Williams-Sonoma Inc (WSM) 2005 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the Williams-Sonoma Incorporated second quarter 2005 earnings release conference call. [OPERATOR INSTRUCTIONS] As a reminder this conference is being recorded.

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

Please go ahead Mr. Nelson.

Good morning.

This morning's conference call should be considered in conjunction with our second quarter 2005 earnings press release including financial statements which we issued earlier today.

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

These statements address the financial condition, results of operations, business, initiatives, growth plans, and prospects of the Company in 2005 and beyond, and are subject to certain risks and uncertainties that could cause actual results to differ materially from such forward-looking statements.

Please refer to the Company's current press releases and SEC filings including reports on forms 10-K, 10-Q and 8-K for more information on the risks and uncertainties that could cause actual results to differ materially from these forward-looking statements.

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 will now turn the conference call over to Ed Mueller our Chief Executive Officer.

Good morning.

Thank you for joining us.

With us today is Howard Lester our Chairman;

Laura Alber our President of the Pottery Barn brands;

Pat Connolly our Executive Vice President and Chief Marketing Officer; and Sharon McCollam our Executive Vice President and Chief Financial Officer.

We are very pleased to be here to deliver to our shareholders another quarter of record financial performance.

In the second quarter of 2005, on revenue growth of 12.6%, we increased our diluted earnings per share by 13% to $0.26 per share.

During the quarter, we invested heavily in the growth of our emerging brands, and completed the national roll-out of our daily store replenishment program to all our brands.

We also strengthened our instock position on core merchandise inventories, and improved our direct to customer order fulfillment rates.

We're very proud of these results and believe they reflect the power of our multichannel strategy, our ability to build strong brands, and the competitive advantages that we have created with our operational flexibility and supply chain execution.

In our core brands, net revenues increased 10.7% in the second quarter.

Driven by low double digit growth in Pottery Barn, and high single digit growth in Pottery Barn Kids and Williams-Sonoma.

I will let Howard and Laura discuss the performance of each of these brands later in this morning's call.

In our emerging brands which include West Elm, PBteen, Williams-Sonoma Home and Hold Everything, second quarter net revenues increased 33.2% primarily driven by strong performance in West Elm and Williams-Sonoma Home.

In the West Elm brand net revenue growth in the second quarter continued to exceed our expectations.

Increased catalog circulation, strong performance in E-commerce and incremental revenues from new stores drove these better-than-expected results.

Particularly encouraging is the fact that all five of the new West Elm stores currently rank within the top 20% of volume producing stores in the Company.

And three of the five have consistently ranked in the top 10%.

Also encouraging is the growth of our West Elm customer database.

Our initiatives to broaden the merchandise assortment, soften the color palate and enhance the lifestyle presentation are clearly attracting many new customers to the brand.

Which is critically important as we accelerate our growth plans in 2006.

In Williams-Sonoma Home net revenues also exceeded our expectations in the second quarter.

A better-than-expected consumer response across merchandising categories drove these strong results.

During the quarter, we continued to invest in our infrastructure as we prepared for our retail launch in the third quarter.

In the Hold Everything brand during the second quarter, the consumer response to the overall merchandise assortment was below our expectations.

Although we expected a negative impact from the merchandising transition, the weakness we saw in both the retail and direct to customer channel was once again disappointing.

To address the inventory-related impact of these lower-than-expected sales, we implemented an aggressive inventory markdown and disposition strategy, which resulted in a significantly lower gross margin than anticipated in the second quarter.

Operationally, in the second quarter we completed the national rollout of our daily store replenishment program.

Although it is still early, the new program is operating smoothly, and the feedback from our stores continues to be positive.

As expected, we are seeing an immediate reduction in the average number of days that our goods are in transit, and a gradual improvement in our store by store inventory levels.

Longer term, we expect to see three additional benefits from this program.

Including improved customer service due to lower out of stocks, lower operating costs due to less inventory in the back rooms, and reduced inventory shrinkage and damage due to less handling of the merchandise.

As we look forward to the third and fourth quarters, we are continuing to focus on the three strategic initiatives that are fueling our success, driving profitable top line revenue growth, increasing pre-tax operating margin, and enhancing shareholder value.

Consistent with our strategic effort to drive profitable top line revenue growth we are continuing to invest in new growth opportunities in both our core and emerging brands.

In our core brands, we are increasing retail lease square footage and catalog circulation, refining the retail and catalog merchandising strategies in the Williams-Sonoma brand, expanding our traffic generating merchandise assortment in the Pottery Barn Kids brand, increasing our outlet leased square footage to continue to maximize our return on excess inventories and implementing new marketing strategies that will drive growth across channels, including E-marketing and gift card initiatives.

In our emerging brands we are very focused on building our customer databases and expanding our multi-channel capabilities.

In the West Elm brand, due to the strong performance of our new stores, we have increased our store count guidance by one additional store that will open late in the fourth quarter.

We are also increasing our catalog circulation, electronic direct marketing, and online customer acquisition efforts throughout the remainder of the year.

Although we continue to believe that it is too early to predict the ultimate size of West Elm, the strength of the consumer response to our new merchandising initiatives is confirming our belief that West Elm over time has the potential to become our largest brand.

We believe that the key success factors necessary to achieve such growth will include increasing categories in the merchandise assortment, evolving the merchandise aesthetic to appeal to a broader consumer base, executing an effective retail strategy, and capturing the mine share of the large consumer segment that West Elm targets by leveraging our strength in multi-channel retailing.

In the Williams-Sonoma Home brand in the back half of the year we are increasing catalog circulation, adding order placement functionality to the current E-catalog Website, and opening our first three stores in the third quarter.

We continue to believe that the retail launch is going to accelerate the growth in this brand due to the customer's desire to see the product and experience the brand's design authority.

In the Hold Everything brand although there is a significant amount of new merchandise in our fall and holiday assortments we are approaching the back half of the year very cautiously based on our year to date results.

At a minimum we know that our margins will remain under pressure due to the ongoing impact of the inventory disposition strategy that we implemented in the second quarter.

Also in the back half we will be assessing the performance of each of our 2004 and 2005 merchandising strategies and evaluating the overall market position for the brand long term.

While we perform this assessment, we are suspending all new store opening activities.

Consistent with our second strategic initiative to improve profitability in our core businesses, we are projecting an increase in our 2005 pre-tax operating margin of 20 to 40 basis points.

The key drivers of this pre-tax operating margin improvement are expected to include ongoing expense reductions in the furniture delivery network, a reduction in direct to customer shipping expense due to an improved in stock position on direct to customer merchandise inventories, and a reduction in corporate overhead expenses as a percentage of net revenues due to strong expense management initiatives.

Operationally, our three key initiatives for the remainder of the year include expanding warehouse capacity to support higher inventory levels and emerging brands growth, insourcing a portion of our East Coast furniture hub operations to develop a new gold standard for furniture customer service, and identifying operational disciplines to reduce returns, replacements, and damages, particularly in furniture.

Furniture sales currently represent approximately 28% of total company merchandise sales on a trailing 12-month basis.

Consistent with our strategic initiative to enhance shareholder value, we remain dedicated to delivering on the commitments we have made to our shareholders.

In the back half of the year, however, we are planning to drive significant growth in our emerging brands by adding additional stores and increasing catalog circulation.

As these initiatives inherently create a higher level of uncertainty in our forecast, we believe that it is prudent to remain conservative in our outlook.

Therefore despite strong earnings in the first and second quarters, we are reiterating our fiscal 2005 diluted earnings per share guidance in the range of $1.84 to $1.88.

Representing a year-over-year increase of 15% to 17.5% on revenue growth of 12 to 14%.

I will now turn the call over to Sharon McCollam for more details on the second quarter 2005 financial results.

Thank you, Ed.

Good morning.

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

First, we will review our second quarter 2005 financial results and our 2005 earnings guidance.

Next Howard will provide you with a business update on the Williams-Sonoma brand.

Then Laura will provide you with an update on the Pottery Barn brand and finally we will open the call for questions.

I would now like to talk about our second quarter earnings results.

In the second quarter of 2005, diluted earnings per share increased 13% to $0.26, versus $0.23 in the second quarter of 2004.

Throughout the quarter, we continued to see benefits from our distribution, transportation management, and overhead cost containment initiatives.

These benefits combined with a strong consumer response to key merchandising strategies allowed us to deliver another quarter of record financial performance.

And for the 20th consecutive quarter, we met or exceeded the earnings per share guidance we provided to our shareholders.

Let's look at what drove these strong results.

Net revenues in the second quarter of 2005 increased 12.6% to 776 million.

Retail net revenues in the second quarter increased 13.4% to 434 million.

This increase was primarily driven by an 11.8% increase in retail lease square footage and a comparable store sales increase of 3.7%.

Direct to customer net revenues in the second quarter increased 11.5% to 342 million, with catalog and page circulation increasing approximately 8.9% and 17.4% respectively.

These circulation increases compare to catalog and paid circulation increases of 23.3%, and 32.5% respectively in the second quarter of 2004.

Internet revenues in the second quarter of 2005, increased 32.2%, to 173 million, contributing for the first time more than 50% of total direct to customer revenues.

Gross margin expressed as a percentage of net revenues in the second quarter of 2005 was 38%, versus 37.6% in the second quarter of 2004.

This 40 basis point increase was primarily driven by expense reductions in shipping costs, partially offset by rate increases in merchandise cost of goods sold, and occupancy expenses.

The improvement in shipping costs was primarily due to ongoing expense reductions in the furniture delivery network.

The rate increase in merchandise cost of goods sold was primarily attributable to increased mark downs and other inventory related costs in the Hold Everything brand, higher transportation costs associated with the daily store replenishment program, and a greater percentage of furniture sales to total sales.

In the second quarter of 2005, furniture sales increased 27%.

The rate increase in occupancy expenses was primarily driven by a year-over-year increase in distribution lease square footage.

Selling, general and administrative expenses were 246 million, or 31.6% of net revenues in the second quarter of 2005, versus 215 million, or 31.1% of net revenues in the second quarter of 2004.

This 50 basis point increase as a percentage of net revenues was primarily driven by higher catalog advertising expenses.

Partially offset by sales leverage on corporate employment costs.

Increased paper costs across all brands, in addition to higher costs associated with increased catalog and page circulation drove the majority of this catalog advertising expense increase.

I would now like to discuss significant year-over-year working capital balance sheet variances.

All comparisons are versus quarter end balances at the end of the second quarter of 2004, which are included in this morning's press release financial statement.

Cash and cash equivalents at the end of the second quarter of 2005 increased $35 million to 154 million.

This is the highest second quarter balance in the history of the Company.

Despite investing over 77 million in share repurchases over the last 12 months.

Merchandise inventories at the end of the second quarter of 2005 increased 27.2% to 522 million.

This above sales growth increase is consistent with our strategy to reinstate our core inventory levels, with the majority of this increase being in core furniture.

On a two-year basis, inventory growth is substantially in line with sales growth, however.

Prepaid catalog expenses at the end of the second quarter of 2005 increased 17.3% to $55 million.

This increase was primarily driven by higher paper costs.

Incremental costs associated with the Williams-Sonoma Home catalog, which had minimal costs on the balance sheet in 2004, and the timing of expenditures for the Pottery Barn, West Elm and PBteen catalogs.

Prepaid expenses at the end of the second quarter were 39 million, up $11 million.

This increase was primarily driven by the fourth quarter 2004 prepayment of our 2005 data center hosting fees and a second quarter 2005 prepayment of book income tax liabilities due to timing differences between book and taxable income.

Customer deposits at the end of the second quarter of 2005 increased 28 million to 165 million.

This increase was primarily driven by sales growth-related increases in unredeemed gift certificates and a year-over-year increase in customer orders in transit at the end of the second quarter.

I would now like to briefly discuss our 2005 guidance.

As we look forward to the back half of the year, we are mindful of the fact that approximately 57% of our full-year revenues and approximately 75% of our full-year earnings will be generated in the third and fourth quarters.

We are also mindful that during this time, we will be continuing to invest heavily in the growth of our emerging brands, particularly in the fourth quarter.

As these growth initiatives inherently create a higher level of uncertainty in our forecast, we believe it is prudent to remain conservative in our outlook.

Therefore, for the third quarter, we are reiterating our diluted earnings per share guidance in the range of $0.29 to $0.31, representing a year-over-year diluted earnings per share increase of 20.8% to 29.2%, on revenue growth in the range of 12.9 to 15.1%.

Although this is projected to be our highest EPS growth quarter of the year, it is important to remember that our third quarter 2004 results included all of the start-up costs for our East Coast distribution center, in addition to substantial out of market shipping costs.

But did not include the shipping costs benefits we are currently seeing from the insourcing of line hall management which was not fully operational until the fourth quarter of last year.

We are also reiterating our fourth quarter diluted earnings per share guidance in the range of $1.07 to $1.11.

Representing a year-over-year diluted EPS increase of 12.6 to 16.8%, on revenue growth in the range of 11.3% to 13.7%.

And for the full year, as Ed mentioned, we are reiterating our diluted earnings per share guidance in the range of $1.84 to $1.88 representing a diluted earnings per share increase of 15 to 17.5% on revenue growth in the range of 12.2 to 13.5%.

Although we are remaining conservative, the strength of our brands, our strong operational execution, and the consistency with which we have been able to deliver on our commitment provide us with a high level of confidence in our ability to deliver the earnings per share guidance we are providing here today.

I will now turn the call over to Howard to discuss the Williams-Sonoma brand.

Thanks, Sharon.

And good morning, everyone.

We're very pleased with the performance of the Williams-Sonoma brand in the second quarter.

Net revenues in the brand increased a better than expected 7.2%, and we saw a significant improvement in gross margins due to a substantial increase in full price selling.

Reducing markdowns continued to be a major focus and the results have been gratifying.

Through the second quarter, we have seen a 35% reduction in markdown sales versus last year.

In the retail channel, for the reasons we discussed in our last call, we expected to see a 2 to 4% comparable store sales decrease in the second quarter due to planned reductions in markdown inventories.

Stronger-than-expected full price selling, however, allowed us to substantially exceed these expectations ending the quarter with a decrease of only 0.2%.

We were also very pleased with the performance of our new and expanded stores.

In the direct to customer channel, revenue growth in the second quarter also exceeded our expectations.

The successful redesign of our catalog, combined with a substantial increase in online marketing drove the highest quarterly year-over-year revenue increase in nearly five years.

In E-commerce, although traffic to our site increased only slightly due to a year-over-year reduction in promotional activity, we saw a 20% increase in conversion, and a 5% increase in average order size.

We also saw strong results from increased electronic direct marketing, and online search, in addition to online bridal.

All of which are significant long-term growth opportunities for the brand.

From a merchandising perspective, during the quarter, we saw positive growth in all major merchandising departments with particular strength in electrics, cook ware, cutlery, linens, and core food.

As we look forward to the third quarter, and the balance of the year, we're excited about the momentum that we're seeing from our new initiatives.

In the retail channel, we will continue to drive our full price selling initiatives and are optimistic that comparable store sales will be positive by the end of the third quarter.

We will also begin rolling out our small store visual presentation and SKU rationalization strategies based on the early successes we have seen in our first test stores.

In the direct to customer channel, we will continue to implement our catalog redesign strategies, in addition to refining our catalog circulation plans, including channel specific birthing and frequency optimization.

Also in the back half of the year, we will be expanding our partnership with CBS by participating in a promotional DVD campaign that features CBS celebrities presenting innovative cooking ideas from our New York flagship store.

The DVD will be distributed in both retail and direct to customer channels.

We will also continue to receive ongoing national publicity from the five-minute cooking school series that is taped at our Columbus Circle flagship store.

This series continues to provide significant brand exposure, promotes the brand's authority in home cooking and entertainment.

Let me now turn the call over to Laura Alber to discuss the Pottery Barn brands.

Thank you, Howard.

Good morning.

I would like to first talk about the Pottery Barn brand.

We are very pleased with the performance of the Pottery Barn in the second quarter as net revenues increased 11.3%, versus a robust 23.2% increase in the second quarter of last year.

A positive consumer response to both core and seasonal merchandise particularly in furniture and textiles and a higher instock position on core furniture inventories drove this year-over-year increase across both channels.

As discussed in our previous call, however, we did take markdowns throughout the quarter to move through seasonal inventories in outdoor furniture and entertaining.

In the retail channel, comparable store sales for the second quarter increased an impressive 5.6% on top of a 10.2% increase in the second quarter of 2004.

The direct to customer channel also delivered strong growth during the quarter, driven by successful catalog and Internet only merchandising initiatives and strong momentum in E-commerce.

During the quarter, unique visitors to our website increased 8% and conversion rates continued to exceed industry norms.

We also significantly expanded our electronic direct marketing initiatives, including E-mail campaigns and paid search.

We continue to be encouraged by the multichannel potential of online search.

As we look forward to the third and fourth quarters we are very encouraged by the strong consumer response to our fall merchandise assortment, which was introduced in late July.

Thus far, in the third quarter, key merchandising categories, especially furniture and textiles are delivering positive year-over-year sales growth.

We are also focused on peak season execution and will be continuing to leverage and drive the following brand-building initiatives.

Adding one major transitional force set in the third quarter in addition to increasing the scale and newness of our existing floor sets, improving our holiday gift giving assortment, maintaining our instock positions to minimize lost sales, and expanding our online marketing initiatives to drive increased traffic to both our retail and direct to customer businesses.

I would now like to talk about the Pottery Barn Kids brand.

In Pottery Barn Kids, second quarter net revenues increased 9.9% versus a 15.7% increase in the second quarter of 2004.

A positive consumer response to both core and seasonal merchandise particularly in furniture and textiles drove this year-over-year increase.

This increase was partially offset, however, by lower-than-expected nursery sales, which resulted from quality issues on certain crib inventories.

As furniture and textiles exceeded our expectations again this quarter, order fulfillment rates continued to run substantially below targeted levels.

Although our vendors are aggressively working to replenish our instock positions on these key SKUs we do not believe that we will reach our targeted inventory levels until the fourth quarter.

In the retail channel, comparable store sales in the second quarter increased 4.1%, and the performance of new stores was very strong.

We are particularly encouraged by the ongoing success of our new bedding and gift-giving assortments, in addition to the renewed strength of our decorative accessories.

In the direct to customer channel, sales growth continued to be driven by direct to customer only merchandising initiatives and a strong performance in E-commerce.

E-commerce growth continued to be fueled by a substantial increase in electronic direct marketing, combined with increased traffic to the website.

As we look forward to the third and fourth quarters we are encouraged by the early consumer response to both our core and seasonal merchandising strategies, including back to school gear.

To date, third quarter year-over-year sales growth in all merchandising categories is positive, and we are very optimistic about our seasonal and gift-giving assortments.

In retail in the back half of the year, we will be adding one additional floor set between Halloween and Christmas to keep our seasonal messages fresh throughout the holiday season.

We will also be substantially expanding our holiday gift assortment to include a greater number of gifts for all age groups.

I would now like to talk about PBteen.

As we anticipated in our last conference call, the second quarter continued to be challenging for PBteen, due to a weak product offering, and weak presentation in the spring and summer catalogs.

Although we did see positive year-over-year sales growth, it was not the growth we had originally planned based on our catalog circulation increase.

What is encouraging, however, is the immediate improvement in consumer response that we saw when we dropped our back to school catalog in late July, which incorporated many of the changes we had discussed in our last call.

As we look forward to the back half of the year, we remain confident in our growth strategy in this brand, including introducing new merchandise categories, and aggressively pursuing the significant opportunity we identified last year in holiday gift-giving.

In both our fall and holiday seasons, we will substantially increase our catalog circulation in addition to our direct -- electronic direct marketing as we continue to leverage our database and identify new customers for the brand.

We also plan to remain proactive in building new marketing strategies that will increase teen interaction and further enhance the mind share of the brand.

We have seen impressive results from our own internal initiatives including contests, surveys, and sweepstakes, and we'll be increasing our activities in these areas in the third and fourth quarters.

Despite the short term product and presentation issues that we saw in the first half of 2005 we remain very confident in the long term growth potential of PBteen and its role in our life stage marketing in the Potter Barn brands.

I would now like to open the call for questions.

Thank you very much. [OPERATOR INSTRUCTIONS] Our first question today will come from Neely Tamminga with Piper Jaffray.

Great.

Thank you.

I just had a question here as it relates to gross margin guidance going forward, Sharon.

I understand that the daily store replenishment program is probably more expensive because of the increase in transportation costs, but just wondering what your guidance is, is there a particular level of gas prices that your guidance is predicated on?

And then peeling back the merchant on Q2, the differential between your beginning of quarter expectations, and where gross margins actually came in, is the differential really related more towards the markdowns at Pottery Barn or was it more related to the daily store replenishment program.

Actually, Neely, I am going to address your Q2 question and then address the future guidance.

As it relates to the Q2 guidance shortfall -- margin shortfalls related to our guidance, approximately 30 basis points of that shortfall was driven by the inventory disposition strategy in Hold Everything.

And then we did see higher-than-expected markdowns in Pottery Barn not due to the markdowns on the outdoor furniture so much, but more due to the fact that Laura made a decision in all of the Pottery Barn brands to clear her seasonal merchandise earlier than we had anticipated because they wanted to set the fall floor set with a very clean aesthetic on the floor, so I can let Laura speak more to that if people have further questions about that.

But really, 30 basis points of the mix was driven by Hold Everything.

As it relates to the issue with gas prices, we are seeing fuel surcharges in every aspect of transportation in the Company today and we believe that based on the volumes that we are currently doing and the maximization that we have achieved in cubing out trucks, containers, et cetera, that we are -- our margin guidance reflects where we expect to be with an assumption that we do not see any relief in fuel prices.

We have some caps on our fuel price increases in several of our contracts, but again, within a range, we feel that our guidance adequately reflects where the market is saying fuel prices are going today.

Next we will hear from Lauren Levitan with SG Cowen.

Thank you.

Good morning.

Sharon, could you also elaborate on the variance in the second quarter to the original DTC revenue guidance?

And then separately, I was hoping you could discuss where the Company stands in terms of the life cycle of investments in the emerging brands, with Williams-Sonoma Home stores starting this quarter, and West Elm, substantially ramping up, is it safe to assume that this year could represent the peak level investments in the emerging brands relative to the revenues they generate?

Thanks very much.

Lauren, I will take your first question, which is the shortfall in our guidance on DTC revenue.

That short fall was primarily driven by two thing, the first was that we had a greater number of customer orders in transit at the end of the quarter.

So from a revenue recognition point of view, we had sales that came very late in the quarter, and they were not delivered by the end of the quarter.

The second contributor was a shift, if you look at our guidance on retail, we substantially exceeded our retail guidance, but we had a shortfall in DTC.

So versus our guidance we saw a shift in consumer behavior in the Pottery Barn brand.

Also, I think it goes without saying that we also had a shortfall due to the performance of Hold Everything during the second quarter.

But the two biggest contributors were the revenue recognition and the shift in channel sales in Pottery Barn.

As it relates to the investment in the emerging brands, what you call the life cycle, Lauren, I don't believe that you can say that.

Our guidance for 2006, we've got our high level guidance out there which says that we're going to be in low double digits to mid teen revenue growth, and mid teen to high teen EPS growth, when we think about that, we are considering in that guidance an ongoing level of investment.

We're just now early in opening these stores.

We will have additional investments in merchants and inventory management teams and not to mention the actual store investment, the initial stores that we open predominantly in Williams-Sonoma Home or especially there will be some of our more magnificent stores and we would expect that there would be pressure from the margins due to that so I think that we are still early in our investment stages in the emerging brands and I think based on what we believe the potential of these brands are, it is extremely early in their life cycle.

So that's how we're thinking about it.

Next is Peter Benedict with CIBC World Markets.

Hi, Sharon.

Quick question.

Can you talk to us about how you think about share repurchase activity versus investing in the business in terms of do you see capacity, investing in the emerging brands, et cetera?

Just trying to get behind your thinking behind that decision.

Thanks.

Peter, as we think about share repurchase, I think there is one fundamental strategic point of view in the Company which is to the extent that we believe it makes sense, we want to return capital to our shareholders, and have a return to our shareholders.

That's a more strategic thinking about cash and share repurchase.

But as we think about investing in the business, I would tell you that our investments necessary in the business to drive the type of growth that we're talking about, we have our cash generation from the operations of the business are extremely positive and very strong, as you know.

And we believe that our cash flow is more than adequate to invest in the things that you mentioned, and then things beyond that.

So we expect that we will be generating excess cash.

The projections we have over the next several years, and that it would be very unlikely absent an acquisition or some other event that our cash flow would be more than adequate to continue a very strong share repurchase program.

Next we will hear from Michael Baker with Deutsche Bank.

Hi, thanks.

Good quarter.

Another sort of financial question like that.

What do you think happens with the stock option expensing next year?

Have you given guidance there yet?

We have not given guidance, Michael, on the expensing of stock options.

What I think is going to happen is it appears that companies will be expensing stock options.

I think as we think about the expense, we already made significant changes, which you can see in last year's annual report, in the level of stock options we were issuing.

It was actually I believe three years ago, that all employees below the director level were eliminated from the stock option plan, so we feel that we've made the changes necessary, and we're moving forward with the expensing as the rules become more clear.

Next we will hear from Charles Grom with J.P. Morgan.

Thank you and good morning.

It looks like for the second consecutive quarter your gross profit margin strength came largely from better shipping expense management.

As we look out to the balance of the year, how sustainable is this going forward?

I believe that we have seen strength there for many quarters and we would expect to continue to see benefits, and I think what is a great call-out that was mentioned earlier by Neely is that these benefits are coming even when we are taking significant charges on the fuel surcharges.

So the operational improvements that we have made in the business, which by the way is a supply chain issue, but it also comes greatly from the point of product design, to the ultimate customer delivery, we are making changes throughout our supply chains, to accommodate the benefits that we are currently receiving in our shipping margins.

So we feel very confident that we will be able to sustain those through the end of the year because we had several initiatives that we implemented earlier this year that have not -- we have not achieved the benefits of as of yet.

Rex Henderson with Raymond James and Associates has a question.

Thank you for this opportunity.

I wanted to ask you about the prepaid catalog expense line.

Although the year-over-year growth has come down this quarter versus the previous two quarters it is still a little higher than the sales.

I was wondering first of all can you quantify for me a little bit about, of the three components you mentioned how much they contributed to that growth?

And when do you expect to see that prepaid catalog expense growth kind of normalize and grow in line with DTC sales?

I think when you think about the prepaid catalog growth, you have to remember that what is left on the balance sheet is for next quarter.

So if you look at the high end of the range, in direct to customer revenue growth, for Q3, you see it at 15.9, and the catalog growth this quarter was 17.3.

But what Rex, drove the increase, we had substantial paper cost increases, and approximately 35% of your total balance is coming from paper costs.

So that increase is above and beyond your actual revenue growth.

In addition to that, last year, at this time, we had virtually very little costs on the balance sheet for Williams-Sonoma Home because the Chambers catalog had been fully amortized off and the Williams-Sonoma Home catalog production costs had not occurred yet.

So as a result of that you basically have almost totally incremental costs on the balance sheet this year for the Williams-Sonoma Home catalog so that is driving it as well and then we had a few timing differences on the West Elm Pottery Barn and teen catalogs which you are always, by the way, going to have.

Everything every quarter doesn't change.

I would say in 2006, we will continue -- we should see more inline growth in prepaid catalogs because we don't -- because the Williams-Sonoma Home catalog sales growth should be more in line with the growth in the actual catalog costs so we would expect to see it more normalized in '06.

Our next question will come from David Magee from SunTrust Robinson Humphrey.

Hello?

Mr. Magee, your line is open.

Please go ahead with your question.

Hello?

David Magee, your line is open.

Please go ahead.

Yes, hello, this is Kris Raplejay on the call for David this morning.

You can hear me now?

Yes, hi, Kris.

Sorry about that.

Just a follow-up question about DTC, it looks like the ranges for both the third and fourth quarter are up slightly from the ranges that you gave in last quarter and I was wondering if you could give some more color to that increase?

Absolutely.

Our increase in our DTC revenue guidance is being driven by increased sales in Pottery Barn based on the strong consumer response that we're seeing to the fall Pottery Barn assortment.

Especially in furniture.

In addition to that, when you look at the Q3 numbers, the revenue recognition issues that we saw in Q2, those will flow over into Q3.

So those are really the two key drivers, Kris.

Next we will hear from Colin McGranahan with Bernstein.

Good morning.

Thank you.

Actually two quick questions.

One, Sharon, if you could just do a variance analysis as well on SG&A, obviously some nice flexibility looking at I think originally 130 to 150 basis points of deleveraging came in only at 52, obviously revenues came in a little bit toward the lower end in total, so some expenses had to come out.

What did you cut?

You mentioned leverage in employment costs.

Did you actually reduce store level labor?

And where did that additional better-than-expected leverage come from?

That's the first question.

And then secondly, can you talk about the more strategically, as we think about West Elm and the growth of the circulation, what is the overlap today on West Elm's circulation in terms of households versus Pottery Barn.

In other words, what percentage of the West Elm circ actually also received a Pottery Barn catalog and how do you see that going forward?

Colin, I will take the first question and then I'm going to let Pat Connolly discuss circulation for West Elm.

On your question regarding the SG&A and the favorable performance that we had in SG&A in Q2, that was primarily driven by lower than we had expected catalog production costs and then as you mentioned the cost control initiatives that we had in the corporate area.

No cuts.

Just the ongoing management.

But we had expected to see substantially higher increases in paper costs and actually other cost aspects of the catalog.

We forecasted or projected that.

And clearly, they did not materialize.

So we're very pleased with that.

And I also think that that is very attributable to some of the contracts we have in place, et cetera.

So I think it is very good news, and we expect to see some of that continue throughout the balance of the year.

I would now like to ask Pat to address your question regarding West Elm's catalog circulation, and how that crosses over with Pottery Barn.

Colin, on West Elm circulation, there is some overlap with Pottery Barn but we target the catalog to different segments of our database.

Also, on West Elm the Internet business is very strong.

It is a very significant part of the total DTC business.

But we're seeing very good growth in our customer initiatives on West Elm overall and very little if any cannibalization between West Elm and Pottery Barn when we mailed the West Elm catalog to people who have received the Pottery Barn catalog.

At this time, we will take a follow-up question from Lauren Levitan with SG Cowen.

I was hoping Howard could elaborate on the small store initiatives.

I know you mentioned that you were planning to roll those out.

Maybe you could give us a little better sense of how those stores have been performing and what the roll out plans are going forward?

Thank you.

Laura, the -- we've only done a handful.

So we only have a few of the stores done.

We are seeing good results.

They were better at the beginning, in the first store, than they are now, although that shopping mall is also having troubles, it's stones down here in San Francisco, our store in Cherry Creek is beginning to comp up.

So we know it is right.

We also have some assortments that are not complete.

Our tabletop assortments, the whole redo of that is as I've said before, really won't be in place until after the first of the year.

We will have a little bit in there this fall.

What we are seeing, though, is some adjacency changes that are having a very significant impact on certain categories of goods.

So our current plan is to cover all the stores by the first of the year with some degree of changes.

Now, most of that will just be changing merchandise assortments and some signage, that are over the cook ware or tabletop, or just those round blade signs that we have up there on the wall would be the only expenditure.

And then we just move goods around.

So we can accomplish that in all those stores before we enter the Christmas selling season.

And that's our current plan.

Alan Rifkin with Lehman Brothers is next.

Yes, Howard, with respect to the Williams-Sonoma division, you said that you accelerated the markdowns within the quarter.

Can you maybe comment on further markdown activity in the third and fourth quarter?

And also comment on inventory levels, where are they versus your plan at this point?

I think you might be talking about Pottery Barn, not Williams-Sonoma.

Because we operate on about half the markdowns that we had last year.

So is your question directed to Laura and Pottery Barn where they do accelerate markdowns?

We did just the opposite.

Hello?

Just one moment, Alan's line will be open.

Mr. Rifkin will rejoin us in one moment.

Hello?

Hello, Alan, did you hear my answer?

Yes, I'm sorry, the question was directed toward Laura with respect to Pottery Barn.

Laura, can you maybe comment on your inventory levels within that division specifically and how you for markdown activity going forward?

Sure.

For the summer season, we had seen a slower start to our outdoor furniture business than we expected.

And the business really gained momentum towards the back half.

And as a result, we had additional inventories that we needed to mark down before we went into the fall season.

And I felt that it was very important to go into the fall season with a clean floor set of fall so that the customer could clearly see the statement that we're making which they're reacting very positively, to, by the way, without a lot of noise from summer markdowns.

So we did take the markdowns deeper and faster than we have in the past.

And as we go into Q3, I feel good about where we are in terms of clearing through what is left of that merchandise, and focusing on regular price selling.

Our next question will come from Kristine Koerber with JMP Securities.

Yes, hi.

Just a follow-up question on SG&A.

Maybe you can talk about how much more -- you've been pretty good as far as tightening overhead costs over the past couple of years, I mean how much more room is there really to tighten costs on the SG&A line as far as overhead goes?

And then Laura, maybe you can talk about the catalog circ increase planned for Pottery Barn teen.

How much of an increase are you looking for?

Thanks.

Kris, let me address your first question which is the SG&A question.

We will continue to maintain our cost containment initiatives in SG&A, and as we have sales growth, we should be able to see leverage.

As we reach certain levels of growth, certainly we will have to make additional investments going forward and our guidance over the next several years, over the three-year guidance we've given, assumes that we would have to do that.

For instance, eventually, you are going to need additional corporate office space.

And things of that nature.

But overall, organizationally, we remain committed to our SG&A initiatives, and are very optimistic that we can continue to contain them going forward.

As it relates to circulation, on Pottery Barn teen, we do not give specific circulation by brand.

But as Laura mentioned, in her speech, she did say that she was increasing her circulation in the back half of the year.

So that is how we're thinking about it.

But we don't give specific guidance on circulation.

We have time for one final question.

And that final question will come from Michael Novak with Frontier Capital.

Hi, just a couple of quick questions on Hold Everything.

How much is that division costing the Company on a full-year basis?

And why does the market -- I know you put the growth on hold, but why does the opportunity there outweigh the financial and managerial distractions?

And then lastly, would it be possible to carve out the division for a possible sale?

Thank you.

Okay.

I will take that, Michael.

We don't give specific guidance on brand by brand like that.

Our answer is real straight forward.

We are evaluating the merchandise 2004, 2005, we think we got out in front of ourselves in 2005, with the merchandise, made some changes too quick, and we are going to look at the holiday assortment and then we will step back and see all of our channels, and decide what to do with it.

It is way to early to discuss any of the other things that you're talking about so that is kind of where we are.

Thank you very much.

That is all the time we have for questions today.

I will now turn the call over to Mr. Ed Mueller for closing communities.

Well, we would like to thank all of you for joining us in our second quarter conference call.

We are really proud of our results we discussed today.

And excited about the opportunities that lie ahead for us in the remainder of 2005 and particularly beyond that.

We appreciate your time and interest and look forward to our next call next quarter.

And have a great day.

That does conclude our conference call.

Thank you very much for joining us today.