RH (RH) 2006 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to today's teleconference. At this time, all participants are in a listen-only mode. Later, there will be an opportunity to ask questions during our Q&A session. Please note, this call may be recorded. I'll now turn the program over to Mr. Chris Newman. Go ahead, please.

Thank you. Good afternoon, everyone, and thanks for joining us. I'd like to remind you that our call today will include a webcast slide presentation. The conference call and accompanying slide presentation will be available through a live audio webcast at our website, www.restorationhardware.com, under investor relations. Leading our call today is Gary Friedman, the Company's Chairman, President and Chief Executive Officer. Ken Dunaj, our Chief Operating Officer is also with us today and will be joining us for Q&A at the end of our formal remarks.

Before we begin, I need to remind you that certain statements and information on this call will contain 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 statements concerning or relating to the Company's goals for sales growth and the expansion of operating margins in future periods, the Company's guidance for future periods, the Company's future initiatives and other statements containing words such as expects or words of similar import.

Important factors there the 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 10Q and Form 10K and our release posted on the Company's website regarding our results for the fourth quarter and full year of fiscal 2006. 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 I'd like to turn the call over to Gary.

Thank you, Chris. I'm going to briefly review some of our 2006 full year and fourth quarter results, highlight our key accomplishments this past year, outline our key growth and operational initiatives for 2007, and then end with an overview of the transformation happening in our business and how we view both the short-term and long-term opportunities for the Company.

We are pleased to report record sales and earnings for fiscal year 2006. Total revenues increased 23% to $713 million with comparable store sales increasing 5.8% and direct to customer revenues up 52% to $244 million or 34% of total revenues. Operating margin improved by 130 basis points as we earned $10.6 million in operating profits. EBITDA excluding the impact of 123(R) increased to $36.3 million versus $20.5 million, an increase of 77% reflecting a significant improvement in cash generation. We are particularly pleased with our fourth quarter results, despite operating in a difficult and highly promotional home furnishings environment, we were able to deliver industry leading results with comparable store sales increasing 9.1% and direct to customer revenues increasing 59% in the quarter. Operating earnings, while negatively impacted by the higher promotional -- higher than planned promotional activity increased to $15.7 million for the quarter.

2006 marked a year of significant accomplishments and continued investments in both long term growth and infrastructure. During the year, we expanded our Restoration Hardware Home catalog, launched our first two category extensions, the Restoration Hardware Outdoor and Gift Catalogs and introduced a new brand, Brocade Home. In addition, we developed our third category extension, the Restoration Hardware Bed & Bath Catalog, scheduled to premiere mid April. When you see this new catalog, you'll recognize that it represents a premium positioning and truly distinguishes us in the marketplace. In an effort to further extend our brand into new markets this spring we plan to launch Restoration Hardware to the Trade. A new division targeting both home builders and the hotel and hospitality markets.

2006 was also a year in which we began to take important steps towards transforming our operations in supply chain. As you know, Ken Dunaj joined us as Chief Operating Officer last year. Ken has worked quickly to upgrade talent and develop plans to build a world class supply chain and operational infrastructure to support our multibrand, multichannel and multimarket strategy. Later in the call I'll discuss our progress on this front along with the specific initiatives we're focusing on and investing in this year.

Now, let's turn to 2007 and see how the year unfolded. First and foremost, we're coming off a successful year and feel we're well positioned to continue navigating through the challenging and promotional home furnishings environment. Certainly, our operating margins will be impacted. For the year, we have factored approximately 50 to 70 basis points of margin pressure into our guidance. In addition, we are making significant growth and infrastructure investments that will have a deleveraging effect in the first half, particularly the first quarter. We expect to see the benefits of these initiatives in the third and fourth quarters. Therefore, earnings improvements for the year will be weighted towards the second half.

As I mentioned, there are two categories of investments. I'll cover our growth initiatives first. We're expanding our Home, Outdoor, and gift catalogs. The total number of pages will increase by approximately 32%. We're continuing to develop Brocade Home including the launch of a website in March. The premier mailing of our Bed & Bath Catalog is scheduled to be in home mid April. The rollout of our trade division will begin in the spring and initial planning and development is under way to prepare for the spring '08 launch of Restoration Hardware Kids. We expect these initiatives to begin to bear fruit in the second half of 2007 and into 2008.

Now, turning to our operational initiatives. We're reengineering our home-delivered furniture network, adding predelivery inspection and new reverse logistics and returns processing. This initiative is targeted at reducing furniture returns and damages. A distribution center redesign and new racking installation in -- in our east coast and west coast furniture distribution centers is well under way, and will improve space utilization and productivity.

We're installing a new warehouse management system in our furniture distribution centers designed to improve order integrity, order tracking and productivity. We're consolidating our small package direct-to-customer operations from three distribution centers to one centralized center, designed to improve instocks, inventory turns, and inbound and outbound freight. We are making investments in sourcing and production management with objectives to -- to reduce cost of goods in core merchandise categories in the second half of this year, and we're developing an integrated multichannel order management system scheduled for deployment in the first half of 2008.

Our investment in these supply chain and infrastructure improvements will begin to create leverage in the second half of 2007 and into 2008. The cumulative impact of our investments in the first half will be about $0.10 per share which we expect to recover in the second half. We expect the payback on these initiatives in addition to the benefits of cost production efforts we are undertaking to generate full year operating margins in the range of 2% to 2.3%. So despite the market trends and general industry performance, we remain confident that we can continue to make meaningful progress this year. Longer term, we believe we can achieve more significant improvement in the order of 100 basis points per year. Clearly, 2007 is a big investment year for Restoration Hardware and we are confident that we'll -- it will prove to be a very good year that positions us for more dramatic growth going forward.

Now, let me turn your attention to the slides included in this webcast. I'm going to discuss a transformation happening in our business and how it is affecting our financial reporting metrics. Slides. Coming up. On the first slide, you can see how our -- our business has changed. In 2000, our direct business, catalog and web, was $20 million which represented only 5% of the Company's total revenues. Today, we have catalog and web sales of $244 million, which accounts for 34% of total revenues for the Company. Our direct revenues have compounded in excess of 50% for the past five years. As you can see, there's clearly a fundamental shift happening in our business.

Now, let's turn to the second slide. You have heard me talk about direct-centric growth, which is a strategy we employed to expand our business beyond the four walls of our stores. We've stated that our strategy is to size our assortments to the potential of the market versus limiting our assortments to the size of the store. Because the catalog and website offer a flexible platform, we have focused on expanding our assortment through page count growth in our core catalog and the introduction of category extension in the form of stand-alone catalogs. In this slide, you can see the page count growth and resulting assortment expansion from spring 2005 to spring 2007. We have increased the page count in our home catalog from 168 pages to 228 pages, and at the same time, expanded our assortment to include the Restoration Hardware Outdoor catalog at 132 pages, and we're introducing the Restoration Hardware Bed & Bath catalog, which adds another 92 pages.

So you can see here, in spring 2007 we will mail our customers 452 pages versus 168 -- 8 pages just two years ago. This catalog -- this does not include the 100 pages we are planning for a Gift catalog this holiday nor the 84-page Brocade Home catalog that is currently in circulation. This expansion of our assortment and our catalog and online creates a natural shift from our retail stores to our direct channel as our customers essentially have a bigger and bigger store to shop from.

Now, there's a couple of ways of looking at the shift. One, is to panic and to try to prevent the shift or loss of sales in the retail segment by marketing the channels against one another. Or two, the course we are taking, which is to embrace the flexibility and opportunities that the different channels present, merchandise them aggressively, and take a channel-neutral approach, letting the customer decide which channel best fulfills their needs. In the early days of the web, I remember retailers worried about slowing sales in their catalog channel, while web business was booming. Some catalers -- catalogers actually cut circulation as they ran the business units separately trying to maximize product -- profitability in the catalog channel independently, virtually ignoring the natural shift of transactions migrating to the web, especially as faster computers and high speed internet -- net access made it easier than picking up a phone and calling a call center.

I think it's similar to managing a bank 15 years ago and complaining that the teller business is down, the teller business is down. Meanwhile, ATM's were being installed outside every bank, grocery store and gas station and that -- and that side of the business is growing exponentially. I believe that is happening in our business today -- I believe what is happening in our business today is what was happening in the banks back then. With a dramatic expansion of our assortment in our catalogs and online, we are creating a national -- natural -- natural shift of business from our retail stores to direct channel, a shift that will only continue to accelerate as we pursue our direct-centric multichannel growth strategy.

Turning to the next slide, you can see that we have decided to lean into the shift and organize our Company to maximize the potential of this new paradigm creates. In 2006, we implemented a multichannel reorganization. We shifted the responsibility from merchandising and marketing individual channels to merchandising and marketing across all channels. Our focus now is to maximize the business across multiple channels synergistically versus segments independently. Turning to the next slide, we believe similar synergies exist in the operational functions of our business. This year, we will begin to reengineer our supply chain to support our multichannel strategy. We have significant opportunities to consolidate inventories and leverage shipping methods throughout our current network.

Turning to the next slide, the real point here is what we were doing is good for our customers. Our best customers shop multiple channels. They do not discriminate. The top 10% of our customers represent 67% of our business, and our best customers shop multiple channels and are exponentially more valuable than those who shop one channel. Here, you can see the retail-only customer has an average order value of $283 and shops on average 3.8 times per year, for a total retail customer value of a little over $1,000. A direct-only customer has an average order value of $578 and shops on average 3.2 times per year for total direct-customer value -- total direct-customer value of $1,850. And you can see the dramatic difference of the value of our best multichannel customers, spending on average $1,800 and shopping five times per year with an average -- with a value of $9,000. That's eight times the value of our best retail-only customer and five times the value of our best direct-only customer.

Turning to the next slide, our strategy, it should not come as a surprise, is to maximize sales and profitability by customer, regardless of the segment or channel where they choose to transact. The evolution of our business model is driving total revenue growth and operating efficiencies rather than individual channel or segment growth. Therefore, we have made the strategic decision to discontinue reporting on comp store sales. We recognize that this is a key component used in measuring the performance of retailers and it's something you were accustomed to working with. However, given our -- given how our Company has changed in recent years, it no longer captures a meaningful picture of our multichannel business.

Turning to the last slide, you can see here, a blueprint of our growth strategy. This gives you a high level view of how we plan to grow the business over the next several years. I was -- I would point out that everything in yellow represents existing businesses. Orange represents new business initiatives for 2007, and red indicates new business initiatives scheduled to launch in 2008. Clearly, where we see the most short-term opportunity is in direct. We're adding new catalog titles, new brand and new markets, while also expanding -- expanding our core Resto business.

The lower capital requirements and higher returns of our direct-centric strategy provides us with the financial flexibility to fund our operational and infrastructure investment over the next few years, as we build the back end of our business to support an accelerated expansion. That -- that will service well as we begin to once again open new stores in 2009 and beyond. Our short-term goal, as you can see on the slide is to achieve sales of $1 billion and operating earnings of 4% to 5% by 2009. Longer term, we believe we have developed a multibillion dollar growth platform with the potential to reach high single digit operating margins. With that, let me turn the call over to Chris.

Thanks, Gary. We're extremely pleased with our results for 2006, particularly in light of the challenging retail home furnishings environment. You heard the highlights from Gary, so I'll get right into the quarterly results and performance by segment. For the fourth quarter, which was 14 weeks this year, net revenue was up 27% to $243 million. Q4 gross margin was down 100 basis points to 37.8% reflecting lower product margins due to a higher than planned mix of promotional selling. We held SG&A expense as a percentage of sales flat to last year at 31.3%. That includes 150 basis points of increased year-over-year expenses. Of that amount, 30 basis points can be attributed to the adoption of 123(R), 80 basis points is related to investment spending that includes Brocade, as well as our supply chain and systems infrastructure, and 40 basis points is related to incentive compensation expense.

Income from operations, inclusive of $900,000 in costs associated with 123(R) was $15.7 million. Operating margin came in at 6.5%, which compares to 7.5% last year and primarily reflects the promotional environment during the holiday selling season. We generated fourth quarter EBITDA of $21.4 million. That's up from $19.7 million a year ago. Excluding the noncash charge of $900,000 for 123(R), EBITDA would have been $22.3 million, an improvement of $2.6 million against the same period last year.

Moving to segment results. Retail net revenues increased 17% for the quarter as we experienced a 9.1% increase in comparable store sales versus a 5.5% decline last year. The retail comp metric is based on a 13-week comparison to last year. The balance of growth in our retail segment is due to the extra week of sales in 2006, and the two additional outlet stores we are operating in 2006 versus 2005. Retail comps were driven by an increase in average retail dollars per transaction of 4% combined with an increase in total retail transactions of approximately 4%. Contribution in the retail segment was $30.6 million, which equates to a margin of 18.4%. This compares to contribution of $25.9 million and a margin of 18.1% in the fourth quarter of 2005.

The year-over-year change in contribution margin can be traced to a decline in gross margin which was more than offset by SG&A leverage. Gross margin in the retail segment declined 180 basis points as a result of lower product margins and the increased mix of outlet business in this segment. This was somewhat offset by occupancy cost leverage. As I mentioned earlier, the product margin declined is due to a higher than planned mix of promotional selling during the holiday period. SG&A expense for the segment improved 200 basis points reflecting leverage of advertising and other costs on very strong comp sales of 9.1%. At the close of the fourth quarter, we operated eight outlet stores. Outlet revenue totaled $8.2 million, that's up $2.8 million versus a year ago when we operated six outlet stores. As most of you know, these stores are designed to liquidate returned, damaged, or discontinued goods. While this revenue has been reflected in the retail segment, it was not considered in the calculation of our comp store sales.

Now, turning to the direct-to-customer segment. Revenue was up 59% to $76.4 million on top of a 20% increase in last year's fourth quarter. Circulation in catalogs distributed during the period was up 65% with pages circulated up 46%. The higher growth rate in catalog circulation reflects the addition of our new Restoration Hardware Gift Catalog which was introduced in 2006. The web accounted for 56% of direct-to-customer revenue in the quarter.

Fourth quarter profit in the direct-to-customer segment was $9.8 million representing a contribution margin of 12.9%. That compares to $7.6 million and a contribution margin of 15.8% last year. The year-over-year decline in margin rate primarily reflects increased SG&A cost as a percent of sales. Gross margin for the direct-to-customer segment was essentially flat, a supply chain leverage was partially offset by lower product margins. SG&A expense deleverage by 300 basis points due to the higher circulation which includes the launch of Brocade Home.

Looking at the balance sheet, the outstanding balance in our line of credit at the end of the year was $68 million, up from $58 million at the same time last year. The increase in borrowing levels reflects cash generated by the business offset by a year-over-year increase in inventory of $34 million. That's up 22% from the end of 2005 and is in line with full year revenue growth of 23%. Merchandise inventories stood at $193 million at the close of the year.

Turning now to guidance for the full year and the first and second quarters of 2007. Before I review the specifics of our guidance, I thought it would make sense to briefly review two major factors that are influencing us in 2007. First, as Gary mentioned, we expect the difficult environment will continue to pressure our margins for the foreseeable future. This continued margin pressure will impact us most significantly in the first quarter of 2007, as we expect our product margins to be down approximately 100 basis points relative to last year. This margin pressure is an extension of what we experienced in the third and fourth quarters last year. For the year, we expect product margins to be down slightly since 2006.

We expect to see improvement starting in the second quarter and continuing throughout the balance of the year, as some of our product cost reduction initiatives begin to yield benefits and the year-over-year comparison eases in the third and fourth quarters. Second, the growth in infrastructure investments occurring in the first and second quarters of 2007 that Gary referenced are expected to benefit earnings in the second half of the year. In the first two quarters, the investments we are making will impact operating margin by 150 basis points in Q1 and 100 basis points in Q2. This translates to about $0.05 per share for each of the first two quarters. We expect the benefits from these initiatives in addition to savings from cost reduction efforts we've undertaken to generate roughly 75 basis points of operating margin improvement in the second half of the year, or about $0.09 per share.

Now, for our guidance for the full year. We expect total revenue of $790 million to $815 million. This equates to a growth rate of 11% to 14% over last year's 53-week period. Operating margins are expected to be between 2.0% and 2.3% for the year, an improvement of 50 to 80 basis points versus 2006. We expect to generate EBITDA in the range of $39 million to $42 million reflecting growth of 21% to 30% against 2006. Inventory is expected to increase 10% to 12% versus 2006 which is 100 to 200 basis points lower than our projected sales growth. Capital expenditures are are expected to be between $15 million and $18 million with investments targeted primarily against the supply chain initiatives Gary described earlier in the call. We anticipate that interest expense will come in between $8.5 million and $9 million for the year.

And our effective tax rate is expected to be 40%. The entirety of which will be booked in the fourth quarter. This does not include any potential impact from the implementation of FIN 48 which we will adopt in the first quarter of fiscal 2007. These expectations translate to earnings per share of $0.10 to $0.15 for the year. For the first quarter, we expect total revenue to come in between $145 million and $150 million. That's a growth rate of 9% to 12% over last year. Operating margins are expected to be between minus 3.5% and minus 4.5% of sales reflecting a year-over-year decline of 90 to 190 basis points. This can be traced to lower product margins due to the competitive home furnishings market, as well as the investments in our supply chain and future growth initiatives that I articulated earlier.

EBITDA is expected to be between a minus $1 million and positive $.2 million for the first quarter. Inventories expected to increase 10% to 12% over the 2006 first quarter in line with our expected sales growth. We anticipate interest expense of approximately $2 million for the period. And our effective tax rate will be close to zero, as I described earlier, the total provision for the year will be booked in Q4. These expectations translate to a loss per share of $0.19 to $0.22 for the first quarter.

For the second quarter, we expect total revenue of $198 million to $205 million, a growth rate of 10% to 14% over last year. Operating margins are expected to be between a positive 1.0% and 2.0% of sales. That compares to an operating margin of 1.2% last year. We expect the second quarter to look better than the first quarter. That's because year-over-year investment spending will be lower, product margins will be higher, and revenue growth will be stronger. Second quarter EBITDA is expected to be between $7.5 million and $9.6 million. Inventory is expected to increase 20% to 25% over the 2006 second quarter, driven by receipts for higher expected revenue growth in the third quarter. Interest expense is anticipated to be between $2.1 million and $2.3 million, and our effective tax rate will be close to zero.

These expectations translate to earnings per share in the range of a $0.01 loss to $0.05 per share of income. Thanks for your attention this afternoon. And now, I'll ask the operator to open up the call for questions.

[OPERATOR INSTRUCTIONS] And we'll take our first question from the site of Rex Henderson. Go ahead, please.

Good afternoon. The question is on Brocade Home. You didn't talk much about its growth or how it's tracking relative to your expectations. Can you update us on how Brocade Home is doing?

Yes, Rex. We're happy with Brocade Home. It's performing right in line with this plan at the moment.

And do you expect it to reach profitability or be a contributor to operating income by the end of next year?

I would say we expect Brocade to reach a scale that will enable the brand to be profitable in 2008.

Okay. Any idea when we might see brick and mortar Brocade Home, or if?

No projections at this time.

Okay. Thank you very much.

Thank you, Rex.

Thank you. We'll take our next question from the site of Kristine Koerber with JMP Securities. Go ahead, please.

Yes, hi. A couple of questions, first of all with the business transformation, does that mean store growth is on hold until 2009?

I think, Kristine, as we've communicated in the past, we will selectively look at store opportunities that -- that present themselves with very favorable economics. Otherwise, we're focusing our capital into really building the back-end platform to leverage the Company in future years. So it will be very selective as we look at store growth.

Okay, and then can you give us a little more color on what you're doing as far as the initiatives to the Trade, hospitality and home builders?

Yes. I -- we're not giving too much commentary around that point only because it's -- it's a brand new initiative and we're operating somewhat stealth mode, based on a competitive perspective, but we believe today we have -- we have built a credible assortment in many of our categories that now will allow us to compete effectively and to break into a market that wasn't previously available to us.

And how are you going to target the industry, the Trade?

We'll be targeting the Trade with the direct sales force.

Have you hired people on, or is this -- is it current personnel, existing personnel?

Yes, we currently have a General Manager our Trade division who is at the moment building a team.

Okay, and then as far as guidance Q1, basically the $0.10 hit to Q1 and, or I guess the first half of the year, it sounds like you should make it up in the back half of the year, but still targeting only $0.10 to $0.15 in EPS. Am I -- am I missing something? Shouldn't the back half of the year be a little higher?

I -- I think I would look at the business from an operating earnings point of view and not an EPS point of view. I think the confusion, there's -- I think there's a lot of confusion on the street regarding our stock today and the EPS calculation because of the tax loss carryforward situation that we had last year, and how it plays into when we pay taxes, if we pay taxes, and how that comes into effect, and then the differences in that year to year. I don't know if Chris wants to talk more about that point.

Yes, I mean, we've -- the guidance that we've offered to get to that $0.10 to $0.15 for the year assumes a 40% tax rate and that is a higher -- higher tax base than what you saw in 2006. Partially, it's because of NOL carryforwards. Partially it's because of being an alternative minimum tax situation for 2006, but that's why the comparison year on year, when you look at EPS, it's not really a consistent comparison year to year.

Yes.

And that's why we're focusing on the operating profit, operating margin.

Yes. I think that's a really important point. It seems like most analysts and many investors we've spoken to even this past year have been confused by the tax loss carryforward hit during earnings. We had to take the prior year and how it affected our taxes this year and then the year on year comparison it will -- it will set up in '07 versus '06. So, we think the best way to keep score on our business is operating earnings.

Great. Thank you.

Thank you. We'll take our next question from the site of Laura Champine with Morgan Keegan. Go ahead, please.

Chris, it looks like your prepaid expenses doubled year-over-year. Can you talk about what that is?

Gary talked about a lot of our catalog growth that we have in the beginning of the year and both in Outdoor and the launch of the Bed & Bath book, as well as the continuation of Brocade. All of those would be contributing factors.

Okay, and then on the -- on the same-store sales issue, the stores are still about 60% of your sales. I mean, was there a particular catalyst that drove you to discontinue that metric and maybe you could talk about, just to reassure us, how that was tracking so far this quarter?

Laura, in terms of the same-store sales, I think we talked about how the business has transformed. It's happened over time. We don't believe it's the appropriate metric to use in gauging our business and the guidance that we've offered in terms of revenue growth is the information we're releasing at this time.

Thank you.

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

Thanks, hi, everybody.

Hi, Laura.

Just back to that sales question that Laura had. The guidance -- it looked like you were just giving a total revenue number and you weren't even offering guidance on what the mix might be between direct and retail. Is that how you're going to report it going forward, just one revenue line?

That's right now what we think is the appropriate way to guide the business, as I think you saw in the press release. We expect to provide more clarity around this when we report first quarter results as we redefine the key financial metrics that we look at for the business and that we talk to people about.

Okay. But it probably is fair to assume that direct is going to continue to be faster growing than retail, given what you said about the catalog pages and given we're not opening new stores into

I think that's absolutely the correct assumption.

Okay.

What's happening is because we are realigning many things in our business to support this multichannel growth effort including back-end operations, and we don't want to be victims around history just because the Company went public in '98 with a different business platform, with different reporting. We want to have the right reporting and the right metrics that we use to make decisions and run our business, and we believe those are the numbers and the metrics that we ought to be talking about to our investors.

Any thoughts on like when direct comes 50% of the business? Could it be there at the end of '07 or '08, and when you get to the $1 billion revenue, what the mix should be of direct and retail?

I think -- I think it's a question that we can answer more clearly when we talk about the metrics we'll be using to measure the business with at the end of the first quarter, but you can quickly see a way towards direct becoming the majority of our business within the next three years.

Okay. And switching gears a little bit here, just -- I understand the guidance. There are -- I understand the costs in the first half of the year. I don't quite understand looking back at last year why the gross margin should start getting better in the second quarter, because you -- you had a tough comparison, I mean you had a great performance in the second quarter gross margin last year. So help me understand what you're seeing differently in gross margin Q2 versus Q1.

Sure. Sure. There's two things. One -- one is really that we began to take actions towards the back half of last year on product cost and those benefits will begin to flow in the second quarter so that will help us. The other part of it is that as we look at our business mix shifting and we continue to move forward with the Bed & Bath catalog and the Outdoor catalog, those will be benefits to margin in the second quarter relative to the prior year.

Okay, just -- because those categories have higher margins basically?

You can make that assumption.

Okay. That makes sense. Well I'll let someone else get in the queue, and I thank you.

Thank you.

Thank you. And we'll take our next question from the site of Kevin Foll with Magnetar. Go ahead, please.

Hi, guys, congratulations on a nice year.

Thanks, Kevin.

Can I ask a question, I guess in terms of how to think about merchandise margins for the full year '07, given and talk about how much of that is going to be mix shift versus kind of better full price selling?

I would look at it as primarily mix shift. There will be a little bit of full price selling improvement. but then the other benefit that we talked about is cost reductions that we -- that you should begin to see again in the second quarter and increasingly throughout the year.

Yes, because cost of goods --

Cost -- cost -- product cost reductions.

Yes.

Okay, so -- so it looks like from a merchandise margin standpoint, expect it to be down a little bit in the first quarter, up slightly in the second quarter and then kind of building beyond that in the second half of the year, based on easier compares -- combination of easier comparisons and mix shift and -- and better product costing?

That sounds fair. I think as we said in the first quarter, we're looking at about 100 basis points of product margin decline year on year.

Yes, I think, Kevin, the unknown I think for all of us right now, is we're clearly operating in a headwind in a difficult home furnishings environment, and there's a lot of promotional activity in the marketplace, and our focus is to build profitable market share in this difficult environment. So we're evaluating product pricing and go-to-market strategies weekly, monthly here, and we think in a -- in an environment like this, we have to be flexible and take our -- our best game to the market week by week, month by month. And as -- I think as the market improves and the environment improves, so will our margins, but while there is a headwind in front of us I would expect margins are going to be difficult. What it looks like in the second half of next year, I don't think we have visibility to yet.

Okay. And can you talk a little bit about -- you talked about page counts up about 36% in '07. What about the circulation, number of books mailed?

I -- I think what we've spoke to, I spoke to in --

A single kind of mailing window.

Yes. In the spring -- in the slide I referred to showed core Restoration Hardware year-over-year.

Okay.

And the -- the Home book -- I think the -- if you refer back to that, and make sure that I quote this right, but that pages circulate -- the pages mailed to our customers up 32% in the -- the Home book in the spring.

Okay.

Yes, as far as --

We haven't provided specific guidance on circulation or page growth in the mail. We're just trying to show for some of our key customers how many more pages they will be getting in the mail.

I see, okay. And then last question in terms of that's on postage increases in '07. Talking to some of the paper guys there, the -- I guess the tax on the mail is going to be disproportionately high for kind of odd-shaped mail, i.e. catalogs, and I'm just wondering kind of how much of an increase are you baking into your plan for '07?

We -- the numbers we've released today include the impact of the postage changes and ,so they're fully reflected in the numbers we guided to, but we're not providing specifics on what we see as the postage increase.

Okay. Alright. Thanks a lot. Good luck.

Thanks again.

Thank you. We'll take our next question from the site of Scot Ciccarelli with RBC Capital Markets. Go ahead, please.

Hi, guys, how are you?

Good, Scott. Thanks.

Good. Just using the mid point of the guidance that you did provide at the annual guidance, I'm coming up with about a 50% to 60% improvement in operating profit. Is -- is that what you guys are kind of suggesting by what you've told us at this point?

Yes, we are.

Okay, just making sure I did that right. That was number one. Number two, I understand the sourcing improvements in terms of helping the margins, but are you guys expecting any kind of turn in the promotional environment as well, or do you expect kind of the same environment that you've been seeing to continue through the year. Your crystal ball as good as it is at this point?

That's a -- I wish I could answer that question. I -- I think the things we're hearing and seeing suggest that the second half could foresee some changes. I think what -- what is -- I think the question is what is the timing, as the market changes, then what is the timing? Most of the data in the home industry says that, as home sales go, so do a big percentage of retail sales in home furnishings categories. What the lead time is, as the -- as the home market kind of reaccelerates to how it impacts retailers. I'm not sure. I think that the key thing for us is, we're not being victims on this side and just saying, oh, throw in the towel, it's going to be down.

We've got a lot of merchandising and marketing strategies keyed up for the second quarter, third quarter and fourth quarter that we think are better than where we are in the first quarter. So we've just redesigned all of our catalogs, we've got new catalogs coming online, we've got new strategies happening in all -- all channels and -- and marketing strategies that for competitive reasons we don't want to talk about the details, but we feel confident in the numbers we're providing, and we've baked in what we think is margin pressure into those numbers. If the market changes does that release some of the margin pressure? Probably does. But until now -- until we see a change, we're just trying to be kind of conservative as we can.

So kind of hope -- hope for the best, plan for the worst at this point?

Yes. What I was going to say is that the improvement we're counting on, or believe we will see in the back half of the year is not predicated on the environment getting better.

That's a good point. Yes. It's not.

Fair -- fair enough, and last question is now that Ken's kind of been in his seat for awhile and gotten to see the whole operation front and back, is there any difference in terms of how he's thinking about the improvements on the operating margin side? I saw, obviously, your commentary regarding 2009 type goals in terms of operating margin, but is there a difference in progression possibly that may have been contemplated, versus what was contemplated before? Thanks a lot.

Well, Ken is sitting here. Maybe we'll let him take that.

Yes, I think that as the investments continue this year and into next year, you would -- you could assume that the return on those investments will begin accelerating into '08 and into '09. So the wider expansion towards the end of '08 and into '09, I think will be as a result of the supply chain improvements that we're making.

Okay. Got it. Thanks a lot, guys.

Thank you.

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

Good afternoon, everyone, and let me add my congratulations for a solid holiday season in a tough environment.

Thank you.

I guess what would be helpful, if we could just -- looking at 2007, how you guys have mapped it out, if we just take away the impact from what our likely increased promotions, what the is just the pure product margin or your IMU looking like first half versus second half? Are you seeing improvements exing out promotions, etc.? Can you talk about how that's trending in your business?

I don't think that's the level of detail we normally disclose, but I think when we talk about the pressures in the first quarter, and we talk about the sourcing improvements that will begin to take -- take hold in the second quarter and beyond, there is some IMU change that would be related to that. That's about as much detail as I can provide.

Okay, okay. Fair enough. Or do you feel comfortable commenting -- the past year you've closed out you had a pretty nice run at improvements in the product margin, exing out promotions. Is that holding stable?

Yes, it is.

Yes. Okay, great.

The sequential change that we had in the first half of last year as we lapped the product assortment changes in the third quarter of 2005, those -- those margins are holding.

Okay.

And I think as I mentioned we're making investments into our sourcing and production management teams, because we believe there is continued opportunity to improve product margins long term in the Company. So I don't think we're on the back side of that hill any time soon. I think there's still several years of opportunity here to continue to improve product margin.

Okay, great. That's help -- that's very helpful. And then, Chris, if you could -- we just -- I just want to clarify the numbers when you talked about -- right at the tail end of your commentary on the SG&A impact first half versus second half. I think you said Q1 up about 150 basis points and Q2 up 100 basis points. Is that correct?

I said that the investments that we're making in growth and infrastructure in the business is 150 basis points. It may not all be SG&A. The bulk of it should be, but it's operating margin impact in Q1 and Q2 is 100 basis points year on year.

Okay, and then second half, you said 75 basis points higher?

75 basis points of net improvement.

Oh, great.

So for the year, it's pretty much a wash, and we see benefit in the back half of the year offsetting that first half investment.

Okay, great. That's really helpful, and I know you're -- you're talking about minimal store growth. Should we assume any store openings or closings in '07?

I would not assume any at this point.

Okay. Okay. And then, I'm sorry, just one more commentary. I know you've tried to make this painfully obvious, but I'll ask it anyway, as far as the tax rate in Q3.

Q3 will be consistent with Q1 and 2.

Okay, excellent. Thank you very much. I appreciate it, guys. Good luck with Q1.

Thank you, Crystal.

Thank you. We'll take our next question from the site of Rob Wilson with Tiburon Research Group. Go ahead, please.

Yes, thanks for taking my call. Gary, could you talk about your catalog redesign that you referenced in the press release? I -- I do notice some changes in your catalog.

Yes. We went through a pretty extensive effort to try to accomplish a couple of things. One, communicate our quality differentiation in the marketplace more clearly. Two, present our assortment authority in categories in a more dominant way. Three, present the goods in a much more aspirational manner. And four, make it much easier to shop for -- for customers. And I think if you lined our catalog up today or any of the catalogs, and we just sent out a marketing packet and I think some of you may have been on the -- on the mailing list where we sent out a packet with our Home catalog -- completely redesigned Home catalog or Outdoor Catalog in our new Bed & Bath book, hot off the press. Although someone called me this morning and said one of them -- they were all hand bound on the Bed & Bath, so the pages weren't in the right order on one of them. I thought, oh, Christ, good marketing pack.

But if you look at them side by side to other catalogs in the industry, I think you'll see it is dramatically different in its organization presentation and focus. And we spent about six months and a lot of effort to do that, and I think it's going to pay off for us in just the performance in our business, and I think continued differentiation and positioning of the brand in the marketplace.

So you got a good early read on this remerchandised catalog?

We're -- we're pleased with the response, yes.

Okay. Going back to your comp store sales reporting, is it fair to say that if you continue to increase catalog circulation, that may yet increase your comp store sales anyway?

It depends on how you look at it. I think here's the -- here's the key point that I probably wasn't clear enough in my presentation, I thought -- I was thinking about it as the questions were coming up. If you kind of take that snap shot of spring where in '05, we mailed 168-page spring Resto book. This spring, we're mailing three books: Home, Outdoor, and Bed & Bath, 452 pages. The key point here is the incremental pages reflects an assortment expansion that is not available in our retail stores, so you're not necessarily marketing more goods that are in the retail stores.

You're really growing your assortment beyond the four walls of the store and offering the customer a bigger assortment outside the four walls of the store. And the whole point of sizing -- sizing the assortment to the potential of the market versus limiting the assortment to the potential of storage. And I think that -- that previously and traditionally, in retail companies, most of us are relatively new in this multichannel, trichannel game, however channels you look at it. Now, we have a fourth channel with our Trade business, I'd say trichannel and now I say multichannel, so I'm changing the terminology all the time, but the -- you generally had a much bigger retail business than a catalog business. People had a really big retail business and relatively small catalog business or a really big catalog business and really small retail business, but traditionally it was the retail business that was the -- the predominant driver of a retail Company.

Traditionally, companies had two sets of merchants, maybe three set of merchants driving retail, a set of merchants driving the catalog, and in some cases companies had a set of merchants driving the web. And -- and what you had was a lot of times your best people and your biggest effort merchandising, your least flexible and lowest potential platform as it relates to assortment. So what we've done which I think is strategically important and I think we're the only ones that have done it that I know of at least in our sector of the -- retailing is we've kind of pulled everybody up above it, and assigned a multichannel merchandising leader across the Company, and then multichannel merchandising leaders above categories. And now we think about it categorically, and we don't think about it by channel first. We think about what is the potential for the bedroom business in the marketplace? What is the potential for the bath hardware business in the marketplace? How do we size that assortment to maximize the potential and then how do we express that assortment in the different channels which all have different opportunities as it relates to?

So it's fundamentally a different way of thinking about the business, as long we're talking about the business, we think it's kind of breakthrough thinking, and we think we're on the front edge of thinking about the business the right way for the long term. And we think it presents a lot of exciting opportunities, but what it doesn't do and what you can get confused by is, oh, my God, you're mailing a lot more catalogs and a lot more pages. True. But you're not necessarily marketing more goods that are -- that are specific to the store.

But it's still an advertising vehicle in some fashion.

Sure, but you look at a business like ours where 10% of your customers is 67% of your business. Our business is primarily about selling more to our best customers, not exponentially growing our customer base. We would like to do that, but that's a more expensive way to grow your business. So if you're putting -- if you're taking your best customers that are the biggest percentage of your business and you're putting a bigger offer in front of those customers in kind of, let's say your virtual channel, which is the catalogs and the web, than you are in your store channel, you're just naturally going to have that customer, I think, respond more to the direct channel, and have business migrate to that channel. And I think it's going to -- the reference on the teller business, the bank is saying it's no different.

It's saying, like the teller business is down, well, yes. You put more ATM's out there so it's easier for customers to transact with ATM's than it is to go into the bank. And -- or, as I said, many years ago in the web business, I remember early on, people used to panic about, oh, my God, the catalog business is off, and I'd always ask the question, well, how is web -- how's web sales? Well, web sales are way up. Well, why do you care? Well, because. We're measuring the profitability. My P&L is down. Well, but it's just customers transacting. So it's -- I mean that's the way we look at it and we think it's the right way to look at it, and the right way to run our business going forward.

I guess that segways into my next question. How are you going to bonus your store employees now?

That's another good question, yes. We are looking at different alternatives, and what is the right way to build the right compensation plan for them, so good, very good question. We're having discussions in the Company right now about that.

Okay. Chris, if you can just give us your credit availability at the end of the year?

That will be in our K. We -- we don't have any credit issues, however.

Okay. It was higher than last year?

Our outstanding debt was higher, and our availability was akin to last year.

Okay. And finally, the extra week. What was that worth for you in sales?

The extra week was roughly 2% points for the year.

2% points of sales?

Yes. Growth. Total sales. Total revenue growth for the year.

And one last question. Your capital expenditures in '07, what -- what are those looking like?

I believe we got it to $15 million to $18 million, and we said the lion's share of that investment would be geared against supply chain initiatives.

Okay. Thanks for taking my call.

Thank you, Rob. I think we have time for one more.

Thank you. And we'll take our final question from the site of Craig [Smissen] with [Clenenden] Retail Space. Go ahead, please.

Yes, gentlemen. I believe my question was answered, but just wanted to be sure. As far as the brick and mortar retail stores, and you don't anticipate opening any until some time in 2009. Is that on the mark?

As select opportunities present themselves that would have favorable economics, we will look at those opportunities and make a store-by-store decision, but I would not expect any meaningful store growth over the next couple of years.

Okay.

Thanks, Craig.

Thank you. I'll turn the call back over to our moderators for closing remarks.

Okay. Well, thank you, everybody, for your interest, and we look forward to talking to you specifically with more detail in our financial reporting at the end of the first quarter. Thank you.

Take care.