RH (RH) 2014 Q4 法說會逐字稿

Good afternoon.

I'd like to welcome everyone to the RH fourth-quarter and FY14 Q&A conference call.

(Operator Instructions)

Thank you.

Cammeron McLaughlin, Investor Relations, you may now begin your conference.

Hi.

Good afternoon, everyone.

Thank you for joining us for RH's fourth-quarter and FY14 Q&A conference call.

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

Prior to this call we posted a video presentation to our Investor Relations website, ir.restorationhardware.com highlighting the Company's continued evolution and recent performance.

Before we start 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 release and video presentation issued today.

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

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

Please also note that these forward-looking statements reflect our opinion 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 may discuss 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 the non-GAAP to GAAP measures in today's financial results press release.

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

With that, I will turn it over to the operator to take our first question.

(Operator Instructions)

Your first question comes from the line of Adam Sindler with Deutsche Bank.

Yes.

Good afternoon, everyone.

Thanks for taking our questions.

I guess obviously the base question here is the revenue slowdown that we're looking at for 2015.

If you'd maybe help us understand what is driving this.

It does seem to imply a pretty significant slowdown in the brand comps as well.

And obviously given that you're saying 2015 is a bridge year, but then sort of as you think about this longer term, getting back to 20% next year.

But if we take, and this is two parts, near term help us understand?

But then longer term if we could help understand the maybe disparity, if you will, between longer-term guidance of $4 billion to $5 billion once the network is fully built out versus the 20% CAGR because you'll have 20%-ish, even below that CAGR, would get you to the $4 billion in change in just several years from where you ended 2014.

Which question do you want me to start with?

If you could just start with the near term, please, would be great.

Sure.

Thank you.

Well, let me talk about this.

The way we think about our 2015 revenues and why they should accelerate in 2016 is twofold.

One, all of the new real estate opened in the back half of this year.

So while 2015 will only receive a partial benefit from those new galleries, 2016 will have a much greater benefit as they roll into the next year.

And then two, our development accelerates, our store development pipeline accelerates in 2016 with current plans to open seven new next-generation galleries in the following year.

So really 2016 gets the benefit from the new stores.

And if you think about the stores that opened this year that roll into 2015, we really only had one of these big stores, Atlanta, that opened this year, right, that rolls into 2016 -- rolls into 2015.

So that's why we see this as a bridge year.

I think that additionally, as we kind of mentioned in the press release and video presentation, we have two new yet to be disclosed businesses opening in the second half of this year.

We believe those businesses will ramp throughout 2016 as we add a second and more informed mailing of each of those sourcebooks.

So you've got two factors, really.

You've got the later openings this year, and then you've got those four stores really rolling into 2016.

You've got the two businesses that we will be disclosing in the next quarter or two, and those will ramp in the back half of this year, and then be fully realized in 2016.

Okay, that makes sense.

And then just on the longer term, if you could help us think about the guidance of sort of a longer term CAGR of 20% versus the $4 billion to $5 billion in sales once the network is fully built out.

Appreciating that you're ramping openings in 2016, should we expect acceleration from that even?

Given that you did mention 9 signs for 2016 and 25 identified, or in advanced negotiations?

Or is there sort of a number where you'd like to cap yourself, just so you can make sure you can execute properly on all these because they're not cookie-cutter?

Yes, they're -- right now, our plan is for 2016 to have seven of the next-generation Design Galleries.

As we look into 2017, could that ramp?

I mean, it could.

I think, though, what I'm hearing as you ask me the question is you're kind of modeling this out.

You're saying, if you grow at 20% a year, you're going to hit this $4 billion to $5 billion.

Exactly.

The way to think about the $4 billion to $5 billion in the real estate is that is just one of our initiatives, right?

So the real estate transformation is one of our initiatives that tied together with our expanded product offer gets us to $4 billion to $5 billion once we have transformed the real estate in North America.

Beyond that, there is strategies here to continue to drive the product offer in multiple new ways that we have not disclosed.

And there is an international expansion plan for the business.

So you really -- it's not just looking at the real estate move as the only move, right?

So we believe that we can continue to grow the business in the 20%-plus range for the foreseeable future based on the strategies that we have and the initiatives that we have in our pipeline.

But you have to kind of look at the real estate as just one of the things we're doing.

Got it.

That was very helpful.

Thank you so much.

Your next question comes from the line of Matt Nemer from Wells Fargo Security.

Afternoon, everyone.

Thanks so much.

Two questions.

First on Atlanta, can you provide any additional color on the early performance relative to that 12- to 18-month payback forecast?

And you mentioned that it's the direct lift is one of the stronger lifts among your new format stores, and I'm curious what factors might be driving that.

And then secondly, in terms of the new concepts, do you have any more detail on the timing of RH Kitchen and the other concepts, and whether or not they're included in your revenue guidance?

Or would that be upside to your revenue guidance?

Thanks.

Let me try to take those.

Karen, you can add some color if I miss anything here.

But as we've said, we're very pleased with the early reads from Atlanta and we expect the sales in Atlanta to further accelerate as we introduce the new businesses we plan to launch in the second half of this year, and then additional new businesses that we have planned for 2016.

So one of the things, when you step back and you think about these new stores that we're building, we've built them for the future pipeline that we have in progress.

So we didn't build them for today, we built them for tomorrow.

So Atlanta is the first store to include all of our current businesses: RH Interiors, Small Spaces, Baby & Child and Outdoor.

Additionally, there will be two new businesses introduced in the second half of this year, Both core to RH.

So both will be within the home realm of the business that relate to the RH business.

We think both open up entirely new markets and are significantly incremental to what we're doing today.

So they're categories that we don't serve today.

And those categories will be launched in a catalog, and they will be then inclusive in these next-generation Design Galleries, right?

So Atlanta will benefit and continue to ramp in the second half of this year.

And then will continue to ramp further into 2016 as it benefits from those new businesses for the full year and it benefits from new businesses that will be added in 2016.

We have announced Kitchen.

We have not announced the date that we're launching Kitchen.

Kitchen is not one of the two businesses that we will be launching this year.

So I can end that speculation, because we've already gotten e-mails from people that said, is one of the two businesses Kitchen?

And so we probably should have made that more clear.

So kitchen is not.

Kitchen has taken us a little bit more time, as we are approaching the Kitchen business in a fundamentally different way than anybody has in specialty retailing.

And we're very excited about it.

We just have to do more work to be able to execute Kitchen at the level we expect to.

But the two new businesses that we are launching, I think I mentioned on the last call, one of them I believe represents our finest work ever, and might represent one of the biggest market potentials that we've addressed with a new category, a new business.

And the second one I think is also significantly incremental.

But one I think is a game-changer.

We're not ready to talk about it yet because we want to talk about it when we can show it to you fully visualized, and you will hear more about it on our next call.

So as you think about Atlanta, we're very pleased where Atlanta is tracking based on the categories and the businesses it has in it today.

We have expectations that it will further accelerate in the second half as it gets two new businesses, which the square footage is designed to take.

And it will continue to accelerate into 2016 when we introduce at least one more business, and that could be Kitchen.

I would just add all of the metrics internally are on track.

The direct list you mentioned, why is that happening?

I think it's just if anyone has been there or seen it, it's just we've often said that these stores serve as somewhat of a billboard.

So I think the impression that you get even just driving by that thing versus being hidden in the mall in 7,000 square feet, the advertising, the marketing that we get from the brand just from having that store physical presence is no surprise.

It's driving the direct lift.

But at the same time we're very pleased that it's been as strong as it has been.

And with respect to all those payback metrics, just as a reminder none of the direct lift is factored into those.

That's kind of gravy because if it's not in that four-wall contribution.

I would say, and let me just maybe back up and give color on all the stores.

It might short-circuit some of the answers as we go.

We've opened in really the last 12 months four stores: Greenwich, New York -- Greenwich, then we had an expansion of New York, we opened Melrose and we opened Atlanta.

They're all very different.

And I think it's important to note as you think about the business and the indications or reads you should take from each of them.

Greenwich was really a full line, a basic full line Design Gallery.

So Greenwich was more like a Houston or our initial LA or our Scottsdale store.

So it was about the same square footage expansion as those and it only has the core RH business and it then has an expansion of the RH Outdoor business.

The New York expansion -- and by the way, we're very happy with Greenwich.

Exceeding our plans, very excited there.

The New York expansion is the one store we've been disappointed with.

And let me tell you why we believe that has not played out to our expectations.

It is the only store that did not relocate to a new location.

So what we did in New York is we added two floors above an existing 1.5 floors.

We closed the basement and we then went up two floors.

So we expanded our square footage and we had an expanded assortment of our Interiors business and we put some Outdoor on the top floor in New York.

That store has not gotten the lift we expected.

So we're disappointed with that.

What's the lesson there?

The lesson is, it's the only one that did not go into a new location and does not have -- there is no physical change from the exterior of the store.

So we believe that just expanding a store in its space without changing the facade or changing the presence of the store is a key lesson for us, that the customers don't know enough has changed.

You can't see it from the outside.

Melrose on the other hand is in and of itself is another kind of store change.

So Melrose replaced one of our first, what we called full line Design Galleries.

So we opened in LA in an ex-William Sonoma Home location that was a temporary location for us.

We had signed the Melrose location.

We knew it was going to take several years to develop and build.

And we didn't want to wait in LA to have an expanded assortment of our business in the market.

So we picked up the Williams Sonoma Home location when Williams Sonoma closed those stores.

We were able to build that out, remodel it, put it in a courtyard and present our brand.

We were very happy with the lift.

We've learned a lot.

But we already had a store in development.

So Melrose represents just a better version and bigger version of full line Design Gallery.

It's not a next-generation Design Gallery.

It does not have Baby and Child.

It does not have Small Spaces.

So it's just a bigger version of a full line Design Gallery.

And we're very pleased with the results in Melrose.

Atlanta as I said, is the first full Design Gallery.

So that's the only one that represents the new model.

And we're very pleased with the early results in Atlanta.

And we're very excited to continue to feed that footprint with the businesses that we've developed in the pipeline that are designed for all these larger stores.

Thanks so much for all of the color, and good luck this year.

And your next question comes from the line of Jessica Mace with Nomura Securities.

Hi.

Good afternoon.

Hi Jessica.

My first question, if you could just clarify on this bridge year for 2015.

Is it fair to say that the dynamic is fully related to the timing of opening stores?

Or could you tell us if there's any change in what you expect in your comparable sales growth?

Well from our internal plans it has everything to do with the later development of the real estate and the real estate coming on later.

And so just to be clear, we don't expect this Company to continue to comp at 25% forever.

And that's never been an expectation.

So the real estate is essential to continue to have the 20% range revenue growth.

Understood.

And then if you could provide any further color on the performance of the gross margin expansion and the SG&A performance in the fourth quarter?

And maybe just some of the timing for the significant benefits you expect to see in 2015?

Sure.

So for Q4 our gross margin was actually right in line with what we had been talking about for the whole last half of the year.

We had talked about the half having 50 to 100 basis points expansion.

Our actual was 90 basis points gross margin expansion in Q4.

That was 30 basis points, which was right where we had talked about.

And then SG&A was also kind of similar.

We had said we expected modest deleverage, and the biggest drivers within SG&A, we were flat in Q4.

We had some deleverage of advertising, as we have been talking about with the expanded page count.

And that basically offset some of the great leverage we had all across the rest of the P&L with a lot of our fixed G&A costs.

So that's kind of the story and the color on Q4.

With respect to 2015, just in general that operating margin expansion that we're talking about, we expect the majority of that to come from SG&A leverage this year.

The biggest driver being advertising leverage, which Gary mentioned some of the optimization we're going to be having with our sourcebooks this coming year.

But we do expect to have some modest gross margin expansion in 2015 as well.

Great.

Thanks very much.

Thank you.

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

Thanks a lot, and good afternoon.

The question I would ask just relate the direction of operating margin to your store opening trajectory.

So your incremental margins are likely to increase nicely in 2015 as revenue growth slows a bit to your plan and the operating margin expansion stays somewhat similar.

If any of that reflective of less new footage?

And I guess the other question related to this, as you look at 2016 is there any reason why incremental margins would change at all from where they are going to be this year?

In other words, should you be able to get good operating margin expansion a year out, even as the rate of average footage growth accelerates?

We would expect the operating margin to continue to expand.

One of the big drivers there, Matt, is related to the real estate transformation.

The occupancy leverage that we're getting with these new deals is really significant.

So we have this legacy portfolio that's highly productive and leveraging.

And as these new stores come on, those are such superior economic deals than we've seen that that occupancy leverage is going to continue.

Let me just build on that.

I think if you study the slide that Karen puts up that shows the path to the 15% to 16% operating margins to get to the mid-teens, there's really a couple key things and a way to simplify it.

If you take the real estate transformation and you say, take any market and say, we are going to meaningfully increase the sales in that market.

And in that market we also expect to have occupancy leverage, not only in that market, right, but we'll have occupancy leverage across the greater Company because we're increasing sales.

The other thing that happens is when you have a significant increase in sales, we're not planning to increase advertising in that market to drive those sales, right?

So those sales happen as a result of the real estate transformation.

So advertising leverages significantly in each of those markets.

So you've got two big levers.

And then you've got the other levers of those incremental sales across the entire infrastructure of the Company.

Again, what's very different here than I think many other businesses that are growing, is we've spent years and years and years building this assortment.

Remember, in the typical market less than 10% of our assortment is displayed at retail.

So we've built the assortment.

We have more things coming, but we've built the vast majority of the assortment.

And now by opening these new stores we will get the sales and the leverage because it's not like we're building the assortment as we're trying to drive the sales.

We've already built the assortments.

So we just have to unlock those assortments into the marketplace.

We will -- by transforming the real estate that will meaningfully lift the sales in every market, that will drive down occupancy, that will drive down advertising cost, and it will drive down overall SG&A across the Company and across the board.

Great.

Thank you so much for that.

Appreciate it.

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

Hey, guys.

Question just on the operating margin.

Thanks for the color on the year and how you're seeing gross margin and SG&A.

But if you think about the first quarter kind of implying flattish, maybe up a little bit.

And I understand that the revenue is a little lighter there.

But as you go across the balance of the year, you're obviously guiding to a lot more operating margin expansion.

I mean, the revenue growth rates implied over the following three quarters aren't materially higher than what you've got in the first quarter.

So I'm just curious, other than just sales leverage, are there any other puts and takes, Karen, we should be thinking about in terms of what's maybe pressuring the early part of the year that may fall off for the back half?

Yes, sure.

So Q1, if you just think about what Q4 looked like, just roll that forward to Q1 because we expect the same thing.

We expect the modest gross margin expansion but the ad costs.

Our books mailing once a year have pretty much a one-year cycle.

So when we double the page counts and we have a deleverage in ad cost in Q2, Q3, and Q4 it's just going to continues into Q1 until we lap that and have the benefits of some of the optimization we're having with our next year in 2015, the coming books.

When those optimization efforts hit in Q2, that's when you'll start seeing the ad cost leverage.

So in Q1 you still have a little bit of the deleverage that we saw throughout the year.

Now that really helped in another year with very little square footage growth drive a lot of our sales and the great things that happened in our business.

But in Q1 you're not going to see the same level of operating margin expansion as we will in Q2, Q3 and Q4 in 2015.

Okay, that's perfect.

And then just thanks very much for that.

And just as we're thinking about 2016, and Gary you said maybe seven of the new Design Galleries coming online.

Do you think any of those come early in the year?

Do you think the timing would be more spread, as best you can tell at this point?

Or should we be thinking back half of the year for the 2016 openings as well?

Yes, I would say it's still going to be weighted back half but we may get a couple of them open in the first half.

But because they're all big development deals, they're just really hard to gauge.

We actually just until several weeks ago thought we had eight, and then one of our major landlords had an issue with moving a critical tenant that they needed to move and the store gets pushed by six months into the following year.

So I wish these could be simpler and more predictable, but they're not.

And many ways they're probably the most complex development deals that I think anybody has been involved in retail because, even different than a department store where you're just looking for a pad.

They've got pads for department stores and you've got a simple build.

These are -- they have to make the room for us or find the room for us, or we have to find a building that works.

So we're confident in getting them all done.

But as we're doing them, I think we're learning and we're learning about the complexities.

And while it's rolling out a little slower than we might have originally anticipated, I think the benefits from that, I think we're smarter, we're making -- we're learning lessons, we're making a lot of good changes and continuing to tweak these and make them more productive.

And I think we'll still be able to hit our long term targets here.

I think in this one year and this bridge year, we would have hoped this year would have been more like seven or eight stores and it wound up being four.

Understood.

Thanks for the color.

Your next question comes from the line of Oliver Chen from Cowen and Company.

Hi.

Congrats on a solid finish to a great year.

We had a question related to the inventory needs over the next year.

How should we think about the magnitude of cash outflows?

And is there a delta with the new concepts?

And then also Gary, you mentioned quality and service as a theme.

How will that interplay with the financials in terms of margins, or how you see traffic and awareness building?

And finally I wanted to ask you a little bit about supply chain.

And supply chain feels like a great long-term opportunity as well as ongoing.

And how that may intersect with the customer experience.

Thank you.

Okay.

I'll start with the inventory one.

And that one, very similar to what we have been saying, is the business does require a night-in-stock position.

So we will continue to make inventory investments to make sure that that strategy (technological difficulties) improve our in-stocks and make sure we're not having high back orders, continues on that path.

We are really happy with the investments we made last year.

It actually was one of the reasons we were able to navigate some of the port issues in the back half of 2014, having made some of those investments.

And then we will make investments for the product, the newness and some of the product categories that Gary talked about.

So on the year we do expect to continue, or we hope, to grow inventory slightly ahead of sales, very similar to what we did actually the last two years.

So that really won't change and we won't see significant improvement in turns until we start to grow more of the square footage and start to kind of optimizing those inventory investments and have a little less newness and more growth by square footage as opposed to offer.

Okay, thank you.

Great.

Let me try to take up your other two questions.

I think one was related to the theme of quality and service and how that will impact the P&L.

I think we believe that as we position this Company at the luxury end of the market and position the brand there that there's an opportunity to continue to elevate our service and elevate the quality experience that our customers get.

And we're making multiple investments, and we'll continue to.

And they all have pretty good return timing.

So let me just talk about some of them.

One, you heard about our push into design services.

We're finding out that as we invest into offering a very high quality level of interior design, the payback on those investments is very quick and it differentiates us in the market.

And a lot of people today, it's interesting a lot of people say they have free design services.

And -- but not many people have really certified and qualified interior designers on staff where people that are qualified to go in and do somebody's home.

Many times I think other people out there that are in the industry that say they have design services are taking some junior person who may be as good at visual merchandising and letting them into somebody's home and try to give them advice on how to design a home.

Or other people may have people who think they are good at decorating and they call them an interior designer.

We're building a world-class interior design platform.

And we believe we have the credibility to do that because I think if you look at the execution in our galleries, we execute as well as world-class interior designers the way we present in our stores.

But we think there's opportunities to elevate the service, to add installation services, to be more full service like an interior designer.

The question is, at what point do you charge for that service, and how high do you take that service before really it doesn't make sense to do it for free.

So we're doing a lot of work around interior design services and believe we can elevate that effort over the next several years.

Some other things that we're focused on is the continued in-sourcing of our home delivery hubs.

I think I've mentioned in past calls that our bias is to have more control than less control and to have more control of every aspect of our business all the way to the customer.

So we continue to make investments and to take control of our supply chain based on that final delivery.

And that kind of piggybacks onto another key investment we're making and a system that we're rolling out this year, and that's our new final-mile system.

I think we've mentioned this before, but it's a new scalable state-of-the-art delivery and scheduling platform that provides visibility to all aspects of the delivery cycle.

And it enhances the customer experience through improved inventory accuracy and scheduling efficiency.

Today we're dependent, especially where we have third parties on systems that don't give us full visibility that we don't -- we have communication gaps and visibility gaps throughout the system, and we lose efficiency and it impairs our ability to deliver world-class service.

And it's also more costly.

So we think that there's significant opportunities as we roll out final-mile, which should be fully rolled out by the end of this year.

And we'll be seeing, we believe, big impacts and payback on that investment.

The other thing we'll be implementing this year is a salesforce/customer relationship system, management system.

And it's really the leading customer relationship management solution that will provide a single view of the client for Galleries, all of our stores and our client service centers.

It elevates the customer experience by enabling associates to service clients faster and more accurately with seamless access to order, product and other key information, and including the customer's lifetime value.

We can see the lifetime interaction and value of this customer.

And today we don't have that.

So we're still today operating kind of in the Dark Ages from a customer relationship management point of view.

So when we roll out this salesforce system, this is going to leapfrog us ahead.

We're also -- we have some other things that we think will just improve the operational performance of the Company and execution of the Company.

Well, first let me finish on the supply chain.

The last piece is our new distribution center in Northern California.

We talked about this, it's a new 1.5 million square foot DC in Patterson, California.

It's the next planned step in our long term growth of our network, and it's a really next-generation kind of distribution center.

Each one of these we get smarter, we get better, we execute better, we take learnings from those and we can then take those learnings into our existing centers.

But all of this gives us the ability to continue to grow the Company and gives us enhanced flexibility.

So we're building a network that we believe gives us the ability to grow and the ability to be flexible and to accept new businesses and new ideas and not have a supply chain that locks us in.

And then the other investment we're making is into a new Oracle financial system.

We have a planned replacement of, I think, what do we have?

Lawson.

It's an aging financial system, very aged.

And this is really state-of-the-art Tier 1 solution from Oracle that will give us better data, better reporting and better information throughout the organization and be able to manage our financials better and be able to manage the business better.

So a lot of investments that will -- all of these will help us raise the level of quality, service and execution throughout the Company.

So I think that kind of ties into the supply chain question also.

Yes.

That's really, really helpful.

It sounds like really great infrastructure developments.

And Gary, just as a follow-up.

Where are you with lead times roughly, and is there a way to dimensionallize what the big opportunity is on that overall kind of lead time picture as you look to efficiently match supply and demand?

Yes, we're doing a lot of work there.

Ken Dunaj, our Chief Operating Officer, has recently taken over inventory management.

He has a new leader in that area of the business.

I think we have more intelligence, more energy and passion behind inventory management than ever in the history of our Company right now.

And these guys are working all the way up the supply chain and really creating interfaces with our vendors at a level of really sophisticated companies.

So you'll hear more about this.

I mean, there's many things we can talk about here.

But it's kind of the next step of evolving this Company.

We've been able to position ourselves where we are today because we have brought a product to market that really didn't exist, and in many cases we created a new market.

I've always said that furniture of this quality has never been made in these quantities before.

So we're building a new railroad.

And initially it was a lot of muscle and hard work and investment to kind of scale this in the early stages.

Now we're in a position where we're making more meaningful investments, system investments on both sides, with our vendors and internally here.

And connecting those and building a kind of supply network and a supply platform that we think will be very unique in our industry.

So all of that should help us with lead times, help us with inventory flow, the way we're systematically placing orders now.

All of it will -- I think we'll get better.

And the other thing that I'd think about as you think about our Company.

Remember our business, and I said this a few times before, our business has been growing horizontally, not vertically.

Meaning we've been expanding our product offer and expanding into new products, new categories, new businesses.

That is always less efficient because you have so much newness.

As we start to shift, and again shift, not meaning that we're not going to have continued newness and new businesses and categories because you just heard me talk about the fact that we have two new ones that we're going to introduce this year and we have another one next year possibly two next year.

So that will continue to happen, but as a percentage of our total assortment, it becomes a smaller percentage.

And then as you think about the vertical growth we will shift to, we will start opening stores, new and bigger stores.

Our square footage will grow.

So the square footage is about growth coming from the existing assortment, right?

So that's where you start to get leverage on the inventory and you start to have much more predictable -- your business becomes more predictable, your turns get faster and you have much better use of and returns on that working capital on that inventory.

But how we've been growing the Company has been the least efficient way from an inventory point of view because when you grow horizontally and you have the percentage of newness we have, every inventory buy that's new is some degree of wrong, right?

It's either over-bought or under-bought.

It's never right.

The vendors, it's the first time the vendors are making it.

So they're not efficient yet.

And it takes a -- really, a good year to really start to optimize any new product or category investments or business investments that we make.

So we're still cycling through all of that newness of last year.

But each year the newness becomes a smaller percentage and each year, we will be ramping up the square footage growth and the percentage there.

And so the business model will change here.

It will become a lot more efficient from an inventory and working capital point of view.

Thank you.

Thanks for sharing all those details.

Appreciate it.

Your next question comes from the line of Brian McGough with Hedgeye.

Great., thank you.

I appreciate you guys taking my question.

So I hate to waste my airtime here on like a nitpicking numbers question, especially with having you on, Gary.

But one thing is on the square footage growth rate for the upcoming year.

You had mentioned in the video, Karen, how it looks like you'll be coming in around 27%, and that's down from low 30%s, call it, that you had previously given.

I've gotten about a dozen e-mails already asking what's going on there.

And I guess I'm wondering, as far as the size of the stores being added, I'm assuming those haven't changed.

I'm wondering if maybe there could be any slippage by a month or two?

Just as you mentioned, you're dealing with local landlords and just a different group than a mall REIT.

And then lastly, I guess I'm wondering how many, or how much of that could be driven by fewer legacy stores being closed?

Which are maybe staying open for maybe in the back half of the year when you open up these new concepts that you had hit on, Gary, that you'll have real estate available in order to show your new stuff?

Yes.

So you're exactly right.

Our original target was 30% to 40%.

We kind of started to ratchet that down throughout the year, as we did see some slippage.

There is one full-in Design Gallery specifically that was going to be in Q4 that bumped into 2016.

But in addition to that, there's two things going on with the legacy stores.

One is we originally planned to end 2014 at about -- if you go back, we originally at the beginning of this year said we're going to end this year at 7% and we ended at 10%.

Part of that is some of these legacy stores we thought we might close.

When we opened Greenwich we thought we'd close Westport.

But we kept Westport open.

So there's been a few of those where in our original plan there was a few other legacy locations this year that we were going to close that we didn't.

So that, having a higher base this year makes the growth next year smaller.

And then there's a couple other small stores here and there in our plan, and for example, Baby & Child is not in the Greenwich market.

It's not in a lot of these markets where we have whatever you want to call it, first generation full-in Design Gallery.

If there's not a Baby & Child expression, we still want Baby & Child in that market.

So the play between some of those smaller ones, we might still have 30% square footage growth.

Right now our best estimate is 27%, but I would say if anything, there's upside to that, and now I want to miss 2015.

Great.

That's all I needed.

Thank you very much, Karen.

Thank you.

Thanks, Brian.

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

Good afternoon.

Just to go back to the, let's say, the plan for next year as you're seeing it at around seven, do you feel just big picture, similarly confident about all of those opening next year or is there like a number where you'd say, okay, these are highly likely and then there's one or two that have a little potential flex?

Just so we can have a sense for kind of a confidence (inaudible)?

That would be my first question.

Yes.

I think I would say today we feel very confident about those seven.

And I would just hate to qualify anything, but they are development jobs.

So could is something move?

It may, but we also have some other opportunities where something might come forward.

So we think we've got the pipeline well positioned.

We believe seven is the number we will hit next year.

And that's how we see it today.

I would just add that whether it's seven or six, the way -- if there's a store that was going to be in December, we're going to have demand for that store but it's not going to have a big meaningful impact on revenue next year.

There's -- what I think is the important thing is to know that all of the stores -- the stores that we're adding this year in 2015, all the stores we're adding in 2016, we have a lot in the pipeline already for 2017.

We're kind of hustling, like there's been a lot of work done on the real estate trenches.

We have nine leases signed and a lot more deals that we've identified, and it's moving along.

We're extremely pleased with the economics we're getting in these lease deals and the locations we've been able to secure.

So I think just making sure, if you're looking out in 12 months trying to be laser specific, this is going to be a harder one to model.

But I think the long-term growth and that 20% revenue and the operating margin expansion we expect from this strategy is quite strong.

And I think that one of the points I made on the last call is we manage the business to optimize the earnings and the performance, right?

And this year honestly -- and I know people are really focused on the revenue slowing.

Could we beef up the revenues and spend more to drive more?

And we could.

We believe that the way to optimize the earnings of the Company this year, the crossover for the optimization is to pursue the plan we're on.

And what we don't want to do is become victims to short-term kind of thinking and say, let's try to jack-up the revenues and spend more ad costs, and temporarily have higher revenues and not optimize the earnings of the Company.

I think what we're building here is a really durable business that will stand the test of time and that will dominate its market.

And whether something moves between quarters or between a year here, from our point of view as long-term shareholders, and my point of view as the largest shareholder, is not the right way to think about our business.

The right way to think about our business is, are we constructing something that's durable and is lasting value, that will dominate its marketplace and win?

And I would tell you today I'm pleasantly surprised that we're guiding operating margins in a 10.3% to 10.6% range.

I don't believe anybody had us modeled in the mid-10%.

And I believe our guidance looks as good as anybody else's guidance in our industry today.

And I don't think anybody would have thought we would get here.

And by the way, the other thing I'd say is that since we've been a public company, in the two years that we've given you guidance at the beginning of each year, we've materially beaten the earnings guidance that we've given you.

Has our top line moved around, up and down?

Absolutely.

And is this stock volatile?

Absolutely.

Straight up between $55 and $100.

And that's why I made the point about traders versus investors, because we manage this business like investors.

We manage this business like it's the last place we will ever work and we own 100% of the Company.

And we believe we will build the best company the home furnishings industry has ever seen, with the best model and it will be the most durable business that we have.

And I think this is going to be a great long-term investment,.

But I tell you, like I've got it.

Stock goes up and down, makes us all feel good or bad short term.

But I think what we say here is, we have to look beyond these bumps.

And we have to make decisions to build a great enterprise.

And that's what we're doing.

So whether it's seven or six next year, whether the sales are 14 to 16 this year and accelerate.

We have a business today that is going to have a mid-10s% operating margin, that's growing faster than anybody in the home furnishings industry.

We have the most exciting new strategy.

We have the most exciting new stores that the retail industry has ever seen.

And this is going to be a big win.

It may not happen exactly to everybody's timing as you think about this over the shorter term, but over the longer term this is the place where we believe is the right place to invest if you're a long-term shareholder.

That's great.

And it's clear that you, at least in terms of whatever delays there are, it's largely related to, if not totally related to, factors not related to the internal store performance or the website performance.

The other just very quick question is, are you explicitly in your guide for the remainder of the year assuming the recapture related to the port issue that you have talked about or is that potential upside, if you will?

We have it in our guidance.

We characterize $10 million to $12 million.

There may have been other loss demand that we didn't characterize, because we could have given you a higher estimate and talked about what we might not get back.

Quite frankly of the $10 million to $12 million, that's what we believe will shift from Q1 to Q2.

And I'd also say that in the back half of next year where we've got two new businesses launching, I would believe that we're on the more conservative side versus aggressive side in how we're planning and forecasting those sales.

And if you look at history and you look at it how we're guiding earnings, we beat earnings by a significant amount each year.

So we don't guide -- from our point of view we don't necessarily guide earnings really aggressively from an annual perspective.

That's how I'd think about this, if you look at history here.

Much appreciated, thanks.

Your next question comes from the line of Aram Rubinson from Wolfe Research.

Hi.

Thank you for taking the call.

This is Cody Ross filling in for Aram.

So you have given increasing importance to generating free cash flow.

What are you guys doing to drive that results and what types of goals are you aiming for?

Is there a working capital to sales goal that you guys are aiming for or an accounts payable ratio?

Any color upon that would be great.

Thank you.

Yes.

I would just say that is one of the higher priorities for me, and I think we feel pretty good we have our eyes on the prize.

We've talked about that 12 to 24 months.

I guess three months has passed so I should I should take it down by three months on each end.

But I think we feel very good about it.

There's initiatives across the board in the Company, everything from some of the inventory stuff we're doing to how we're managing the sourcebooks to how we're managing vendor terms.

All the working capital line items are kind of being worked on.

But we aren't going to go disclose as to any specific internal target.

But I would just say we feel very confident that that important goal is kind of around the bend.

Great, thank you.

And just one quick follow-up on that.

Are we in any way seeing a slowing or sacrificing of growth in order to help drive free cash flow at all?

No, absolutely not.

I think the benefit of some of the real estate strategy is how much the landlords are willing to contribute on the capital front, but what the convert allowed us to do, and I alluded to this on the call, is there's certain instances where it doesn't make sense financially for the unit economics of a specific deal to take their capital.

If the returns they require on that capital hurt the deal and make the four-wall contribution and the occupancy not as good for the long term, we now have the flexibility to use our own capital where it makes sense or to use their capital where it makes sense.

So we're really balancing the free cash flow goals with that long-term operating margin target in check.

So I think that its been a really nice way for us to balance and make sure we're really optimizing each and every deal.

Great.

Thank you very much.

I appreciate it.

Your next question comes from the line of Lorraine Hutchinson from Bank of America Merrill Lynch.

Thank you.

Good afternoon.

With the two new businesses launching in the back half, should we expect incremental catalog or advertising spends to be coming through to support that business?

Yes, and those are in our guidance.

Okay, great.

The timing will be a little different.

I think I alluded to in our prepared remarks on the video that we're decoupling some of the books this year.

We're decoupling Outdoor, decoupling Baby & Child based on our learnings.

And these two new businesses, we are decoupling from the big mailing.

So the way our books will flow and hit the marketplace will be different than a year ago.

And I know it's early on Outdoor launch, but you mentioned modern and contemporary furniture there.

Have you gotten any reaction to that?

The books are just getting in home this week.

This week.

Okay.

And then lastly, Karen, on the ports issue.

Are you seeing congestion in the East Coast where most of your deliveries were diverted to, or is there some other delay that's coming through?

No, the biggest thing for us is a significant portion of our imports do come through the West Coast.

But we really, back in April of 2014, almost a year ago we put mitigation plans in place.

So we were not that heavily -- of course things slowed down, but we diverted a lot of our goods through the East Coast ports.

We took that reliance from over 80% on the West Coast down below or around 50% and increased our weeks to supply to kind of manage through that.

So we were pretty -- we've navigated pretty well through the end of 2014.

In February, things started slowing even more, and all of the congestion.

So really for us it's just some of the receipts, that $10 million to $12 million for us is receipts that we thought would land in the latter part of the quarter in Q1 that are now going to shift into Q2.

So of course is there some loss demand?

Sure, but for us we're characterizing it more of a shift versus a significant loss.

And we don't -- of course, we have cancels when we have back orders and things on special order that are taking too long.

But so far we feel pretty good that's just going to come in in Q2 and shift.

Great, thank you.

Your next question comes from the line of Cristina Fernandez with Telsey Advisory Group.

Hi, good evening.

In the past you've talked about revenues shifting to retail from the web as the new stores open.

With the learnings that you've seen from the last couple of stores, do you still think that's the case or has the consumer behavior changed, that perhaps the web will be the main driver going forward?

Retail as we open these new next-generation galleries will be the majority of the driver.

There'll be times that, for example when we launch these two new businesses this fall, those will be -- the majority of the business will be all direct, because we -- besides Atlanta we won't really have a presence of those businesses at retail until we open Chicago, Tampa, Denver and Austin.

So we will continue to grow and offer new businesses and new collections.

It depends on what the ratio of the next-generation stores are.

So as the ratio of the next-generation stores becomes bigger, you'll see the business shift more towards retail.

On the other hand, we also believe that there's just behavioral changes that are happening in society as technology accelerates and we have faster devices and mobile devices and you can shop any which way, and just as we all develop new habits, right?

We become comfortable with new channels and ways to shop.

So as I said, an underlying shift that is is moving towards direct.

But remember, 90% of all retail sales are done in retail stores today, right?

Only 10% is done in direct.

So we're unusual being 50/50.

And as we like the way we're positioned.

But retail, we still believe is the most important channel going forward if you want to maximize a business or a market.

And I would just add, just because I have to bang this drum, that for us as a reminder, very little is cash-and-carry in the stores.

A lot of it is being shipped from the distribution center.

So we really -- our retail galleries are a showcase.

They are a showroom.

They are an opportunity for people to come in and interact and look at the product.

But we absolutely know that people go home and then order from the comfort of their living room.

So we don't really think there's a huge difference in our profitability.

The brands are synergistic with -- the channels are very synergistic and move together.

So we don't really care where they order because -- of course we want to maximize all of our profitability, but if they order in the store or they order online, a lot of times they're going to the store it's still getting shipped direct.

So it's not -- we don't focus a lot internally about trying to drive it to one channel or the other.

We work on making sure all of the channels are maximized and that our retail experience is -- all that product is available for them to consume.

I think Karen makes a really great point.

At the end of the day, we really look at the productivity in the marketplace.

We look at the capital we deploy in a market with a combination of our investment into a gallery, into our advertising through our sourcebooks, in our electronic marketing and so on and so forth.

I think the fallacy that you hear today, and it kind of surprises me, is all these companies want to talk about, well their direct business is growing faster, and this is happening, and their direct channel is their most profitable channel.

It all depends on how you're allocating cost.

I don't know how you make more money when sales shift from retail to direct, because your occupancy cost doesn't go down.

Your overhead doesn't go down.

So I think there's a lot of companies that are out there -- in fact it goes up in some cases.

You're seeing in certain people that are now just getting into the direct business, and everybody is all excited because they're growing their direct business and they're missing their earnings because they are finding out that it's expensive to handle the goods, to ship the goods and so on and fulfill the goods.

And so honestly, I think there's a lot of old math and old thinking that's in the industry.

At the end of the day you've got to build a platform that can serve the customer wherever they want to shop that presents your brand better than anybody else.

And it shouldn't matter where the customer transacts at the end of the day.

If all is said, when virtual reality comes to everybody's homes in so many years -- I just came back from the Ted Conference, and where virtual reality's going, we're going to be sitting in our homes being in a different world.

It could probably in four to five years you could be in a Restoration Hardware three dimensionally, sitting in your living room.

Should we care if they place the order in a store or from their couch?

No.

We shouldn't care.

And I haven't seen one retailer yet that has said, look, our direct business makes more money and we're growing that faster.

I haven't seen their earnings growth, but they talk about it a lot.

I haven't seen one yet.

So we look at the business holistically as a multi-channel platform.

And we look at it by market and how do we maximize our revenues in each market and maximize our profitability in each market.

If there are no further questions, this does conclude today's conference call.

Great.

Well, thank you everyone for joining us, and we look forward to talking to you next quarter.

Thank you.

You may now disconnect.