RH (RH) 2016 Q2 法說會逐字稿

Good afternoon, my name is Jennifer and I will be your conference operator today. At this time, I would like to welcome everyone to the RH second-quarter FY16 Q&A conference call.

(Operator Instructions)

Ms. Cammeron McLaughlin, you may begin your conference.

Thank you. Good afternoon, everyone. Thank you for joining us for RH's second-quarter FY16 Q&A conference call.

Joining me today are Gary Friedman, Chairman and Chief Executive Officer, and Karen Boone, Co-President, 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 continued 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 law, 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, 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 this over to the operator to take our first question.

(Operator Instructions)

The first question comes from Adam Sindler with Deutsche Bank.

I have a couple of questions here. I guess some of the more interesting news in the release was about the pull-forward into the second quarter from the third quarter. I'm just wondering if you could let us know, as you look to the third quarter, if you think that is going to be felt more in direct or in the retail business?

Then sticking with the top line, when we were talking about Waterworks, good detail there, 4% to the quarter. Are there seasonalities to that business similar to yours, are they different than yours? And then, I am not sure you provide any guidance, but as you think about it on an annual basis, what do you think Waterworks should contribute to your top line?

Sure, Adam, this is Karen, on the pull forward, substantially all of that beat that we had in Q2 was a pull-forward from Q3, and that was higher sales, a higher percentage of our sales were coming from in-stock products versus stuff that was on backorder or special order. And then we did have overall faster shipping than we expected on some of the backorder and special order products. A lot of that was in our outdoor business. Direct versus retail split, we don't really look at it that way, it is both, and we would expect it to have a similar --

More direct business, really.

So in Q3, I would not expect that to have a meaningful impact on retail versus direct, split.

Okay.

And then on Waterworks, they do have some seasonality, they don't have a typical Q4 like a typical retailer, because of the trade business and a lot of the project base that happens in the spring, so we only had two months of the quarter in Q2, and we will have a full third quarter. So for them Q3 will be a little bit higher than their Q4, which is a little bit of a flip versus us. We have not disclosed the specific EPS impact that it will contribute, but it wasn't very meaningful in Q1, it was only about $0.01, and it will pick up once we have a full quarter in Q3 and Q4, but it's not going be a meaningful part of our earnings growth on the year.

I just want to follow up, if I may. The 90% in stock on modern is, I think, ahead of plan. I know that at least previously you had talked about once things had leveled out, you were potentially looking to expand your assortment in modern. And I wanted to confirm the fact that as we go through that process, when you do, that there potentially could be another pullback in levels. Is that something that we should consider?

One, this is Gary, we're not really ahead of our plan, we said that we would be about 90% in stock at this time, and we are 90% in stock. So, we are right about where we thought we would be with modern. As we continue to expand that assortment, I wouldn't anticipate that we would have issues going forward.

So, depending on customer reaction to new products or not, we may sell out of some faster than others. Whenever you have product growth, you don't exactly know how to forecast those new SKUs, so you could affect in stocks slightly. Now we have the vast majority of the base of the product in stock, the factories are performing well, and the business is performing well. So you don't have anything like we had at the start-up of the business, launching a 544-page book.

Excellent. I appreciate it.

Adrienne Yih with Wolfe Research.

Gary, can you talk about the timing of the new product, when will it be at a level that you want it to be as we go into the third quarter and the fourth quarter? And then how much of newness? And then, Karen can you talk a little bit about the inventory, the sales inventory spread obviously improved a lot. What type of inventory, what was the aging of the product that you got out of stock on, and when should we see that more in line on a parity basis? Thank you.

Maybe can you clarify for me a little bit on the question? There are a couple of questions on newness and the timing of new product?

You talked about obviously shifting it with the marketing books, the spring book moving into the fall season. So I'm just wondering when you feel you will be in the full position, the way that you want to be, as we go into the fall holiday season?

Sure. Sure. Okay. So the books are now starting to get in-home this week, and they will be building through November, as we roll out these books. As far as the -- a couple of things, one we have some new product hitting the stores that we will roll out over the same cadence, and then our in-stock should build, and we should by mid to late fourth-quarter be fully in stock.

Okay thank you.

Then, on the inventory, we came in at the end of Q2, right where we thought we would. We started off the year with a plus 30, in Q1 we said it would be very similar, it was a plus 27. So we thought we would half that, as far as making progress with our SKU rationalization and inventory optimization, and that is exactly where we landed.

By the end of the year, we do expect to have inventory growth right in line with that sales growth, which is really just a modest 1% to 3%. So we do think that by year end, we will have made progress. Some of that happens through lower receipts, and then some of it just happens from making further progress and the inventory efforts we have been talking about. But we feel really good about the complexion of the inventory, we're not really worried about, we don't have a lot of high-fashion, high things that were going to go bad, if you will.

And then just a recent question on the Hanjin, do you have any inventory that might be susceptible to some of these delays?

We don't actually contract directly with them, there are some of our carriers who might contact with them. So in through their alliance, but less than 2% of our goods are on their vessels, and we have already notified all of those customers that have ordered the products, so we expect to have very minimal, if any, impact to our business, because of that bankruptcy.

Thank you very much, and best of luck.

Matthew Fassler with Goldman Sachs.

My first question relates to the buying cycle. You talked about the move to the membership program, elongating or extending the buying cycle. How do you know, or how do you think you know that this is actually a prolonging of the buying cycle? Have you seen the people come back and close transactions with a longer lead times, just in terms of differentiating what would be an extended cycle versus perhaps the customer not coming back at all?

Matt, as you know, we have one full quarter now. The second quarter is their first full quarter on membership. So, we're continuing to track these trends and look at it, but it is pretty clear to us, looking at it today, that the pressure to close your transaction is very different than what it was, when we had end of events happening simultaneously by quarter -- excuse me, by category, whether it was a lighting event or a rug event, an upholstery event or a friends and family event, so on and so forth.

So, we are seeing fewer transactions at a higher average transaction, which is a very good for the business, by the way, long-term, that should mean that we have fewer deliveries, we have more efficiency through the business in the supply chain. But, we're still early on to see, obviously, to see if there is fall off, negative affects over the long run.

The other thing that makes it a little unclear, as you are trying to evaluate all of the moving parts right now is, we are up against the book drop from last year, and we have no book drops from last year. So there is a massive shift in customer contact, circulated pages, newness from last year, so on and so forth. So, the real key is going to be looking at this in the fourth quarter and into the first quarter of next year, because then we will have comparable slightly up total circulated pages year on year.

You will really see the performance of the business, and you'll also see the performance of membership change, right? Right now, the only marketing that we have had outside of the initial ads that we did in the New York Times and a few newspapers is really email marketing, and our outdoor book, which has limited circulation. So, the first real marketing of membership will be in the fall source books that are going out.

You really need to look at this over the next couple of quarters and see how the consumer is responding to the marketing the membership, to the fact that you have got more apples to apples marketing, and circulated pages. Looking at it right now, in the trough of the business, with no books -- against the books last year, you can draw a wrong conclusion. So we have said to ourselves, we really have to look at this thing through Q4 and Q1, to really make sure that we have it in our sights.

I would say, today though, just the early data, and looking at the percent of the business that we are doing on membership, looking at the average order of membership, looking at the buying cycles that we can see with the limited data we have, we like what we see today. My sense is it is going to get better, not worse.

That is helpful, and then just a quick follow-up related to that. If you could talk about how your customer is receiving the member program, their understanding of it, perhaps the mix of member-driven sales within the total business? Any metrics or qualitative insight you want to give us as to how they are receiving the member effort?

Yes. Some of the early feedback was, people were confused by the Grey Card. Originally we called it the Grey card was the major marketing effort, and we got feedback from customers and throughout our stores and at our care centers, that some customers thought it was a credit card offer.

So we reposition that as the RH Members Program as opposed to the RH Grey Card and tried to eliminate the confusion. We are making tweaks here and there. But the numbers and the sign-ups and the percent of the business we are doing all is tracking, really within a few percent of where we thought it would be. I am honestly surprised it is accurate, but it was all math.

One thing I would say, because I think people are somewhat confused, a lot of people think we are eliminating promotions. Well, we are, but we really just created a consistent promotion. The membership was to, the goal of membership was to eliminate the peaks and valleys in our business, which really create havoc in the operational infrastructure, and the vendors trying to supply the goods with these peaks and valleys, ordering the goods correctly.

It's really chaotic running the business on what evolved to post 2008 or 2009, a very promotional retail environment. And probably not as difficult if you're in the apparel business, right? But we are in a really logistically difficult business like furniture, it is very costly and it affects execution.

So our goal was really to evolve the business to a more consistent model. So, really, we went from an erratic peak and valley promotional cadence to a consistent promotional cadence called membership. A lot of people have brought it to me over time, gosh the last person to try this, JCPenney decimated the business. We're not going off of promotion, it's 25% off all of the time, you give us $100, but you're getting a better promotion than a year ago.

The real key here is letting the shift of the book drops, it's creating the most unclarity around our business. The books are the major marketing vehicle for our business and shifting the books by six months changes a lot, so you have really have to let the books get in here at the end of Q3, into Q4, watch the business and the trend, then we will have a second drop, we will have modern hit in Q1. When we look at how we think the business will sequentially build and the changes we articulated in the video and in the press release, we like the model that we see in 2017 today.

Thank you so much.

Steve Forbes with Guggenheim Securities.

So Gary, when you think about putting RH Modern in the design into the legacy galleries, how do you take those efforts and put them into a smaller box size, while maximizing the impact to consumer? Is it something, do you edit it by taking a very small handful of the best sellers and create a smaller design space in the box? What should we expect as it relates to the pace of the rollout of these initiatives, looking into the fall here?

Sure. Good question. Again, it is basically a math equation, right? It is taking a look at the best-selling modern items and collections.

We have got pretty good data, we've been doing this a long time, that we can extrapolate when take something that is source book and web only, and we put it into our retail stores, we have communicated to you that we get a 50% to 100% lift on the item when we show it at retail. So, we can extrapolate taking, now we have data.

The first few stores that we put modern into didn't have the best of modern, it just had our best guess of what we thought would sell with modern. In many cases, because we ramped up in such a difficult way, it was really all we could get, right? So the first stores, honestly, I am surprised at the success that we had with modern, it didn't even have the best of modern, we had no data.

Now we have got data on modern, we know what the best sellers are, we know what the best collections are, and we now basically do our math, and we say we take this to a tri-channel item and, we're putting it at retail, we know we're getting these lifts and we basically edit -- we're changing out about a third of the SKUs, so we're taking out the lowest-performing SKUs that have been in the retail stores for the last year and a half, the last 18 months, taking those out and replacing those with the best modern SKUs, and our math says that we're going to get positive arbitrage.

Then, when you think about the Design Ateliers, our typical legacy store has a great room in the middle, and that great room has walls all the way around it, and left and right hand side, there are generally four small walls that would have, generally, a repetitive cabinet, right, because we are very disciplined in how we present the goods. So you have two of one cabinet, two of another cabinet, and those two cabinets come off the floor, and they are replaced by Design Atelier cabinets, right in the center of the store.

The other thing we do is a take out the cash wraps, our business is almost no cash and carry anymore. That's why the earlier question, was much is retail, and how much is direct, when you think about the pull forward and things like that, we think of our whole business as direct. We have showrooms and we have source books and we have a website.

Those are places where customers interact, but all of our goods are direct orders. The customer places an order and we ship it direct. So we're taking out cash wraps which are really not needed anymore in our business, none of our new galleries are built with cash wraps, all of our business is really done through an iPad, so we pick up the pad.

So we give up two cabinets, but we pick up a floor pad, and we give up two dining tables. So net-net from a product and productivity point of view, we really don't lose anything as far as product presentation, putting the Design Ateliers in, because we take the cash wrap out. And we are replacing just some cabinets, which are not the highest-performing SKUs, and we get another full pad of furniture where the cash wrap was, which was a living room pad, which was the most productive pad that we have in the business.

Then, we get the center of the store now, it communicates clearly that we're a design business, and I think more dominant in any other store of our kind. It's very dominant. You will see a very big change. As far as the communication, we are in the design business.

Remember, if you look at all the other retailers that have moved into design services, most everybody has free design services today, and it is really commoditizing and devaluing the service, because the level of service that get is very different, depending on who you are interacting, and why I made my comment in my prepared remarks in the video, that we get a lot of people that are marketing design services, and they are sending a couple of salespeople into your home, or a consultation with a salesperson, or you have someone who might have minimal decorating experience. We have got, we have now been doing this for several years and never really marketed it, besides one-page in our source book.

We haven't been sending emails about it, we haven't really marketed the program. We wanted to get really good at it. Now we have armed our people with tools and training, we have a specific design ethos in our company that everybody is trained on, we now are installing Design Ateliers, and now we're going to really market this program. And you are going to see it visually in our galleries, in a very dominant way.

We think that is another meaningful, positive move to the business. We are very excited about it. That is how it plays out, the pieces come together.

And a quick follow-up, is there yet a plan to roll out Waterworks to the next generation galleries, and potentially the legacy galleries themselves?

Not anything that we are ready to communicate. We have a lot of ideas here. Waterworks is a tremendous business, they are the best brand of their kind in their category, I don't think anybody is close.

Strategy number one here is to not screw it up. Sometimes big businesses can goof up really good smaller businesses, and we're taking time, spending time really discussing and debating our strategy, how do we evolve and marry the brands together in an appropriate way. We are going to, first and foremost, our efforts are to really amplify and advocate for the Waterworks brand. I think their business has been undercapitalized for a long time, running without capital, they have got tremendous product, I do not think it is exposed very well in the market. So, we're going to support them.

I think we announced, San Francisco, one of their new flagship locations opening in San Francisco, if you are in LA, go see their new flagship in LA or in Chicago. They have a tremendous strategy to build their brand, and I think there will always be an independent nature of Waterworks, because it is a very different business. It deals to the trade, to architects and contractors. We're much more of a retail-facing business.

We think there is an opportunity over the long-term to have much more exposure and visibility and transparency of that business directly to the consumer. But, we want to be careful with it. We don't want to infect the brand at all, and have anybody think that we are lowering our quality. The only interest we have is to make that brand better, and then in an intelligent way, integrate these brands and allow us to -- access to their consumer, which is the highest demographic in the entire industry.

And to serve our consumer better. You will see this move like a clock, it is going to move very slow, we are in no rush here. We feel very lucky that a brand of the caliber of Waterworks is now part of the RH family and platform.

Thank you.

Peter Benedict with Robert W. Baird.

I will pivot over to maybe some more macro stuff, maybe it's hard to read, just given all the things going on in the business. But any update on what is going on in some of those markets you have spoken to in the past, Texas, Miami, the Canadian markets, or any other regional commentary that you can share?

We have been tracking those, and we did see some improvement, so that negative 4 drag that we talked about for the last three quarters went down to a negative 1, so there was some improvement there. So we're very, I would say cautiously optimistic about that, planning for something similar as we think about the back half. And we're anniversarying last year, we're coming up against anniversarying a tougher compares, so that's good for our business in the back half.

That's great. Was the improvement across all three, or was anyone more impactful than the other?

We haven't given a lot of details for each one specifically.

The way I'd think about it is last year, we articulated we were a drag of 2 points in the first half, and a drag of 4 points in the second half. So we're up against the 2 point drag, right? So you would expect it to moderate, because you are up against the drag. What that tells us is, if you take last year's 2 points and this year's 1 point, you have got 3 points, which tells you it is 1 point better. But the business didn't really come back, so to speak, it just didn't get worse. Does that make sense?

Yes.

And maybe got 1 point better. But, what we like about that is it is not in a continued decline year-over-year. So as we go into the second half, we are up against a 4 point drag to last year, that can be neutralized year-over-year, and that provides lift, right?

Right. Then Karen, what's the latest on free cash flows, again a lot of moving parts here, your latest view on when you think that could evolve in the business? Thank you.

Yes. Sure. We stepped off that goal for 2016 on the last call, just given where we took our guidance quite a bit lower, but we still feel very optimistic, it's still a very important goal for us, so I'm not committing to it for 2016, but I feel very good about 2017 and beyond, especially with some of the earning things that we're going to cycle as we head into 2017.

Okay. Great. Thank you.

Michael Lasser with UBS.

How should we think about the spread between brand growth and comp growth in 3Q? Is it going to be wider than 1,000 basis points that you saw in 2Q?

Yes. Great question and this is one we want to make sure we're giving some clarity and information on. We do expect that gap between brand comp and non-comp will continue to widen. We have a couple of things going on there, one, the Waterworks is not going to be part of comp, we're going to be put that in the comp base when we anniversary the acquisition, so one year from Q2.

So that will have a full quarter in Q3 and Q4, as opposed to just part of the quarter in Q2. We also have additional new stores coming on, because we have a 14-month comp period for our new stores, some of the ones from last year won't join into the comp until Q4, even if they were open in Q3. We have the new vintage that's opening with the new stores this fall, and the outlets that we're opening won't be in the comp base either. So we will see that widen even further.

Will that continue into the fourth quarter?

Yes.

And in a bigger picture to your question, and it will be a couple parts, you mentioned that Grey memberships are trending in line with your expectations. How should we think about overall customer acquisition to the brand? Presumably you indicated that you might miss out on some of the marginal customers that come in and buy on promotions, and get into the brand. Are you missing out on those customers at the rate that you anticipated? And with that, how is that going to trend into the holiday season? This may be a separate question, because you're going to have a more focused customer who tends to spend more, how do you think about that impacting the fourth quarter where you are competing for a broader pool of spending with giftable items?

Sure. The way to think about it is, first and foremost, you have to get up against the books, apples to apples. The best time for us to answer the first part of that question is probably in the first quarter, when we have had a chance to look at the new source books hit, and how is the consumer reacting to the marketing of the membership, and what does that look like.

It's the murkiest time to really look at it right now, right? But I'd say, even in the murky times, I feel on the more positive side than the more negative side. So I feel very good today, based on the fact that we are going through a murky couple of quarters, where we don't have a book.

As it relates to customers entering the brand, and specifically around holiday, I think we have communicated that we are going to pull stocking stuffers the last of the legacy left over RH business off the floor, and we are installing these Design Ateliers, and we're really -- it's the last little pieces of moving the business to a true design platform, and not like a typical retail business. So I don't see us competing for that customer.

Might we lose someone buying a couple of towels for a holiday gift? Yes. Might we lose some throw sales? We might.

We're going to give away stocking stuffers sales. We're not going to put all of the Christmas lights up in the store. We don't think that renders the brand more valuable, not the brand we're building today. So to build great brands you have to decide who you are and who you are not, right?

Brands are defined as much by what they don't sell as what they do not sell. So we will be very disciplined this year, editing and eliminating things that we believe render the brand less clear and less valuable, and that is all in our forecast, we have talked about that. They are low-margin businesses, and they're not business that we want to be in long-term. And we think replacing it with a real statement about design services and having in-store Design Ateliers, you don't have to get that many design customers to make up for a whole lot of little stocking stuffers or picture frames, or other things.

We will let other people kind of battle out for that turf, that is not really the turf that we want to dominate. You can buy that stuff anywhere, it's hard to be really distinctive and unique. So we are going to get really good at the few things that we want to own, and be great at, and hence the discussion around Waterworks. Waterworks is one of the best brands in the entire trade industry, it's really the only recognizable brand of its kind, when you go behind the iron curtain.

And that gets us into the serious bath business, the serious kitchen business, the surfaces business with tile and stone, wood floors, kitchen cabinets, so on and so forth. So we are evolving away from a retail business. All our legacy stores that are sitting there in the mall, where you're seduced into saying, gosh, I have this real estate in the malls have all these people for five or six weeks. Shouldn't we sell stuff to the random people walking by? Yes, maybe we had to do that to survive historically, but that is not what we have to do anymore, and that is not our strategic direction. So, all of those stores will close.

It would look ridiculous, if you have seen our Chicago gallery or Melrose gallery, or any gallery to have stocking stuffers, and tchotchkes, and giftables, and Christmas lights, and stuff that you can buy at Target, for God's sake, mostly. It's hard to differentiate that stuff, so that is not who we want to be. We're giving up some of that business, it is in our plan, and it's no different than we do not want to have the same promotional cadence as everybody else.

That is not what our business looks like. If you go highest end of the business to the trade, that business is an interior design-facing business. Obviously some consumers get into those showrooms with their interior designers, but that business is done on promotion, designers get 25% to 40% off the business. That is why we can't be a luxury brand like Hermes that has no promotions.

Because, at the highest end of luxury apparel, there is no promotions, at the highest end of luxury furniture, it's 100% on promotion. So, we're now 100% on promotion, we are aligning ourselves with the highest end of the business. We have made it a membership model. We think that was the right way to thread this needle.

No one has ever done this before, so I appreciate all of the concern and trepidations and skepticism. We have the same feeling. But, we think that the decisions that we are making this year for the business, while it is pressuring short-term earnings and results, if you never make these decisions, you never actualize the potential of the business or brand.

So, we're making some tough decisions that are painful in the short-term. Our math and our bridges say, we really like what the other side looks like right now. Unless we make some very bad assumption and calculation that we are going to mail all of these new books and nothing happens, right? And that has never happened in my 30 years in the industry. So I think our data says that the outlook looks pretty good, despite the fact that we're going to give up some customers that are not as high a value.

If I could sneak one more in, how have you thought about your further push in the design services impacting your relationship with the trade, with interior designers? And if you could frame how much of the business has been done through that constituency in the past, so that we can get our understanding of what the impact might be?

We are not going to release those numbers, right, because it creates a blueprint for our competitors. But, I will tell you that initially, some of the anecdotal feedback was, when we went to the Grey Card in the membership program, and we went with a full-time promotional positioning for buy into the membership and you get 25% off, that was -- we got a certain level of feedback, anecdotal feedback from our teams and some of the trade designers they were working with.

The data and the performance of that group would indicate it's not an issue. Now, I don't know if that means overtime it becomes an issue. We were thinking, do we need to provide more incentive for that group? Do we need to provide another different level of service for that group?

But I think our business, the value equation of RH is very disruptive, the product assortment of RH is very disruptive. No one has our product assortment, no one has product this quality, made in quantities, no one has our real estate positioning, no one has our source book circulation, no one has the traffic on a website that we have, and now no one is going to have the design services that we offer, and our design services are designed to also support the interior designers and trade clients.

We act as a design office for them. They can come in with us, and our interior designers work as their design assistants and we manage their whole project, and we manage all their orders. So we are a huge value to that constituency.

Because they are generally entrepreneurs, small businesses, they have got a lot of back end support. If they are placing orders from 12 different showrooms, and they have to manage all those orders individually, and lead times and issues, and late orders and deliveries, and 12 different deliveries, all the logistical costs, and then all the administrative costs and managing all the paperwork and following up all the orders. We do that all in a centralized place, with an offer that nobody has. We are like taking a big swath of a design center and a lot of showrooms and putting them into one business, in a cohesive organized way, with a service experience that doesn't exist at the high end of the industry.

Again, we are not perfect today, by no means. We look at it like we are just, just now in the very early stages of who we are going to become. And that is why I refer to the point of moving beyond just creating and selling product to conceptualizing and selling spaces. Thinking about the business more as a design platform more selling a whole room, a whole home. I think a lot of you saw the video that went out of the house I did, and I did the house to show what can RH can do with a total home, top to bottom.

And I think you're going to continue to see our business evolve in a very dynamic way, and become more unique and more differentiated. We're not going to be a business that is going to be out there slugging it out with Amazon or anybody else that goes online, that has a mass-market approach to a category. It is a very different business.

Cool. Thank you so much.

Oliver Wintermantel with Evercore ISI.

I have just two clarification questions. The first is the shift of the book drop into the third and the fourth quarter. So all else equal, if the pages are, and I think you mentioned that they're comparable, should there be a additional SG&A pressure in the back half, and looking at your guidance for the third quarter and the full year? It looks like it might be roughly around 150 basis point SG&A deleverage in the third quarter. But is that the right way to think about it? And if that is, could you maybe tell us how much help that was to SG&A in the first half?

Sure, it actually is not going to be a drag on SG&A. The biggest thing in Q3 that we are coming up against, or that we have that we did not have in Q2 and we won't have in Q4 that is unique to Q3, is some of the investments that we are making in our product in the floors. So, we have a big new floor set, the installation of the Design Ateliers, the cost of getting all of that product, all the people involved in that effort, the new stores that are opening, so three of the four new stores are going to be Q3, so all of those pre-opening costs. That is the biggest drag on Q3. The advertising, because last year we had the spring books, and then we also had modern, we will actually get some benefit in the second half from advertising.

Got it. Thank you. The other one was the guidance for the full year. When you said the adjusted EPS, $1.60 to $1.80, but then you have these items about customer accommodation, membership deferral and the inventory SKU rationalization, that gets you to the pro forma of $2.50 to $2.80. Then, in the video, you mentioned that you cycle all headwinds from 2017 and operating margin should be up and sales expanding. If I look at the consensus numbers of the $2.32 next year, I just want to make sure that I understand where you base it off of, that adjusted number or the pro forma numbers.

Yes. So, we are really wanting to stay away from guiding 2017 at this point. What we were trying to do is just show that some of these costs that we have had this year, we don't expect to be ongoing and continuing parts of our business. So the cost related to RH Modern and all of the production issues that we had in the customer accommodation, the SKU rationalization and then this one-time deferral, because once we anniversary the launch of the RH Members program, we will be on a normal and more consistent, as we collect the revenue. Even though it will be deferred, it will be the revenue from prior periods getting recognized.

So we won't have the ramp-up to where we will have a consistent cycle of booking that revenue. We were really just trying to say that there is a lot of more one-time temporal things that aren't going to repeat into next year. We are not necessarily trying to set guidance for 2017.

Thank you very much.

Matt McClintock with Barclays.

Gary, you just said that you are not trying to be Amazon, but you just brought over Alex from Amazon to help with the supply chain. Can you maybe walk us through some of his priorities, his initial priorities for the supply chain? It seems like there is a lot of puts and takes going on in that area of the business. Thanks.

We think that we have tremendous opportunity to match the customer experience, deliver on the front end of our business to the customer experience we deliver on the back end of our business. I think we have taken leapfrog steps and moves on the front end. If you look at the difference between one of our old galleries and one of our new design galleries, it is not even close. It is not evolutionary, it is revolutionary.

And if you look at the quality of our people and how they have evolved in our galleries over the past several years, I think, under DeMonty Price's leadership, massive change. The design organization that we have put in place, the leadership team that is in place, I put our store teams, gallery teams up against anybody in retail. The quality of the people. Culture. Passion. Belief in our vision, and in our strategy and our brand.

I don't that we have had the same evolution on the supply chain side of the business, and if you look at, the disconnect that I talk about today is, we in many markets, we have an HDL, whether that HDL is insourced or outsourced, meaning that we have our people running the home delivery hub. We basically are shipping goods to a home delivery hub. In some cases, we control that hub and in some cases we don't.

But we are handing off the goods to delivery teams and truckers that are not our people, and they are not our trucks. You may get a truck that has a Restoration Hardware logo on it, you may get a truck that has Penske logo on it, you may get a Ryder truck, or truck maybe driving with Pottery Barn goods or other people's goods. And they are not our people, they are quite frankly, and doesn't mean that they all have to be our people. But I think, just because of the nature of most supply chain cultures, come at things from a low cost point of view, and I think we have got to look at our business from a high touch high service point of view.

We're going into people's homes. If it was okay to go into people's homes with people that had no connection to our culture, that were being contracted out daily, so there is no continuity at all, you would argue then, well why shouldn't we do that in our galleries? What should, in Melrose Avenue, or in Chicago, in any of our galleries, right?

Why wouldn't we just put labor in there too? It would be cheaper. I would argue that our results would be much lower, and I believe that our customer satisfaction levels, our missed opportunities in building on sales, our return rates, our failed deliveries, our exchanges, on and on and on.

The back end of this business is so costly. I have always said for years, being in the furniture business, it is an ugly baby, but it is ours. You have to love it, and you have to care for it, but it is a tough business.

We have now elevated this brand, we have elevated the product, we have an average ticket that is significantly higher than our competitors, right? We should be getting massively more leverage, but we are not, and we are not because we are not executing well. We have multiple failed deliveries, we have multiple return issues, and we have a strong view that if we invest and take the level of the delivery to the level that matches the brand, we will see these metrics get massively better, and we should get real leverage.

But, today if you really look at the supply chain cost and the architecture of it, I think it is architected for an old business, it is architected for the old Resto, it's architected for a Pottery Barn type business, or a much lower-end business. And that's not -- Our galleries are different. Our people are different, the time services are different. Our home delivery needs to be different, and it needs to be high quality and high touch.

I think if you look at reviews on our Company online, you talked to each other, you are customers. If I took what is the number one complaint about RH, it is that final mileage, the final delivery, we screwed up, it wasn't the same quality that you expected. I think that is the last piece of the puzzle to solve here. I tell you that DeMonty, our Co-President and Chief Operating and Service and Values Officer, is just setting a whole new level of standards for the organization. He has made multiple changes throughout the organization at many senior levels, and is bringing in a quality of leadership that we haven't had before.

So, I have just never felt more passionate and enthusiastic about what can happen operationally in this Company. I could go on and on and on, I won't, but I tell you, I think it is the next one, two and three years. I was just talking last night with DP, which is what we call DeMonty, and I think it will take him about three years to make it perfect. His standards are perfect. He doesn't know anything but that. But I will tell you, 6 to 12 months from now, you will see massive change. For example, last week, we had 3,000 home deliveries?

5,000.

Excuse me, 5000 home deliveries, and how many did we have Resto employees on the trucks?

Around 1,500.

1,500 Resto associates accompanied deliveries last week of 5,000 deliveries. We have never done that before. Customers are sitting there just massively delighted and surprised. We're actually getting design jobs, because we're going into customers' homes.

We're not making customers interface with strangers and delivery guy, they are interfacing with the quality person that they'd interface in the stores. So you're going to see us make transformational changes here. I think that we're going to bring the level of execution and quality and service up to a level that is in alignment of the brand that we built.

Thanks a lot for that.

Operator, do we have another question? Are you there, operator?

Is the phone still live?

Jennifer, are you there, operator? We are getting close to the end of our call time anyway, so if anyone can hear us now, I think we're going to wrap up the call now. Thank you for your time, and we will talk to you next quarter.

Thanks you, everyone. Talk to you soon.