RH (RH) 2018 Q2 法說會逐字稿

Good afternoon.

My name is Jessie, and I'll be your conference operator today.

At this time, I'd like to welcome everyone to RH's Second Quarter Fiscal 2018 Q&A Conference Call.

(Operator Instructions) Thank you.

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

Thank you.

Good afternoon, everyone.

Thank you for joining us for RH's Second Quarter Fiscal 2018 Q&A Conference Call.

Joining me today are Gary Friedman, Chairman and Chief Executive Officer; Ryno Blignaut, President, Chief Financial and Administrative Officer; and Karen Boone, former President, Chief Financial and Administrative Officer.

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 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.rh.com.

With that, I will turn the call over to Gary for some brief opening remarks, and then we'll begin our Q&A session.

Great, thank you for joining us today.

Before we start, I'd like to take a moment and welcome Ryno to his first call with us.

We are very excited to have him join team RH.

Welcome, Ryno.

And I would also like to take a moment and thank Karen Boone, who is also on the call with us today, for 6 tremendous years of leadership.

We will all miss her bright light, and we are very, very happy for her and her family in this next chapter.

And we know she's close and just up the road, and so -- but couldn't be more happy for you, Karen.

This is the first call we've ever had 2 financial experts on the call.

So this will be a little interesting, but we're all here to answer your questions today.

And with that, I'll open the call.

Operator, we're ready for our first question.

(Operator Instructions) Your first question comes from Chuck Grom with Gordon Haskett.

Just first question is on the revenue miss in the quarter along with the downward revisions to the third and fourth quarter expectations.

Just can you discuss how much of that came from internal decisions, particularly the SKU rationalization versus perhaps external factors, the consumer, macro, et cetera?

Chuck, this is Gary.

I think as we mentioned in the letter, it's very hard to be precise given the inventory optimizations last year and even harder to be disappointed when you've got gross margins up 800 basis points year-over-year.

And so as we've said, we've got a clear focus in optimizing our business model.

I mean, this is the year where we're going to manage the business with a bias for earnings versus revenue growth.

Like any retailer, and almost all do, you can always pull levers and promote the business.

So we could easily put a lot more revenues on the -- post a lot more revenues this quarter, and we could post a lot more revenues in the next 2 quarters, but it would be at the expense of optimizing earnings.

And we're in a funny time from my point of view.

So I told the team here, I said, look, you got people here with decline -- if you look at our industry, we've got a lot of people with declining operating margins, but they post a couple of points of incremental revenues, and everybody thinks that's great news.

That's not what we're focused on right now.

We're focused on -- we're focused this year on optimizing this new operating platform, this new operating model.

So when we pivot back to growth next year, we've got the best business, the best brand and the best operating platform in the industry.

And that's what we're doing.

So I think you know -- and you have decisions day-to-day, week-to-week in this business.

And our decisions are going to be made with the bias for earnings versus revenue growth.

So if people are unhappy with the fact that we took earnings up 14% and took revenues down 2%, honestly, that's their problem.

Our focus is to optimize this business this year and to position ourselves through the long term, so...

Okay, great.

Makes sense.

And then just a pivot towards next year.

When you think about all the moving parts that you're going to have going on in the business as you pivot back towards growth, in order to bridge to that mid-teens goal that you guys brought forward a year today, how should we think about the most appropriate revenue run rate for 2019?

Yes.

Look, well, everything is still the same.

Our long-term targets, as we stated, is 8% to 12% revenue growth with earnings growth substantially better than that.

Obviously, we think in the short term, it's going to be substantially better than our long-term targets from an earnings point of view.

But you're going to see us aggressively pivot back to revenue growth next year.

And we've been holding back a lot of ideas.

We decided to make that decision.

And I -- look, I couldn't be more happy.

We've got a company that has went through a massive, massive transformation, right, and created an entirely new business model here.

And our results are massively better than we or anybody else anticipated.

We came into this year and our first outlook was for 9% to 10% operating margins, and everybody thought we were crazy.

And now we've raised the numbers for a third time, and the numbers are pointing in the 11% to 12% range.

And so we've made a big step forward, and the step to the mid-teens is a very short one away.

So there is more upside in this model than we anticipated.

It is coming faster than we anticipated.

And I wouldn't be surprised if our long-term outlook becomes an even more robust long-term outlook.

We just want to get a more -- a couple more quarters under our belt, and it's going to be very clear what this looks like.

And it's -- look, this is going to be a model that throws off 50% to 70% more earnings than anybody else in our industry when we're done.

Great.

And then just my last question is you talked about accelerating the pace of the new Design Galleries in '19.

I'm curious if you've sized up the opportunity long term, both here in the U.S. and international, in terms of the total number that you think you could do over the next, say, 3 to 5 years.

Yes.

Well, we said we're going to accelerate the growth because of the development of the prototype.

So you'll really start seeing it in the out-years, right, because we -- as we do these deals, as we start to ramp up our case.

So '19, I think from a new store format point of view, will be something like '18.

And then you'll start to see a ramp beyond that.

One of the points we put in the letter was as we talked about the fact that we're developing a secondary market gallery at 10,000 to 18,000 square feet, and if our predictions are right and that test works, that will open up -- it will open a significant amount of more market.

But I think the real thing we look at long term, and as we think about this company, is we clearly see a $4 billion to $5 billion opportunity, maybe greater in North America.

But if you stand back and you look at the distribution of wealth globally, we -- the distribution of wealth in America, you've got, what, about 1/3 of the billionaires live in America.

I think it's 15% to 20%, which -- whatever report you look at, percent of the millionaires living in the United States.

And if you look at somebody’s business like LVMH, right, who's a -- they're a collection of luxury brands, a very large business, is well distributed globally.

25% of their business is in North America.

So as we've been focused more on this global opportunity, we think the opportunity for RH is very, very big, and it gives the confidence to put out an initial number of $7 billion to $10 billion, and that number is, from my point of view, very conservative.

But it's a little bit about the long-term runway and long-term sustainable growth on what we believe will be the best operating model in the industry that will be superefficient from a capital point of view.

We like where we're going.

So nothing's changed.

Okay, great.

And Karen, congrats on your retirement.

Thanks.

Your next question comes from Steve Forbes with Guggenheim Securities.

So I wanted to start with the new product development, right?

You mentioned RH Beach House and RH Color within the release.

So can you touch on how you plan on introducing these new categories to your customer?

Is it catalog only?

Will it be in future galleries?

And then I wanted you to touch on Waterworks, right?

If you think about where we are relative to the acquisition a couple of years ago, can you discuss whether there's a larger integration effort around this brand on the horizon here?

Sure.

Well, you'll see us in '19 launch both RH Beach House and RH Color.

The way to think about this is RH Beach House -- well, why don't -- let me answer your question specifically.

As we do when we launch all new businesses, they'll be launched with a Source Book, they'll be launched with a lot of identification on the website and possibly an adjunct website that's integrated, if you will, and as well as some of the product in the stores, we'll do some testing, I think.

I think as you -- if you think about, kind of how to think about the opportunity there, the wealthy and affluent customers generally have more than one home.

And all the data says that the second homes have twice as many bedrooms as the first homes, which has a huge opportunity to sell into -- to sell in this market, whether it's beach house, whether it's ski house, but thinking about targeting second homes and presenting goods and presenting collections that are specifically focused on those homes and presenting ideas that are -- and clearly give people ideas how to furnish their second homes.

So we're very excited about that.

We're working on it for several years.

RH Color, if you kind of think about RH, we're kind of famous for neutrals, and there's a reason for that.

That's, by far, the largest percentage of the market.

But there is a good percentage of the market that is a color-driven market.

And for us, over the last decade, we wanted to have a real point of view, we wanted to stand for something, we wanted to dominate something.

And also, sometimes it's hard to integrate color.

It's got to be done with real thought and real focus.

And over the last several years, we've been developing this strategy, this concept.

We feel very good about it.

We think we're going to come to the market with a very exciting assortment, color-focused, fabric-focused.

That will be presented unlike anything else in the marketplace.

That will make a big impact.

And I think it could open up another 25% for the brand and can be a very important part of the brand long term.

So you'll see us come after that aggressively.

And we think it'll amplify the brand and open up the aperture for the brand.

So you'll see that be introduced with its own standalone Source Book and integrated into the website.

And you'll see an impact, if not select store -- if not all galleries, select galleries to start with.

And then just a quick follow-up on the reverse logistic network.

Can you just touch on where we are, right?

Obviously, gross margin here is benefiting from a variety of different factors.

But where are you specifically as it relates to the outlets, the build-out of the outlets and capturing that benefit associated with the reverse logistics?

Sure.

The way I think about that, there's 3 big pieces here.

You've got the redesign of the distribution center, network redesign.

That's -- I'd say we're 80%, 90%.

We've got a couple of more moves that you'll hear about later this year as we optimize the distribution center network over the next kind of 12 months.

And then as you kind of think about the outlet and reverse logistics redesign, I'd say we're probably 2/3 into that.

The real key is how do you -- one, we've changed a lot of the process in reverse logistics.

We stopped sending product back to distribution centers.

We have them coming back to the local home delivery centers and then – than going to outlets.

But our outlet architecture does not adequately mirror our revenue architecture in the U.S. And so we're building that out and trying to get to how do you get to equilibrium, how do you handle and dispose of returns and damages in the most cost-efficient, margin-efficient way, handle it the fewest times, move it the least amount of times and optimize the margin and turn the goods in the most efficient way.

So I'd say we're 2/3 and probably 60% through that.

And over the next, I'd say, 2 years, we will finish that out, get the equilibrium.

And so there's still optimization to go there and margin enhancement.

The biggest opportunity is margin enhancement, inventory reduction, turn improvement.

And then when you think of the home delivery, customer experience reconceptualization, we're at the very, very beginning there with our test in the Bay Area.

I'd say we're -- couldn't be more excited about the early results.

And from 2 levels, one from just a customer delight point of view.

I mean I used to only get letters about us kind of somehow goofing up a delivery.

And now I'm getting letters and pictures from customers about how excited they are about the experience.

And it's a complete transformation.

And so we're beginning to measure the data.

We like what we're seeing early on with reductions of returns, increase of stick rates, reductions of exchanges, and so on and so forth, being able to service the customer and one, make sure it's perfect when they get it, but if, for some reason, there is something wrong, to be able to dispatch a medic in minutes not weeks to a customer's home to resolve an issue.

So we think it's, long term, it could be the most valuable thing we've done long term from a revenue enhancement, cost reduction, returns and exchange reduction, improved stick rates, so on and so forth, the biggest thing we do.

And it'll be a multiyear project.

I think it's going to be 3 to 5 years to tackle the entire country.

But we'll perfect it.

We'll then go to another market, we'll learn, we'll perfect it.

And I would imagine, as we get better and we learn more, we'll probably go faster.

But right now, it's not about making it a little better, it's about a massive leapfrog beyond what anybody else does.

Your next question comes from Geoff Small with Citi.

I just wanted to also touch on the gross margin, which obviously came in meaningfully better than you had planned.

I was hoping you could break out the 800 basis points of improvement between the full price selling, the lower outlet revenue and the supply chain changes.

And just also curious how the back half gross margin opportunity breaks down between those factors.

Well, it's the -- no difference than we articulated in the letter, right?

It's really coming from better full price selling, improvements in the supply chain.

But it's significantly on the product margin side, you're seeing massive improvements there.

And so as we look at the back half, obviously, we start to cycle some of the margin improvement, right, as we come around in the quarters.

But we think we've got – we still got meaningful product margin improvement, and we will see continued supply chain improvement.

So we -- obviously, we had enough confidence in the numbers.

We took the numbers up in the second half and believe that there is meaningful upside as we look ahead and again be even more meaningful upside as we look into next year.

That's helpful.

And on the topic of the acceleration in sales growth targeted for next year, can you help us understand what you're looking for in terms of comparable brand revenue growth and also the level of contribution from the new initiatives across The Gallery openings, the expansion of Hospitality and the extension of the RH brand?

You've got a lot of questions in that question.

So the -- if you think about the impact of -- let's start with the brand expansions and the product expansions.

I mean, we're very efficient, I think, at introducing new products and expanding the brand.

And because we do it the way we do through a Source Book and online, we don't take big inventory risk initially, so we get very good return on investment.

And as long as we're more right than less right from a product point of view, from a customer acceptance perspective, so we should expect really good flow-through, at least that's what we've always had on any of these businesses.

So -- and that's how we'd think about that piece of it.

Opening the new galleries is highly accretive.

You're talking about a meaningful revenue pickup on a modest, generally, rent increase and so on and so forth.

So the return on investment and the profitability returns on the new galleries is very accretive, right, right from the get-go.

And then Hospitality, Hospitality will continue to be less and less of a drag on our P&L.

We had to initially build the team and the leadership team and the kind of corporate structure at Hospitality to be able to begin to open multiple units.

That reaches scale somewhere around $50 million to $70 million in Hospitality sales, is when we start to have corporate SG&A on Hospitality more in the kind of the targeted range where the deleverage goes away.

So we will hit that number sometime next year and begin to leverage Hospitality.

And we expect Hospitality by the fourth quarter will be clearly profitable, all-in, right?

The business at its 4-wall level today is very profitable.

We just have to -- we should get enough scale to offset the initial investment, and that begins to happen in the fourth quarter.

So we've got -- we have a very profitable business in Hospitality at the 4-wall level.

We've been fine-tuning it.

And the other thing I'd say, you got to be careful when you think about something like Hospitality that's a brand enhancer that drives traffic.

And what -- you have to look at it in an integrated way.

How did we really think about it?

We've always thought of this business in an integrated way, what are the other contributions it drives?

So clearly, we drive substantial traffic.

We drive 3x to 4x more traffic into a gallery, in a gallery that has Hospitality than a gallery that doesn't have Hospitality.

Our numbers show that we get an x lift -- for every dollar of Hospitality we drive, we get x in growth on the retail side.

And we've got really good metrics around that.

It's very consistent.

Obviously, I'm not going to say what that is.

We're not going to give everybody a blueprint of what to expect.

But when you look at it with the -- in an integrated fashion and the incremental revenues that it drives, it's massively accretive to our business model.

And you would do it every time you could.

So the key here is executing really, really well.

We always say inside our company that anything we do has to render everything else that we do more rather than less valuable.

And that's true for -- especially true for Hospitality.

Hospitality has to render the core RH brand more rather than less valuable.

The only way it would render it less valuable is we have poor quality, poor execution, right?

So the experience has to be stellar.

The quality of the food has to be stellar.

And we believe that's what we're delivering today.

And we're being very thoughtful and focused about building quality into the DNA of this experience and then being able to ramp from there.

So a big, big test for us will be RH New York.

So that will, by far, be our highest volume restaurant in the company.

We think it's a spectacular setting.

I mean, it's the -- I think it's the most beautiful rooftop in all of New York, if not all of the world.

It's got views of downtown and Freedom Tower.

It's going to be incredible.

I think it could be the hardest table to get in the entire city.

So -- but it puts a lot of pressure and a lot of focus on us to execute at the same quality levels that we have in all of other Hospitality experiences, and that's what we're committed to.

So -- but we know with each one of these, we're learning a lot.

We know that -- big test, new learnings.

I just couldn't be more proud of Brendan Sodikoff and his team.

I mean, it's -- not a lot of people can scale this quality of a Hospitality experience the way they have.

And so we're just going to be really focused, really thoughtful.

But the good news is the financial model now is unveiling itself.

It looks way better than we thought, and it's now a real investable business.

It's very helpful.

Best of luck in the third quarter.

And Karen, best of luck in retirement.

Thanks.

Your next question comes from Daniel Hofkin with William Blair.

Just a quick question.

I guess, when you talk about potential acceleration a little bit in the second half, is that relative to the 8% kind of underlying comp that you reported in the quarter?

Or is that total revenues?

Just how are you thinking about that?

That's my first question.

Yes, that's total revenue.

Total revenue, yes.

Okay.

And then in terms of longer-term store targets, can you update us on your thoughts there domestically and what that split might look like between the 2 main types of new galleries you're talking about?

Well, we've said last time that we believe that probably 2/3 or so of the forward galleries will be the new prototype, right, which is -- and when I say the new prototype, it's really our best thinking of the past 5 years, everything we've learned from categories, space allocation, flow, the different experiences in stores, the Hospitality experience, how we think about rooftops and gardens for outdoor furniture.

And we think we've really got a super well-designed and efficient model.

It's going to be no less spectacular than anything you've seen us build.

It's just going to be way more efficient from a build point of view and from a productivity point of view.

So those -- you'll see those start to ramp, and those will be kind of the dominant part of our rollout.

And they're just more predictable from a time and cost perspective.

And the capital efficiency of those new format stores, I think, will be the best of anything we've done.

In addition to that, we'll continue to have, what I call, what we refer to as bespoke galleries in the major markets, New York being one of them.

That, obviously, is opening here this week.

And galleries like San Francisco, or if you look at [cast in] Chicago, et cetera, galleries that are really tailored to a market that really optimize a market and then optimize the brand presence in the market, what they communicate about the brand regarding design leadership, our respect for great architecture.

We say we're obsessed with great architecture in this company.

We either find it, readapt it or rebuild it.

And these kind of iconic locations, I think, communicates something about our brand that makes it very hard for others to emulate.

And then we've got, what I'd call, bespoke galleries, indigenous bespoke galleries, that are really targeted to kind of key second-home markets where the wealthy and affluent visit and vacation.

And places like The Hamptons, where we have a gallery today, and we may do something more spectacular long term.

And they have been very successful in The Hamptons.

We're opening in Yountville, something that's very indigenous to Yountville, an integration of food, wine, art, design.

You see food and wine becoming more dominant even than design because that's the Valley and that's the language to speak there.

But I think it's the #1 tourist attraction right behind Disneyland in the State of California, but it's the #1 attraction for the wealthy and affluent customers.

More people travel to the Napa Valley than almost anywhere.

And then places like Aspen and other places like that, you'll see us focus on those.

Again, really -- I mean we have great returns in those markets and -- but we have exceptional brand-building, right, with the wealthy and affluent customers.

And then we're working on the secondary market stores.

We look at some of these secondary markets beyond the kind of 60 to 70 we initially targeted.

And as we study those and get closer to those, we see a lot of opportunity, and we see those markets kind of dominated by regional or small local players that we think we can be very disruptive.

But you just want to size to the potential of the market, preferably you have the right capital investment and make sure you have the right returns.

So that's what we're working on next.

And if those are successful, that could open up the market for us.

I don't want to say exactly how many yet, we've got to see how well they do.

And then, obviously, international will be the next big step and could be really the next big idea for the brand.

I mean, I think our brand internationally will be even more disruptive than it is in the U.S. because you've got significantly less competition.

Your next question comes from Michael Lasser with UBS.

So Gary, you mentioned that -- in the letter that revenues were a little short of expectation.

So if you broke that down between members and spend per member, how did each one of those components compare to what you expected?

Did you recruit fewer new members than you thought?

Or did each one of those members spend less than you thought?

Yes.

Again, I mean, like when you've got this kind of massive margin difference, it's not in those finite details, right?

I mean, I've been doing this for 40 years, I've never had gross margins increase 800 basis points in a quarter.

I've never had gross margins increase, I think, 500 basis points in a quarter.

I don't know if there's anybody in our industry that's ever forecasted sales with 800 basis points of margin improvement and a focus on optimizing earnings, right?

So -- and so I wouldn't get lost in the details here.

I kind of stay motored up and say, look, what is this model looking like?

I mean, just stand back for a minute and you look at our revenue growth and say the -- I mean the only person, I think, in our industry that grew revenues faster than us this quarter, despite the fact we have, by far, the best earnings, are the people that don't make any money, okay?

So guys, they can have -- there are some big market caps out there on businesses that are not profitable.

And we've got a funny market today, and it's no different than when we decided to make the move to membership.

I said, look, we have to be willing to march into hell for a heavenly cause, right?

We want to get to a better place.

No different than this quarter.

Humans are creatures of habit, right?

We're all retailers.

So we have this habit and this twist that says, oh, revenues, revenues are a little softer than we thought, like we can do this, we can do that, we can do that, but like, we're not going to do anything.

We're going to optimize earnings.

We're going to make decisions with a bias for earnings, and we're going to fine-tune this model.

This may be the only chance in my life that I get to do this.

And by the way, this may be the only team that has ever done this.

I've never been in a retailer that is focused like this on optimizing the model.

And no different than the move to membership and the value unlocked, that membership focus that, that membership created, the long-term value creation of creating a leapfrog model and then pivoting back to growth, then pulling growth levers.

So not moving back into promotions, but -- and we could have easily drove a lot more revenues.

We beat earnings by plenty.

So that's not -- it just means -- I think we just look so different at every level, like what we're doing.

I mean like whether it's the move to membership, whether it's building the galleries we're building when other people are shrinking stores.

I mean like on and on and on and on.

I mean look, it's -- I told the team, I didn't really care what the stock did today.

I said, look, our stock could go up $20, could go down $20, like we're -- our revenues are lower than guidance.

We took revenues down 2%.

We took the earnings up 15%.

I'll take that trade any day.

It may not be what the external world expected, it was better than we expected.

Slightly different on the revenues, only because we're trying to sit here and forecast revenues with 800 basis points of margin expansion.

As the model goes -- and we -- then we adjusted it.

As we learn, we're adjusting it.

But we're adjusting it, we're taking earnings up.

And so...

I would add, too, that make no mistake that we're super happy with membership.

That is the game changer for the company...

Yes, game changer.

Membership revenues are up, yes.

Yes.

Our membership should grow generally with sales.

The math is such that you're always going to become a member.

We would -- I would add that as interior design services have taken off, these new galleries and average order values increase, you wouldn't expect to -- that $100 with a much bigger order size.

But overall, membership, we couldn't be more pleased with how it's performing and what it's done for our business.

Yes, look, we're going to look back here, people are going to look back here and realize what we're doing.

And that what we're doing right now while again somewhat unconventional for our industry, is going to prove to be, I think, transformational for our industry and transformational for our business and brand long term.

So -- but this is just another quarter and another step in our journey.

The biggest news that's going to happen this week is our brand is going to arguably open the most innovative retail store in the world, in the most important city in the world.

And like -- and I don't even know when the last time that was done.

I guess, if I look back, it was probably 35 years ago, 32 years ago, when Ralph Lauren opened the Rhinelander Mansion on Madison Avenue, and I think that changed everything for their brand.

I think when people see what we've just done in New York City, and the echo that's going to create around the world and how that's going to elevate our brand, I think it's going to make a huge difference.

Something that you can't do with digital advertising, something you can't do with anything than anybody else is trying to do or how they're trying to market their brands.

So I tell everybody, you really want to see where we're going, come show up this week in New York.

And as you more transform into this newer model, is there a point at which you expect the top line will become more predictable, the ability to predict the top line will become easier?

And are there levers that you would push to grow membership on some of the more mature galleries that have been opened?

Of course, it's going to be more predictable.

Again, that's the whole point.

Like give me names -- if I ask everybody on this call, name retailers that have improved their gross margins by 500 basis points or more in a quarter.

Again, I don't think anybody's even got one they can put on the list, let alone name somebody who has improved margins by 800 basis points in a quarter.

And this is -- we're going through different times.

It's not about the [Internet] and the sales forecasting, it's about are we developing a leapfrog operating model and platform that will put us in a position to dominate and win long term?

That's the key here.

Don't get lost in the detail.

You're going to miss the forest here.

The key here is what does this business look like, what does this model look like and what is this value the company is going to be over the next several years.

We think the value is going to be significantly higher because of the work we're doing.

So we've got a stock that's massively volatile today for everybody that's looking at it from a short-term point of view.

That's not the game we're playing.

We're playing a long-term game, and we're playing to win long term.

We think we run -- we run this company like we own 100% of it, right?

Your next question comes from Curtis Nagle with Bank of America Merrill Lynch.

So I just wondered if you could just quickly go into the free cash flow guidance.

So you're maintaining $260 million or it is over $260 million.

It looks like the first half came in maybe a little light.

So just hoping you guys could maybe mesh out how you think the rest of the year is going to play out.

And do you still think that inventory will be a source of funds?

Yes.

Should we -- sure, $260 million is still our number.

And again, I would point out that it's better than $260 million.

Inventory, we're still tracking at $450 million to $475 million.

So we do expect it to still be a source for us this year and obviously, not as big as last year, but it's still tracking in line.

And our forecast had always called for more of that to come in the second half versus the first half as we work through going from 4 DCs to 2 DCs and some of the receipts of getting the inventory received in the right place.

And we've continued to make progress in making sure with our SKUs that we don't have every SKU in both DCs.

Some of the lower-velocity SKUs are now only in 1 DC, and some of that again was effected through receipts versus sales.

Yes.

I would say, Curtis, neither earnings nor cash flow is below our expectations, neither one of them.

The only one is the top line, it's a bit below our expectation.

Got it, okay.

That makes sense.

And then just a quick follow-up.

I guess, what are we expecting for the outlet business?

I think you added another 4 stores.

How did it perform?

How did sales perform for the quarter?

And where do you think you're going to end up by year-end in terms of total top line?

Yes.

It's evolved.

The outlet business is evolving as we're trying to kind of design the network and reach equilibrium, right, without -- equilibrium without a lot of transportation cost, right?

So we're -- it's a completely new model that we're designing and building.

And so it's going to take us, I think, probably till the end of next year to kind of really get the model all fine-tuned, get all the outlet stores in all the right markets and optimize that business.

So we think we've got continued margin enhancement opportunities, cost reduction opportunities and transportation in the outlet business.

And we do have in the press release, you can see that we do disclose the dollar amount of outlet revenue, it was about $38 million this quarter.

And that's down from $51 million last year at this time.

That's going to continue to be a smaller number than last year into Q3 and Q4 as well.

So we'll be below last year's overall outlet level.

But again, as we grow the business and put the outlets in the right location, we're not expecting that to be a big growth driver long term, it really just the way we dispose of our reverse logistic inventory.

Your next question comes from Matt Fassler with Goldman Sachs.

This is Cecile Origenes on for Matt.

Could you talk more about your real estate strategy, specifically how you're thinking about your exposure to the mall?

And at what point can or will RH be largely out of the mall?

Yes.

That's not necessarily the goal.

I think it all depends -- I think you have to ask yourself, which mall, right?

And there's some really productive shopping centers in the world and ones that the best developers are investing into and no different than we are, creating next-generation shopping destinations for consumers.

So we have no headlines that says we don't want to be in the mall.

I think most of the press that talks about a lot of the decline in sales is about the secondary, tertiary malls in the United States that are losing Sears, losing JCPenneys, losing whatever anchors.

All the dying retailers that are kind of a big part of the decline and the decay.

But there's a lot of developing centers that are really fantastic and will continue to be fantastic, if not even stronger, long term.

So let's start there.

But I'd say that we look at every market and try to say, what's the optimal location in the market for the brand today and long term.

And when you're making long-term real estate decisions, it's not just where it's at but where you think things are going.

When we made the decision to do the deal in New York in the Meatpacking District, right, it’s 5 years ago, right?

And now the project's got approved, developed, built, delayed because of the streets under construction, but we -- I think we're pretty good at figuring out where things are going.

And now you've got the Whitney Museum that's opened right across the street from us now.

Since we -- our hope was always to kind of anchor kind of the Meatpacking with kind of a luxury business because there wasn't really any luxury in the Meatpacking.

And now with the Whitney coming in, we can anchor the Southern corner of the Meatpacking, that Gansevoort Street, where we're going to have our first guesthouse at 55 Gans, we could tilt the street and create a luxury destination.

Now Hermès took the corner across the street from us, Loro Piana took the other corner, Pastis is reopening across the street from our guesthouse.

And I think what you're going to find is that the Meatpacking is going to be kind of one of the great retail destinations and traffic destinations in New York City for years to come.

I mean, they are all kind of different, look at Chicago.

We made a bet in the -- in really the most affluent neighborhood in all of Chicago.

We're right in the middle of the Gold Coast in a historic building.

And so we -- and we believe the Gold Coast is a good long-term bet, a great long-term bet.

And so -- and we -- if there's an opportunity to do a bespoke location that speaks to the brand, that's great.

We will not do that if it means compromising revenues and earnings because we don't want to be in a mall.

I think people that are too black and white, linear with decisions like, oh, I'll never open a retail store; oh, we'll never go into a mall, just going to miss opportunities.

You've got to keep your mind open.

You've got to really do the math on all these things.

You've got to understand where the investments are going to be made and where things are going.

So that's why I respond to almost anything.

When somebody says, oh, I'll never open a retail store; oh, this; oh, I'll never open a mall.

I mean, that kind of thinking is going to miss a lot of opportunities.

I think you have to leave your mind open and just try to be as smart as you can and maintain maximum optionality and make the best call for your business.

So I may not [pick at vanity] malls, like good luck to the retailers who want to take that strategy.

There's a lot -- there's going to be a lot of great shopping experience that's coming.

Your next question comes from Peter Benedict with Baird.

Congrats Karen, and welcome, Ryno.

Thank you.

First question, just around -- curious, Gary, around the supply chain to support the new concept launches.

I mean, how much of that is kind of piggybacking or leveraging kind of existing vendor partnerships and relationships?

And how much of that is striking up with new folks?

That's my first question.

Really, 100% is existing relationships.

Okay, great.

That's good to hear.

Circling back to the member conversation.

I mean, you guys ended last year with a little over 400,000 members.

You were adding net around 25,000 a quarter.

I think that was the pace last year.

Is it safe to assume that pace has continued?

Or do we -- when should we expect a leveling off of that?

Just trying to understand maybe where you're sitting right now in terms of member count.

Yes.

Actually, you'll -- you should expect an acceleration of that pace.

So look, you've got the dynamic.

Again, if you think about the SKU rat, right, the SKU rat brought down retail, brought down average orders, accelerated individual transactions and would accelerate something like membership, right?

And now we're anniversary-ing that, and so you've got membership growth slowing, although it’s still positive.

And now you should expect, as we cycle around membership growth, we'll grow faster.

It'll accelerate.

Okay, that's helpful.

And then last one, just the tax rate that's assumed in the second half adjusted earnings guidance, what should we be thinking there?

We're using 26%.

We're not assuming any benefits from stock ops and exercises in that number for the second half.

We just saw the main driver of the 4% in the first -- in this quarter.

The last question we have time for today comes from Brian Nagel with Oppenheimer.

So Gary, you've spent a lot of time on this call and in the letters talking about the prioritization of profit over revenue and the strategy behind that, the effects on the results here.

Just wondering, could you maybe articulate a little more, within that strategy, specific product decisions, market decisions that have made -- been made?

And as we're thinking about that, is it more a function of what's -- is it more of this transition period while you find that balance and then going forward, it will be less of a tradeoff because the business will actually be operating under that philosophy?

Correct, yes.

I mean, specifically, we've held back -- when we said '18 will be a -- remember, we came out and said 2017 is about execution, architecture and cash, right?

And we said we wanted to execute our new membership model, right, architect a new operating platform and optimize cash by increasing revenues and earnings and decreasing inventory capital spend, right?

That was 2018 -- 2017.

Now we said, as we got through that, we -- based on that focus, we are able to begin to see opportunities that we just couldn't see before, right?

And we've said we're not done here.

We need more time to focus.

And we've been -- when we came to '18, we said 2018 will be about a continued focus on execution, architecture and cash, right?

And so by doing that, in '17, we said we weren't going to launch any new businesses or brand extensions outside of RH Hospitality.

In '18, we had things planned to launch, okay?

And then we said, look, we need more time.

We wanted to focus more here because we think the long-term opportunity of building a massively differentiated model and more efficient model is once-in-a-lifetime.

I mean, once you get back on the tracks running, it's hard to do the work we're doing.

You need all the brains in the game, you need a complete collaborative cross-functional effort and it takes the time and attention of every leader at the top of the organization to lead the organization through the kind of massive change we're leading the organization through.

It takes an inordinate amount of focus and discipline.

So we said 2018 will be a continued focus on execution, architecture and cash.

The businesses that we were going to launch in '18, we held back, right?

And we focused for another year.

And that's a tough tradeoff because we're in a business where a lot of people just get overly focused on the top line and never focus on the bottom line.

They just never build a great model.

This will be the last -- I'm sure it's the last retail business I ever lead or build, right?

And I've always said since I was a stock boy at the Gap, and I grew up in the retail business and I used to get these stupid memos from headquarters telling us to do this and do that.

And I used to think about like all these knuckleheads at corporate, like don't they know what inefficiencies they're driving, like -- I mean, don't they understand the business?

They're wasting this money or doing these nonoptimized things.

I just said like one day, if I grow up and get to run a retail company, like I'm going to try to make it great and try to make it superefficient and not -- stop the dumb things.

And I've got a shot to do that, and this is it.

And that's what I'm committed to do as the leader of RH and what this team is aligned and focused on doing.

And we couldn't be happier with what we've learned.

We couldn't be more ecstatic about what we're accomplishing.

But once again, because we're unique and we follow our own path, we're hard to understand.

And so -- but we're just trying to be super clear to you guys.

Like look, we -- I mean, I -- you can read all the letters of the last 2 years, I mean, it's laid out.

In 2017, focus on execution, architecture and cash; 2018, a continued focus on execution, architecture and cash; that we will manage the business with a bias for earnings versus revenue growth; that we will hold back the launch of new businesses and category extensions and so on and so forth.

So that's what we're doing.

We could've launched RH Color and RH Beach House this year.

We could be doing a lot of other things, but we wouldn't be able to get to the business model.

I mean, we're in an industry today where most retail business models, operating margins are declining, not growing.

They're declining.

You've got people going from in the 10% range to the 8% range.

You got some people, I don't have to name names, but they've gone from 15% to 4%.

You've got allocation of capital and trying to shift sales or try to grow sales online and all people are doing is shifting sales from retail to direct and creating a higher-cost model.

And I think it's all because people are running around, working real hard on all the wrong things.

And they're not disciplined and they're not focused, and they're trying to win and get a pat on the back quarter-to-quarter.

We're not doing that, okay?

We might be one of few retailers in the industry that truly have a real long-term view here.

So -- and that's how we're leading the business.

It reflects leadership in the business.

Look, I'm, by far, the largest shareholder in the company, if you take all of my options and incentives, right?

So I've got a big stake in the long term, not in the short term.

And our leadership team has the same incentive and motivation.

And we want to do great work, great work that we're going to be proud of, great work that we're going to be inspired by, great work that is going to inspire others in this world to try to do great work with their lives.

And so it's a different game, it's not a quarter-to-quarter game, it's -- and by the way, you kind of -- even though we're playing the game, we have the best earnings growth in our group, and I don't know if anybody really has much more of a better revenue growth.

Maybe somebody's got a percent better, something like that, but not with the earnings, generally, with flat or declining operating margins.

So the investors who want to reward those people are probably just short-term investors.

They're probably moving money around.

And so we've had the same long-term investors for many years here, including the people that are inside the company.

And that's how we're making the decisions, and I think our long-term shareholders are going to be greatly rewarded.

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

Great.

Well, thank you, everyone.

Again, I want to welcome Ryno, I want to give Karen a big ovation and sendoff, goodbye.

She's looking at -- been a great partner of mine for 6 years.

And thank you for everything, Karen.

And I just want to say to our entire team, all of our people, all of our partners, all of our shareholders that are on this call, the work we're about to unveil in the most important city in the world, I think, will make everyone proud.

And for those of you that aren't here, I hope you get here soon, because this new gallery, even though I didn't design it, I've been involved in every detail for 5 years, it's just taking my breath away.

I think it is truly the most innovative and most inspiring new piece of retail work this world has ever seen in the most important city in the world.

And I couldn't be more proud of the work we're doing.

So can't wait till everyone sees it.

And those of you that are in New York City, come by and say hi.

We'll be here all week.

We've got a lot going on.

And the official opening to the public is on Friday.

We'll be here all day, and come say hi.

So thank you, everyone, appreciate your time and interest.

Ladies and gentlemen, this does conclude today's conference call.

We thank you greatly for your participation.

You may now disconnect.