Williams-Sonoma Inc (WSM) 2003 Q2 法說會逐字稿

Good day and welcome to the Williams-Sonoma Inc. second quarter 2003 earnings release conference call.

At this time, all participants are in listen-only mode.

We will conduct a question and answer session after the presentation.

As the reminder this conference call is being recorded.

I would now like to turn the call over to Mr. Steve Nelson, Director of Investor Relations at Williams-Sonoma Inc. to discuss forward-looking statements.

Please go ahead, Mr. Nelson

Good morning.

Please note the information provided on this call should be considered in conjunction with this morning's press release.

The forward-looking statements included in this call may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

These statements address among other things the financial condition, results of operation and business of the company and are subject to certain risks and uncertainties that could cause actual results to differ materially.

Please refer to the company's current press release and SEC filings included but not limited to reports on form 10-K, 8-K and 10-Q for the full text of forward-looking statements disclosure.

The company undertakes no obligation to update or revise any forward-looking statements to reflect events or circumstances that may arise after the date of this call.

I would now turn the conference over to Ed Mueller, our CEO.

Good morning and thank you for joining us.

With me today are Howard Lester, our Chairman, Laura Alber, our President of Pottery Barn Brand, Pat Cowell, our President of williams-Sonoma Brand, Pat Connolly EVP and Chief Marketing Officer, and Sharon McCollam, EVP and CFO.

We are extremely pleased to be here today to discuss our second quarter 2003 financial performance.

Although the economy in the second quarter continues to fluctuate, we remain focus on delivering against our strategic initiatives and drove our business to a new level of success.

On revenue growth of 17% we increased earnings for the quarter by over 26% while continuing to make substantial investments in our new and emerging businesses.

Despite continued volatility in overall retail environment throughout the quarter we delivered to our shareholders the best second quarter financial performance in the history of the company.

We are very proud of these results and believe it exemplifies the tremendous consumer appeal of our brand, effectiveness of our multi-channel strategy and competitive advantage that we have created with our supply-chain execution.

During the quarter we were encouraged by the performance of both our existing and emerging brands.

Our existing brands drove impressive sales growth in addition to record earnings.

Emerging businesses, Pottery Barn Teen and West Elm continue to exceed their sales targets and drove substantial excitement with their target consumers.

We continue to be very optimistic about the long-term growth potential of both these new businesses.

As we look forward to third quarter and balance of the year and we are continuing to focus on the strategic initiatives that are fueling our success; driving top line sales growth, improving our pre-tax operating margins and most importantly enhancing shareholder value.

Consistent with our strategic effort to drive top-line sales growth, we are continuing to invest in new growth opportunities in both our existing and emerging brands.

In our existing brands we are closely monitoring our in-stock positions on retail and DTC inventories, increasing retail square footage and catalog circulation, introducing new merchandise assortments and testing new marketing initiatives that enhance our brand authority.

In the emerging brand we are investing a strategy that will allow us to acquire new customers and build brand awareness.

For Pottery Barn Teen, Laura Alber is leading this effort.

To assist us in leading these efforts in our other emerging business, Dave Dematay has been hired as President of emerging brands.

In this newly created position, Dave will be driving the repositioning of Hold Everything, developing multi-channel rollout strategy for West Elm and working on the evolution of Williams-Sonoma Home.

As many of you already know, Dave comes to us with 20 years of retail experience most recently as President of North America Coach.

One of Dave's immediate successes will be the opening of our first West Elm test store in New York later this year.

Consistent with our strategic initiative to drive pre-tax operating margin improvement, we are continuing to focus on reducing the major cost drivers in our business.

Although we have made significant progress on this initiative over the last three years, we have continued to identify new opportunities in our key expense categories.

We are currently very focused on three key cost reduction initiatives.

Optimizing transportation costs, reducing customer returns, and improving furniture quality and supply chain processes.

We expect our progress in these areas will be gradual and incremental and have dedicated teams in place to address each opportunity.

We are confident in our ability to drive our pre-tax operating margin from 9- to 11% over the next three years.

Consistent with our final strategic initiative to enhance shareholder value, we remain committed to executing again all our key business strategies and delivering the EPS guidance that we have provided to our shareholders.

Although we saw improved sales momentum during the second quarter we believe that we will continue to operate in an unsettled economic environment in the back half of the year.

Based on this premise, we have increased our full-year guidance by 1 cent to a range of $1.25 to $1.28, reflecting our 1 cent better-than-expected EPS achievement in the second quarter.

We believe the guidance we provided today for the third and fourth quarters representing a 12 to 15% revenue increase and a 22 to 27% EPS increase supports our strategy to execute against a conservative, but flexible business plan and we remain committed to delivering these results.

I will now turn the call over to Sharon McCollam.

Thank you, Ed.

Good morning.

I'd like to start by outlining the agenda for the remainder of this morning's call.

First, we will review our second quarter 2003 earnings highlights and third quarter and fiscal year 2003 earnings guidance.

Next, Pat Cowell will provide you with the business update for the Williams-Sonoma brand.

Then, Laura Alber will provide you with business update for the Pottery Barn, Pottery Barn Kids and Pottery Barn Teen brands and finally as Ed said, we will open the call for questions.

I would now like to discuss our second quarter 2003 earnings highlights.

In our last conference call, we committed to driving top-line sales growth generating positive comparable store sales in our three key brands, improving our pre-tax operating margin and delivering our earnings per share guidance in the third quarter.

We are very pleased today to report that we were able to deliver against all of these commitments and for the 12th consecutive quarter, we have met or exceeded the earnings per share guidance we have provided to our shareholders.

For the second quarter of 2003, we delivered diluted EPS of 15 cents, which was 3 cents above the second quarter of 2002, 1 penny above the high end of our guidance and 25% better than any other second quarter in the history of our company.

Net revenue for second quarter of 2003 increased 17.1% to $580.4 million versus the second quarter of 2002, with strong performance in both the retail and direct-to-customer channels.

Retail sales for second quarter of 2003 increased 17.3% to $335.3 million, versus the second quarter of 2002.

This year-over-year increase was driven by incremental sales in 44 new net stores and comparable store sales growth of 6.5%.

Net sales increases in Williams-Sonoma, Pottery Barn, Pottery Barn Kids and outlet partially offset by a planned reduction in Hold Everything with the primary contributors of this increase.

Retail execution during the quarter was very strong and we saw significant sales benefits from the ongoing inventory reinstatement initiative that continued throughout the quarter.

Direct-to-customer sales for the second quarter of 2003 increased 16.5% to $206.3 million versus second quarter of 2002.

This increase was primarily driven by year-over-year sales growth in the Pottery Barn, Pottery Barn Kids, Williams-Sonoma and Hold Everything brands, in addition to incremental sales from the Pottery Barn Teen and West Elm catalogs.

This increase was partially offset by year-over-year decrease in the Chambers catalog.

Internet sales for the second quarter increased 55.1% contributing over 33.6% of total direct-to-customer sales.

As we have discussed previously, 50- to 60% of these sales, are generated by customers who have recently received a catalog.

Gross margin in second quarter of 2003 was 37.1% versus 37.4% in the second quarter of 2002.

This 30 basis point reduction as a percentage of net revenue was primarily driven by an overall increase in markdown activity in 2003 compared to exceptionally low markdown activity in 2002.

Higher freight cost from distribution center to the stores due to incremental expense associated with the ongoing reinstatement initiative and a higher cost of merchandise from euro-based vendors, primarily in Williams-Sonoma due to the weakening of the U.S. dollar.

This decrease was partially offset by improved shipping profitability for merchandise delivered to customers reduced with cost to reap more (ph) returns replacements and damages and lower occupancy expenses.

Although the second quarter of 2003 gross margin of 37.1% was 30 basis points lower than the all-time record gross margin delivered in second quarter of 2002, it was 130 basis points higher than any other second quarter gross margin in the history of the company.

SG&A in second quarter of 2003 was 32.1% of net revenue versus 32.7% of net revenues in second quarter of 2002.

This improvement as a percentage of net revenue was primarily driven by lower employment and other administrative cost offset by higher advertising costs.

Lower employment costs were primarily driven by reduced incentive compensation and the year-over-year elimination of restricted stock expenses, lower administrative costs were driven by the ongoing corporate-wide initiative to control discretionary overhead expenses.

The advertising cost was primarily driven by catalog productivity impact of new catalog concepts, including the April 2003 launch of Pottery Barn Teen and the substantial year-over-year circulation increase in West Elm.

Net interest expense in second quarter of 2003 was a credit of $100,000 versus an expense of $200,000 in second quarter of 2002.

This decrease in net expense was primarily due to a higher level of capitalized interest on long-term capital projects in 2003.

Depreciation and amortization expense in the second quarter of 2003 was $25.2 million, versus $22.4 million in the second quarter of 2002.

Deferred lease amortization in the second quarter of 2003 was $4.7 million versus $3.8 million in the second quarter of 2002.

I would like to discuss second quarter 2003 significant year-over-year cash flow highlights and balance sheet variances.

Cash at the end of the second quarter of 2003 was $81.8 million, versus a $193.5 million at the end of fiscal year 2002.

This year-to-date decrease in cash of $111.7 million was primarily due to a net usage of cash in operating activities of approximately $66.5 million, capital spending of $71.8 million and positive impact of proceeds from the exercise of stock options of approximately $26.4 million.

Merchandise inventories at end of the second quarter of 2003 were $376.9 million versus $250.4 million at end of the second quarter of 2002.

This increase of $126.5 million was primarily due to the successful execution of our decision in late 2002 to reinstate our core merchandise inventories in the Williams-Sonoma, Pottery Barn and Pottery Barn Kids brands.

Pre-picked catalog expenses at end of the second quarter of 2003 were $41.3 million, $12.9 million versus the second quarter of 2002.

This increase was primarily due to the timing of catalog expenditures, increases in circulation and page count and the addition of the Pottery Barn Teen catalog in 2003.

Prepaid expenses at end of the second quarter of 2003 were $25.2 million up $6.3 million versus the second quarter of 2002.

This increase was primarily due to higher prepaid store rents due to increased store count, higher prepaid insurance cost due to increased premium and higher prepaid maintenance cost due to entering into a long-term maintenance agreement with a strategic computer vendor.

Other current assets at end of the second quarter of 2003 were $8.5 million, up $4.9 million versus second quarter of 2002.

This increase was due to a secured deposit of $5 million for purchase of the corporate aircraft.

Other long-term assets were $19.5 million at the end of the second quarter of 2003, up $12.8 million versus second quarter of 2002.

This increase was primarily due to higher prepaid maintenance cost due to entering a long-term maintenance agreement with the strategic computer vendor and increase in cash surrender value of life insurance policies held in conjunction with the company's non-qualified executive deferred compensation plan.

Accounts payable at the end of the second quarter of 2003 was $145.1 million, up $33.5 million versus the second quarter of 2002.

The increase was primarily due to higher inventory payables due to increased inventory levels, higher freight payables due to a change in freight payment processors and higher catalog payables due to timing of expenditures.

Customer deposits at end of the second quarter of 2003 were $109.6 million, up $23.9 million versus second quarter of 2002.

This increase was primarily due to an increase in the customer liability associated with recognizing revenue on delivered basis and an increase in unredeemed gift certificates due to strong growth in gift certificate sales.

I would like to briefly discuss our outlook for the third and fourth quarter and our guidance for the balance of the year.

As we look forward to the third and fourth quarters, recognizing that 60% of our full-year revenues and 80% of our full-year earnings will be generated in that timeframe, we are continuing to be cautious in our economic outlook.

Based on this premise we are executing against a conservative business plan and remain extremely focused on the key operational initiatives that are consistently driving our business.

Strong merchandising, aggressive inventory management and solid supply chain execution.

For the third quarter as discussed in this morning's press release, we have narrowed the range of our diluted EPS guidance from a range of 16 cents to 19 cents, to a range of 18 cents to 19 cents.

This upward change was driven by the elimination of a 1 to 2 cent cumulative effect charge that was expected to be recorded in the third quarter in conjunction with the implementation of the new accounting rules for consolidating variable entities, otherwise known as FIN 46.

Based on recent clarification of these new rules our consolidation estimate has been revised and no cumulative effect charge will be required upon implementation.

Therefore, we have narrowed our guidance range to exclude the impact of this 1 to 2 cent per share cumulative effect charge.

For the full year we have increased our diluted EPS guidance from range of $1.23 to $1.27 to range of $1.25 to $1.28.

This increase reflects the impact of the 1-cent better than expected earnings that we delivered in second quarter, and on the low end of the range, the narrowing of our guidance range in third quarter due to revised estimate for the implementation of FIN 46.

Although sales momentum in all of our businesses has improved in the second quarter we believe that there is still potential for economic uncertainty in back half of the year.

Despite this concern, however, we are optimistic that our fall holiday assortment and strong execution will allow us to drive the business.

The strength of our brand and our management team's proven track record in delivering on their commitment provides us with strong competence in our ability to deliver the EPS guidance we have provided to our shareholders today.

I would now like to turn the call over to Pat Cowell, to discuss the Williams-Sonoma brand.

Thank you, Sharon.

Good morning.

I'm proud to be here today to discuss the exceptional second quarter performance in the Williams-Sonoma brand.

Net sales for the brand increased over 17% for the quarter, with excellent results in both retail and DTC channels.

In the retail channel comparable store sales increased by robust 12.1% and new stores exceeded sales targets.

A positive consumer response to our merchandise assortments, the outstanding retail rollout of our sweeping new customer service initiative focused on going home with the customer and a higher in-stock position on our retail inventories drove this impress of retail performance.

In the DTC channel e-commerce business continued to deliver significant growth.

Traffic on the Web site more than doubled and conversion rates again exceeded industry norms.

The incremental summer catalog in early June fueled a new level of customer excitement and benefited all three sales channels during the quarter.

This catalog fueled a significant summer gap for the brand by aligning the channels and providing a fresh assortment during a time that was typically limited in new product offerings.

Another key driver in second quarter performance was the continued growth in our bridal registry business.

Bridal registry during the quarter increased over 24% with the registry value increase of over 34%.

A key component of this registry value increase was strategic alignment with the Chambers catalog that we announced last quarter.

The successful addition of the bed and bath assortment from our chambers catalog, contributed over $2 million and added registry value during the quarter and momentum continues to build.

As we look at early results in third quarter we are very encouraged by continued resilience of our customer.

The expansion of tabletop offering, the key sales initiative for third and fourth quarters and consumer response to the overall merchandising assortment continue to be very strong.

We were also very optimistic about our mid-October launch of the new premium line of Kitchen Aid high-end electric's that will be sold exclusively on our Williams-Sonoma stores through the holiday season.

As we look forward to the balance of the year and we will continue to focus on the execution of our seasonal and core merchandise assortments, the leveraging of our strategic Internet partnerships and ongoing development of corporate sales program, as well as aggressive management of our in-stock position on core merchandise inventories.

I would now like to turn the call over to Laura Alber.

Thank you, Pat.

Good morning.

This morning I will talk about the performance of the Pottery Barn, Pottery Barn Kids and Pottery Barn Teen brand.

I will start with Pottery Barn.

We are pleased with the performance of the Pottery Barn brand in the second quarter.

Net sales increased 8.5% with solid performance in both the retail and Direct-To-Consumer channels.

A positive consumer response to our new product offerings, a strong emphasis on core assortment and a synchronized multi-channel marketing effort to support our summer merchandising themes drove strong results.

In the retail channel, comparable store sales increased 2.6%, double last year's comparable store sales increase of 1.3%.

What was particularly encouraging about this increase was the breadth of categories that gained momentum, including high-end textiles, decorative accessories, and entertaining and upholstered furniture.

In the Direct-To-Consumer channel, the e-commerce business continues to fuel strong growth.

Site traffic increased over 45% and conversion rates exceeded industry norms.

We also saw continuing momentum in our bridal registry business, which continues to be a significant growth opportunity.

New registries created during the quarter increased over 8% while average registry value increased over 29%.

In addition to delivering solid sales growth in second quarter Pottery Barn also delivered extremely strong earnings.

The ongoing success of profit improvement initiatives, including optimizing transportation cost, reducing customer return and improving supply chain distribution processes were significant contributors to the better than expected earnings.

As we look at early results in the third quarter and we are encouraged by momentum in our core businesses and the overall consumer response be to our new fall assortment.

We're also confident that our improved in-stock position on core merchandise inventories will support our year-over-year growth initiatives.

Additionally, we are excited about the debut of new Pottery Barn book series.

The new Pottery Barn design library will be available to our customers in all three channels this month.

The initial consumer response has been tremendous and we are optimistic that this will continue through the back half of the year.

We believe this book, like cookbooks in Williams-Sonoma will amplify our authority in home design and our draw customers closer to our brand more than ever before.

Our visual strategy for the third quarter is also greatly enhanced over last year, focused heavily on our Destination businesses.

Dominate features displaying core fashion and seasonal items in interconnected lifestyle scene will be center stage in our retail stores during the fall season.

Now, I would like to talk about Pottery Barn Kids.

We are pleased with performance of the Pottery Barn Kids brand for the second quarter.

Net sales for the brand increased 40.6% for the quarter driven by year-over-year store growth, positive comparable store sales and continuing momentum in Direct- To-Consumer channels.

Strong execution in the retail channel continued be a quarterly highlight.

Consistent with our aggressive retail expansion strategy we opened three new stores during the quarter and added one new store to our store development calendar for the year.

At the end of the quarter Pottery Barn Kids operated 66 stores versus 42 stores a year ago.

With 40 of the 66 stores in comp basis at end of the quarter, comparable store sales increased 5.7%, driven by extremely strong performance in single-store markets.

Comparable stores sales in the multi-store markets, although, improving continue to trend negatively due to significant pressure that rapid opening of new stores imposes on performance of existing comparable stores.

Another highlight in Pottery Barn Kids business in second quarter was success of the direct-to-consumer business, especially the ongoing momentum of the e-commerce business.

Expanded focus on personalization on key merchandise categories, highly productive Internet partnership and significant growth in baby and gift registry contributed to strong growth in this channel.

Baby and gift registries created during this quarter increased over 220% and the average registry value increased over 77%.

Also in the second quarter we've launched our national in-store summer concert series.

The traffic generated by this brand enhancing events substantially exceeded our expectations and based on this strong response we'll to offer similar programs going forward.

We believe the strategy will differentiate Pottery Barn Kids brand from the competition and lay a firmer foundation for long-term relationship for their customers and their children.

In addition to delivering solid sales growth in second quarter, Pottery Barn Kids also delivered extremely strong earnings.

The ongoing success of supply chain initiative combine wide significant advertising and SG&A leverage drove these better than expected earnings results.

As we enter the third quarter we are encouraged by initial consumer response for our back to school and early fall assortment.

Additionally we are excited about third quarter rollout of new major customer service initiative that we call Ages in Stages.

This includes educating our associates on developmental life stages of growing children in enabling them to advise their customers on age-appropriate product selection.

Like the summer concert series we believe this program will allow us to continue to enhance long-term relationships with our customers and their children.

I would now like to talk about Pottery Barn Teen.

We are thrilled with the second quarter performance of Pottery Barn Teen.

On a circulation of more than $4.8 million catalogs, the largest new catalog circulation ever test marketed at the company.

The consumer response has consistently exceeded our expectations and we are consistently identifying strategies to attract new customers to the brand.

Since the initial launch, we have continued to identify new customers to the brand by prospecting with our catalog, developing a catalog request Web site, launching an e-catalog and by leveraging unsolicited media coverage.

The strength of the Pottery Barn name, combined with the outstanding merchandise in the Pottery Barn Teen catalog has allowed us to secure significant press attention since its launch including product features on MTV, editorial credit and promotional tie-ins with Teen magazine and opportunity for television partnerships for the fall.

As we look forward to the third quarter and the balance of the year we could not be more excited about this concept.

The operational aspects of the initial launch have been well executed and we are aggressively working to replenish our inventory to support better than expected consumer demand.

We have also accelerated the launch of our e-commerce site to late September.

We believe this site will drive significant brand awareness and become a major shopping destination for these customers.

In summary we are excited about all of our merchandising strategies in the Pottery Barn brand and confident in our ability to drive our business in the back half of the year.

Although we are remaining cautious in our economic outlook, we will continue to focus on the retail execution of our seasonal and core merchandise equipment and the improvement of our visual merchandising and the expansion of Internet partnerships and e-commerce opportunities and also on the management of our in-stock position on core merchandise inventories.

We will also continue to focus on our number one strategic objective, exceeding the expectations of our customers and our shareholders.

Now, I would like to open the call for questions.

Thank you.

The question and answer session will be conducted electronically.

If you would like to ask a question today please do so by pressing the star followed by the digit 1 on your touch-tone telephone.

If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment.

We will take our first question from Dana Telsey at Bear Stearns.

Good morning everyone.

Congratulations on this terrific result.

Can you talk a little bit on the sales trend?

How much of it was driven by traffic, how much of it driven by average transaction and as you go forward to the back half of the year, for each of the different brands, what should we be watching for pricing wise and merchandise wise that all of you are excited about?

Any new categories whether it is in the furniture area, in particular, that we should be focusing on?

Thank you.

Dana, I will take the first piece of your question and then I will let Pat and Laura discuss the merchandising strategies for the back half of the year.

As you know, we do not release traffic or average ticket information.

We don't have traffic counters in our store.

So, that information is not information that we currently are giving.

I will now let Pat Cowell talk about the merchandising strategy for Williams-Sonoma for the back half and then we will have Laura talk about Pottery Barn and the Kids business.

Thanks.

I think that the summer business has been driven second quarter business, we had a new summer catalog, as I mentioned.

We also made a plan to change some of our tabletop business more into serve-ware and additional linens and the big outdoor program and that is carrying over into the fall.

We have tremendous number of new products coming around the Halloween and then obviously our seasonal foods, we have a lot of new things coming.

But our tabletop business, which is a great business for us, we've changed that and more appealing I think to the customer that is looking for larger serving pieces versus sets of dinnerware.

We still have our stuff, but moved into things more Mediterranean, a lot of things from Europe, a lot of hand-painted items in the serve ware business and the linens go right along with it.

So the tabletop area has been a big product for us in the summer, moving into the fall and then, of course, our seasonal goods and Christmas area are again substantial and a lot of newness.

So newness and freshness has really driven the business in Williams-Sonoma.

Sure.

In Pottery Barn, I will start with Pottery Barn first and then move to Kids.

As I said we are pleased with our initial results of the fall merchandise and believe our holiday assortments are stronger than they were last year.

In fall, we are continuing to focus on the revitalization of our core merchandise for example natural fall you will see an expanded assortment and we have also added sizes in our drape business that the customer has been requesting for a while now.

We are really seeing that those very simple changes are making a big difference with our customers.

As we look forward to Christmas, our textile assortments are much improved over last year and our holiday trim assortment is extraordinarily beautiful I believe and has very compelling new categories to help our customers decorate their homes.

In the Kids business, we are really focused on desks for every age in the fall season and are seeing strong consumer response.

We also continue to build our consumables strategy at retail in the kids business and are seeing strong results from our new tabletop introductions, as well as more of the functional accessory pieces as I said in Home office and in Storage.

We will take our next question from Anne-Marie Peterson at Thomas Weisel Partners.

Hi, good morning.

I have a question for Pat Cowell.

Laura commented on profitability of her brand.

Pat, could you comment on what you are seeing with respect to bottom line trends at Williams-Sonoma?

That would be great.

Anne, I'm calling in from a distant place.

I have got Sharon there with the numbers in front of her.

So if I could ask Sharon to comment on that?

Anne-Marie we are - obviously when you look at the total company PNO, we don't give profitability by brand.

We are limited to profitability in the 10 Q by channel.

But, what we can say is when you look at the overall profitability of our business, Williams-Sonoma is a significant piece of our business and clearly the momentum in Williams-Sonoma has to be there in order for the whole company to be successful.

So we are very pleased with the contribution of Williams-Sonoma.

Some of our big supply chain opportunities, as you know, are very much focused in the Pottery Barn business.

So they get the benefit or bigger piece of the benefit on a lot of those initiatives.

But the profitability in Williams-Sonoma is absolutely fine.

Sharon, if I could add one thing Anne- Marie, the issue we looked at last year and every season where we our performers - some of our performers, how are they doing and so we targeted the summer season, which is usually a slower season from the end of Mother's Day, July 4th is big.

But we targeted the summer catalog book, which drove business into the stores, and we also looked at expanding our outdoor selection from last year to this year.

Those things made big hits and helped drive a lot of newness into the store and thus bring the customers in.

Moving on, we will take the next question from Mark Rowen at Prudential Securities.

Thank you.

Good morning.

A Couple of questions, first, Sharon, can you talk about the markdowns that you talked about affecting gross margin and does that just go hand-in-hand with your new inventory strategy where you got more inventory, so you would have to take more markdowns to get rid of some of the stuff that is not selling?

Should we expect slightly lower margins because of that with the new inventory strategy going forward?

Second, the West Elm store that you are opening in New York in the fourth quarter is that just a test store or do you have a bigger rollout planned for next year?

Finally, are you seeing any changes in the real estate market, are things opening up a little bit, are rents coming down?

OK, Mark, I will take the markdown question and then I will let Howard respond to the real estate question.

We have on the markdown strategy, if you remember last year our inventory in the second quarter were at the lowest level that we had seen in probably the last five years in the company.

As a result of that, we had very little merchandise on sales.

Clearly the entire retail environment has been more promotional.

But, more specifically within our businesses, we use second quarter as an opportunity to do some very strategic things especially in Williams-Sonoma.

In the Williams-Sonoma concept as Pat referred to they were working on a significant transition in the table top area and we were clearing some patterns that we had historically carried and bringing in the new merchandise and so that was a big stores piece of the markdown and then as we go forward we have - we run a more normal promotional strategy in our stores Mark.

Our markdowns last year were too low and now I will let Howard respond to the question on real estate.

Mark, the two-part question first the West Elm question.

That is a test.

It is our first test store.

We're doing that in the Dumbo (ph) section of Manhattan Brooklyn just kind to the Brooklyn Bridge, where our head quarters are with West Elm.

It is a test.

We are looking at additional stores next year, but we are going to get early reads on this store first.

Second part of your question, with respect to real estate market, we are finding that about the same.

Our position is getting stronger, I think.

The other retailers I think we are going to - we are in a coveted position where they want us in the mall.

But rents are not weakening as you know we have got this concentration of malls going to just a few people now, and I think that will put pressure on rents in short term.

Then, we will see what happens.

Moving on we will take our next question from Colin McGranahan (ph) at Sanford Bernstein.

Hi good morning.

Just following up on Mark's question on the gross margin a little bit.

First, shipping costs, again you know really nice improvement there.

You are beginning the anniversary some pretty significant improvements, I think about a 121 basis points down in third quarter.

Can you just bring this up to remind us what is driving continued benefit or continued gains in lower shipping costs?

If you look at or assume reasonable occupancy cost it implies merchandise margins were down pretty substantially.

I understand you talked about markdown strategy.

Can you help us get a little bit more comfortable with merchandise margins being flat to up, given your guidance for gross margins in the 3rd quarter, and then I will have a follow up.

Colin, we obviously give extensive guidance.

If you take the press release that we gave you, we have given you gross margin guidance for Q3 and the full year.

So in your model I am sure that you will come to a point of view on Q4.

But as we think about benefits of shipping costs, we have made substantial progress in that area.

I would tell you that we have during the first part of this year, we identified additional significant opportunities in the way we are handling our business and with whom we do that.

We will continue to see benefit in that area.

I think the part that is very important about that is that, the fact we have been able to lower the cost, Colin, allows us not to have to adjust the top line.

We have not made an adjustment to our shipping charges to our customers in almost two years now.

As a result of that, we are clearly being able to benefit the profitability of our company by improving the execution on the supply chain side.

So, I think we will see and we have guided, actually, if you look at our guidance, we have guided to see an additional improvement in the back half and we have other opportunities that we see going forward in the future years that we think will also have significant impact, clearly not like the last two years, but we are still looking at optimizing transportation costs.

OK, just the second question.

Looks like on the inventory build it was a little bit more skewed to Williams-Sonoma brand than I expected here in the second quarter.

Can you give us a sense how the 30 to 40% inventory build in the third quarter is going to be allocated between the brands?

I didn't give guidance on that, Colin.

You will see actually a bigger increase in the Pottery Barn brand.

The reason being that Williams-Sonoma in the third quarter of last year was able to get back in the stock.

When you think about the strategic timing of when we decided to reinstate the inventory, Williams-Sonoma was about late second quarter or early third quarter and Williams-Sonoma was able to make progress in Q3 of last year.

The Pottery Barn brand have of course have lot longer lead times.

So they were much slower in reinstating their levels.

You will see bigger increases in the Pottery Barn brand in Q3 than you did in Williams-Sonoma.

Our next question comes from Lauren Levitan at SG Cowen.

Sharon, elaborating on the inventory.

I know in the past you said that as we enter the second half you expected Pottery Barn and Pottery Barn Kids to be at a level that you feel comfortable with.

Can you comment on whether or not you achieved those levels maybe as Laura and if you have anything to add on that?

That would be helpful.

Also, I am wondering if you could you talk about the anniversarying (ph) of last year's credit card promotion in third quarter at Pottery Barn, if there will be anything to potentially anniversary any sales you may have gained there?

One last question if I could with respect to the gross margin.

I know you said part of the reason for some of the pressure on gross margin in the second quarter was the function of currency and the pricing on European-based goods.

Do you see that stabilizing in the back half and is that one of the sources that is positive increase in the gross margin you have given guidance for?

Thanks very much.

Let me start with Laura responding to the question about her inventory levels.

Thank you.

We have made improvement in both Pottery Barn Kids at inventory level.

But in Pottery Barn in particular, we continue to refine the percentage of inventory in core and fashion and as we continue to focus again very strongly on core, we are working to increase our levels in core in the store and of course, are always pockets of inventory where we can do a better job.

Look for continued improvement in our inventory flow to stores and the balance between foreign fashion and Pottery Barn.

In Pottery Barn Kids, we have made substantial improvement.

The stores have really commended us on giving them what the customer is looking for.

So, we've done what we said we were going to do there, as well.

In terms of the credit card promotion, you are right that we're anniversarying (ph) that, actually this week and were doing is focusing on using the credit card to build long-term loyalty with our customers by putting together a program that is not just an activation offer, but that keeps them coming back and spending more by giving them a rebate on purchases.

But, you won't see that at the exact same timing as when we did the 10% off last year.

The last question, Lauren, more color on the gross margins in the back half.

And what I would say to that is that we are continuing to make progress in the gross margins in our business as it relates to the euro.

We have clearly gone back to our vendors and are working on our pricing, our vendor pricing and we believe that by the end Q3 and gong into Q4, that situation will see improvement.

I don't believe that we could say that it will go back to where it was, but will see improvement going into the late half of Q3 and Q4.

As you think about our gross margin, you have to remember there are a lot of things that go into gross margin; you have your shipping profitability in that gross margin in the guidance.

You also have benefits that were continuing to see from lower returns, lower damages, lower replacements, so when you look at the improvement in the gross margin Lauren, you can't just think about cost of merchandisers, a lot of cost that are below the cost of merchandise that are better setting us in those categories.

Next we will move to Alan Rifkin, at Lehman Brothers.

Couple questions if I may.

You mentioned as the SG&A rate declined despite higher advertising cost especially associated with the newer concepts, namely West Elm and PB Teen.

How much of an impact in second half do you think will see on the EBIT margin as result of higher advertising expenses and would I be correct to assume as you start to anniversary the expenses in first half of next year negative impact should lessen?

We haven't given guidance Alan for next year and of course you know that we will be doing that later on in the year going -- right after we release Q4 earnings and will give specific guidance about that going forward.

One of the things that we intentionally plan to do is continue to invest in our new businesses.

We have quite a few growth vehicles and it is our intent next year to continue to invest in them.

So, assuming that we need to talk about that and will discuss that at the appropriate time.

As it relates to the SG&A expenses, we have been very, very pleased with our expense control.

I'm sure you saw in the Q2 results.

In Q3, when you think about the guidance that we've given at 33.8 to 34.1, that is again leverage from last year or from last year this third quarter.

So, we are continuing to see the benefit of cost reductions and Alan, there are too many to enumerate.

Our employment cost, travel costs, consulting costs; it is an overall corporate focus on spending.

So, it has become part of our culture and part of our discipline.

We are very pleased with it.

we will now move to Mark Friedman with Merrill Lynch.

Thank you.

Good morning, everybody.

Two questions.

One, little bit more insight update if would rewind on West Elm?

How the catalog is progressing?

I don't know if I heard that in prepared comments.

What the plans are for fall as it relates to the catalog, I understand you are testing a store and that is great.

On the Williams-Sonoma Home, more about that business, especially how you are looking to position that relative to Chambers given that you started to do some online work with Chambers?

Thanks very much.

Mark, Howard.

I will try to take that.

The West Elm catalog continues, I think, to perform above our expectations.

We've been particularly pleased with the results we've had in that it did not have any endorsement from any of our other brands.

I think that is significant.

We are - we will be releasing another version of the catalog that will be a test this fall that will deal more with just core merchandise to see if we can soften the assortment alone a bit and see where that takes us to determine how broad an appeal we can get in the consumer base.

So we're continuing to test as we made with in our open a store and I would think by the first quarter of next year, we'll have a pretty good view of where we're going to go with the business.

With respect to your question about Williams-Sonoma Home, the positioning of that.

We'll have more to say about that, I think, as it develops.

We are in early stages of it.

Chambers will probably become a part of that business and dissolve into Williams-Sonoma Home would be our preliminary thinking at this time.

It would be the anchor for the textile piece of the total strategy.

And I think the quality level and the price points would be consistent with where Chambers has been historically.

And next we will hear from Joan Storms at Wedbush Morgan.

I'm sorry.

I was going to ask about inventory at Pottery Barn.

My question has been answered.

Thank you.

Thank you, we will next to Janet Carpenburg at JJK Research.

Good morning.

Good morning, Janet, how are you?

Good.

I wonder about the Pottery Barn inventory build, if it had been completed in second quarter and if you saw acceleration in comps as the inventory builds and if you expected to see more of a climb here in August or if that is all behind you at this point?

You know, it's not that we didn't achieve our goal of building inventory.

As we did that, we found even more opportunity.

Really, the repositioning of course has led to bigger increases in some of our core collections like dinnerware and Saucelido dinnerware.

Ans as we built your inventory we continue to say what is the right level for Pottery Barn inventory?

As we get more information, we continue to see more opportunity.

So, this we've made improvements and will continue to do so.

We think it will - we know it will continue to drive business across the board.

Next we will move to Rob Wilson (ph) with Tiburon Research (ph).

Thank you, you going to anniversary private label credit card program.

Do you see impact there?

Can you talk about fulfillment rates and increase in inventory?

Have you seen measurable increase in fulfillment rates?

Thank you.

I will let Laura answer those questions on private label credit card and then talk broadly about fulfillment rates as total company.

Thank you for bringing up the PLCC question, we failed to answer it earlier.

On the private label credit our focus is to ensure this is a long-term strategy and we are going through - we will know this week if it has impact on our business from short-term perspective, but feel very strongly that our long-term positioning of the credit card as not just activation offer is very important.

That was always in our original plan.

We did the activation offer to get people into the card.

Now that we have people in the card, our goal is to retain them and attract new people into the card based on the amount they purchase versus having people just get the 10% off for signing up and cutting up the card.

We believe that will have a much more important long-term effect on the brand than continuing with activation offer.

Rob, on fulfillment rates we are extremely pleased with our fulfillment rates in the Williams-Sonoma business.

In Pottery Barn, we have actually seen improvement in fulfillment rates, but had some big run away items.

That affects overall fulfillment rate, but on the number of skews we are disappointing customers on, we believe we are making progress and we made substantial progress in Pottery Barn Kids business.

Last year this time we were really in serious trouble in Pottery Barn Kids.

We were running in the low 60s.

You know, that was not where we needed to be.

We've made great progress in Pottery Barn Kids on this issue, although we have run away products and those of course overall affect the rate.

And we'll now take a follow-up question from Colin McGranahan at Sanford Bernstein.

Thanks.

Actually its been answered.

That does conclude the Q and A session.

Miss.

McCollam, I'll turn the conference back over to you.

Thank you very much for joining us today.

This is Ed Mueller, I just like to say that we are extraordinarily proud of the results this quarter and hope that you can get the benefit of the team on the field right now.

We are really confident we will continue to do what our shareholders want and produce great results.

We appreciate your attention on the call and hope you have a great day.

That does conclude today's conference.

Again, thank you for your participation.