RH (RH) 2005 Q4 法說會逐字稿

Welcome to today's teleconference.

[OPERATOR INSTRUCTIONS]. And I would now turn the call over to your host, Mr. Chris Newman. Go ahead, please.

Thank you. Good afternoon, everyone, and welcome to Restoration Hardware's fourth quarter and full-year 2005 earnings release conference call. My name is Chris Newman, I'm the Company's new Chief Financial Officer.

I'd like to remind you that the call is being recorded and will be available for replay via webcast on our web site at www.restorationhardware.com under Company Information, Investor Relations Event Calendar or by dial-in at 888-562-0852 until April 6, 2006. Leading our call today is Gary Friedman, the Company's the chairman, President, and Chief Executive Officer. Murray Jukes, our Vice President and Controller is also on the call. At the end of our remarks, we'll open up the call to questions.

But before we begin, let me address a few preliminary items, starting with a brief statement regarding forward-looking statements. These statements will include, without limitation, statements concerning or relating to implications of the Company's revenues, sales, and financial results for the fourth quarter and full fiscal year of fiscal 2005.

Statements concerning guidance for the first quarter and full fiscal year of fiscal 2006, statements relating to the Company's anticipated revenue, comparable store sales, direct-to-customer sales, and earnings per share for future periods, statements relating to the impact of total revenue and order deferral on the Company's results in future periods, statements concerning the anticipated benefits of certain growth opportunities for the Company, and other statements containing words such as "believes," "anticipates," "estimates," "expects," "may," "intend," and words of similar import.

Important factors that could cause differences are contained in the Company's filings with the Securities and Exchange Commission, including the MDNA section in our most recently filed form 10-Q and 10-K and our release posted on the Company's web site regarding our results for the fourth quarter and full year of fiscal 2005. Any guidance we offer represents a point-in-time estimate. We expressly disclaim any obligation to revise or update any guidance or other forward-looking statements to reflect events or circumstances that may arise after the date of this call. And now let me turn the call over to Gary.

Thank you, Chris. Good afternoon. I'm going to comment on the highlights of the fourth quarter and review some of our important growth and operational initiatives for 2006.

Our results for the quarter were in line with our most recent guidance issued on January 17, and we remain pleased with the customer demand for our product in all channels. As discussed, the shift of our business to a higher percentage of direct-to-customer orders and special order furniture created a higher than anticipated total order in revenue deferrals that negatively impacted our results in the fourth quarter. Total order and revenue deferral for the quarter was $25.9 million, a 57% increase over last year. The company believes that the total order and revenue deferral has an impact on comparable store sales is approximately 4% versus last year and approximately 3% versus the original guidance for the quarter. We expect that the reduction in the total revenue and order deferral balance will provide a positive benefit to our results in future periods.

For the first quarter, we expect the benefit to contribute 2-3 points to our comparable store sales. We are not anticipating the same benefit in the same channel due to the continued rapid growth of furniture which results in a larger deferral at the end of the first quarter. A majority of the shift of delivered revenues is due to the introduction of our outdoor furniture catalog in March.

The demand for our core businesses remains strong as we are forecasting comparable store sales to increase 6% to 8% on top of a 5% increase last year, with merchandise margins of several hundred basis points drew to strategic repositioning of our product mix. With the most recent remodels we believe we have significantly strengthened the position of our stores in the market as a destination for high-quality furniture, lighting, textiles, hardware and bath hardware and accessories.

Healthy trends continue in our direct-to-customer channel, where we recently introduced our new outdoor furniture catalog. We believe it offers the most comprehensive and well-positioned collection of outdoor furniture in the marketplace. The premiere issue was in homes March 7th, and we are pleased to date. We anticipate that direct-to-customer revenues will increase 20 to 25% in the quarter, on top of the 50% increase a year ago. We also expect the trend will accelerate in the second quarter as we benefit from an additional mailing and increased circulation of the outdoor catalog in the period.

Looking forward, we are very excited about the many growth and operational initiatives designed to further strengthen our business and our brands. In addition to the launch of the outdoor catalog we will continue to grow our core book through category, page count, and circulation expansion. Our book and page productivity continue to increase, as we improve our product mix, build our database, and refine our circulation and web marketing strategies.

In our retail stores, we are focused on a core business in-stock strategy, to our increase our potential in Restoration Hardware franchise businesses. With the dramatic changes the brand has undergone in the past several years we've not had the selling history in many of the new categories to adequately forecast or replenish our stores. We believe there's a meaningful opportunity to increase comparable store sales over the next several years. Also, as previously mentioned, we plan to test the new brand this fall, targeting a broader value market with a catalog mailing in September.

We believe there's a tremendous opportunity to introduce a fresh brand that offers great design, quality and value to this large consumer segment. Costs related to the startup of the new brand equates to approximately $0.01 per share in each of the quarters this year. We have also embarked on the first phase of our strategic supply chain and systems infrastructure initiatives.

We are working on plans to install new order management and warehouse management systems in our storage, distribution centers, call center, and home delivery providers. Our goal for phase one is to simplify the order process in our stores, call center, and on line, and to ensure order integrity and visibility throughout the supply chain. In addition, we are building a tri-channel merchandising database that will greatly enhance our ability to plan and manage our inventory across channels.

By fall we have have rolled out our home delivery network strategy that calls for consolidation of our home delivery providers, allowing us to install common systems plus better manage and evaluate our performance. We believe we're -- we are in the early stages of realizing the supply chain opportunities in our company, and continue to think of this area as having several hundred basis points of operating margin gains in the years ahead.

More importantly, we believe our supply chain initiatives will have a positive impact on our customer experience. Our investments related to these activities equate to approximately $0.01 per share in each of the first three quarters. Also today, we announced that John Tate, our Chief Operating Officer, has resigned for personal reasons, and plans to return to his home in North Carolina to spend more time with his family. As you know, John joined Restoration Hardware as a board member in 2003 and became our Chief Operating Officer in fall of 2004. John has made many significant contributions in his brief tenure here, stabilizing reducing costs in our distribution network, developing a three-year supply chain and system strategy, and building a strong and talented management team. While we are saddened by John's departure, we are grateful that he will remain in his role and help in recruitment and on-boarding of a successor to ensure a smooth transition. At this time I will turn the call over to Chris.

Thanks, Gary. This afternoon I'll first take you through our financial performance for the fourth quarter and full-year fiscal 2005. Then I'll provide guidance with respect to our expectations for the first quarter and full year of fiscal 2006. At the end of my comments I'll open the call up for questions.

Fourth-quarter net revenue was up 2% to $191 million versus $187.9 million in the fourth quarter last year. Retail revenues declined by 3.3% for the quarter, with comparable store sales for the quarter down 5.5% versus a 5.7% increase last year. Direct-to-customer revenue was up 20% to $48.2 million, on top of the 51% increase in last year's fourth quarter.

Along with the increases in revenue, we experienced expansion of our gross margin of 260 basis points. Selling general and administrative expense in the quarter, expressed as a percentage of sales was higher than the prior year by approximately 430 basis points. I'll cover the drivers of the change in gross margin and SG&A later in my comments.

Income from operations was $14.4 million in the fourth quarter, versus $17.2 million last year. For the fourth quarter, the Company reported a net loss of $19.5 million, or $0.52 per share inclusive of a noncash charge of $27.9 million or $0.74 per share. This noncash charge provides a full valuation allowance against the Company's net deferred tax assets, and is associated with the guidance provided in the statement of financial accounting standards, SFAS 109. This valuation allowance is based on the cumulative U.S. losses of the Company and will have no impact on cash flow or future prospects, nor does it alter our ability to utilize the underlying tax net operating loss and carry-forward in the future. Excluding the noncash charge, earnings per share for the fourth quarter was consistent with the Company's most recent guidance.

Turning to the retail segment, as mentioned, we experienced a 5.5% decrease in comparable store sales. As covered previously in the Company's guidance on January 17, 2006, the comparable store sales performance was negatively impacted by a greater than expected total order and revenue deferral, which is comprised of back orders, special orders, and in-transit deferred revenue orders. The total order and revenue deferral for the quarter was $25.9 million, a 67% increase against the total order and revenue deferral of $15.5 million last year. This total order and revenue deferral was consistent with a $26.3 million estimate we issued in our January 17, 2006, guidance.

The 5.5% reduction in retail comps was negatively impacted by approximately four points due to the increase in the total order and revenue deferral. Retail comps were driven in total by an increase in average retail dollars per transaction of 22%, and a decrease in total retail transactions of approximately 23%, reflecting the changes in our merchandising strategy, and specifically the expected decrease in decorative accessories.

In the fourth quarter of 2005, we opened one new retail store in Cincinnati, Ohio, and one new outlet store in Rentham, Massachusetts. In total, revenue for our six outlets was $5.4 million in the fourth quarter, up $2.4 million from last year. The outlet stores have been designed to liquidate returned, damaged, or discontinued goods. This revenue has been reflected in the retail segment, but is not considered in the calculation of our comp store sales.

For the fourth quarter of fiscal 2005, our retail segment realized a $25.9 million four-wall contribution after cost of district management, or an 18.1% contribution margin as stated as a percent of segment revenue. This compares with a $30.6 million contribution at 20.7% of net retail revenue reported in the fourth quarter of the prior year. Segment gross margin for retail improved by 120 basis points, as a result of much higher product margins which improved by 260 basis points reflecting the shift from low margin accessories and discovery items into our core businesses and a slight improvement in supply chain costs, which was partially offset by a deleverage of store occupancy resulting from the negative comparable store sales. Selling general and administrative expense for the segment deleveraged by 380 basis points largely a result of the negative retail comp and investments made for the holiday season.

Turning to the direct segment which included sales from both the catalog and internet, revenue was up 20% to $48.2 million, on top of a 51% increase in last year's fourth quarter. Catalog circulation for the fourth quarter was down 14%, with pages circulated down 6%. Productivity per page was up significantly in the fourth quarter, as we successfully refined our circulation to focus on optimizing productivity per page. Catalog revenue grew 11% in the quarter to $23.7 million, and internet sales grew 30% to $24.5 million for the fourth quarter. Our catalog continues to provide significant product and overall brand exposure in our retail trade areas, as well.

Segment profit in direct was $7.6 million in the fourth quarter, a 15.8% contribution margin. This profit compares to a $4.9 million, or 12.1% contribution margin last year. At the total company level, we continued to see expansion in our gross margin. In the fourth quarter, gross margin increased to $74.1 million or 9% versus fourth quarter of the prior year. This of the result of increased revenue, coupled with a 260 basis point improve ment gross margin expressed as a percentage of revenue to 38.8% from 36.2% in the same period last year.

The improvement in gross margin at the Company level was the result of significant improvement in product margins of 250 basis points and continued improvement in our supply chain and distribution costs which were partially offset by deleveraged store occupancy costs. Selling general and administrative expense at the total company level was $59.7 million in the fourth quarter of 2005, or 31.3% of net revenue, compared with $50.7 million or 27.0% in the prior years' fourth quarter.

The primary drivers of the increase in SG&A cost as a percent of net revenue of the deleverage resulting in the decline in comparable store sales and the higher growth we experienced in our direct-to-customer segment. As we have shared with you previously, in periods where we experience more rapid growth in the direct-to-customer channel than in the retail channel, we'll have the effect of deleveraging SG&A costs for the Company because of catalog advertising, which is a significant cost driver. Income from operations for the quarter as mentioned was $14.4 million versus $17.2 million for the same period last year. EBITDA for the fourth quarter of fiscal 2005 was $19.7 million as compared to $21.4 million in the same period in fiscal 2004.

Now for the full year: Total revenue for 2005 was $581.7 million, an 11% increase over the prior year. Comparable store sales for the full year were about flat against last year's 7.8% comp. Direct-to-customer net revenue increased 34% to $160 million on top of the 75% increase a year ago. Within our direct-to-customer segments, net revenue grew 28% within catalog and 43% from sales on the internet. For the year, circulation of our catalog was flat and pages circulated expanded by 19%.

Income from operations was $0.9 million for the fiscal year versus $4.1 million in fiscal 2004. Included in income from operations is a $1.6 million charge for the accelerated depreciation for removing certain store fixtures resulting from the remodeling efforts which occurred in the second quarter. The company's net loss for the year ended January 28, 2006, was $29.3 million inclusive of the noncash charge of $27.9 million for the full valuation allowance we recorded in the fourth quarter. EBITDA for fiscal 2005 was $20.5 million as compared to $20 million in the prior year.

From a balance sheet perspective, capital expenditures for the year were $29.7 million with the largest portion of the spending occurring for the remodeling efforts of $17.0 million, and depreciation and amortization expense for fiscal 2005 was $19.5 million. The outstanding balance in our line of credit at the end of the year was $58.1 million, up from $33.8 million at the end of last year. The increase in borrowing levels reflects the increase in inventory, up $14.4 million or 10% from the prior year. And the higher capital spending associated with the store remodels we completed in the third quarter. Finally, common shares outstanding were 37.8 million at the end of the year. Up from 33.1 million last year because of the preferred stock conversion we executed in July, 2005.

Turning now to guidance for the first quarter and the full year of 2006. For the first quarter, we expect total revenue growth of 15% to 18%. Comparable store sales growth will be between 6% and 8%, including the favorable impact from fourth-quarter revenue and order deferral between 2% and 3%. We expect to see first-quarter direct-to-customer revenue increase by 20% to 25%. We expect our operating loss to be between $3 million to $4 million, which includes the estimated impact of SFAS 123R of approximately $1.3 million. Interest expense for the quarter is expected to be approximately $1.5 million.

We expect first-quarter 2006 results to be in the range of a loss of $0.12 to $0.15 per share with a basic share count of $38 million. Because of the valuation allowance provided against the Company's deferred tax assets, the income tax benefits or expense will be close to zero in 2006. Together, the impact of implementing SFAS 123R and not recording a tax benefit in the first quarter is between $0.08 and $0.09 per share.

For the full year, we expect total revenue growth of 18% to 20% and comparable -- comparable store sales in the low to mid single digits. Revenue growth in our direct-to-customer segment is expected to be in the range of 35% to 40%. Our operating margin for the year is expected between 1.5% and 2.0%, which includes the estimated impact of SFAS 123R of approximately $4 million or 0.6% of sales. Year-end inventory is expected to increase approximately 5% as our outlet strategy moderates total inventory growth. Capital expenditures are expected to be no more than $15 million.

As a result of the valuation allowance provided against the Company's net deferred tax assets, income tax benefits or expense will be close to $0 in 2006. Our weighted average diluted share count is estimated at approximately 40 million shares. With that, I'll turn the call open to questions.

[OPERATOR INSTRUCTIONS]. We'll take our first question from Kristine Koerber.

Hi. A couple of questions. First of all, with John Tate's departure, does that affect any of your supply chain plans or IT plans going forward? I mean, are we going to see any delays at all?

It does not, Kristine. John is going to continue in his role until we transition to -- in a new COO, and we don't anticipate any slowdown in any of our initiatives.

Okay. How long do you think it will take to hire a new person then?

It's really hard to say at this point.

Okay. Then can you talk about your in-stock levels? I know you were working on increasing in-stock levels in the first quarter. Where do you stand?

Sure. We -- I'd say we're okay right now, not great in some of our core categories. We will see improvements toward the end of the first quarter and beginning of the second quarter, particularly in windows and bedding and furniture. As I mentioned in the last call, really windows and furniture were the two areas that hurts the most in the January period. And we're still kind of recovering there.

But we have an initiative in the Company today where we're -- we're fiercely focused on kind of what we call the 10% of the items that produce a very large percent of our business. And we think that will pay big dividends as we make some investments in some of those kind of core categories. And find out how high is the demand here. In many of our core categories, whether it's bath, hardware, bedding, window treatments, so on and so forth, we continue to chase the demand.

Okay. As far as your long-term operating margin goal, I think you've talked in the mid to high single-digit range. How far out do we have to look before we can see kind of that mid single-digit range?

Far out?

Is this three years, five years?

I kind of think about three years as the mid single-digit range. Kind of number. And maybe five years for the higher single-digit range. I think what we have today is we have the concept today as kind of completely rearchitected. So in -- in many ways we -- we talk about the fact that the last several years here Restoration Hardware should have probably been kind of a venture-backed company, not necessarily operating in -- in the public forum as we built the concept.

Now we've got the concept built, and I think our concept looks as good -- our model looks as good as most people, and I think we'll see consistent growth, consistent leverage. We'll be working on building a back end that also gives us leverage. If you think about all the investments we've had to make to get to where we are whether product design, merchandising, sourcing throughout the organization we had to build a vertically integrated merchandising and marketing machine. Now we've had the opportunity to grow the business and leverage that infrastructure as well as invest into the back end, and we think there's plenty of leverage there.

Okay. Great. Just lastly, as far the new concept, launch of a catalog, where are you getting the data base customer file for that? Sounds like you're going after a slightly different customer.

Yeah. It is a different customer. Just like any new concept would we will initially rent names. And there may be some names in our files that might be appropriate. But mostly all new names. If you think about it here. five years ago, Restoration Hardware only did $20 million in direct business. We built this business to -- $160 million over the last five years, that same way.

Great. Thank you.

Your next question from the site of Rex Henderson with Raymond James and Associates.

Good afternoon, thank you for taking my call. A couple of questions about the supply chain. You articulated a little bit of general guidance on how much margin you can get. You said a couple hundred basis points. Do you have any idea what the consolidation of the home delivery system can offer you over the next few quarters?

Rex, we're not -- we're not specifically guiding on that yet. But I'd think about the supply chain long term. I think it's worth probably somewhere between 3 and 500 basis points. When you think about the impact on product margins and that cost levers all the way through the Company. That's really a big, big key of building the operating margin over I think the next five years.

Okay.

And so the home delivery network is just a piece of that. The whole direct-to-customer piece. You've got the retail distribution piece. You've got the inbound freight, and inventory management pieces. As we look at the supply chain end to end and core categories, it's almost an individual business as we architect what we call for business excellences within categories.

On the catalog business, have you seen any further impact from mail or postage costs and paper costs that have affected the SG&A there?

Paper costs definitely went up last year pretty significantly. But we've been able to absorb that and still get leverage in the business because of our -- our growth.

And how about postage costs went up 5% in January?

Right.

And are you able to absorb that?

Yeah. It's built into our models. Okay. All right. Thank you.

We'll take our next question from the site of Crystal Lanigan with D A Davidson.

Gary, a few questions. It didn't sound like John on the call today.

He's not.

Okay. We get to ask you the fun, detailed questions then. I know a lot of us are curious, on the last conference call, you and John were able to quantify a fair amount of where you stood as far the delivery and the supply chain. And do you know where you are now with a 45-day delivery compliance rate if you will?

Sure. We are. We're just over 80%, and then in major markets, we're in the mid to high 80's. And if you look at where -- where we -- where we're having a shortfall, primarily two issues. One of them is the customer is not ready to accept the goods. The goods are in the market, but the customer is -- wants them delivered later.

And -- and/or issues with some vendors may not be meeting the deadlines. Particularly one vendor in particular that kind of caused a lot of pain and a lot of late deliveries. And we transitioned part of our business as -- as we're up to speed, we've transitioned some business away there that vendor.

Okay. That of the upholstery vendor that you've been struggling with --

That is.

Okay. Where is the order of cancellation rate trending for you?

Our cancel rate is about 6% to 8% today.

Okay, it's come down a bit. Okay, okay. Great. Then you started to talk somewhat about moving toward vendor managed inventory levels. Are you still working on that, or can you give us more insight into what's going on there?

I would just say again, don't want to give away too much as far as strategy. We're looking at end to end. If you look at how our business is segmented today, there are big chunks of businesses. You have a very big cabinet/hardware business. A big bath hardware business. Big lighting business and bib bedding and window treatment business and so on and so forth. And we've got a pretty senior guy running our inventory management who is a 17-year gap veteran. A woman who's very senior in our global supply chain. Who previously worked at pottery barn and came here with me in the beginning.

They are constructing a a full view of how we look at how we look at the ordering, the procurement where the goods sit. How they move through the supply chain. How we replenish the stores. And beginning all the way back to the vendor. So in some cases, we may be holding goods in other place beside RTC.

Okay.

And be able to replenish quicker and holding product at a lower cost.

How long does it take to put a program like that in place?

it depends on the vendor and how important you are with the vendor and how consistent your business could be. I think the good thing about if you think about that program for Restoration Hardware, because we've architected this business around core -- these core product categories that aren't going to have a significant amount of change and seasonality to them, it -- it is much easier than, say, if you were -- you know, in a more of a fashion business.

Okay. Then moving up, I noticed the March upholstery and leather sale looks like you're a -- a little bit of a change, and then it's in-stock-only items?

Yeah, that's anniversarying what we've done in the past during that period when we bring in the outdoor furniture and outdoor furniture kind of takes the main runway down the middle of the store. And that upholstery gets pushed aside. We've always kind of held a -- kind of a quiet event on stocked furniture during this time.

Great. Then a couple of questions for Chris. Have you talked yet, or have you determined or give us guidance as far as'06 store expansion by quarter?

We have no plans for new store growth in 2006 in the mainline stores. There's the potential for two additional outlet stores, two to three, and they'd be paced later in the year. Second and third quarter most likely.

Okay. So unlikely any store closings at this point?

None, none in the plans currently.

Okay, great. Then you did give us the Q1, looks like Q1 options impact, then the full-year options impact. So it looks like, is it fairly safe to assume, fairly even spread across the quarters, or would there be any -- any unusual weighting between the quarters at this point?

No, it's fairly -- it's fairly even across the quarters.

Thank you very much.

Sure.

Okay, we'll take our next question from the site of Laura Champine from Morgan Keegan.

First a quick housekeeping question, Chris. What do you expect in 2007 and beyond as a tax rate or how would you model for taxes beyond this year?

I would model them consistently with how you're modeling 2006.

That's no impact either way?

Correct.

Okay. And then, Gary, can you sort of outline what kind of background we should expect for your next COO or what core competencies do you expect that person to have?

We're going to look for the best player, best operator we can. If we had a preference we'd like them to -- to have some deep supply chain experience. We think that's where long term the biggest opportunities lie in the Company. Someone who has led and managed, those areas.

Great. Thank you.

[OPERATOR INSTRUCTIONS]. We'll take our next question from the site of Janet Kloppenburg with JJK Research.

A couple of questions. Hi, Chris.

Hi, Janet.

Are the inventories higher than they should be right now? Higher than you'd like them to be?

No.

No? Up about 10%. Is that -- that's the balance is good there between the channels?

Yeah. We think our inventories are really well proportioned today. in pretty good shape. If anything, we'd lake to have more inventory in some of the core categories. I think I mentioned in the last call, in some of these core businesses we just haven't been able to keep up with the demand, and there's some challenges if you think about the product we're selling today, some of that a very high value product. The ability to manage that inventory and SKUs across a number of stores, it's more difficult than a a lower ticket kind of group or -- a product.

Okay. And then with the kinds of comps that you're calling for, 6% to 8%, do you -- will you be able to get leverage on the gross profit line and on the selling general -- on the occupancy line, excuse me? And the SG&A line with that kind of comp?

Sure. Sure we will, yeah.

Okay. And I'm wondering at what comp level you need. What -- what's the comp level you need to leverage both of those expense lines?

Are you talking about retail just in the retail segment or across the overall business?

Across the overall business is probably better.

Well, yeah. It's a little tricky question when you think about --

You can give it to me whichever way you want is fine.

If you think about what's happening with our business, Janet, we've got big merchandise margin improvement. Then occupancy leverage from the comps and the retail side of the business. Then we've got SG&A deleveraged because the direct business is growing faster than the retail business. So the direct business carries its biggest cost is the advertising cost.

Right.

So, probably should think about the comps if you look at it more at a retail level. Probably need about a two to three comp to get leverage and occupancy and other expenses.

Okay. And can -- at what level are you able to leverage -- at what level of dtc growth are you able to leverage the advertising costs?

We're planning the advertising costs relatively flat this year with -- with pretty good growth. And so that's how we look at it today. We've got a healthy model on the direct-to-customer business. As that grows and becomes a bigger portion of the business it leverages the entire company.

Okay. On the order deferral, how do you want us to think about that going forward? Will it for the rest of this year, Gary, be moving higher, or will it -- at some point will it flatten out? Can you address that a little bit?

Let me take a crack at this. We spent a lot of time on it, and we think we understand it pretty well now. If you go back to Q3 when we first had -- right after the remodels when we changed the mix dramatically, a couple of things happened. We launched a special order furniture business that was beyond our expectation.

The second thing had happened in our retail stores is a bigger percentage of our transactions became direct-to-customer transactions. Things like pleated drapes, some high-value bedding. Some of the other categories. If you go into stores today and you buy bath hardware, we -- we carry it in five finishes. Only the show finish is in stores. The direct-to-customer retail portion of the stores increased significantly in Q3. On top of that you had the special order business that increased significantly. So our in-stock furniture went down. Our special-order furniture went up. And special-order furniture had a 45-day lead time. For in stock we delivered in one or two weeks.

Then the other key part to this is that our direct-to-customer business continues to grow much faster than our retail business. So all of those combined, in that third quarter we we saw our deferral go up to $24.3 million versus the year before at $15.9 million. So we got caught off guard by that big of an increase. We had expected it initially to come down in Q4 because we thought after the launch of the special-order furniture, that was going to decrease, and and we thought those levels would come down. And what happened was the special order furniture actually increased in Q4 over Q3. Didn't decrease. And the percentage mix of the businesses and these categories of reservation drove it higher, plus I mentioned we had some kind of key out of stocks from our friends and family event in our furniture category.

So our deferral actually grew from Q3 at $24.3 million up to $25.9 million in Q4. And we had a very in-store original guidance of $6.4 million. We had estimated at the time of the call, the last call, at $6.8 million, and actually came in at $6.4 million variance. Pretty -- we're pretty close now at forecasting this thing. As we look at Q1, you have a couple of things happening at the end of Q1. You've got -- you've got some of this retail demand now coming into the quarter. So the comps on the retail side of the business are going to be helped by two to three points.

Right. Of the six to eight.

Right. Of the six to eight. On the direct side of the business, we actually have it going slightly the worth way. And what's happening there is because of the new outdoor catalog and high content furniture and basically all of it is home delivered so you've got a two to three-week in transit, we have a big deferral going out of Q1 on the direct side. We're basically doubling that outdoor furniture category.

That's going to affect the deferral going forward?

Right. So you've got -- so in Q1, we're getting helped on the retail side.

Right. Because you're going to fill the orders from the third --

Yeah. Call it call it 2 -- $2.5 million to $3 million, somewhere in that range. We're not getting helped on the direct side.

Yes,

So -- so a piece and not quite half of that $6.4 million variance in Q4 is -- is going to come down in Q1. But not all of it. In Q2, we see the same dynamic happening. Because of the growth in outdoor furniture, and the growth of the category that's creating a bigger deferral and the growth of our direct business in total creates a bigger deferral out of Q2. We're kind of in -- you're peaking in June and July in outdoor furniture. So the deferral in Q2 we think is going to stay in the low to mid 20s. Then our forecasts today say in Q3 when we anniversary this blip of deferral, we'll get another benefit somewhere around $2 million to $3 million. If you think about somewhere around a $3 million benefit of the $6.4 million in Q1, if's probably another $3 million benefit in Q3.

Okay.

So it should cycle out over the course of a year. But the other thing to think about is the deferral is going to stay at this much higher level. If you look at our deferral by quarter in year-ago periods, we averaged about $15 million a quarter in ending balance total order and ending deferrals. We're now averaging $22 million to $25 million a quarter. So the business model changed for not seeing that. But when you think about it the thing we feel good about is it's not a demand problem, it's a timing issue. on how this comes down. Then you got a bigger deferral bucket going forward because the mix of the business has changed.

Right. Okay. And Chris, could you help me a bit? I thought you said the retail business had a 25% four wall contribution? And then what of the 18.1? Is that fully allocated? Number or what is that?

Let me flip to those pages. It was -- Q4 -- yeah. For the fourth quarter, it was an 18.1% contribution margin in 2005 against a 20.7% contribution rate last year.

18 point --

18.1%.

Versus 20.7?

Correct.

And is that -- an allocated operating margin for the business, or is that just a four wall contribution?

It's a four wall contribution

And the same parameter for the direct business is 15.8 versus 12.1?

Yes.

That right?

Yes.

You believe both of those businesses can move higher here in this year, the -- the '06 year?

One thing I would say is on the retail side, that is a fourth-quarter number. So it it's not that high for the full year.

Are you going to give it to us for the full year? Will it be in the --

I think -- I think it's in the 10-K, when that comes out.

Okay.

And we believe there's opportunities in both.

To -- to jog those higher?

To move upward, yes.

Okay. All right, guys. I'm sorry I asked so many questions. Thank you.

Thank you.

Okay, we'll take our next question from the site of Robert Wilson with Tiburon Research Group. Go ahead, please.

Yes, thank you. Could we go through the components of the -- the retail channel and direct channel, Chris? You said that -- I believe you said the product margins were up 260 basis points in the retail channel. What were the product margins in the direct channel -- I may have missed that.

I think it was the Company was 260-- the Company, the retail, and the Direct were all in the 250 to 260 basis point range.

Okay. Then typically you disclose SG&A components in the direct channel. Could you give us some help there because I'm assuming you had some leverage in the direct channel given that it was higher 375 basis points overall in the direct channel.

Yes, the direct channel we saw 50 basis points of leverage. In the fourth quarter. Is that what you needed? I'm sorry, Robert? Was that? Rob, you there?

If you're still on the call, press the star-zero again. Okay. Here he is, one moment. Okay. Go ahead, Mr. Wilson.

Rob?

Rob, when you ask tough question, we knock you off the call. Operator, is he still being connected?

Yes, Mr. Wilson, if you could press star-one on your touch-tone phone. Mr. Wilson, your line is open.

You guys there?

Yes.

Okay, I'm sorry. I'm trying to get a sense for the components of the 370 basis point increase in profitability in the direct channel in Q4 between gross profit margin and SG&A.

Yes. It's --

Overall you're saying 370 basis points improvement if I'm not mistaken, right?

Is that correct?

Yes.

Correct.

Can you help me understand how you get the 370?

Sure. Gross margin is up -- no.

Do you have another question while we're working on those numbers?

Yeah. Gary, one question I had for you is with the outdoor catalog, you've de-emphasized the outdoor category at the store level, have you not?

We have by one collection.

Okay. So is there an impact on the comp store sales in Q1 and Q2 related to that?

There's -- there's somewhat of a tradeoff, Rob. What -- what we've done is we've -- there's a cost -- there's a merchandise margin cost in transitioning as much of the furniture that we were transitioning in the retail stores. So to bring in three full collections of outdoor furniture, we had to eliminate three full collections of indoor furniture. And there was a cost to that. So what we said is there's probably -- we thought a more profitable way to run the business was to only transition two collections.

We were mailing the outdoor catalog, have more of the business go to direct where you don't have a transition cost. And capture most of the business that you could at the retail level. But we are planning the outdoor furniture business down at the retail level with significant growth on this -- on the direct side. Then we're planning the indoor component of our furniture business with one extra collection up. They're -- there is about, I think, it's 24 stores that were -- that we're bringing in, as we get into the peak kind of outdoor selling time, that we're bringing in the third collection to to kind of maximize the outdoor -- the outdoor business.

So we're kind of looking at the entire model, the ins and outs, the costs, the margin, the tradeoffs and the inventory. We think we're taking a much more profitable approach to this category. Tri-channeling is how we look at it.

So looking at your comp sales guidance for Q1, that's, you're giving up some outdoor business. So that's actually suggests that your core businesses are even stronger?

That's -- that would be true.

Okay. And I'm assuming those 24, 25 stores are your largest stores?

Those are our highest volume stores and our large evidence stores.

Okay. Did you ghat answer, Chris?

Yeah, you ask the tough questions, Rob. Let me tell you. This is when we bump him off again. We've got --

It's a little bit confusing because you give total company, then you give retail and direct. And it can be a little confusing for -- for others.

Chris --

Believe me, Rob, I know. We have gross margin expansion of 420 basis points.

Indirect?

Indirect. Offsetting 50 basis points of deleveraged -- being offset by 50 basis points of deleveraged to give you the 370 margin expansion.

Okay. And then the retail channel, you had higher product margin at 260 if I'm not mistaken. Is that what you said?

260 was the product margin piece of it, yes.

You had higher SG&A of 380?

Correct.

What else did you have there? Higher occupancy of -- is that the difference?

Yes.

Okay. That helps. Thanks for taking my call.

Thank you.

We'll take our next question from the site of Kevin Foll with [Magnatar.]

Hi, guys. Can you talk about your 68% comp increase for the -- for the first quarter? I know how much of that you're talking about is deferral. Can you talk about how much is unit growth versus selling prices given the mixed shift in the business?

Yeah, we -- we will continue to have a -- a much higher average transaction and lower unit movement and -- and lower number of transactions until we lap the third quarter. So the third quarter is when we remodel the stores. If you think about this we had about -- on average 26 wall fixtures, about a three to four-foot-wide fixture that were kind of items and -- and accessories. Kind of the remaining piece that was left. We transitioned those out of the business. All the perimeter space then was engineered to reflect our core businesses. So those were lower retail, lower ticket product, and lower margin product replaced by higher ticket and higher margin product. So -- so that started in Q3, so our transactions will be down significantly, and our average transaction will be up significantly until we lap Q3.

Okay. And then on the -- could you just talk about margin expansion components in '06 -- how much is gross margin versus SG&A? At all? Kind of a ballpark?

Yeah. I can -- for 2006, we see the margin expansion is primarily driven by gross margin.

Okay.

So basically flat. We may see some leverage in SG&A, but the -- the majority of it will be driven by the gross margin line.

Okay. And -- and then the circulation I guess for '06, did you give that? I may have missed it. A difference in circulation.

We didn't give it. Yeah. We've got 32% increase in books, 25% increase in pages roughly.

Then with increased productivity you get to the 35% to 40% increase in the business?

Correct.

Okay. And then last question, any kind of early reads or kind of what gives you visibility in the 68% comp in the first quarter, any early reads on spring and the new catalog or anything like that?

Yeah. I think new catalogs, we're very pleased with the response to date. And, we -- we are performing right on plan across the Company and in our spring assortments. And we continue to see strength in our core businesses and like I said, we don't think we've really met all the demand in the core businesses today. We have plenty of opportunities on an inventory management point of view. That -- to have selected investments where we think we've got a lot more upside.

Great. The stores look good. Have a -- good luck.

Great. Thank you very much.

Thank you.

Okay. We'll take our next question from the site of Laura Richardson with BB&T. Go ahead, please.

Thanks. Most of my questions have been asked but I'll ask one that seems a long way off at this point and it's in terms of next year at the holiday season. Do you think you're going to be going through the same kind of merchandising transition you have for the last several with less novelty merchandise and -- and more -- more core merchandise?

No. What you have here is a concept in 2001 that 47% of the total business was -- was discovery items and accessories. And that number is now this year will be somewhere between 17% and 20%. As we've grown core categories and we the -- those categories used to -- what I call litter the perimeter walls. Now they're really contained to the selling floor in a few kind of seasonal display walls in the store.

So now we -- like -- as I explain it to even Chris who just joined us, we've now kind of bottomed that business out, we still will take not -- negative comps through the business in Q1 and Q2 because we made the change in Q3. When we anniversary that in Q3 we will begin growing that category. And so we -- we actually think it's like in any kind of -- when you make major changes, you tend to swing the pendulum too far one way or the other. As we stand back and look at it now, we think there's a -- an opportunity to actually expand the category to a degree, layer on more gifted content at holiday, and make the sales floor more productive.

So it will be the first time we -- we will feel very confident as we think about the fourth quarter comparatively, because it will be the first time we're not shrinking that category intentionally.

Thanks. Then my other question is something I thought I understood from reading the press release, but then I didn't understand the answer to the question. It's on the tax guidance. Because to -- from reading the press release, excuse me if I'm incorrect, it sounds like there will be zero tax. Either -- tax credit or tax expense on the income statement this year. Is that correct?

That's correct.

Then should it go back to something more normal like 38% next year?

No. We -- we would --

Or there could be no tax either next year 2007?

There could be no tax either. We've to demonstrate a pattern of sustained profitability before you would see a tax rate. Because of the valuation allowance.

Okay, thanks.

We'll take our next question from the site of Crystal Lanigan with D.A. Davidson. Go ahead, please.

Gary, one quick follow-up. The last time you had the conference call you discussed how the bath event starting at right after Christmas seemed like results were shaky. You weren't sure where it was going. How did that end up flushing out, and is that a strategy you would redo again this coming year?

Yeah. If you remember, Crystal, we moved the bath event up one week to start the day after Christmas, because we wanted the storefront not to look like markdowns and look stale and we brought the bath event forward, and had the new fashion colors, towels, etc., and looked fresh. What we -- what we -- what we didn't do is we didn't move the catalog mailing up that week. And so we kept the catalog mailing a week later. So we overplanned that first week at the bath event.

So we underperformed in that first week. You know, as we stand back and look at it now, we think we -- our plans were too aggressive. We didn't consider the impact of the catalog in that first week. So we misplanned that -- that first week. Then as we got to the end of the bath event, we actually -- we actually overperformed. So net-net, we're really very happy with the bath event except for that first week.

Great. Thank you very much.

We'll take our next question from the site of Ross Haberman with Haberman Fund.

Two questions for Chris. Chris, how many of your stores are marginal to losing money at the store level today? And just what's going to be the D & A for '06?

The D & A for '06 we will get. In terms of the stores that are losing money, the impairment we took for two stores is really reflective of -- of those that are cash negative if you will.

Okay.

So we don't have more stores than the two that we impaired last year.

I'm sorry. The D & A for the whole company for '06?

$20.1 million.

Okay, thank you.

Thank you.

Okay. We'll take our last question from the site of Carter Dunlap with Dunlap Equity Management. Go ahead, please.

Thank you. A little bit of a bigger question and update. A lot of the focus on the IT projects we hear about or the supply chain, I've kind of lost track of the stuff that you had hoped to do in the store, customer facing stuff like the POS and the ability to do sort of regional, in-stock lookups. Where are those targets and where are we on those?

Well, the next kind of -- the piece we're focused on this year as I mentioned earlier in the call is -- is to upgrade our order management system in our stores and call centers, and -- and on line, and to upgrade our warehouse management systems. One of the difficulties we've had here is - this company was never built with any kind of infrastructure to support a direct to customer business, including even supporting the customers that -- excuse me, the furniture side of the business and the stores, which it really act like a direct-to-customer business. So the challenge we've had is we've had a very poor order management platform that the stores call into. That -- that is integrated into a warehouse management system that is not -- not designed to fulfill an order. It's really designed to replenish retail stores. It's a WMS system that's really a store distro system.

So we've got a couple of very bad integration points and platforms that aren't designed to really -- to really support a very important part of our business. You know, today roughly 35% to 40% of our revenues in our retail stores travel direct to customer. So that -- the key for us is to -- to install a proven -- we have a proven order management platform that we're installing, working to install. And -- and warehouse management systems and -- and we're moving down the road with [Knighted], which is in Barnes and Noble and places that can fulfill retail distributions and orders, direct-to-customer orders. Then on the store side, we will be installing order terminals in the future in our stores, where the stores won't have to call the call center.

They'll actually just look up the product, have real-time visibility and place an order in the store. And that -- that is the first big step for us. And then in the next year or two, depending on how we pace it, the next step will be replacing the POS in stores, and then replacing the merchandising systems and inventory management systems.

Just qualitatively, some of those date lines I heard sound like a long way away. Is it -- I realize it's an integrated series of links and bottle necks.

The biggest piece is targeted for late this year. So that what I talked about as far as the order management system and the warehouse management system are -- are targeted for the third quarter of this year. Like any -- any systems integration they all involve some level of risk. And we are in a position that if we're not 100% ready, we can delay it until the beginning of the following year.

Right now we're targeting Q3, if we can't have it 100% ready to execute in Q3 our plan is to delay it through holidays and bring it live in the first or second quarter of the following year. Those are the two main implementations. The order of management systems and the warehouse management systems that support a, you know -- picking and fulfilling orders.

Okay.

Okay.

Thanks.

And then the terminals in the stores. That goes along with that.

With the --

Hello?

The -- the terminals in the stores go along with the first part?

The first part. Then following -- following after that would be a point of sale platform. We'll get most of our leverage by -- by just simplifying that direct-to-customer business in our stores. That's where we have most of the problems today. We can -- we can ring a sale relatively well. We don't have a -- we don't have a great POS system. You know, in -- it can't take a gift card. That's probably the biggest hindrance.

But the major problem is really trying to place orders in our stores and -- and the order integrity throughout our system. We don't have good order integrity once we've ticketed the DC and once we ship it to the home delivery network. Part of the system is the implementation, also installing the warehouse management system in all of our home delivery providers. So we can have visibility all the way through the supply chain to delivery to the customer.

Thanks.

Okay.

Thank you.

That concludes the Q&A session.

Okay. Thank you, everyone, for your interest. And we will talk to you next quarter.

This does conclude today's call. Thank you for your participation and have a wonderful day.