RH (RH) 2015 Q2 法說會逐字稿

Good afternoon.

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

At this time, I would like to welcome everyone to the RH second-quarter FY15 Q&A conference call.

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

After the speakers' remarks, there will be a question-and-answer session.

(Operator Instructions)

Thank you.

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

Thank you.

Good afternoon, everyone.

Thank you for joining us for RH's second-quarter FY15 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 in addition to further details on the upcoming launch of both RH Modern and RH Teen.

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 results 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 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 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 these 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 the call over to the operator to take our first question.

(Operator Instructions)

Oliver Chen, Cowen and Company.

Hi, congratulations on all the growth and the innovation.

We had a question related to -- Karen, your comments were helpful on the fourth quarter and dimensionalizing the growth you'll see there.

Do you expect the outside EPS growth to continue into the earlier quarters of next year, as you have that non-comparable benefit from some of the new product lines?

And also, we were also just curious on the FX front if the Chinese yuan is having any impact in terms of how you're sourcing?

Yes, so on the first question, we do expect to [continue to] have benefits from these new businesses and new stores.

We're not ready to commit to a specific level of EPS growth, but we are very excited about the businesses and the stores and do expect those to continue and add to growth in both revenue and earnings in 2016.

And with respect to the FX front and the devaluation of the yuan, we do have -- we expect to get some benefit.

We are a little bit hesitant to commit to how much, just because a lot of our vendors are -- a lot of the product costs that we have is raw materials and goods that aren't -- that are getting imported in, and so some of the savings is just on the labor.

So we expect there will be some impact, but we're not going to commit to any specific levels just yet.

Okay.

And Gary, the RH Modern, congratulations, it looks really differentiated.

What do you think we should think about for Teen and Modern as a percentage of sales over time?

Or how should we think about how you view your market opportunity relative to your existing business?

And I was also just curious -- thank you.

Yes.

Sure.

Well is think there is a logical point of reference out there for Teen, so you can draw conclusions based on that.

And I would say in Modern, there is no logical point of reference, but it's a significantly bigger market than Teen or Baby & Child.

So if you stand back and think about the Modern business, and by the way, Modern could also have an aspect of Teen and Baby & Child in the future.

But Modern is covering every aspect of the home except for those two rooms, so you've got living, dining, bedroom, bathroom, outdoor.

You'll have accessories, textiles, window treatments, rugs, et cetera.

So I'd think about it as an entirely new business.

It's framed in a -- we believe a very new and differentiated aesthetic that we have not really offered today, so we believe it opens up a whole new market in many ways.

As I mentioned last quarter, we believe there is an opportunity to really create a new market because there is really no destination in store that has aggregated all the categories and presented them in an integrated fashion in the modern market today, from our point of view.

Thank you, Gary.

And Gary just a final question.

What is your vision for the customer relationship management part of the future of retail?

As you guys invest in your supply chain systems and your shipping and your CRM component, I'm just curious about a broader question about how you see that evolving and how it may have the most impact on your business.

Yes.

We've got a pretty large and complex strategy.

I don't know if I'd say complex, but I think very logical strategy for how we think about the customer long term, and have an integrated not only view of the customer but a really much more intimate relationship with our customer going forward where we are working across all channels of it now.

And there's aspects of systems that go to that.

There's aspects of the supply chain and delivery that go to that and things that we are doing at the supply chain and delivery side of the business.

There's aspects of the service level in the stores and design services, and so on and so forth.

It is a very holistic strategy that we are pursuing on multiple fronts, and when we're ready, we will lay that out in a meaningful way to you.

I think if we told you everything we were working on right now, it might be like a mind jump.

It might overwhelm you.

But we are working on basically almost in every aspect of our business, I think in very new and distinctive way.

The innovation on the operational end of the business and on the service end the business is every bit as meaningful as on the product end of the business and the category and new business aside.

But unless you wanted to watch an hour video, we are going to give it to you in pieces.

Thank you for that and congratulations on the most exciting stores in retail for sure.

Thank you so much.

Thank you.

Matthew Fassler, Goldman Sachs.

Thanks a lot and good afternoon to you.

I want to start off just by getting an update on the performance of Atlanta as the, I would say the first effort and the newest store format that you've got.

Yes, Atlanta continues to exceed our original projections and expectations met, so we are very excited about Atlanta.

Atlanta will also -- Atlanta was built to receive both RH Modern and RH Teen, so it will be receiving those new businesses.

We're going to give those to Atlanta in probably the January/February period just because we have got -- we wanted to hold enough of the inventory to have into these four new next-generation stores where we've got them somewhat merchandised differently.

Where we have got a full floor of modern, 15,000 square feet, 13,000 to 15,000 square feet, depending on which of the stores you pick, and then also we have the freestanding Modern store.

So we are going to hold on Atlanta, but Atlanta is performing above our expectations and will continue to grow and be impacted in positive way.

With the addition of RH Modern, we will have a full floor in Atlanta, and RH Teen will have a half of a floor in Atlanta, so the store will continue to grow and ramp.

And then we have many other new categories and businesses in the pipeline that will continue to feed these new next-generation design galleries in the future.

Gary, it sounds like Chicago has some new features.

On the video, you talked about some different things.

Can you talk about direction now, the economics, the operation and execution.

Does this add to complexity?

Do you outsource that complexity and how unique is what you are thinking about Chicago, (inaudible) for Chicago than it is for that market?

Yes, I'd first start with the view that we don't do anything unless we can do it as well or better than anybody in the world.

So I'd start there.

I would say if you look at this Company since we went public and take a look at anything we have done, whether it's new businesses, new categories, new stores, change the mailing cadence of our catalogs, take catalog page count to levels that one's ever taken them to, opened supply chain distribution, insourcing, I think what people underestimate is how well this Company executes.

And I think compared to other people in our sector, I know it looks like we are going so much faster, and it's true and we are.

And we are doing so much more, and it is true and we are.

But we are a different organization, we have different people, and we have different methodologies and processes.

And I think that to focus on, we are adding a restaurant and a wine bar in Chicago, is so little compared to everything else that we are doing that is so important.

I would just -- we are going to always do a lot of things, but a cafe and a wine bar in a store and creating a different kind of experience, it is like a little test.

I wouldn't focus too much on it.

We've got the best partner in Chicago, the best restaurant operator is our partner.

But just think about it this way, Matt, we test and prove and scale new businesses here on a regular basis every season and every year since we have been a public Company.

We have hit our numbers every year and every quarter.

We do what we tell you we are going to do.

We're not perfect, but we are pretty good.

But I wouldn't focus on a restaurant and wine bar in one store and get worried about complexity.

It's inconsequential to the big, strategic things we are doing.

And then finally for Karen, are there any financial consequences associated with the launch of Teen and Modern in the third quarter?

You talked about the sale and the ramp and how that impacts Q3 versus Q4.

Anything on the SG&A front that to think about as we model off the cadence of expenses through the year?

No.

Just to give a little color, more broadly, specifically with respect to Teen and Modern, no.

What will have an impact, we do expect some modest deleverage in gross margins in the back half, but that's more a function of the new [DC] that's opening that I mentioned on the video.

So have that 1.5 million square foot DC, that will put some pressure on supply chain occupancy just until we anniversary that next year.

And then shipping continues to -- shipping costs continue to be higher as we mix in more furniture and there are some higher parcel rates.

So that will put some pressure on gross margins in the back half, only modest for the half Q3 will be more pronounced than Q4.

But we do expect to continue to have modest leverage in product margins and retail occupancy, so that's a little -- and then on the SG&A front, we expect to have great leverage in the back half.

Got it.

Thank you so much, guys.

Brad Thomas, KeyBanc Capital Markets.

Hi, good afternoon.

Wanted to follow-up on the real estate side of things, and with Modern having its own standalone location here, I was wondering, Gary and Karen, if you could give us an update on your thoughts on the potential for some of these concepts to have their own standalone location.

Yes, I think that is a very good question; it is one that we are spending a lot of time here on.

We are so early in Modern.

We -- as it developed and evolved during the last year, as we really put our focus on it as an organization, and again, we worked very differently than I think any retail Company at least I have ever worked for; we work in a real project-based approach.

I think about it's more like a technology Company when we have teams that all of a sudden come together and focus on big projects and bring them to life.

And because we do it that way, these things tend to evolve and we see a lot more and we can move a lot faster.

And as -- I can just tell you, and I will put this out here so you can understand the perspective of how we work.

When we introduced the idea for RH Modern in our long-term plan to our Board, probably 18 to 20 months ago, it was planned to be a 120-page book.

When we focused the organization on it and began to work on it, then that's when you really start to learn and things start to come together.

And we started seeing opportunities we couldn't see until we focused on it.

Expanded, we thought it was going to be a 300-page book just a quarter ago.

Now it's going to be close to a 500-page book; it'll probably land somewhere between 480 and 500 pages.

We're in final photography on it today.

We just showed you I think, what was it, about 40 spreads in the video?

So you just saw less than 10% of the book.

So you can just imagine right, look you just saw less than 10% of the book.

Most people launch books with like a 60-page catalog, and we are launching with 500 pages.

It is hard to think about the model, but as it's come together, we started to believe the assortment could really deserve its own retail presence.

And at first we thought it was going to a floor or a half-floor of the new design gallery.

Since it filled out, we thought it could take its own floor.

We think, now we think it's a bigger idea than we thought about 18 to 24 months ago.

But I think that is what happens in other kinds of businesses, right?

Like if you think about Apple, how big do they think the iPod was going to be?

How big did they think the iPhone was going to be?

When they launched the iPhone, the average phone was $49 and everybody had a Motorola Razr.

They had a Nokia, and then that phone changed everything, right, and the industry changed.

We think not comparing RH Modern to the iPod or the iPhone, but I would say that comparatively, if you look at our industry and you look at Modern, there is nothing like it.

There is nothing like this concept anywhere in the world.

We are the first ones to bring this comprehensive and complete of an assortment to a marketplace at one time.

No one has ever launched a business with 500 pages.

No one has ever launched a business like this, especially a store concept like this with 18,000 feet in a freestanding location, or 15,000-square-foot stores.

Now you'd say like well gosh, is that really risky?

Well, I don't know; I'd look at everything else we have done.

We have grown RH from a business that was a few hundred million dollars to $2 billion by making big, important strategic moves.

We don't spend a lot of our time like a lot of other companies on little, tiny incremental moves.

we look at big, strategic moves and things that will change the markets, change our Company, and that is where we put our time and attention and effort, and we think this is big.

I think this can be as -- I really think it can be as big as RH is today or bigger than we are today.

There is no reason to believe that RH Modern can't be a multi-billion dollar business in the US.

And take your points of reference on anybody else doing anything, whether it is look at West Elm or anything else, which is a business I'm familiar with, obviously.

It doesn't have anywhere near the assortment we have today that we are launching with.

And so I think this thing is going to be massively disruptive and create a new market, and you may see freestanding stores.

You may see it integrated, but we are such at the early innings of this.

But this is a big idea.

We are not going to get it all right on the first swing, but we've got a lot in the pipeline.

And this could be -- this book could go to 800 or 1,000 pages within 12 months.

And this is going to be a big deal, from my point of view.

I think it is the most important new business we have launched in the history of this Company.

So we have big plans for it.

And we think, as I said in the last call, there are so many converging trends that create an opportunity to create a market.

And I think we've identified those trends, we have spent a lot of time on them.

And the other thing is this business is a business we know.

Here is another thing where you go, wow, RH Modern is like a brand-new business.

It is but it isn't.

It is every category that we're already in.

It is every product line that we're already in.

We know the percent of the business that should be living room, dining room, bedroom, bathroom.

We know how sizes sell versus other sizes.

We know how finishes sell versus other finishes.

We know the lighting business.

We know the window treatment business.

We know the rug business.

We know the bedroom and bathroom textiles business.

So the great thing about this and why we can go so fast is we know this business.

This is a parallel business with a different aesthetic that can be presented in a compelling way that I think is going to completely open up the aperture and the acceptance of the RH brand.

So sorry, that was a little bit of a ramble, but this is a big deal.

I think it is the most important and significant new home furnishings business to be launched in the last 15 or 20 years.

That's very helpful.

Thank you, Gary.

And if I could ask just a financial housekeeping item.

It looked like payables was a nice source of cash for you in the quarter.

I know that's a goal for you this year to work with your vendors to try to extend terms.

Any update on the progress in those discussions with your vendors?

Yes, we are making progress.

We have a ways to go, I'll say.

But I would say between the HSBC program we are opening up and offering to our vendors and then just some of the deposits that we used to have and making sure that, as they grow, we get some improvement, we are making progress.

But there is still a ways to go.

Great.

Thank you so much.

Thank you, Brad.

Aram Rubinson, Wolfe Research.

Hey, good afternoon.

Great results.

Thank you for taking the question.

I'm hoping you can help on the shape of your customer and customer adoption, specifically where are, I don't know, your demographics in terms of awareness, trial?

What are you doing with prospecting?

And I'm just curious how business is to new customers versus existing, and whether those existing customers are pushing the edges of the assortment?

I know those are a lot of things to think about, so don't expect answers to all of them.

But I'm just trying to get a sense as to whether or not your business and what the shape of the adoption curve is looking like.

Yes.

Aram, this is Gary.

I would say that we think about all those things and they are all good questions.

They're not necessarily answers that we want to give out in a public way because it's educational to our competitors and others in how our business is responding and how we think about it.

But again, I would just focus on our execution.

I think we have been pretty good at introducing businesses, introducing categories, expanding categories, dimensionalizing businesses, and reading and reacting to and responding to how those businesses develop and perform and how our customer reacts to what we merchandise.

But so those are just ongoing things that we do, and we are constantly learning, we are constantly improvising, adapting, improving, as we go.

So I don't know if there's anything specific you want to focus on those questions towards?

Yes, you completely deflected it, which I understand.

That's smart of you.

So maybe I will ask another one altogether.

The pace of innovation is huge, and of course, we all call for companies to innovate and then we get a little scared when they do innovate as rapidly as you do.

Just give us a sense internally of the guardrails of what it is that you guys say no to, and what does it is that those things have in common so we get that it's not like everything is getting green-lighted.

Yes, I would think we say no to about 97% of the things we talk about.

And it's also about --

Just to give you a quick perspective.

We go through two significant strategic reviews in the Company a year.

And as we go through those things, we always have ideas that get surfaced, current things we're working on, new things we're working on, new things to come to the table as thoughts connect.

We see new opportunities in new businesses, and we go through a very rigorous strategic process here, where every idea is dimensionalized and valued based on its financial value, its strategic value, and its emotional value.

And so the financial value to the Company is sometimes the more obvious one.

What is the revenue value?

What is the earnings value?

What is the cost reduction value?

What is the efficiency value when we think about the financial value to the Company?

And then we go into the -- we rank everything on strategic value.

How does it position us in the market?

What competitive -- how does it create competitive differentiation?

And how does it position us long term to win?

And so we go through many discussions around that, and we try to value thinks strategically.

And then we try to value things emotionally, and emotionally, as it relates to two constituencies: one, our consumers.

How does what we're doing, how will it connect with consumers?

How -- why will they care about it and will they connect to it emotionally?

And two is our people.

How will our people connect to this choice, this initiative, this strategy?

Because to get great people and to get great people to do great work, they have to really care about what they do.

We like to say inside, maybe I shouldn't say this publicly, but now I guess I couldn't.

Okay.

But they have to give a blank right, about what we're doing, and they have to feel connected and passionate to it.

And so the emotional value is important internally and externally.

Our people, it has to connect to our people, and it has to connect to our customers.

And so we go through a process of taking whatever 50 or more ideas, and we go through a rigorous process to value all of those.

And then we force rank those, and we say if there was -- if we could only do one thing or die trying, what would we do?

Right?

If we could only do one thing, and by the way, as we value all of those, there's also with the financial value, what is the financial capital and the human capital we have to invest into each one of those that helps us dimensionalize how we think about the complexity, the difficulty, the returns, and so on and so forth.

But then we try to see them clearly, and we debate -- we spend a lot of time debating them and getting clarity in the value.

Once we get clarity on how we see the value of each of those choices, and then we force rank them.

If we do one thing or die trying, what would we do?

We debate the hell out of that, and then we pick one and we align on that as an organization, as a team, and we figure out what's the human capital and financial capital we have to deploy against that, and what is the return we're going to get against that?

And then we build the strategies, we take that and we translate it into a strategy and into the tactical moves to execute it.

And then we go to the second thing, what is the second we'd do or die trying?

What's the third thing we'd do or die trying?

And then we try to understand what is the bandwidth of the organization, and do we have the resources, do we have the capital, do we need more capital, do we need more resources?

How do you create the risk profile, and we go through a whole risk assessment on each of these things, and we look for initiatives and choices and projects and strategies where we have a great degree of asymmetrical risk to the upside.

So it is probably not much different than how you guys -- how investors manage a portfolio.

Right?

And except maybe there is not as much emotional connection to it.

But we are leading thousands of people here.

They have to really care about what they are doing to do great work.

That's a great answer.

Thank you and I'm sure the emotions are on our side too, but it's great to hear your passion.

Daniel Hofkin, William Blair.

Good afternoon.

Congratulations on the fine results.

Just maybe if I could ask for a little bit of color on the quarter just big picture, not like little pluses and minuses, but if there were any kind of larger categories or let's say the best friends and family event that you feel were call outs one direction or the other, and the trend over the course of the quarter?

Just interested also with, Gary, with your commentary on the video in mind, what you think might have contributed to the different growth rates between the channels, not necessarily saying one is better than the other but just what might have contributed to the difference?

And then I have one follow-up question.

Thank you.

Where do we start at?

Nothing real surprising categorically how the business performed; it ramped the way we thought it was going to ramp.

I think when you stand back and think about what is different this year versus last year and how we think about the business, the majority of our books were in home last year, late June and 100% by mid-July.

So there is really three key points to consider.

One, our books this year, spring books this year had 1,300 less pages than last year.

So just stand back and think about that.

Our spring books had 1,300 less pages than last year.

So we had -- that is a pretty big move.

We had to be very scientific about how our business was going to perform quarter to quarter, week to week, category by category, because that is a significant difference.

The second point I would say to think about as you think about the business and the big moving parts strategically.

Beginning mid-October, we will have two new businesses and 700 new pages versus zero in the same period last year.

Right?

So we just came up against a period where we had 1,300 less pages, and our business over that period has basically performed in the mid-teens and then started -- we expect it to tail off in Q3 because really, the books were 100% in-home mid-July, 70% in home late June, 100% in home mid-July.

So the shipping -- the revenue recognition and the deliveries on those really ramped in Q3.

So we come up against the build in Q3, and if you just look at our numbers from last year, our business tailed off last year in Q2 to 14% and then reaccelerated, as we told you it would last year, in Q3; and then accelerated to 22%, accelerated further in Q4 to 24%.

And I think those are numbers that are pretty close to what we told you would happen.

This year it's a little different; the timing is different.

The newness has got a different cadence to it.

So here you are going to see us coming up just like in Q2, you're going to see the business tail a little comparatively because of the timing of the new businesses and the ramp of last year's book.

But that fact that, I sit back and I go, the fact that we could mail 1,300 less pages and still have double-digit growth is really meaningful to me.

Because what we're doing here, and it goes back to some of Aram's questions and some of the questions that were earlier, we're always testing.

We're always trying to fine-tune our model.

We're always trying to learn.

And our view was as we got into the productivity and the ability to learn about fine-tuning the advertising aspect of the business and the model, and we thought, huh, are we sitting on a business that maybe today, maybe today if we fine tune it actually has an 11% or 12% or 13% operating margin?

If we just, like on a run-rate basis, if we pulled out -- and it is an interesting conversation because a lot of conversation around Amazon, and Amazon now is starting to try to provide clarity and take investments out and future growth out.

What is the core business operating on?

If we really look at our core business and we dial and right size the advertising spend, if we really take a look at the investments we are making to lay the track for the supply chain for the future growth, which we have to invest ahead of.

If we really look at all the investments on the new businesses and we start to right-size that.

We acted like a private equity Company; we said, we're going to buy this Company today.

I think we are buying a Company that probably has a 12.5% to 13% operating margin, but we are investing ahead of that.

And so as we fine tune this thing, you're going to see us start to understand what is the underlying operating margin as we get smarter here, as we dig into this model, and as we fine tune this model?

And then what are the pieces as we grow?

But if you just stand back and say, wow, they just reduced 1,300 pages and they are still going to be in the double digits in Q3 when they are up against the book ramp last year?

I that is phenomenal.

Then I sit there and I'd go, now we're going to add 700 pages, not a recontact.

Like a lot of companies will mail a book again and it's a recontact and it's the same goods.

We have 700 new pages of product hitting in late Q3, and that is up against zero in the same period last year.

So that is going to put the business in a position to now ramp.

We're not going to get zero for those 700 pages; it is all new content.

So that's -- and we have lots of data that says what new content should -- how it should perform.

What is the productivity per page by category, so on and so forth, and we think we're relatively conservative in how we are thinking about this.

And then on top of that, we have four new next-generation galleries opening in October and November.

We have a new freestanding modern store that's opening that's a pretty significant size store.

In total, I think indoor and outdoor square footage about 18,000 square feet, and two new Baby & Child freestanding stores opening.

So when you think about whether it is categories, those are the big moving parts.

The business is coming around against a ramp last year; 1,300 less pages.

Now you're going to have 700 pages against no pages last year; all those pages are incremental.

And then you've got all this new real estate coming on board.

And those are the important dots to connect as you think about the business.

Yes, and then on the quarter specifically, the promo strategy was the same, everything was pretty much as we expected it to be.

On your question on retail versus direct, we have said many times that we are channel agnostic and don't necessarily care whether they order in the store or whether they order at home, especially based on how our shipping model works.

But I would point you to last year's retail growth with an easier compare.

Retail only grew 9% last year and direct was 19%, so there's always some of that going on.

But we don't, again, we couldn't be more channel agnostic as far as caring where the customer orders when they choose to transact.

I think the other thing that's affecting that -- could affect that a little is we are making meaningful investment into design services, and we will continue to be.

You saw in the video we are launching this fully integrated design Atelier.

We studied architect offices, interior design offices, and basically, we think we have a revolutionary new part of the store that we will be launching that will really enhance the customer interface in how they design their home, whether they are doing it themselves, whether they're with their interior designer, whether they're with one of our interior designers, or whether they're with an architect and an interior designer.

But because of our investments in interior design, I think we are also bringing more customers into the store.

We are creating more transactions in the store environment.

And how do you project that?

I'm not sure.

I don't know, and honestly, quite frankly, I really don't care.

I don't want to try to focus -- I don't want to have a bunch of statisticians here trying to track where the transaction is happening and why, because I just don't think there is a lot of a value.

I think we can watch those trends and we can react accordingly, but if it shifts one way or the other, we will add more service and more support.

But the adoption rate with cell phones and iPads and other things would tell you it should go one way, but we are really enhancing the store experience.

We are making really important investments in design services and our ability to service the customer at the store level.

We are building stores that no one's ever built before.

Our business could shift the other way.

And at the end of the day, who cares?

It is really -- are sales and earnings growing?

As I said, Ken Dunaj says, well, the left-hand side of it, the equal sign is important; it is really the right-hand side that counts.

Fair enough.

That makes sense.

Just my other question is a corollary to all that, as you think into next year and you guys already talked about the many more new store days next year when the initial galleries to the full year and then also all of the new content.

Just thinking about the year as a whole for next year, without giving specific guidance, what are some of the other things that ought to be positive or negative relative to your longer-term view?

It sounds like potentially product cost could be favorable.

Are there any other things we ought to be aware of at this point?

Yes, I think the thing we worry about, like everybody worries about, is market instability.

What happens with interest rates?

What happens with the market?

At the high end of the foodchain, you have got people heavily invested into markets and if markets are unstable, I think that's something we all worry about.

Not a lot we can do about it, just be prepared to deal with it.

And what's going to be the effect of rising interest rates?

Will it affect big-ticket will expect the home buying -- we don't know.

We have never -- I don't think the country has ever been in this long of a period of this low of interest rates, and so there's unknowns there and that's why, quite frankly, we position the Company and tap the capital markets at opportunistic times and built our balance sheet to be able to execute our strategy in any kind of environment.

Obviously we'll -- if for some reason the economic environment changes and it dictates that we should change our strategy somewhat, we will.

But at the higher, big level, those are the things we think about.

We can see correlations between our business and the market.

And it is interesting, as we all saw the market get beat up and then bounce back and go around, you can see our business week to week move a little bit.

How does that -- what does that mean long term?

We think no matter what, we are going to continue to outperform, we are going to create new markets, we're going to take market share, and we are going to do things better than our competitors, meaningfully better.

Not a little better, meaningfully better.

So I think that is how we think about it.

At the end of the day, the markets will do what they do, the interest rates are going to move the numbers around the way they move the numbers around.

But 3 years from now, 5 years from now, 10 years from now, there is going to be people that win big, and we believe we are going to be one of those people.

That is very helpful.

Best of luck.

Thank you.

Thank you.

Matt Nemer, Wells Fargo Securities.

Afternoon.

Thank you for taking my questions.

First, directionally, I'm wondering if you can just give us a sense for how much the Q4 revenue growth guidance is driven by the new brands and how would you assess the risk of getting that inventory delivered in Q4?

I assume it is just based on when the store is open and when the brand is launched, that it's a bit back-end weighted in that quarter.

Thank you.

Yes.

Well the risk would be baked into our forecast.

So whatever guidance we just gave you, we looked at the opportunities, we looked at the risks, we try to understand everything that could go right and everything that could go wrong and put guidance out there that we believe that is the guidance we can hit.

So that is the way I would think about it.

Okay.

And then just secondly, I'm wondering if there are any early signals from some of your books earlier this year that would show you that the more modern-oriented product, I think there was some new product lines that launched with outdoor that have more of a modern look to them, are a potentially leading indicator for how that business, the new modern business will do?

Yes, I think that is a very good question, Matt.

As we articulated, we had both tested some Modern that we -- there was product that we put in the outdoor book and in the indoor book that were originally developed and targeted for the RH Modern book.

And we thought that we had an opportunity to get some early reads and early customer response to that, and I would say we are extremely happy with the early reads.

Extremely happy.

And that's maybe why you saw this book go from 300 pages to 500 pages.

Great.

Makes sense.

Congratulations.

Thank you.

Peter Benedict, Robert Baird.

Hey guys.

Thank you for taking the questions.

Just a couple.

First, just a clarification.

So the Modern and the Teen product, as that slows in the back half of this year, from a product margin perspective, is that expected to be similar to the rest of the business or is it accretive, dilutive?

How do you think about it that way?

Yes, we would expect it to be similar.

We don't know exactly how it's going to sell yet, so but the way we have the margins planned is implied in our guidance.

Okay.

Thank you.

And then on the cadence of the 2016 openings, any early view as to how you think those are going to start to come through?

Could we see more in the first of -- this year obviously was all second-half weighted.

Any view of that?

And then we think about the square footage growth, I think this year around [16]%, presumably next year it will be higher, but how much higher?

Any early thoughts on that?

Thank you.

We haven't guided that yet, but clearly it will be higher because you will have more store months coming out of this year, going into next year, and then you'll have more stores in the following year.

So we haven't guided square footage growth yet, and we -- I think we gave you directionally, I think we said six to seven stores last time?

Yes.

Yes, so we're still looking at the same six to seven stores.

I would say, those of you that are probably in New York probably read in the press or read online that there was, unfortunately a tragic accident that happened at the location where a developer is developing a site for us.

We haven't been involved in any of the construction yet, but there was an accident that I think the job and the meat-packing store got shut down for four months.

So that was originally a 2016 planned opening, so could that slip into 2017?

It might.

We don't know yet.

We're trying to -- the developer is trying to assess the new schedules of losing four months.

But there was an unfortunate tragic accident and things like that can delay jobs like this.

But it is nothing that's, I'd say, strategic.

Whether the meat-packing store in New York slips from 2016 into 2017, if it does it does.

We have a really good store in New York.

It just means that we won't be able to accelerate the business as much as we had thought in New York.

Weighted average, we are up in the mid-teens this year, square footage growth, and that will accelerate next year.

The exact amount depends on the time of those openings.

The are mostly back half again; there is one that will likely be in Q2, but the rest of those will be in the back half again.

Thank you, Karen, that's helpful.

Just last question, just on the marketing spend this year, obviously a lot of innovation, new concepts coming.

A lot of that was planned, but some, like even that this Modern book was larger than maybe initially thought.

Do you think the marketing spend this year comes in similar to what you spent last year or do those dollars grow a bit?

Thank you.

We will -- the dollars, I won't give the dollars just yet because those are still moving, especially with some of the holiday books and things.

But from a marketing spend and the leverage on the P&L, overall, we are expecting to have on the year 600 less pages because the spring books were so much lower, as Gary mentioned.

So a big part of the SG&A leverage in the back half is advertising, because we had so many fewer pages.

Got it.

Thank you very much.

Thank you.

Cristina Fernandez, Telsey Advisory Group.

Hi, good afternoon.

I wanted to ask about the source books for RH Modern and RH Teen.

How widely are those going to be distributed relative to the spring source book, as far as number of households in the penetration?

Sure.

I think about both of them, Teen, I'd think about more directionally, it will be circulated in the direction of the Baby & Child because you are mailing to a much smaller audience, so you have got a smaller universe you're circulating to and we are going out there at a conservative first mail against that universe.

So I think we are probably in the 60% to 70% range, and we are probably more in the 75% range against the home core book and interiors with Modern.

Thank you.

And then another question as far as the inventory growth of 29%, how much of that is related to Modern and Teen versus the core inventory?

And how are [influx] tracking on the core inventory versus last quarter?

Okay, so on the core, it's doing great.

I would say we have made investments to make sure that our back orders were down, so it is doing fine.

Modern and Teen, a lot of that won't -- some of it's on the water, but it won't really show up until this quarter and into Q4.

So we do expect, because the timing of some of those receipts, we do expect inventory, as I mentioned on the video, to outpace revenue growth, just because we do need to make those investments in Modern and Teen inventory.

Oliver Wintermantel, Evercore ISI.

Thank you very much.

Gary, what do you think will be the impact of the new concept on shopping frequency or average order value for your typical customer?

Do you expect your typical customer to spend more frequently, or comes more frequently, spends more, or do you try to attract new customers with your new concept?

I think it's going to be both.

I think our current customer is going to buy more and we have proven that with the expansion of our assortment over the years.

And I think we will also attract new customers with this new aesthetic, so I think you will see a combination of both happen.

Great.

And then I had one for Karen.

I think when I heard it right, you were guiding to free cash flow positive within the next 15 months.

Can you maybe just give us the drivers, what do you expect is driving that from a working capital perspective or top-line or bottom-line growth?

Thank you.

Sure.

On the free cash flow, what we mean by the 15 months just to be clear, is either this year or at the end of 2016.

For us, it's more meaningful to look at it on annual basis.

So we'll get -- if we don't get free cash positive this year, it will -- we'll get really close, and if not, it will for sure happen in 2016.

And it's really a combination, it's higher earnings, it's some of the real estate investment spend is getting behind us.

We expect modest inventory improvements.

I had mentioned before that we were trying to improve working capital through our vendor terms.

So there is no one thing that is contributing; it's a little bit of all of those items.

Okay.

Great.

Thanks very much.

David Schick, Stifel.

Hi, thank you for taking my questions and congratulations on the quarter.

You talked a little bit about marketing spend and the leverage opportunity in the back half.

My first question would be, Gary, as you think about the breadth as you are continuing to evolve the vision of all the brand is, what's the right level for marketing spend long term for the umbrella, if even that's the right way to think about it, Restoration?

And then just as a follow-up to the free cash flow question that was just asked, longer term, Gary, it was very helpful to hear your thoughts through operating margin, and I know, Karen, you just talked a little bit about it.

But long term, would free cash flow move in that same function as Gary described, or is there anything else at work over not 18 months, but over five years?

Thank you.

The right level of marketing spend for RH core, I think in each of these businesses, we are learning all the time how do you optimize it.

At the same time, the world is changing before us in how to reach the customer, right?

Whether it is through stores, whether it is through print, whether it's through digital, whether it's through social.

There's so many ways to address marketing spend today.

And I'd say that the hardest job in America today at any company is probably going to be chief marketing officer; it's probably why we don't have one.

At the most senior levels of the Company, we are making those decisions and deploying those assets, because I think it's very hard to figure this out right now.

And I think there is a lot of money that's not being spent in a very intelligent way.

So with the most senior levels of the Company, we are paying attention to it and we are digging into it, and we are trying to figure out how to optimize it.

At the same time, how do you grab share and how do you grow the business and how do you invest into the future?

And I think that this year, I think by next year, we will probably have -- we will probably know the baseline on core RH, I would think, from an optimization growth point of view.

But we've got so many new businesses coming on, so whether it is Modern, whether it's Teen, whether it's new businesses that you'll hear about in the near future that will be coming online.

And then the other thing that is unknown precisely yet is what is the impact on advertising spend once we roll out these new next-generation galleries.

Because they are going to be a massive billboard.

And remember, it is probably true at all of our competitors, but at least in our business today, I think, where are we -- 67% to 70% of our new customers come through our stores.

So if you just stand back and think about that metric for a minute, if that is happening where we are 80%, 90% legacy stores today, small mall-based stores, what happens when you have these new next-generation galleries?

Does it go to 90%?

Does it mean you can mail less catalogs?

Does it mean you can advertise differently?

There is just so many things yet to learn.

But one of the things I know for sure is that when we open Denver, Chicago, so on and so forth, our business grows in these new galleries without mailing more books.

So that the square footage and the impact of the real estate grows the business, so that inherently leverages the advertising.

Does it mean long term you can actually mail more books?

Or does it mean maybe long term you should mail more books, then you can even expand the market?

There is just so much left to learn there.

And there's so many things that are evolving, and we are just very curious and very critical and very disciplined about how we allocate and how we place those bets, and that is why today, the marketing spend of the Company is really controlled at the highest level of the Company.

Because you really are in uncharted waters in today's world and environment, and our Company is in uncharted waters, and our real estate transformation, the transformation of our direct business, the way we approach the market from a source book point of view.

So a lot yet to learn, but all the indicators would say there is a lot of leverage in optimization to expect in the future because of what is going to happen with the real estate transformation, and especially the things that we are learning this year.

And then with respect to the long-term outlook for free cash flow, there is nothing that would -- that's three years down the road or four years down the road that would make us think we're not going to continue to generate significant free cash flow once we hit that mark.

I would say one thing that we expect to improve over time is inventory turns.

Just as we have been growing by assortment and as we grow more by square footage, we do expect to optimize some of those inventory investments as we learn from what we have introduced.

Very helpful.

Thank you.

Janet Kloppenburg, JJK Research.

Hi everybody, and congratulations on a great quarter.

Gary, I wanted to get your thoughts on how you think about RH core.

You have two new concepts coming on, 700 pages worth of new merchandise, and as you said, new concepts to be launched.

How should we be thinking about RH core and the level of newness that should flow into that segment of the business going forward?

I would love your thoughts there.

And just one for Karen and then you guys can talk.

It sounds like we should be looking for SG&A leverage to be more significant in the back half than the front half because of your indications on the margin line, at the gross margin line.

If you could just help there.

Thank you.

Yes.

Janet, really good questions.

It's actually one of the things that we are talking about and debating internally.

The core, even though the pages were less, we had better optimization and better density in the books.

So we had -- we still had newness in the core business, even with 1,300 less pages.

And so one of the questions you can ask yourself is the long term, today we believe modern to new business and it's the right way to address it.

Long term, is it a new business but it is really part of the bigger platform and just a bigger way to the core?

One thing you don't know is how the consumer preferences will change over time, how trends change over time.

If things move more modern, does Modern gets bigger?

Does the traditional businesses slow down?

How do you think about trends?

If you think about all the trends in our business, whether it's traditional, whether it's industrial, whether it's modern, or whether it's mid-century.

So honestly, I'm a little ambivalent about it.

What we're focused on is how do we take these -- we are pretty good at encapsulating an aesthetic and a point of view, and then communicating that and positioning that in a market in a very clear and compelling way.

And as things change or shift, we should build a platform here that has the flexibility to maximize it and to move, not have too much rigidity.

That is why we're -- early on here, when I sit about -- when I sit there and I go, do I like Modern freestanding?

Do I like Modern in the bigger store?

How do I think about it strategically?

I like it freestanding in select places, because I think what it does is it breaks through the market.

So in LA, in Miami in New York, like might you make a capital investment that creates a little bit of rigidity with the platform that amplifies a business like modern in some markets.

In most markets, I think about Modern and I think about core, and I like them in the same box.

Because I can have core on one floor, Modern on another floor, all these businesses [have a floor] and I've got a very flexible box and I can move and I can grow or shrink and position the business long term.

I think the key is the breadth of the RH business, when you think of RH, how should you think about it?

I think you ought to think about it as the quintessential taste and style leader for the home market at the high end.

And that means modern, it means traditional, updated traditional, it could mean many other things.

A lot of people say, oh you guys don't have much color right?

You look on the blogs or talk to certain customers and they say, gosh there is no color; they only have neutrals and grays, and so on and so forth.

There's a reason why we have that.

It's the biggest part of the market by the way; it's why we had the best growth in the industry.

Right.

But there's a percentage of the market that is more color-driven, just that there is a percentage of the market that is more modern-driven.

And could you think about a business called RH Colors in the future?

And could we encapsulate color a book and into a catalog?

And could we explode color in a way in the home market that is -- that no one has ever seen?

And then you say, well is that part of core or is that a new business?

And how do you think about it?

And so I think about the broader home business and how do we take as much share and as big a piece of the luxury home market long term and how we will encapsulate those businesses and what we call core, what we call new businesses, it may change over time.

I think you just have to be flexible and not rigid and position yourself to kind of win and move and adapt and improvise.

I don't know if that makes sense or not.

Very insightful.

Thank you.

Yes.

And then, Janet, on in the back half, we do expect earnings and operating margins to accelerate and expand in the second half even more so than the first half.

And that is driven by SG&A leverage being bigger in the second half than the first half.

And the biggest piece of that is advertising.

Will that expand into next year because of the ramp in store openings, Karen?

That we really haven't nailed down the strategy for next year.

So yes, we haven't -- we will continue to learn, as Gary mentioned, and optimize the marketing plan.

And as soon as we do, we will have more to share on how that looks into 2016.

Okay.

Well thanks a lot and congratulations.

Thank you.

Great.

Thank you.

We are now at the conclusion of today's call.

I would like to turn the call over to Gary Friedman for closing remarks.

Great.

Thank you, everyone, for your interest in our Company, and I want to thank all of our team members across the country and all of our partners all around the world who support our efforts that we look forward to talking to you next quarter.

Thank you so much.

This concludes today's call.

You may now disconnect.