RH (RH) 2013 Q4 法說會逐字稿

Good afternoon.

My name is Eva and I will be your conference operator today.

At this time I would like to welcome everyone to Restoration Hardware's fourth-quarter and FY13 financial results conference call.

All lines have been placed on mute to prevent any background noise.

(Operator Instructions)

It is now my pleasure to turn our call over to Ms. Cameron McLaughlin with Restoration Hardware's Investor Relations.

Ms. McLaughlin, you may begin.

Thank you.

Good afternoon everyone.

Thank you for joining us for Restoration Hardware's fourth-quarter and FY13 financial results conference call.

Joining me today are Gary Friedman, Chairman and Chief Executive Officer and Karen Boone, Chief Financial Officer.

First, Gary will provide highlights of our fourth-quarter and FY13 performance, and provide an update on the Company's key strategic priorities.

Karen will conclude our prepared remarks with a discussion of our fourth-quarter and FY13 financial results and our outlook before opening up the call to questions.

Before I turn the call over to Gary, I would like to remind you of our legal disclaimer that we will make certain statements today that are forward-looking within the meaning of the federal securities laws, including statements about the outlook for our business and other matters referenced in our press releases issued today.

These forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially.

Please refer to our SEC filings as well as our press releases issued today, including our financial results press release, for a more detailed description of the risk factors that may affect our results.

Please also note that these forward-looking statements reflect our opinions only as of the date of this call and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events.

Also, during our call today we will discuss a number of non-GAAP financial measures which adjust our GAAP results to eliminate the impact of certain items.

You will find additional information regarding these non-GAAP financial measures and a reconciliation of these non-GAAP to GAAP measures in today's financial results press release, as well as a reconciliation of adjusted P&L items on pages 12 and 13.

As a reminder, the fourth-quarter and fiscal-year periods ended February 2, 2013 included 14 weeks and 53 weeks respectively, while the fourth-quarter and fiscal-year period ended February 1, 2014, included 13 weeks and 52 weeks respectively.

Management will be providing all revenue and earnings growth comparisons on a comparable 13 or 52 week basis.

A live broadcast of this call is available on the Investor Relations section of our website at IR.restorationhardware.com.

With that, I will now turn the call over to Gary.

Thank you, Cammeron, and good afternoon.

2013 was a record year for RH, as we continued to outperform the home furnishings industry by a wide margin.

Net revenues increased 33% and comparable brand revenues increased 31% on top of a 28% increase last year, representing our fourth consecutive year of comparable brand growth in excess of 25%.

This is even more impressive considering the elimination of our fall Source Book and the consolidation of our store base.

In 2013, we expanded operating margins by 200 basis points and grew adjusted net income by 92%, while concurrently investing in our infrastructure and developing new categories and businesses to support our future growth.

We like to remind ourselves that at the start of 2013, we are expecting total revenues of $1.43 billion, and adjusted EPS of $1.34 per share.

Throughout the year, we continued to take market share and outperform expectations, delivering $1.55 billion in total revenue and adjusted EPS of $1.71, demonstrating the disruptive nature of our brand and the powerful multi-channel platform.

Turning to the quarter, Q4 net revenues increased 26% and comparable brand revenues increased 24% on top of the 29% increase last year.

Operating income for the quarter you grew by 41%, and reached 12.4%, an almost 200 basis point improvement over 2012.

Consistent with many other retailers, we experienced softness in late December and January versus our expectations, as a result of the shorter holiday selling season and store closures due to weather, neither of which are systemic or ongoing.

Despite the shortfall, we were able to achieve our earnings guidance, demonstrating the strength of our business model and disciplined cost control.

Reflecting back on the past year, there are several key learnings but none more important than the disruptive power of our product platform.

Our demonstrated ability to innovate, curate and integrate new products, categories and businesses and then scale them across our fully integrated multi-channel platform is, we believe, unique in the industry and a powerful competitive advantage.

Another key learning relates to the transformation of our retail store platform.

Over the past three years, we've continued to innovate, test and prove that we can build a retail experience that defies the current conventional wisdom that everyone is moving to the web and retail stores are dead.

We have proven just the opposite and continue to develop new and more exciting concepts that will create an even more compelling and highly experiential environment for our customers.

Last year we learned we could partner with developers and create a win-win by moving from a tenant who occupies high-cost interior mall space or street space to adding value by positioning ourselves as a next-generation anchor tenant who can help transform a mall or a neighborhood.

This results in unique and dominant location with substantially improved economics and enables us to unlock the value of our current and future categories and assortments.

As I mentioned in our press release, we believe we are a $4 billion to $5 billion company trapped in billion-dollar legacy real estate.

As we have previously communicated, less than 20% of our assortment is displayed at retail, and we have seen that products displayed at retail experience a 50% to 150% lift across all channels.

As I also mentioned in our press release, post the mailing of our spring 2014 Source Books, the percentage of our assortment displayed in our legacy stores will be less than 10%, and the key to unlocking the value of the Company is to present a greater percentage of our assortments at retail.

More recently, we have been focused on further improving our next-generation gallery economics by more intelligently designing the space and value engineering the buildout.

We now believe we can design a store with the same product density and approximately 10% to 12% less square footage and also reduce our buildout cost without jeopardizing sales.

This will lead to higher productivity per square foot, reduced occupancy cost, and lower capital investment than our previously communicated expectations, which will further improve our already attractive returns on invested capital.

Additionally, the ability to eliminate our fall Source Book with minimal sales erosion was the right decision and a profitable one.

We delivered a 32% growth in the back half of 2013, compared to 34% in the front half, in a year where we did not mail a Fall Source Book.

Not only were we able to experience significant leverage of our advertising cost and margin expansion, but we also expect to achieve additional benefits and operating efficiencies as it relates to lower back orders, higher fulfillment, lower shipping costs and other cost savings throughout our models.

As we look forward to 2014 and beyond, we will continue to focus on our top two value-driving strategies -- expanding our offer and transforming our retail stores.

As it relates to expanding our offer, our new collection of fall Source Book -- of spring Source Books will begin mailing at the very first part of May and will be completely in-home by mid-June.

The presentation and organization of these books, we believe, is revolutionary and unlike anything ever seen in our industry.

The spring 2014 mailing will include 13 books, totaling nearly 3,200 pages.

This compares to six books totaling 1,600 pages last spring.

To further enhance the customer experience and improve delivery of our books, we are having our Source Books delivered by UPS.

Books will now be delivered to the front door or an identified UPS delivery location at each address, as opposed to being randomly dropped somewhere around a mailbox.

Each collection of Source Books will be scanned at the delivery and we will be notified electronically daily, which will enable us to send a notification e-mail to our customers that their new Source Books have been delivered.

As a result, we expect that increased response rates will offset that increased cost and greatly enhance the perception of our books and our brand.

Our new annual Source Book approach mirrors the logic of our real estate strategy -- eliminating multiple smaller stores in a market with redundant assortments in favor of one significantly larger store with a broader assortment.

We will now mail a 3,200-page Source Book with a much broader assortment once annually versus two 1,600-page mostly redundant books, creating a much wider net to capture more customers and higher share of wallets.

Turning to our real estate, while the transformation and evolution of our retail stores is still in its infancy, it remains our single biggest priority.

Our five existing Full Line Design Galleries in Los Angeles, Houston, Scottsdale, Boston, and Indianapolis in aggregate continue to perform well ahead of our original target of $850 in sales per selling square foot, with some of the larger markets in excess of $2,000 in selling square foot.

Not only are these stores performing ahead of expectations but the direct business in each of the markets are experiencing strong sales lifts as well.

If addition, the stores that are in our comp base continue to perform ahead of the overall fleet.

2014 is a bridge year as it relates to our real estate transformation, with only three new stores opening -- Greenwich, Melrose and Atlanta -- before we experience more significant square footage growth in 2015.

In May, we expect to open our newest Full Line Design Gallery at the historic post office in Greenwich, Connecticut.

This location will have 14,000 feet of leased selling space and significantly expand our presence in the market.

In addition, we expect to complete the 13,000 square foot selling expansion of our gallery in New York by this summer.

We expect to open our new Full Line Design Gallery on Melrose Avenue in Los Angeles late this summer.

This gallery will have nearly 23,000 square feet of leased selling space and will present 2.5 times the assortment of the current Beverly Boulevard gallery.

We plan to move our Santa Monica Baby & Child Gallery into our existing Beverly Boulevard location once our Melrose Full Line Design Gallery opens.

This fall, we will open RH Atlanta, our first next generation Full Line Design Gallery.

The new gallery encompasses over 45,000 square foot of leased selling space and will display close to three times the assortment of our Full Line Design Gallery in Houston.

As we look to 2015 and beyond, our real estate pipeline is strong and includes opportunities to serve as an anchor tenant in some of the best centers and streets in the country, with significantly larger stores and lower occupancy rates.

We have signed leases for 5 next generation Full Line Design Galleries and are in negotiations for an additional 25 locations.

As we have done thus far with our Full Line Design Gallery strategy, we will continue to size the store to the potential of the market.

Looking forward, we expect stores to be in the range of 25,000 to 60,000 leased selling square feet and believe we are well positioned to significantly accelerate our annual lease selling square footage growth from 8% in 2014 to a range of 30% to 40% in 2015.

Upon completion of our real estate strategy, we continue to believe that we will deliver $4 billion to $5 billion in revenue across our stores and direct channels.

We continue to invest in building a world-class supply chain and systems infrastructure to support our growth, improve our customer experience and reduce costs.

In 2013, we opened our third furniture DC near Dallas, Texas, adding over 850,000 square feet of capacity to our network.

We also completed the 420,000 square foot expansion of our Ohio shelf stock facility during the year, bringing it to almost 1.2 million square feet.

We currently operate six facilities in the US with nearly 5 million total scare feet to support our multi-channel platform.

We also made significant progress in our in-sourced furniture delivery initiative in 2013.

We now have in-sourced hubs in our top eight markets and over 50% of our furniture deliveries are being made through our internal network.

In 2014 we expect to add several additional markets.

By the end of 2014 we expect to fully implement our new final mile software system, designed to dramatically improve service and reduce the cost of delivering furniture.

The best-in-class delivery and scheduling software will allow for enhanced service capabilities, such as installation, as well as provide visibility and control of all furniture inventory, deliveries and pick-ups, plus provide our drivers with a mobile-based technology for electronic proof of delivery and photo capture.

We continue to align ourselves with the best creative partners in the world.

We continuously work to enhance our vendor relationships and ensure that they have the capacity to scale and support our future growth.

No one has made furniture of this quality in these quantities before and we believe our proprietary network of artisan partners creates a long-term competitive advantage.

We also will continue to invest in and strengthen our leadership team.

Today we announced that Doug Diemoz has joined RH as Chief Development Officer.

Doug will have responsibility for leading the Company's future international growth and global expansion effort.

In addition, Doug will be responsible for developing some of our emerging new businesses.

As you've read in our press release, Doug has nearly 20 years of operational, financial and international experience at MEXX, William Sonoma and Gap.

We are thrilled to have Doug join team Resto, and look forward to developing our future international expansion plans, which will help propel our long-term growth.

I am continuing to assess our human capital needs post Carlos' departure and in developing an organizational construct that I believe will enhance and lead the Company into the next stage of growth.

I will keep you posted this plan develops.

I can assure you that the team who have developed the past four years of industry-leading results has plenty of capacity to continue to exceed better than -- better to execute than anyone in the industry.

My primary focus remains on growth and execution of our core business and real estate strategy and continue to apply a slower burning fuse as relates to our newer business initiatives.

While we are still in the very early stages of a highly evolutionary brand and business, our record financial results 2013 illustrate the power and disruptive nature of our business model and our ability to gain significant market share in the home furnishings marketplace.

We continue to deliver industry-leading growth in both revenue and earnings, while at the same time investing in future opportunities and our infrastructure to further fuel and support our long-term plans.

And while we are all accountable for the quarterly and yearly discrete time measures of being a public Company, our energies are equally focused on the transformational stages we are moving through that will define our brand and business and more importantly, redefine our industry.

Real value has always been created by those who have the courage to lead rather than follow.

We're willing to destroy today's reality to create tomorrow's future.

We've created a unique and winning brand, one that you should expect will continue to destroy its own reality to create tomorrow's future and we look forward to sharing in the value creation with all of our stakeholders.

With that, I'll now turn the call over to Karen to review our financial results and outlook.

Thanks, Gary, and good afternoon, everyone.

I will start with a review of our if fourth-quarter and FY13 performance and then discuss our outlook for FY14.

We delivered record performance during the fourth quarter.

Total revenue increased 26% to $471.7 million, driven by 30% growth in our direct channel and 23% growth in retail.

We are extremely pleased that we were able to drive industry-leading growth during the quarter despite the shorter holiday selling period and the negative impact of weather on our retail business.

Our direct business represented 49% of sales during the quarter, demonstrating the strength of our online platform even with the elimination of our fall Source Book.

Including our direct business, comparable brand revenue growth increased 24% on top of 29% growth last year.

Given the multi-channel nature of our business and the tremendous synergies between our retail and direct platforms, we believe that comparable store sales growth is no longer a relevant metric for tracking our business performance or to make meaningful comparisons to our industry peers.

Beginning in the first quarter, we will no longer report comp store sales growth and will report comparable brand revenue growth.

You can find a table with the detailed definition and historical data for this metric on our Investor Relations website and in our Form 10-K, which is expected to be filed in the next few days.

Adjusted gross profit increased by 18% to $175 million during the fourth quarter.

Gross margin decreased 20 basis points to 37.1%, from 37.3% last year, in line with our expectations.

While our product margins were still below last year, we continue to see improvement in our product margin trends relative to the last few quarters as we anniversaried most of the strategic pricing initiatives introduced in late 2012.

Our promotional cadence was also very consistent with the prior-year period.

Our DC occupancy cost deleveraged relative to last year, due to the investments made in our Dallas furniture DC and Ohio shelf stock facility during the second quarter of 2013.

These impacts were partially offset by improvement in leverage of our retail occupancy cost.

Lastly, we achieved some improvement in leverage in our shipping and transportation costs in the fourth quarter as we began to see on some of the benefits and efficiencies related to our strategy to increase our in-stock position and lower our back orders.

Our total SG&A expenses increased 9% to $116.7 million in the fourth quarter, versus $107 million on an adjusted basis in the prior year.

As a percentage of net revenues, adjusted SG&A expenses decreased by 220 basis points.

This decrease was predominantly driven by advertising savings resulting from the change in our Source Book strategy, as well as leverage on corporate employment costs and lower corporate G&A expenses, resulting from disciplined cost control.

Adjusted operating income increased by 41% to $58.3 million from $41.4 million last year, and our fourth quarter operating margins expanded 200 basis points to 12.4% from 10.4% last year.

Adjusted net income for the fourth quarter increased 52% to $34 million, up from $22.5 million in the prior year and is calculated based on a normalized 40% effective tax rate.

Our adjusted diluted EPS increased 38% to $0.83 versus $0.60 last year.

Turning now to our full year 2013 performance, net revenues increased 33% to over $1.55 billion in 2013.

Comparable brand revenue growth increased 31% on top of the 28% comp growth in FY12.

Direct revenues also increased 36% on top of the 27% increase last year, with our direct sales in 2013 representing 47% of our overall revenue.

Gross margin for the full year was 35.9%, 100 basis point decline from last year.

This decrease was driven by our lower product margins, resulting from changes in our product mix, strategic pricing on new product introductions and higher shipping costs.

We also made several investments in our DC capacity, which were partially offset by retail occupancy leverage.

Adjusted operating income increased 76% during the year, with adjusted operating margins expanding by 200 basis points to 7.8%, up from 5.8% last year.

We achieved significant advertising leverage due to the elimination of our fall Source Book mailing and we continue the to leverage our other fixed SG&A expenses.

Adjusted net income for the year increased 92% and reached $69.1 million, or earnings per share of $1.71 on approximately 40.4 million diluted shares outstanding.

Turning to the balance sheet, inventory levels at the end of the year were $453.8 million, up 28% over last year and tracking below our total revenue growth.

We ended the year with outstanding debt of $85.4 million versus $82.5 million last year and with over $260 million available on our credit facility.

Our balance sheet also reflects the (inaudible) of approximately $33.5 million of assets related to the treatment of several our Full Line Design Gallery leases as built-to-suit leases.

Under these arrangements, we are required to record an asset with property and equipment and a corresponding liability within other long-term obligations on our balance sheet related to the landlord assets for these buildings, as we are considered the owner of the construction project for accounting purposes.

These assets do not impact our P&L or cash flows and are not included in our capital expenditures.

Our total capital expenditures were $93.9 million in FY13.

More than half of our 2013 capital spend was related to our real estate expansion and included costs related to the buildout of several Full Line Design Galleries scheduled to open in 2014 and the conversion of approximately 30,000 square feet of back room storage space into selling space.

Remaining capital spend included our DC and supply chain investments as well as IT and other infrastructure investments to support our growth.

As we look to 2014, we anticipate capital expenditures to be in the range of $115 million to $125 million, as we further accelerate our real estate transformation and plan for continued investments in our infrastructure.

Turning to our outlook, for FY14 we expect revenue growth of 18% to 20%, to a range of $1.825 billion to $1.86 billion.

We expect adjusted diluted EPS guidance in the range of $2.14 to $2.22.

This is based on adjusted net income in the range of $87.6 million to $90.9 million, and assumes a share count of approximately 40.9 million diluted shares outstanding.

As we discussed with you last quarter, we expect that our revenue growth will accelerate in the second half of the year as we benefit from the product newness introduced with our spring Source Book and as we execute our real estate plan.

For the first quarter, we expect net revenues to grow 14% to 16%, to a range of $345 million to $350 million.

As we previously discussed, we're up against a tough compare, as our first quarter of FY13 benefited from a strong inventory position, allowing us to ship product earlier than anticipated.

We expect adjusted net income to increase 62% to 99% to a range of $3.7 million to $4.5 million, translating into adjusted EPS in the range of $0.09 to $0.11, based on 40.7 million diluted shares outstanding.

In closing, we are extremely pleased with our record performance in 2013.

We continue to remain focused on our growth strategy, including the expansion of our offer and the transformation of our retail stores and remain confident in our ability to drive long-term growth and value for our shareholders.

Our long-term financial goals remain as follows -- revenue growth in the low 20%s, adjusted EBITDA growth in the high 20%s and adjusted earnings growth in the mid- to high 20%s.

With that, I would now like to open up the line for any questions.

Thank you.

(Operator Instructions)

Our first question comes from the line of Matt Nemer with Wells Fargo Securities.

Thanks so much.

Congratulations on a great 2013.

First, I wanted to ask a few questions on the Source Books.

Gary, could you give us a high level preview of what's different this year in terms of the 13 books versus 6?

And then, how should we think about the incremental cost of the size of the book and the UPS delivery strategy versus the incremental savings that you didn't get last year from cutting the fall book.

Sure.

First, Matt, we're not talking too much about the specifics of the book because we'd rather have it get out there and have the customer react to it and -- as opposed to giving our competitors any kind of head start as to what we're doing.

But let's just say there's a very new and, we think, highly logical and new experience that is going to especially translate well when shopping by lifestyle and/or category.

It's something that's very new and I think you'll see it when it gets out there.

As it relates to the ad cost and how do you think about going from 1,600 to 3,200 pages, think about -- if you think about my comments in my prepared remarks, the idea of going to fewer, bigger books, like fewer, bigger stores, with a much broader assortment mailed once a year, we think is the right way to deploy our ad cost investment to get the greatest return and to grab the most share.

That's how I'd think about it at a high level.

Okay.

Great.

And then --

I'd say directionally our cost per circulated page is lower than a year ago.

Okay.

Makes sense with the much bigger book.

And then secondly, the SG&A dollars were essentially flat sequentially, despite, obviously, a much bigger quarter and I think some of that was the fall book.

But given that, that fall book also doesn't ship this year, is that a trend that -- I assume it will be up this year sequentially.

How should we think about modeling SG&A from Q3 to Q4 going forward?

I don't know that there will be as big of a shift -- this is Karen.

Hi, Matt -- in Q3 to Q4 as you saw last year, because when we moved from mailing the fall book we had a larger percentage of those savings in Q3 than in Q4.

On a relative to the prior-year basis, the compare might look a little strange but the overall level of spend won't be as different on a percentage of sales basis.

Hope that helps.

Very much.

Thanks so much.

Your next question comes from the line of Matthew Fassler with Goldman Sachs.

Thanks a lot and good afternoon.

Two questions, and the first relates to SG&A as well.

Karen, if you could shed some light, just a little more detail on some of the moving pieces on SG&A, given the very strong expense control year over year, maybe trying to size them approximately.

Also, was incentive compensation year on year a factor in the lower cost number?

Yes, sure.

I assume we're talking about Q4.

Yes.

The predominant driver in the savings in SG&A in Q4 was related to the advertising and that was primarily due to the elimination of the fall Source Book.

The other factors weren't as significant.

We did have some leverage in employment cost and some of that was in incentive compensation but we also really did tighten the purse strings on some of the other travel and hiring and other things, just to make sure that we were being conscientious and diligent with the cost control in Q4 once we saw the weather and other things impacting the business in the latter part of the quarter.

Karen, can you also shed some light on how those advertising costs will move around in the first half of the year, given the production of the book and then the mailings, et cetera, sort of how you accrue and book those costs.

Yes, sure.

In Q1 we will continue to have some of the amortization from the prior spring Source Book.

So Q1 will continue to benefit from that change in the Source Book strategy with the move to one mailing per year, but then in Q2 we'll cycle the savings that we had in the prior year and that's when the investment of the additional pages and new products that Gary mentioned will kick in, so we won't see the same leverage to the extent -- or anywhere near the extent we saw in that first year but we'll maintain a nice healthy advertising as a percentage of sales.

Great leverage in Q1, and then obviously Q2 through Q4, not as much leverage comparative to last year.

We have twice as many pages going out.

And then secondly, Gary, I know that there's some categories that are a bit newer in the mix that probably went through their first holiday in terms of being sized for you.

Can you give us some color on how they did and to what degree they contributed to your strong performance here?

Any particular categories, Matt, you're wondering about?

Tabletop would be one.

That was one of those most on my mind.

Also Small Spaces catalog, et cetera, some of the initiatives that are a bit newer for the Company.

We'd rather not give away specific information like that.

That, again, is just for competitive purposes.

But I think I would reiterate what I said in the past, that I would not expect some of the new businesses like tableware that have very, very little store exposure to really materialize and become important until they get a real home in the next generation design Galleries.

Got it.

Okay, thank you so much.

Thanks, Matt.

Your next question comes from the line of Daniel Hofkin with William Blair.

Hi.

Good afternoon.

Maybe just looking for a little bit of color kind of on the quarter for the -- in the fourth quarter, the top line.

You mentioned, obviously, weather and the shorter holiday.

Anything else that you would call out, either, let's say, variance relative to expectations, whether it was impact of the different Source Book strategy or if you had any orders, let's say, that were pushed into the first quarter.

Anything like that, that you would call out that might have affected the quarter on the top line?

Reinforce the comments we made.

I think most of us retailers -- remember, in the fourth quarter we still have a relatively significant gift business and cash and carry business that happens -- that is driven by mall traffic and timing and so on and so forth, and there's two things that I think we missed there.

One was -- and it's hard to do this, every seven years or so you get this shorter selling season and being able to time and forecast that shorter selling season.

You think you can press that much more sales through that area and when we got into the back half of December, and we got into poor weather and a shorter season, we weren't able to kind of hit the numbers we thought we'd hit.

I would say it was also impacted by the fact that we circulated our holiday gift book down in the 20% to 30% range, thinking that, that was the right thing to do.

Reflecting on that and I think as we do more analysis, that looks like it may not have been the right decision.

That there's this concentrated period with an extra million books out there that we would have probably paid for those books and had the revenue upside.

So in trying to kind of optimize the ad cost, I think we made a bad call in Q4 from catalog circulation point of view.

How much of it was the short season, the catalog, the bad weather?

It's probably a combination of all of that.

And then in January you saw the weather issues increase and I know as you read some of the commentary out there that say, well, people are going to still buy furniture, aren't they?

Or people are going to go online if you've got a web presence.

I think if you're a retail customer and you want to go to the store and interact with the goods before you -- say, like test drive a car.

You may not make that sale and if someone's delaying their visits to the store and that was a day that the husband and wife could have gone and now they're kind of snowed out, could have delayed purchases for a month or two, I think so.

Because unless you've moved into a new home and you don't have furniture, the urgency is not as great, right?

It is a purchase that you can put off.

So from our point of view, we can align some of the softness in our business to those weather days and we didn't necessarily see a bounce back in the next few days or the next few weeks.

Now, more as of late, we may think that, that can start happening as the weather starts changing.

I do think that if someone was planning on buying a new sofa or bedroom set and they delayed for a month or two, I get it.

Will they just decide not to buy a new bedroom set?

Probably not.

But then again, today I think we're all battling -- in the high end of the market, we're all competing for discretionary money and in some ways when you look at our growth, some of it's coming from market share.

I think some of it's coming from creating a new market, creating a many compelling reason to maybe refurnish your home.

And if all of a sudden during a period you get a customer that delays that purchase intent and then decides hey, honey, let's go to Italy and they go spend $20,000 on a vacation, I think we're competing against those kind of decisions sometimes.

So that's how we think about it.

I think we missed holiday.

I think we made maybe some incorrect assumptions and got hurt by some of the traffic issues and weather issues other people did, and then I think we get some weather issues even on the broader part of our business.

Not a lot, I'd say.

You can relate our -- most of our miss in kind of the holiday period and the weather issues and so we feel confident that it's not ongoing, it's not systemic.

Kind of a long answer to your question, but I'm just kind of trying to be as transparent with you in how we view it.

That's very helpful.

I guess the just other question, you alluded to on balance a somewhat smaller kind of future prototype, on average, than what you might have thought six months ago.

Is that from more in the kind of size of the last five that you've opened kind of becoming sort of hitting your radar as opportunities, or is that kind of across the board just seeing opportunities for -- to get similar productivity out of a little bit smaller space than what you might have thought you needed?

Yes, I just think it's us getting smarter every day and just being ruthless about where we're going to deploy capital and what kind of returns are we going to get on that capital and what's the asymmetrical risk look like.

Are we creating an upside asymmetrical risk profile on a real estate investment, and how does that look?

How do we think about that market, and really spending the time to have the discipline to get into the data, get into the catalog response in the stores, get into the number of households, get into every aspect of the information that ought to influence what we believe will be the kind of return.

So while you might say hey, the occupancy might not be that much more to build another 10,000 square feet, you have a capital investment to build it out.

Whether the landlord's paying for it or it's our capital, you pay for it one way or the other.

There is no free money.

If the landlord's putting in capital, we're getting charged some yield against that capital.

So if we had a model that said okay, every store is $20 million, why should every store be $20 million?

Not every market is the same market.

It was just continuing to challenge our assumptions, continuing to think about better -- be better investors and better stewards of our capital and getting to every level of detail.

That's just kind of our DNA, by the way.

That's why everything here always evolves and always changes, right?

As new data comes in, as new information comes in, as new thoughts and new debates happen inside the Company, it brings forth a new and better view.

One of the things that I think is one of the strengths of the Company is we have those debates and we continue to evolve and we are quick to make a decision.

We're not the kind of company that gets better information in the first quarter, second quarter and go well, that's the plan in the year.

I'm sorry, that's what we're doing.

We are constantly iterating.

We are constantly improvising, adapting and overcoming and trying to get better every single day.

This is just something I expect you're always going to see this happen.

You're always going to see us adjust and refine.

This is not a cookie cutter, 3,000 square foot retail roll-out that has the same assortment in every market that you slap up a store front and just go.

This is a much more intricate and complex investment strategy.

Understood.

Thanks very much and best of luck.

Thank you.

Your next question comes from the line of John Marrin with Jefferies.

Hi Gary, Karen; congrats on a nice performance.

Just want to focus in on the square footage for a moment.

I know you said you'd be converting some back room space this quarter.

Looks like you did a great job finding some extra room.

Maybe you can help us understand how many stores were impacted by those -- by that expansion and how much -- how those stores performed against the comp, or against the Company average, and what the additional opportunities might look like there.

We had -- this is Karen.

We had 11 stores that comprise that roughly 30,000 square feet and they were converted basically over the course of Q4.

So a lot of them didn't really get that square footage translated until Q4, or towards the end of Q4.

So not very impactful, obviously, for Q4 because a lot of them weren't open and, in fact, some of them were closed or kind of a distraction, I'll say, when there's construction going on or part of the store's blocked off.

For those 11 stores, we would expect them to have -- again, have more selling square footage going forward and more productivity going forward but not something we've -- we're willing to quantify by location or anything.

But again, it was 11 in total and roughly 30,000 square feet that was part of our selling square footage growth in 2013 and will be -- will benefit in 2014 from.

And then, hoping for some more color, maybe a little more color on the five lease signings and the pipeline on 2015.

What specific color are you looking for?

Which markets or are these five all for 2015 and how are the rest shaping up?

Four of them are 2015 deals and one of them will be in 2016.

The 2016 one we can't really disclose the location yet, but we can -- we can give markets?

We'll probably wait to give the specific markets once we have further clarity on timing and such, but we're really excited because we had LOIs on quite a few of these and we were able to in the quarter focus and buckle down and get all the lease deals signed.

Part of that is what's creating some of the learning as we've really put pen to paper and finalize plans and finalize leases, we get a lot better data and are seeing how great these occupancy deals are.

Okay.

All right.

Great, guys.

Thank you.

Thank you.

Your next question comes from the line of Peter Benedict with Robert Baird.

Hey, guys, thanks for taking the question.

First, just on the spring drop starting in May and I guess all in the stores -- or in the homes by mid-June, it's a little later than you were initially thinking.

I think it may have been.

Let me know what happened there.

And then secondly, as we think about the revenue growth profile, I understand the second half is expected to be better than the first half.

How about 2Q versus 1Q?

These books are not going to be in the home until, let's call, it mid-June.

Could you see second quarter revenue growth similar to the first quarter or do you think it will be better?

I think we think it will be better, Peter.

I think the way to think about the books is we have books that are twice the size they take.

It's more complex to print them, to bundle them, to bind them and get them through the system.

So last year our books began getting in home end of April.

This year, they will start to get in end of April but it takes a little longer because they're twice as big.

So the roll-out of them happened slower and will kind of increase as we go.

This is the first time we've mailed 3,200 pages.

I think it's the first time anybody's delivered 3,200 pages, so we're trying to be conservative and thoughtful as we think about what's realistically going to happen here.

We feel confident in going with UPS, who's our major provider of our in-home packages, and what we like about that is that almost everybody -- I'm sure everybody's who's our core customers today shop online and get deliveries at their homes or their condominiums or their apartment buildings and there's a systematic way for UPS to deliver a box or a package and it usually gets there.

As we went through the details, it seemed more risky putting it through a less-certain delivery service and so we -- we're being very conservative on what kind of lift we need for the payback on that UPS thing.

Honestly, it could be very accretive to earnings.

We're just not modeling it yet because we've never done it, but if you went through the logic you'd say, this looks like it's going to be pretty good.

The US post office last year, a lot of our books got in months late.

We had reporting of books getting in very, very late.

Here, we'll know by day how many books get delivered to who.

They'll be scanned.

We'll get that information.

We're kind of in new, unchartered waters once again.

I know that makes everybody somewhat uncomfortable.

It makes a little harder to model us because it seems like every year there's two or three kind of new evolutions and ideas, but I'd say that's kind of who we are.

We will tend to lead and not follow.

We're very impatient and we're very driven to do things better.

We think this is going to be a big move.

All our data tells us it.

I'd say if you look at our history on these kind of moves, the history would say we're a lot more right than wrong.

I think we made a great call last year, mid-year, deciding not to mail a book.

I don't know how many companies would have the courage to make that call.

But we make calls from a very disciplined, data-driven, high-debate environment.

We don't make big moves unless we really see the data that says that has a lot of asymmetrical risk to the good.

So far, I look back and I say -- it's funny, I look back when we raised our guidance at the end of Q2 by, I think, 16%, and our stock went down $10.

I would have bet just the opposite way, but when I have to put myself in the shoes of an investor and say, okay, someone gets on the phone, tells me the revenues are going to go up, their earnings are going to go up and they're not going to mail one of two books?

How the hell is that going to happen?

We made those numbers.

The top line was a little short, but we made the earnings numbers and it was highly accretive.

I think as you guys think about this Company and modeling this Company, I'd say look back at the decisions we've made and the bets we've made and I'd say we're a lot more right than wrong.

But this is just not going to look like a typical retail company that you can model, because we will always be innovating.

That's helpful.

Thank you very much.

Then a quick one for Karen, just -- thanks for the CapEx guidance.

How were you thinking about cash flow, though, and maybe the out look for borrowings as you go through 2014?

Thank you.

Yes.

We will be cash flow negative this year, just given the size of our investments in real estate and other infrastructure investments and that's something we've talked about.

We have plenty of capacity.

We ended the year with $260 million available on our line so don't see even close to any issues there.

But while we continue in this investment phase, especially with the investment with the stores coming online in 2015 and some of that CapEx coming in this fiscal year, coupled with we are a cash taxpayer now.

Last year we didn't pay any cash tax because we utilized all our NOLs, so this will look more like a normal company from a cash tax perspective and that, coupled with the CapEx, will basically generate plenty of cash from operations but all of that and then some will be reinvested in the business for our growth.

Thanks very much.

Your next question comes from the line of Brad Thomas with KeyBanc Capital.

Thanks, good afternoon.

Wanted to just ask about the gross margin outlook for the coming year and what some of the puts and takes are to look out for.

Yes.

Heading into 2014, while we don't provide specific guidance on margin and SG&A, directionally we are expecting to see improvements in both.

For gross margins specifically, as we had discussed, we cycled through now some of the -- or most of the strategic pricing we talked about this last year, so we do see some upside in product margins in 2014.

But there's a couple other things going on to your point in the puts and takes within gross margin and occupancy.

We'll continue to see leverage in our store occupancy costs but there's two other factors at play.

One is, with the first half we're not going to anniversary the supply chain invests we made last year until the latter part of the year, so we'll have some deleverage until the back half when we anniversary the Dallas DC and Ohio shelf stock facility investment.

But then, once we hit the back half we're going to see a bigger drag on occupancy related to pre-opening rent related to several of the 2015 Full Line Design Galleries.

That's going to have an impact as well.

So overall, we see some opportunity with product margins but occupancy, some of the DC things and some of the pre-opening rent is going to eat into a lot of the occupancy savings we've been seeing on our retail base.

Hopefully that helps with some of the moving levers.

I think I'd just build on that by saying to understand our, again, our investment mentality, we've said that we want to buy insurance from an infrastructure point of view than rather take the risk that the infrastructure might fail.

In a lot of cases, I think you've got to look at a company when it gets to our size and complexity, especially on the back end, you have to be as good as the airlines if not better, right?

You have to have a very low accident rate, because if something goes wrong here and we run out of track, both Ken and I -- Ken came into William Sonoma during a time when we under invested and had to clean up a mess.

I had to live through the mess.

We have a very conservative investment strategy that says build enough track.

Don't let the train outrun the track.

So I'd say for the next couple of years, we're going to be more conservative than aggressive from the an investment point of view.

We are going to buy more insurance than less insurance because we're still in a fluid, very early stage development company.

I said to our Board of Directors last week, in many ways we're a $1.6 billion startup, that we are moving through transformational stages in our product platform, our direct platform, our retail store platform, our supply chain where we have a ton of innovation going on that we'll continue to talk about as we move through the year, and even in our financial model and how we think about it.

When you've got growth at this level and complexity in a business like this in the back end, it's just much safer to buy insurance.

We'd like to be able to sleep at night here.

In some cases, you'll expect us to keep buying that insurance and it's protecting the down side for all of us as shareholders.

That's very helpful color.

And if I could add a follow-up for Gary on the hiring of Doug Diemoz.

It's clear that one of his big responsibilities, if not his biggest responsibility, is future international growth.

So Gary, I was hoping I could take your temperature on what your near-term aspirations are from an international standpoint.

International is -- takes a while, right, to built out the blueprint and the strategy, to understand what the capital investments look like, what the different strategies by market look like, by country look like, and then be able to properly sequence the moves and have a progressive return on capital that makes sense.

So I'd say in the short term, we won't be investing really heavily.

We will be studying and learning.

There may be more shorter term opportunities.

When I say shorter term, I'd say two years.

I mean, I think most people know there's certain models in the Middle East and other places.

We've all been pitched, if you've got a good brand, where there's highly accretive kind of international growth deals like that, that don't take capital, that don't take a lot of man power, that don't take a lot of time that can be accretive.

Most of the other international moves I'd say are much riskier than domestic growth and what's very different about a company like ours than if we were apparel or anything else is the back end.

You can say, okay, am I going to build a big DC over there?

Am I going to put all that inventory over there?

Am I going over there with all of the assortment, part of the assortment, why and how and where and where do we think the business is going to come from by market?

International for our business, very, very complex, so we want to have a lot of time to learn and study, build the blueprint, debate the blueprint, look at the sequencing, debate the sequencing.

I don't think you'll see really anything meaningfully happen until at least 2017.

Maybe you might see us doing a little bit in 2016, but unless we start now, we won't be ready, right?

And we've just had so many demands.

We're shipping full containers to London right now for single customers.

We're shipping, what is it, 34% of our business in Miami is going to South America.

We know there's places where we could do a lot of volume.

But again, it's kind of capital sequencing and being really intelligent about that.

Doug is a guy that he understands the home business.

He's got a great financial background and acumen, great operational background disciplines.

He's got a good business mind.

He's a great leader.

Honestly, he called me, he said Restoration Hardware has to be international and convinced us that we ought to start doing the work.

And then on the other hand, this is a guy that's really good the executive, he's got great experience and we think he'll be an accretive member of the team, and especially for me.

I think as I look at my time allocation and say, look, I've got to focus on the expansion of the offer, the real estate strategy, and make sure I understand the investment strategy and cadence in all the operational areas and it all links together.

Without Carlos here, it's only prudent that my time is on the core business.

So Doug will also give me, personally, some leverage in oversight and leadership in some of our emerging businesses and new categories and things like that where I think you'll have another disciplined business thinker looking at, challenging and guiding, leading the thought process and the decision making.

So that's how we think about it short term.

Very helpful.

Thanks and keep up the good work.

Thank you.

Your final question comes from the line of Neely Tamminga with Piper Jaffray.

Great.

Good afternoon.

Couple of just real quick ones here.

Gary, could you helps us conceptualize a little bit the level of innovation and newness in this -- and just call it the 2014 assortments versus the 2013, and maybe how that compares and contrasts with the 2013 versus 2012?

Yes --

And then just one follow-up to that, too.

It seems to us that you guys have been taking down the number of catalogs shipped per addition over the last couple years, and mindfully so.

Just, are you at that inflection point where you can start thinking about prospecting again, and how should we be thinking about that in the advertising costs?

Thanks.

Sure.

Let's talk about the assortment and innovation.

This is -- the way to think about it is, you have last year's innovation work that was done that we didn't launch for fall, right?

You've got all that newness that -- and work we had done for fall 2013 now just basically shifts in timing, right, and it moves into 2014.

And then you've got the other work we've done on top of that.

So you kind of have two seasons in one.

Last year, we had one book going up against two books.

This year, we have one book going up against one book, right?

So we don't have any kind of hill to climb in the second half, but we'll have the most -- as a percentage of newness, it's the biggest percentage of newness growth in the history of the Company.

And on top of that, we think we're presenting it in the most compelling and innovative way, and in many cases, products that we also had that weren't necessarily displayed very well, that might have been represented in a small, little picture and could have been what we kind of refer to as a Dionne Warwick, a walk on by.

If the customer can't see it, you usually can't sell it.

We believe, just based on our data, that presenting some of these products in a better way, they're going to look brand-new to the customer.

I think it's -- from a direct perspective, I think this is the most revolutionary thing I've been involved with in my entire career.

I think it's going to be transformative to our business.

I think we're being rightly conservative in our assumptions, because we haven't done it before.

So any time you go out there and you go into unchartered waters, you just, again, buy enough insurance, right?

Make sure we understand if there's bad weather ahead, we have the ability to pull the right levers and make it back to shore or make it across the channel.

We feel like we've got it thought through, but from a customer point of view, what the customer's going to see, this is every bit as impactful as anything we've ever done.

Okay.

And then on the circulation?

The circulation, we don't give out our circulation for competitive reasons.

What we've tried to do over the last several years is, again, optimize our return on investment from an advertising point of view.

I would say we're always kind of playing with that.

And the other thing I'd say is, we prospect every catalog, every time we drop the book, so there's always a certain percentage that are prospected books.

That number might of move from 15 to 30 in flex, depending on how we assess the data.

But I'd say there is an opportunity.

As we look at the data -- it depends on how you evaluate, Neely, the investment cycle.

It's funny, because, again, you make changes, you have to remember that everything else changes.

If we were sitting here a year-and-a-half ago or so and we were mailing two books a year and we were looking circulation depth over several drops, you'd say well, that book, amortized over six months, looks like this profitability.

Now all of a sudden you look at that same book or those same pages and you say, that circulated book over 12 months, right, is a very different -- it's very different math, right?

It becomes all new math.

You have to do all the math again.

So what we try to do is just make sure we're making decisions where the math supports the decision.

And then, we look at where there's no math, we say well how do you -- there's math to everything, let me just say.

Even though we're in unchartered waters on assortment growth and page count growth and all that stuff, we've got years of data that says when you expand page count, when you expand assortment, when you look at density like this, when you look at that, when you add finishes, when you do this -- all those things, what happens?

The data says this.

We try to make sure we buy enough insurance and it looks like it has asymmetrical risk and then we make the decision to go.

But I would say that there's new math now, moving to one drop a year, and that math would suggest we could circulate the books deeper, but then again, we haven't sent 3,200 pages yet.

Let's see how 3,200 pages looks over some time horizon and then we'll be a lot smarter in about six to eight months.

Call it 10 months, once we get past kind of the six-month cycle on those books and start looking at what the tales look like, and what happens.

Then we'll be smarter six months after that, and six months after that.

Took us two-and-a-half years of data to make the decision to go from two to one books, right?

Understood.

Does that make sense?

Yes, it does.

Thank you and best of luck.

Thanks, Neely.

Any more questions, or we're good?

Okay, everyone.

Well, thank you very much for your attention and interest in our Company.

We're going to continue to try to do our best job for you and we want to thank all of our team across the country and our partners around the world for supporting our cause and we look forward to talking to you soon.

Thank you.

This concludes today's Restoration Hardware's fourth-quarter and FY13 financial results conference call.

Thank you for joining.

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