the third quarter was $164 million, up 4% compared to the prior year's third quarter.

We have 37.7 million common shares outstanding at the end of the third quarter.

Year-to-date capital expenditures were 22 million compared to $10.1 million in the first nine months last year.

The largest portion of spending, approximately 14.9 million, relates to the store remodeling effort which was essentially paid for in the second and third quarters.

Depreciation and amortization expense was $4.4 million for the third quarter,.

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

We expect comparable store sales to be down low negative single digits for the fourth quarter compared to a comparable store sales increase of 5.7% in the prior year.

This reflects the change in merchandising mix from lower margin accessories and discovery items into higher margin core businesses and higher margin seasonal categories.

We expect to see fourth quarter direct-to-customer revenue increase 15% to 20% on top of an increase of 51% in the prior year's fourth quarter.

We expect to see earnings for the fourth quarter of $0.29 to $0.33 per share, with a weighted share count of 39 million common shares.

Inventory for the fourth quarter is expected to increase by 5%.

Capital expenditure is expected to be 27 million to $29 million for the full year.

Now I will open the call up to questions.

Operator?

(OPERATOR INSTRUCTIONS).

Molly Hexal (ph) with Friedman Billings.

I just had a quick clarification question.

Did you say in the first quarter you expect to get back to positive comps?

Did I hear that correctly?

Say that again.

Did I hear you say that in the first quarter you expect to get back to the positive comp levels?

We do.

And then on the special order merchandise that you're seeing above plan, can you quantify for us how much of an increase that you're seeing versus past quarters or what you have seen before?

We're not giving that exact level of detail out at this point.

Can you say is it double, triple, anything like that?

Any sort of color.

Rather not at this point.

And then can you just give us an update on the CFO search?

We have currently engaged a search firm, and are doing a search externally and internally for the CFO position.

We would hopefully expect to have the role filled probably sometime in the first quarter.

Crystal Lanigan with D.A. Davidson.

Gary, I have several questions that are sort of related to how you're approaching Q4.

I am just trying to get a little more detail, if we can, as far as looking at the merchandise transition.

The number of SKUs that you have this year versus last year in Q4, how many -- how much of a cut in SKU count does it look relative to last year?

It is really a shift in SKU count versus a cut in SKU count.

If you look at the businesses that we significantly expanded, textiles, bed and bath textiles, our window treatments, our lighting and that is really where the significant growth was planned.

And then in the accessories and discovery item areas where we cut back SKU count.

That helps.

I guess the question is how to think about -- and you have talked about for quite some time the merchandise margin increase due to the cut of discovery items.

Is there any way to quantify, or give us some sort of directional idea of what we're looking at?

You can look at what the margin numbers looked like in Q3 and what we're guiding Q4.

We think that there will be significant margin upsides into Q1 and Q2.

And then we think that there will be continued upside as we lap over Q3 and Q4 next year, but smaller increases as we get into Q3 and Q4 next year.

You talked about just on the last conference call that some of your special order programs are running north of 60% margins.

Discovery items, is it safe to assume that they were significantly below that -- since I'm assuming most of that was market-based goods?

You had a good portion of the market-based goods, some of it direct imports.

But just the higher seasonality of those product categories created higher markdowns and lower margins.

What you've got now is a model that is a much more predictable model built on one-third core businesses.

This fourth quarter is kind of the final big chess move that we're making here.

So if you think about this concept going forward, you can think about our dominant positions in core cabinet, hardware and door hardware, bath hardware and bath accessories, bed and bath textiles, window treatments, lighting, furniture and then accessories will play its role.

But will play its role more as a layering effect as opposed to kind of the driving force of the business, what it was historically.

So as we have engineered this concept, it should be a much more predictable model.

We should continue to gain market share in the categories that we positioned ourselves around.

I think if you went to a center today and you walked the rest of the store and walked the other home lifestyle stores comparatively and took a checklist by core business, I think we feel we're very well positioned in all of the categories we're competing in now, and positioned well to continue to gain market share.

And we built the concept now around core businesses that are all exclusive products, all direct imports, and all very high margin product categories.

You talk about the bath event starting one week earlier this year.

Is there any other events that are changing, shifting or anything you're not anniversaring relative to last year?

No, there's not.

The reason that we're pulling the trigger on the bath event a week earlier is just looking at ourselves critically, last year merchandise in the mall that week after Christmas when we have got the most traffic, and people out there with gift certificates and exchanges, we would merchandise like 95% of the rest of the retailers with with kind of sale goods up front and markdowns up front.

And we just thought there was a great opportunity to merchandise fresh products.

We're expanding our bath furniture and bath accessory line this year, as well as we have the expanded textiles -- textiles representation.

And you'll see us with new colors and merchandise, and probably a more colorful, fashion fresh way then RSTO has ever been merchandised.

I think it is one of our best looking floor sets.

Since you brought it up, gift cards -- how big of a component is that for you Q4 and then looking forward into Q1 sales?

Not a big component for us, since we don't have gift cards.

And we have gift certificates.

We still operate in an old POS system that doesn't allow us to use gift cards yet.

That will be dealt with as we upgrade our systems over the next year or two.

But it has not been a big component of our business -- gift certificates -- it is a reasonable part of our business.

And then just a couple more housekeeping questions.

It did indeed turn out that the leather sale was extended one extra week back in September?

That's true.

Are you guys giving any guidance as far as '06 expansion yet?

Not yet.

Laura Champine with Morgan Keegan.

I apologize if I missed it, but it does look there's a pull back on catalog in terms of circulation and pages circulated in the guidance for the full year.

Am I reading that right?

What is driving that slight pull back?

Sure.

I think what is driving it is just a cautious approach to Q4, since this is -- since it’s the last quarter with big moving parts.

With the reduction of discovery items and with the planned lower comps in the retail stores, specifically in December, as we make this final shift in the business, we thought it was appropriate to be conservative with the catalog spend in the marketing, and make our best bet to maximize profitability in the quarter.

I think you'll see us return to a more aggressive approach to the direct business as we move forward.

But we thought it was appropriate in this fourth quarter to take a conservative approach.

And other than the product mix shift, which you have been covering, are there any other changes to your assortment or your promotional strategy for this weekend starting this Friday on a year-over-year basis?

How are you approaching the holiday?

We expect markdowns throughout the holidays to be significantly less than last year, as we were planning down our highest -- the biggest seasonal part of our business down pretty significantly.

If you walk into our stores today, while I think we look appropriate for the holidays, we have significantly less holiday decor, wreaths and kind of garlands and less discovery items and less overall accessories.

Last year if you were in our stores, we have a garden room that was merchandised.

We had a game room that was merchandised.

So all of that perimeter space that was kind of noncore businesses and discovery items, what was left over as we kept kind of remodeling the stores and repositioning the assortment, all of that space now is transitioned to year-round core businesses that don't peak the same way in those kind of critical four weeks of December.

That is why we planned the down draft.

Once we cycle around on top of this, you'll see us become more gift focused and continue to layer on the appropriate gifts, and have gift extensions out of our core businesses that will reinforce the brand.

Rob Wilson with Tiburon Research.

Gary, could you talk more about the outdoor living catalog you're planning in March?

Maybe the page counts?

The page count will be somewhere around 80 to 90 pages.

Why would you mail that in September?

Just curious.

We think that there is an extended period that we can target that business to certain parts of the country.

You'll see us -- it is possible we could mail that catalog in January to Florida.

What sort of circulation counts do you think you would be targeting?

We're not giving out those numbers at this time.

We think that there is a significant opportunity in that kind of growing category.

We have seen our business build significantly over the last several years.

If you have seen our direct business growth over the last three years -- in the second quarter you have seen our business expand.

A lot of that was on the back of the outdoor business.

We felt that to continue to expand the business without kind of polluting the core book and overtaking the other core categories for five months of the year, that it was appropriate to mail a more focused offering, on outdoor lifestyle book.

We think it will make a better presentation.

And these categories allows us to expand these categories.

And it also allows us to take the core book and present our year-round core categories in a more clear and dominant way.

I think Murray said that your call center costs were going up.

But why would that be if your transaction counts are going down?

Murray, the call center costs.

Murray was just referring to a year-over-year price increase as that affected our cost as a percent of sales.

It was straight translation of a price increase vs. prior year in our direct business.

But aren't your transactions going down materially?

Wouldn't that drive your costs lower?

In the catalog that hasn't translated yet, because a lot of those higher unit businesses that Gary is editing out at retail are not catalog businesses.

You don't have the same dramatic difference -- the catalog business -- direct business never -- you never had a big portion of the business in accessories or discovery items.

I guess one final question.

I think I still show your operating margin going up in Q4 versus last year despite the lower comp store sales.

That's right.

So you're planning on a higher operating margin?

That's true.

Okay.

Just wanted to check that.

Thank you.

Rex Henderson with Raymond James and Associates.

A couple of questions.

First of all, on the October call you talked about the deferral of furniture revenues into the fourth quarter, and some smaller deferral of furniture revenues from Q4 into Q1, with a net positive impact for the fourth quarter.

I'm wondering what your thinking on that is now.

Does this guidance include any net positive impact from that revenue deferral?

It does.

And as a comp percentage, it is not as big of a comp impact on the fourth quarter as it was on the third quarter.

Can you quantify for us what that impact is?

Yes, the impact is about a positive 1.5 to 2% impact to the fourth quarter.

And it was a negative 3.6 impact to the third quarter.

Secondly, can you -- in the merchandise mix in the fourth quarter, can you -- what level of discovery items are you expecting in this guidance versus where it was a year ago versus where it was say five years ago?

Five years ago it would have probably been 75% of the business in the fourth quarter.

And this year we're not giving out specifics, but it is its biggest quarter, so you're probably looking at somewhere in the 30 to 35% range.

And then versus a year ago it would have been significantly higher, in the 40 to 45% range.

Is that kind of where your target range is for discovery items in the fourth quarter?

Yes.

In the fourth quarter -- if you go into the stores you'll see that we still have the stocking stuffer business.

We still have the two tables of stocking stuffers.

The tools and the toy table.

We still have the layer of holiday decor.

That we still have Christmas tree ornaments and the wreaths and garlands and holiday decor business that we layer in, as well as some kind of key gift items.

And what you're seeing now too is we have changed the business somewhat in giftability is you're just trying to see the early beginnings of taking our current core businesses and kind of making them more giftable.

The extension is kind of giftable approaches.

For instance in our utility business, our cleaning business you have seen us -- if you go in the stores just take the private-label Restoration Hardware cleaning collection and package it in little gift sets of two bottles and a tote, and put it in a gift box.

The extension of giftables and bath accessories.

And we are just in the early stages of that development.

We've got some other exciting things going to announce for next year that as we look at how to make the business more appropriately gift for next holiday season.

We have a huge focus on that in the Company for next year, but it is hard to do it all at one time.

The biggest down draft -- if you think about the model in the fourth quarter is to understand that if you looked at this business in 2001, 80%, 85% of the perimeter center wall space -- if you walked around the perimeter wall -- 85% of the perimeter wall space was discovery items or accessories.

So you walk into our store and you had hardware wall -- you had a couple of hardware walls.

You had a day lighting sconce wall.

And beyond that the rest of it -- and you had a little bit of bath hardware in one of the back rooms.

Beyond that, basically you had kind of a garden room, a book room, kind of a toy and game room, and yet we had -- all just 85% of the space was kind of noncore, nonrelative businesses.

And that is why this business, it is never relevant over the long term, or was going to be relevant.

As we have reengineered the space, now that 85% that was nonrelevant perimeter Wall space is now engineered and focused on the core categories that we want to be famous for.

So it is not too difference then if you look at a grocery store we've got the dairy department and the meat department and the produce department and so on and so forth.

A grocery store has got to be great at those businesses or it doesn't drive the traffic.

And so we are engineering our store to be great at the businesses we want to be in.

And we have had to do that a chunk at a time.

And we've also had to do that without making a major mistake.

In the first couple of years here, and I have told a lot of people, if we had one-quarter of negative high comps, this is a bankrupt Company.

So we had to go step-by-step and reengineer this.

Now this fourth quarter is kind of -- the third and fourth quarter is the last big chess move with these remodels.

So now we've got, I think, a fundamentally sound concept, that if you walk the malls today, I think we look as good as anybody out there.

And now it is something -- we have taken the store line from 3 to 4 million.

And now we've got a base that we can build on.

We've got a high margin mix.

We've got a lot of work to do on continuing to improve our supply chain and efficiencies, but we've got a model now that is not going to move a lot -- move around a lot.

And we can continue to hone it and make it more productive.

One final question on -- kind of a modeling question.

I think we lost you.

Hello Operator?

Rex Henderson with Raymond James and Associates.

(multiple speakers) the last question here.

One final question.

Debt level at the end of the year, any idea where that will be?

Right about $45 million.

Rob Wilson with Tiburon Research.

Just one follow-up.

I guess we do agree your stores look tremendously better.

My only question to you would be how do you know that the customers are actually recognizing your dominance in these core categories?

I think it is going to continue to take time.

I think what we are seeing now in lighting, where if I look back on think about the lighting business, we made a major transition in Q3 right prior to the lighting event.

We refixtured the stores.

We spent about four months marking down the old assortment, and getting rid of the new assortments, bringing in a whole new custom lamp shade interchangeable business.

And we probably just were too aggressive out the box, thinking what kind of impact that was going to make out of the gate.

As we look at the lighting business now, as we move forward over the last six weeks, and now we're post event, the lighting comps that we are starting to see are more in line with what we initially anticipated.

And we have seen -- we are seeing it building month after month, week after week.

And I think it is no different than when you saw us make the first couple of moves we made in 2002.

When we brought in window treatments, and we brought in bed and bath textiles, and we brought in bath hardware.

That was a first kind of big moves we made.

And over the last several years we have seen those businesses double -- over a three-year period.

I would expect we're going to see similar kinds of things based on the investments that which we just made.

We probably were overly optimistic in how quickly we're going to get traction.

Again, you get some dislocation with customers who are coming in expecting to find games or garden stuff or odds and ends, and finding that that stuff is not there and it is replaced with new assortments.

There is a transition time.

But you'll also see us through the marketing of our catalog continue to reinforce our core businesses.

The difficult thing with this concept I think versus starting something new -- if you start something new and you engineer it right, you have got a a concept that is built on our core businesses.

And if you merchandise it poorly for a year the turnaround is basically kind of going back to what you were.

This wasn't really a turnaround of going back to what we were.

This is kind of a do over of really creating something very new and different than Restoration Hardware ever was, except for really the cabinet hardware business, and a small part of the bath hardware business and some of the furniture business.

But now really what we really would have done is architected a premium home lifestyle concept around -- 80% of the businesses are businesses that were are really not relevant to RSTO four years ago.

So now is just the building on it.

I think we have been able to transition while increasing our comp store sales over the last several years, and our average store volume, and taking our direct business from roughly 20 million to 160 million.

And now we've got a real business.

Now it is just building on this business and refining it and making it stronger.

We feel really confident about the future as we look forward.

We've got a lot of growth ideas as it relates to category extensions and brand extensions, and market extensions that we will be unveiling over the next year or two.

We think all the exciting things that John and his team are doing on the operational front is going to make this a real Company.

Is there a marketing initiative you have planned to reintroduce customers to the new RSTO, is there something you have planned going forward?

Not really.

We will just keep doing what we're doing.

We don't think that there is a magical bullet here.

It is just -- when you are a Company our size you can't really afford to go out there and do some big marketing campaign.

So you'll see us continue grow our catalogs, page counts, circulations, category extensions off our catalogs.

We think the outdoor furniture -- the outdoor living catalog is going to be the first category extensions to spin off.

We think we will have other ones to follow.

We will continue to build this brand over time.

And I think as I meet people and give reports -- you meet people who say, oh, you work for Restoration Hardware.

Oh, I know your store.

I go in there for those neat little gadgets and stuff.

That is all I ever heard.

Now I am finally starting to hear people say, oh my God, you guys have the best towels I have ever used.

Oh my God, you guys have great Italian sheeting.

Oh, I love your bath hardware.

It is just like Waterworks but a better value.

It takes time for people to really understand a retail concept like this, especially when you used to be something different.

When they knew you one way, and they don't come to anymore, it takes a while to get them back in.

We think we're on the right path.

And again, we were disappointed with this last quarter's business.

We've got another tough quarter in Q4 from a topline point of view.

But these were really big moves.

We're planning businesses down 30 to 40 points.

We are planning business other categories up 30 to 40 points.

Big giant chess moves.

We came out a little short, but they are the right moves to make for the long-term positioning of this concept.

I wish you well in the fourth quarter.

Kristine Koerber with JMP Securities.

A couple of questions.

One, Gary, looking at the deferred revenues from the custom furniture, is there any solution to the problem, or minimizing the revenue deferrals going forward?

Can you have -- maybe stock furniture with popular fabrics or whatnot?

Yes, we do stock furniture with the advertised fabrics and one to two fabrics in every frame, some three.

This was -- the amount of business that moved to the special order program -- kind of a surprise for us.

We took our best shot at anticipating it based on past performance.

But this is the first time we marketed a 45 day delivery with this many fabrics and leather choices, and we guessed wrong.

The impact I think from shortening our delivery time from 8 to 12 weeks down to 45 days was significant.

And again, we marketed it in a pretty compelling way with the double truck of all the fabrics and the new fixturing in the stores.

Now we understand the business going forward.

We will be able to predict revenue deferral I think pretty accurately.

It was really kind of a onetime event in changing the business that we anticipated special orders to be X percent of the business, and they were 2 to 3X of what we anticipated.

And so instead of having -- we wound up with the furniture sales we wanted, but instead of a certain percentage of them being one to two weeks delivery, a much bigger percentage was 45 days, which pushes the revenues into a higher deferral state.

Going out of a quarter and also going out of the fourth quarter.

This now lapsed through for one year, and you will have a kind of a higher permanent deferral based on the higher percentage of special orders.

But it is not an issue that you want to fix necessarily.

Let the customer buy what they want to buy.

It is really just a timing of revenues.

Can you just comment on the overall response to new products?

Are there categories of products that hasn't worked since the you rolled out the new products in the fall?

I know we've talked about the problems in lighting, but aside from lighting, are there any categories that may have not worked as planned?

Yes.

Pleated draperies was slower out of the gate than we anticipated.

And that is why you see it right now a special price in the stores.

I think the average retail -- the pleated drapes versus nonpleated drapes is almost 2X.

And that takes twice the fabric, and it takes more sewing and so on and so forth, and more labor.

And so I think -- we anticipated that to come out of the gates faster than it did.

I think it is going to be another one that is going to build over time.

I think there is a market there.

I just think that no one has ever really sold pleated drapes premade.

We never sold them before we marketed them.

We've probably were too optimistic on how those would initially get traction.

And then we're not in as good a stock shape as we would like to be in some of our core bedding programs and some of our window treatments and nonpleated because we plan the pleated business as a certain percentage, and we are a little off.

We're missing come business on the textile side, because we're not as well in stock as we would like to be.

We are probably somewhat under bought in some of those categories.

I think that is why our inventories are a little low.

You're going to see us start to invest more in some of these core programs where we just say we never want to be out of stock -- in white sheets and in Silver Stage drapes and so on and so forth.

John hired a terrific inventory leader, Michael Barry, who is a Senior Vice President of Inventory Planning for the Company now, a 17 year Gap veteran is bringing a whole new level of leadership and discipline to inventory management.

I think you'll see our in stock go up, our inventory productivity go up.

There's a big opportunity.

I think we're missing several points right now just from not really being in stock where we should be.

Of the inventory growth for the quarter -- the 4%, how much of that was in lighting?

You've got the -- an impact of a couple of million dollars over in lighting.

And then we would like to own more textiles, as I said, today if we could, and we are responding to that.

Lastly, John, can you tell what inning you are think we are in as far as the supply chain cost savings?

Is this just the start or are we further along?

That is a good question.

I think if you think about it in two components, you think about cost savings from just improved processes, better purchasing, reorganizing your DC, all of those, I think we are in the fifth inning.

If you think about cost savings from a whole different level of technology infrastructure, because most of our existing systems are impaired in some way, we haven't even started to realize those.

When you roll all that in together maybe we are in the third inning, to use your metaphor.

Mickey Strauss with Strauss Asset Management.

Maybe you explained this, but not to my satisfaction.

You changed your guidance for the fourth quarter's comps negatively.

I think your previous guidance was flat to down low single digits.

And that was given before you had this 1.5% improvement from the deferral of sales.

What changed your thinking in this last couple of months?

A couple of things.

One, we're just trying to be conservative in our guidance based on our third quarter results.

And we did pull back catalog circulation as we looked at the fourth quarter to be more conservative from an add cost perspective in trying to fine-tune circulation.

And the fact that we pulled back circulation 16% made us kind of pull back the comp guidance.

Have you -- I know we're talking about a couple of weeks here, but what have you seen in November so far?

It still really early.

The big question for us is when we get into the three to four big weeks.

Right now the business is still kind of driven by home furnishings and somewhat holiday decor.

When it shifts into core gift giving is when we have the most uncertainty -- when we still had a good percentage of the perimeter walls that had a lot of games and garden and things like that.

It is kind of too soon for us to say honestly.

It would probably be inappropriate for me to get any kind of indication.

William Wallace with BB&T.

I'm actually on the line for Laura Richardson.

Going back a little bit to the promotional activity, we saw a 10% off your entire purchase at the Virginia Outlet this weekend.

I was wondering if that is just for outlets?

Is it all of your outlets?

Are you going to do it in your regular stores?

It sounds like a rogue outlet strategy, maybe in Virginia.

They may have had some special goods they wanted to move through.

But it has nothing to do with strategy in the core --.

So it may just be this one outlet?

It could be, yes.

In Q3, can you comment on regional and category sales trends?

I think we commented on the category sales trends.

Regionally not anything that significant to comment on.

No outliers?

Not more than usual.

That's all I have.

Thank you.

Kevin Foll with Magnatar Capital (ph).

I do want to congratulate you.

I do like the stores.

The sheet sets are great.

But going on to -- going back to the holiday of '03, that was a year where you kind of had this similar type of strategy where you focused on less of the impulse items and in more of the core business to focus on the margins.

There was a disruption in the fourth quarter.

You kind of reversed that strategy in the holiday of '04 and went back to 70% units on accessories and gift giving.

And then now this year we're kind of reversing that again.

I guess, would you clarify the holiday '03 kind of misstep was more of a merchandise issue or more of the supply chain issue?

Sure, let me comment on it.

I think if you looked at it -- what has been happening since we -- the first phase of starting to kind of reconstruct the merchandising model here that happened in spring of '02, every year we have been kind of editing back the accessories business.

We didn't edit it back '04 compared to '03, because we didn't really go through any kind of remodel or refixturing or space allocation.

What you saw last year was an emphasis on having more newness in accessories, and kind of discovery items, but not more space.

What you saw in '03 was really the continuous movement of moving away from those kind of product categories in kind of big chunks. '04 over '03 there was not a big movement, because to make the next big movement we really had to refixture the stores again.

And so this year we refixtured the stores and we took the perimeter wall space away from the non-core categories and gave it to core category.

So it is really no change in strategy.

From year to year there has been some differences based on the fact that refixturing and major moves.

That is really how it is playing out.

Can you just give me some comfort on -- you said you're modeling some leverage on the operating margin side to the fourth quarter.

It is kind of tough to understand, given that the good portion of your mix is still retail, and you're modeling a slightly negative comp for the quarter.

Can you walk me through what is offsetting the -- going to offset the occupancy deleverage?

The biggest portion is really the product margin leverage we're going to get.

And that is because we are editing out the lowest margin categories and the highest markdown risk categories, and replacing that with product at significantly higher margin.

Can you quantify at all how much you expect the product margins to improve for the quarter?

Several hundred basis points.

Lastly, on just kind of the long-term visibility on top line, as you kind of normalize and transition through this remodel, how should we think about the business going forward in terms of circulation and long-term comp and topline growth?

We think we will return in the first quarter to positive comps.

We would anticipate -- we should be a positive comping Company.

In the last four years since we started transitioning this business, we have only had a couple of quarters where we haven't been positive comps.

You have seen us improve the store performance from 3 million to 4 million over a four-year period.

We continue to believe that we can out build on these categories, be a positive comping Company.

You'll see us continue to grow the direct business.

And I don't want to call it easy growth, but I would say the easy growth in the direct business is probably over.

None of it is easy.

But we went pretty quickly from 20 million to 160 -- to be somewhere around 160 million this year.

Now you'll see us be more creative in how we approach the direct business, whether it is, as I said, category extensions like the outdoor book.

And in the future we will have more category extensions and separate books or brand extensions, which could be a stand-alone business that carries the RSTO brand.

And then we think we've got market extensions as we go forward.

The other thing that -- as we previously announced we are working on is the introduction of a new concept that right now we're tentatively planning to test a better catalog in fall of '06.

We kind of code-named it East Oak.

But it is just a joke.

But we have a new concept that will be coming up -- that will be introduced as a catalog.

And we will continue to fuel the direct business.

We think that our growth over the next couple of years -- we think our growth will be more direct centric growth then store growth.

If you look at it, we think there is just many opportunities to grow our business beyond the four walls of the store, and leverage our kind of growing expertise in the direct category and our success there.

It also gives us -- it also requires lower capital investment to grow the direct side of the business.

It gives us a higher return on invested inventory.

So we think it is the appropriate way to move forward.

And then, John, if you could just elaborate on -- we are kind of in the fifth inning in terms of the processes and the infrastructure, and the systems are really what need to be invested in.

Do you have the appropriate capital structure at this point to put that money to work?

We do.

We do, and we have a relatively detailed four-year plan about how we will do that, with the first couple of years focused on supply chain systems, and the latter years more on merchandise and inventory planning systems.

I would say, although we're certainly careful, we don't feel capital constrained at this point to get where we need to get.

Great.

Good luck this quarter.

Crystal Lanigan with D.A. Davidson.

I have a very easy last question for you guys.

Just housekeeping.

On Q3 did you open two outlets you said?

Yes, we did.

And then Q4 it looks like plans for one RSTO store and one outlet, is that still correct?

That is true.

There are no more questions at this time.

I will turn it back to you for any closing remarks.

Thank you everyone for your interest.

And we will talk to you next quarter.

Thank you.