Williams-Sonoma Inc (WSM) 2006 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Willams-Sonoma, Incorporated second quarter 2006 earnings release conference call.

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

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

As a reminder, this conference is being recorded.

I would like to turn the call over to Steve Nelson, Director of Investor Relations at William-Sonoma, Inc., to discuss non-GAAP measures in the second quarter press release and forward-looking statements.

Please go ahead, Mr. Nelson.

Good morning.

This morning's conference call should be considered in conjunction with the press releases we issued earlier today.

I would first like to discuss the non-GAAP financial measures that are included in this morning's press release and today's conference call.

In our earnings press release this morning, we announced operating results for the second quarter of 2006 that included and excluded a $0.01 per diluted share net benefit from unusual business events and new accounting pronouncements in order to facilitate a meaningful comparison to our 2005 results.

Please see Exhibit 1 on the press release for a description of the effect of each of these unusual business events and new accounting pronouncements on our second quarter results.

In 2005, due to prospective implementation, there was no impact on new accounting pronouncements and only a fourth quarter charge of $0.07 for the Hold Everything transition.

For the remainder of today's call, we will be discussing our second quarter 2006 results and our quarterly and fiscal year 2006 financial guidance excluding the impact of these items and will refer to these results as non-GAAP.

As excluding these items creates non-GAAP financial measures as defined in Regulation G, a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures, and an explanation of why these non-GAAP financial measures are useful and how they are used by management, are discussed in Exhibit 1 of the earnings press release issued this morning and furnished to the SEC on Form 8-K.

I would now like to discuss our forward-looking statements.

The forward-looking statements included in this morning's 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, guidance, growth plans and prospects of the Company in 2006 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.

All forward-looking statements are based upon information available to us as of the date of this call.

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

I will now turn the conference call over to Howard Lester, our Chairman and Chief Executive Officer.

Good morning, and thanks for joining us.

With us today are Laura Alber, our President, Pat Connolly, our Chief Marketing Officer, and Sharon McCollam, our Chief Operating and Chief Financial Officer.

But before we discuss the second quarter, I want to congratulate Laura and Sharon on their recent promotions and announce one additional promotion.

Dave DeMattei, our President of Emerging Brands, has been promoted to the position of Group President, West Elm, Willams-Sonoma and Willams-Sonoma Home Brands reporting directly to me.

We believe this alignment of the Willams-Sonoma and Willams-Sonoma Home brands is a strategic first step in leveraging the growth potential of the Willams-Sonoma family of brands.

They will be joining our conference calls beginning next quarter.

Now focusing on our second quarter results, we're pleased to deliver to our shareholders another consecutive quarter of strong financial performance despite an overlying softness in top line growth.

In the second quarter of 2006 on revenue growth of 6.4%, non-GAAP diluted earnings per share increased 11.5% to $0.29 per share.

We're proud of our earnings performance and believe it once again demonstrates the operational flexibility and financial discipline that exists within the Company.

In our core brands, Willams-Sonoma, Pottery Barn and Pottery Barn Kids, net revenues in the second quarter of 2006 increased 5.9%.

Although Laura and I will discuss the individual performance of each of the brands later in this morning's call, the performance of the Pottery Barn brand fell below our expectations for the quarter.

In our emerging brands, including West Elm, Williams-Sonoma Home and PBTeen, second quarter net revenues increased 33.5%.

In the West Elm brand, we continued to see strong year-over-year revenue growth driven by incremental revenue from new stores, improved catalog response, and increased traffic in e-commerce.

In merchandising, we saw continuing strength in furniture and textiles in addition to decorative accessories and lighting.

Also during the quarter we relaunched our e-commerce Web site on a new IBM platform and introduced enhanced functionality bringing an improved online shopping experience to our customer.

In the Willams-Sonoma Home brand growth in the second quarter of 2006 was driven by incremental sales in the retail channel from new stores.

At the end of the quarter, we had five stores operating at an average of 15,000 square feet per store.

In the direct to customer channel, consumer demand was in line with our lowered expectations and furniture continued to drive our growth.

In early August, we launched our new Willams-Sonoma Home e-commerce Web site which allows our customer to preview the entire furniture assortment in all fabrics and frames through a comprehensive furniture viewing tool.

Consistent with our strategic initiative to drive profitable top line revenue growth, we are continuing to invest in the growth opportunities that we believe will provide the greatest returns.

Although we think that we are facing a difficult macro retail environment, we are continuing to execute against across the following growth initiatives across brands between now and the end of the year.

We're increasing retail lease square footage by approximately 6%, expanding catalog circulation by approximately 5%, substantially increasing electronic direct marketing and paid search, upgrading functionality on our e-commerce Web site and implementing for the first time the ability to issue and redeem gift cards in our direct to customer channel.

Consistent with our second strategic initiative to improve profitability in our core businesses, we expect our 2006 non-GAAP pretax operating margin to be flat or slightly above last year, despite the substantial revenue and earnings shortfall we are projecting in the Pottery Barn brand.

To drive this increase, we'll remain focused on the following operational initiatives for the remainder of the year: Implementing initiatives throughout the supply chain to reduce returns, replacements and damages; enhancing our daily store replenishment program in the New York metro area where both customer delivery and store replenishment can be efficiently combined; and leveraging the in sourced East Coast furniture hub to enhance the furniture delivery experience for our customers and reduce our furniture delivery costs.

In the second quarter of 2006 total furniture sales on a trailing 12-month basis increased to approximately 29% of net sales versus 28% in the second quarter of fiscal year 2005.

Consistent with our strategic initiative to enhance shareholder value, we remain committed to returning capital to our shareholders through dividends and share repurchase, including the 5 million share stock repurchase program we announced this morning and delivering on the commitments that we have made to our shareholders.

As we look forward to the third and fourth quarters, we, like many retailers, have begun to see a softening in consumer demand, especially in our Pottery Barn brand.

When we last updated our guidance in mid July, we believed that the softness in Pottery Barn was specific to the execution of our summer merchandising strategy.

Today, however, based on continuing softness that Laura will discuss later, we think there is a greater microeconomic issue affecting this customer.

Therefore, as we look forward to the back half of the year, we're doing so with a very cautious outlook.

Based on this outlook and our concern that these macroeconomic issues could also affect our other brands, we are staying focused on the things that we can control;

Customer service, visual merchandising, inventory management and operational execution.

And we are aggressively capitalizing on the marketing opportunities that we believe exist with our multi-channel strategy.

We are also remaining extremely flexible in our decisions in controlling our expenses to mitigate the impact on the bottom line.

Although we believe there could be potential upside from the successful execution of these initiatives, the impact of a greater microeconomic issue is difficult to forecast.

Therefore, we have reduced our fiscal year 2006 guidance to reflect the volatile trends that we are seeing today and our increasingly cautious outlook for the balance of the year.

In this revised guidance, we are projecting a year-over-year increase in net revenue of 6.1% to 7.5% and a non-GAAP diluted earnings per share increase of 6.9 to 10.6.

I'd now like to turn the call over to Sharon to further discuss our second quarter results and provide additional insight on our revised 2006 guidance.

Sharon?

Thank you, Howard.

Good morning.

As a reminder, please note that in our discussion of our second quarter results and fiscal 2006 guidance all financial references are on a non-GAAP basis described by Steve earlier in the call.

In the second quarter of 2006 non-GAAP diluted earnings per share increased 11.5% to $0.29 versus $0.26 in the second quarter of 2005.

Despite a softer top line than we would have expected, strong merchandise margins, combined with tight expense controls and higher interest income, allowed us to deliver better than expected earnings.

And for the 24th consecutive quarter we met or exceeded the earnings per share guidance we provided to our shareholders.

Net revenues in the second quarter of 2006 increased 6.4% to $826 million.

Excluding the negative impact of the Hold Everything shutdown, net revenues in the second quarter increased 8.1% driven by a 7.8% increase in the retail channel, including a 1.2% comparable store sales increase and an 8.4% increase in the direct to customer channel.

Catalogs circulated during the quarter increased 2.1% while paid circulation increased 7.6%.

Internet revenues increased 26.9%.

Gross margin as a percentage of net revenues on a non-GAAP basis in the second quarter increased 30 basis points to 38.3%, primarily driven by a year-over-year improvement in cost of merchandise across all core brands.

This improvement was partially offset by increased occupancy costs driven by the retail rollout of our emerging brands and increased shipping costs.

SG&A expenses as a percentage of net revenues on a non-GAAP basis in the second quarter increased 30 basis points to a 31.9% rate, primarily driven by lower catalog productivity in the Pottery Barn brands and increased employment in the emerging brands.

These increases were partially offset by reductions in our other general expenses.

Net interest income in the second quarter increased $3.1 million to $3.5 million reflecting higher average cash balances and higher interest rates.

I would now like to discuss significant second quarter 2006 year-over-year balance sheet variances.

All comparisons are versus quarter end balances at the end of the second quarter of 2005, which are included in this morning's press release.

Cash at the end of the second quarter increased $34 million to $187 million.

This is the highest second quarter balance in the history of the Company despite returning more than $158 million to our shareholders through share repurchases and dividends over the past 12 months.

Merchandise inventories at the end of the second quarter increased 8.5% to $566 million.

This increase was only slightly above our previous guidance due to the unexpected sales shortfall in the Pottery Barn brands.

Accounts receivable at the end of the second quarter increased $28 million to $75 million.

This increase was primarily due to the timing of store construction and the associated receipt of tenant allowances from landlords.

Prepaid catalog expenses at the end of the second quarter increased 15.8% to $64 million.

This increase was primarily driven by higher pace counts on catalogs circulated, increased paper inventory, and higher postage and paper prices.

Customer deposits at the end of the second quarter increased $10 million to $175 million.

This increase was primarily driven by a sales growth related increase in unredeemed gift certificates and gift cards.

This increase was partially offset, however, by the recognition of $12.4 million in income from a change in estimates in unredeemed gift certificates.

I would now like to discuss our third and fourth quarter earnings per share guidance.

Based on the unexpected softness that we have seen in our Pottery Barn fall season since late July, and the fact that we believe that we are operating in a more challenging macroeconomic environment, we are approaching our third and fourth quarter guidance with a higher level of caution than previous quarters.

But it is difficult to predict how much caution is appropriate, especially when the changes can occur so quickly as they did in the second quarter.

Although we are taking actions to react to these changes, we do not believe it is prudent to assume that all of these initiatives will be successful in the timeframes that we have to respond.

Therefore, in both the third and fourth quarters, we have reduced our revenue and earnings guidance, primarily in the Pottery Barn brand, to a level that we believe reflects the most likely range of outcome, absent of further deterioration in the overall macroeconomic environment.

In the third quarter we have reduced our revenue guidance by approximately $45 million and our non-GAAP diluted earnings per share guidance by 9 to $0.11.

The impact in the third quarter is significantly higher than the fourth quarter because the Pottery Barn sales trend softened so quickly that we had very little time to adjust our top line strategies.

This particularly affected our direct to customer business because once the catalogs were mailed at the beginning of the quarter, there was little flexibility in the short-term to influence sales or adjust catalog advertising expenses.

In the fourth quarter we have reduced our revenue guidance by 35 to $40 million and our non-GAAP diluted earnings per share guidance by 2 to $0.04.

This impact is significantly lower than the third quarter especially on earnings, due to our ability to modify our short-term marketing strategies and execute against a more conservative operating plan.

Other the last six years, we have demonstrated our ability to drive profitable revenue growth in difficult economic times.

Although we are going to be challenged in the third and fourth quarters, we will continue to drive our business by leveraging our key competitive advantages, the strength of our brands, our multi-channel strategy, and our operational execution.

And we will remain focused on one of our highest priorities, delivering on the financial commitments that we have set for ourselves with you, our shareholders.

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

Thanks, Sharon.

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

Net revenues increased 5% and the consumer response to our Mother's Day and our outdoor themes was very strong.

We also saw significant improvement in our merchandise margins due to substantial increases in our full-price selling and successful sourcing initiatives.

During the second quarter, we continue to focus on retail execution by increasing the frequency of our in store events, including book signings by well-known cookbook authors and cooking class offerings.

In the retail channel we had a 2.3% comparable store sales increase, which was an acceleration from our first quarter rate.

We also made significant progress on our small and mid-size store visual merchandising initiative, completing the conversion of 41 stores during the quarter.

In the direct to customer channel, successful online marketing initiatives, including paid search and electronic direct marketing, drove a 12.5% increase in e-commerce traffic with strong growth in the online bridal registry service.

From a merchandising perspective during the second quarter, we saw continued strength in our high-end assortment, including cookware and cutlery along with strength in our outdoor and seasonal foods.

This strength, however, was partially offset by the tabletop category, which despite solid comp growth in the core tabletop assortment was offset by fewer seasonal markdowns.

As we look forward to the back half of the year, we're excited about our 2006 merchandising initiatives, including the introduction of several new innovative products in cookware, cutlery and electrics that will be exclusively available only at Williams-Sonoma.

In the retail channel, we'll continue to roll out the visual merchandising upgrades to a greater number of our small and mid-size stores.

We'll also be focusing on the execution of our year-round entertaining and gift-giving strategies, which are a significant opportunity as our customer prepares for fall and holiday entertaining.

In the direct to customer channel, we will continue to appeal to the interest of our customers with themed cooking ideas from cuisines throughout the world.

In addition, we'll capitalize on the traffic generating aspects of our version catalogs to optimize the coordination of our catalog mailings with key holidays.

We'll also continue to drive growth in the e-commerce channel by increasing electronic direct marketing and expanding our paid search initiatives.

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

Laura?

Thank you, Howard.

Good morning.

I would like to start this morning by talking about the challenges we are facing in the Pottery Barn brand.

Pottery Barn had a difficult second quarter.

During the quarter, net revenues in the brand increased 3.1% versus original expectations in the high single-digits.

Initially, we thought that the majority of the shortfall was driven by things we could control including markdown strategies, the balance between seasonal and core decorating themes and dining table availability issues.

Today, however, after seeing continued softness after the launch of our redesigned fall catalog, we think there are macroeconomic issues affecting us as well.

Although certain merchandising categories performed better than we expected, like furniture and decorative accessories, the growth we saw during the quarter was driven by the strength of our outdoor program, including our separate outdoor catalog.

In the retail channel, comparable store sales for the second quarter decreased .2% versus a positive 5.6% increase in the second quarter of 2005 with the majority of the softness versus our expectations beginning in the month of July.

In the direct to consumer channel, the trends were similar to retail, except the softness began in late June and continued throughout July.

As we now look forward to the back half of the year, recognizing that our fall floor set and catalog had been in our retail stores and customers' homes for more than four week, we are seeing further softness in sales in all channels.

Based on this softness and the difficult year-over-year comparisons we are facing, we are substantially reducing our revenue and earnings projections for the back half of the year.

We believe this reduction is appropriate based on current trends and reflects the continued weakness in consumer response to our current merchandise offering, as well as the continued uncertainty in the macroeconomic environment that we think is particularly impacting the Pottery Barn consumer.

We do not, however, accept that we cannot improve these forecasted results so we are aggressively working on the following initiatives.

First, we have recently changed the presentation of our fall merchandise assortment in both our stores and our catalogs to recenter our marketing message on core Pottery Barn positioning with a primary focus on exclusive design, great value, and great quality.

While the details of these changes are competitive in nature, our early results indicate a positive consumer response and we will continue to implement new strategies as we better understand the changes in our consumer's buying pattern.

We will also be better synchronizing the holiday flow of product to our stores [to] the timing of our customers' needs in addition to more closely coordinating our catalog mailing schedules to drive increased store traffic.

To mitigate the impact on inventory levels due to our lower sales projections, we have taken specific actions across all areas of our product flow, including reducing inbound receipts and accelerating liquidation strategy for overstocks.

We also will remain intently focused on the following marketing and operational initiatives that we believe are significant opportunities for the business as we progress through the year: Promoting our furniture quality and time to delivery as key competitors' advantages; strategically using electronic direct marketing and online page search to drive traffic to all channels; maintaining our in stock positions to enhance customer service and minimize lost sales and marketing our design authority through new initiatives including a new decorative segment on the CBS Morning Show and a partnership with Benjamin Moore to promote Pottery Barn as a color authority for the home.

We are optimistic about the potential impact that of each of these initiatives can have on our back half results and are confident in our ability to execute against them.

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

We are extremely pleased with the growth acceleration we saw in the Pottery Barn Kids brand in the second quarter of 2006.

Net revenues increased 16.8% topping a 9.9% increase in the second quarter of 2005.

Positive growth across all major merchandising categories with particular strength in textiles, furniture and decorative accessories drove this better than expected year-over-year increase.

In the retail channel, comparable store sales for the second quarter increased 8.1% on top of a 4.1% comparable store sales increase in the second quarter of 2005.

Performance of new sources also very strong.

During the quarter, we increased the number of our successful in store family events, grew our baby and gift registry and expanded our seasonal merchandising.

The direct to consumer channel also delivered strong growth during the quarter, driven primarily by better than expected e-commerce performance.

Traffic on our Web site increased 12.7% and we continued to see impressive conversion rates.

As we look forward to the third and fourth quarter, we are encouraged by the ongoing momentum in both the retail and direct consumer channels and the early customer response to our bedding theme, furniture suite collections and imaginative, decorative accessories.

As we progress through the year, we will continue to focus on the following growth initiatives: Improving our in stock position to reduce lost sales and re-establish service levels expected by our customers; expanding our nursery offerings in all three channels, including infant apparel to broaden our registry assortment and complete the customer experience; differentiating our gift assortment to establish top of mind awareness of Pottery Barn Kids as the destination for gift giving for children; and capitalizing on personalization trends through the expansion of or direct to customer assortment.

We will also continue to capitalize on the favorable demographic trends that we believe are important to our business, including the significant increase in new birth to mothers over the age of 35.

This demographic segment is very important to us due to their higher income and greater desire for quality in children's home furnishing.

We believe that the successful execution of all of our brand building initiatives, in addition to the favorable demographics, will allow Pottery Barn Kids to further establish its market position as the authority in children's homes furnishing.

I would now like to talk about PBTeens.

We are very pleased with the performance of PBTeens during the second quarter, delivering an impressive 8.2% year-over-year revenue increase.

What was particularly encouraging is that these results were driven by new product offerings and presentation, both of which were key initiatives to the brand as we entered the year.

From a merchandising perspective, we again saw strong performance in all furniture categories.

A consistently on brand presentation in addition to increased newness drove these results and attracted new customers to the brand.

As we look forward to the third quarter and the balance of the year, we are encouraged by the initial consumer response to our fall merchandise assortment, including back-to-school offerings and are excited about our expanded holiday gift assortment that was specifically designed to appeal to the teen point of view.

During the remainder of the year, we'll be substantially increasing year-over-year catalog circulation and significantly expanding our electronic direct marketing initiative.

We continue to believe that electronic direct marketing represents a significant opportunity for this brand as nearly 60% of its revenues are being generated in the e-commerce channel.

I would now like to open the call for question.

Thank you, ma'am. [OPERATOR INSTRUCTIONS] We'll go first to Lauren Levitan with Cowen and Company.

Thanks.

Good morning.

I guess my question is for Howard and for Laura.

I was hoping you could give us a little bit more color on how you've concluded that the issues affecting Pottery Barn are of a macro nature when see such strong trends in Pottery Barn Kids and Teens and nice ongoing trend in Williams-Sonoma.

I'm just curious if you could comment on whether or not you think the competitive environment that Pottery Barn is facing is worse given the weakness of some players in that space or do you think that brand is potentially more susceptible to these macro factors?

And maybe Pat might have some commentary just within the customer database.

Are you seeing, you know, possibly some of the higher income households holding in there and lower kind of trade up customers really, you know, accounting for the shortfall?

So I guess it's a couple questions rolled into one, but largely just trying to get a sense of how you've reached the conclusion that with, you know, still decent trends in so many other businesses that in fact Pottery Barn's issues are macro related.

Thank s very much.

Lauren, I'm going to have Laura answer that question, Laura, could you take that question for her, please?

Sure.

As we look at our customer base we know and have always known that Pottery Barn has a different customer base than both, you know, Pottery Barn Kids and Teen, which you have a more affluent higher end customer and it is the 75,000 and over customer that we believe has been affected most dramatically by what's going on in the economy and that's consistent with, I think, all that we, have been all reading recently.

And we are also seeing based on our sales performance regionally in our stores that our top markets are performing better than some of the mid markets in our retail chain.

Also different from summer in Pottery Barn we're seeing a more consistent softness across merchandise categories than we've seen before and a very different trend in some of our core merchandise.

Same merchandise was selling at a very different pace only four months ago and that is clearly something that has shifted.

Lauren, it's Howard.

If I might add to that a little bit.

You know, I think, of course, we're not unaware of what's happening with other retailers.

I think mall traffic, my information is that mall traffic is down from where it was six months ago and the Pottery Barn customer, I think, is just uniquely maybe affected.

That would be the good news, I guess.

But we haven't seen it, obviously, as much in our upscale brand, maybe that customer right now is still, you know, above it financially and not affected as much.

But those are the kinds of things that are different today than they were in July when we were talking about this, when we thought that it was just an execution issue, all the evidence pointed to total execution on our part.

Now we're just seeing so much other evidence that makes you think that there has to be some macro sort of influence on what's going on.

I know, Sharon, you said the majority of the cut is related to revised Pottery Barn plans.

Can you talk about whether or not what you're seeing at Pottery Barn is causing you to rethink any of the inventory or marketing spend across the other brands as well?

Thanks very much.

Lauren, the majority of the changes in our guidance are related to Pottery Barn and then within a range, we also took into account the possibility that there could be effect across our other brands although we have not seen any.

And we believe that we've seen a slight level of volatility, but we've had ups and we've had downs and then they net out to where we expected.

So I think that we cannot say at this point that we've seen it in the other brands.

That's not to say that we didn't soften some of our expectations in the guidance because it is possible that this could move out of the Pottery Barn demographic and upward, but we were conservative as we approached it.

Great.

Thank you very much and good luck.

And we'll go next to David Strasser with Banc of America Securities.

I had two questions.

Number one on the SG&A, the savings that, you know, it looks like you're sort of bringing down this dollar growth in SG&A in the back half of the year.

I was just curious what areas and if any of that was customer facing?

And the second question kind of related, just looking at the share count, did you end up buying a lot of shares back towards the end of the quarter?

Just trying to understand the math and the ending share count how we could look at it to model it in the back half.

We did buy the shares back, Dave.

I'll take these questions.

On the share cap question the simple one, yes, the share repurchases we actually back loaded in the second quarter.

So that would be why you would see the very minimal impact on the share count.

In response to your question regarding the SG&A for the full-year guidance, as we look at our SG&A for the balance of the year, we are, obviously, as Howard said, being very cautious in our operating plans and watching the bottom line very closely but there are a couple of other contributors to that.

One is the fact that we will see higher income from unredeemed gift certificates as a result of our change in our estimate from seven years to four years on the breakage, and then we also have a significant reduction in our other general and administrative areas.

Those are the big contributors to it.

Additionally, we have the ability going into Q4 to adjust ad cost, to adjust our marketing strategies and to determine if there is softness on the top line whether or not we want to circ at the levels that we are currently forecasting.

When we drop these catalogs at the end of Q2 into Q2, they were already mailed.

You have very little flexibility in your reaction on the top line.

So this advertising leverage that you can obtain is very important and obviously reflected in what we expect to have happen for the balance of the year.

Thank you.

Just a follow-up.

Do you know -- can you give us the share count at the end of the quarter?

I guess it will be on the Q, right?

Since we cannot predict when we will repurchase shares, it's not really possible to do that.

Okay.

Thank you.

We'll go next to Chris Horvers with Bear Stearns.

Thank you very much.

Sharon, I was curious if you could talk a little bit more about your comp guidance in the back half of the year.

On a two-year run rate it seems like you're accelerating.

Are you expecting improvement in Pottery Barn results and is that partially promotionally driven?

And then secondarily, as you think about where the weakness has been in the consumer, it seems like housing related big-ticket items.

Sequentially how is furniture doing for you?

Well, as we said earlier, furniture has continued to be strong.

Howard mentioned in his prepared remarks that his strong categories in Willams-Sonoma Home and West Elm were furniture.

Laura also reiterated that in Pottery Barn Kids and Teens, you know, Teen had 18.2% growth driven heavily by furniture.

So in all of our brands we have continued to see strength in the furniture category.

As we think about the comps for the back half of the year, your question was, are we expecting to see a significant improvement in the Pottery Barn comp?

The answer to that question is not significant.

We are expecting to see some slight -- virtually no improvement or slight improvement in Q3 and very little in Q4.

So I think we've been very cautious there as we thought about Pottery Barn.

We are excited and I'll let Laura speak to Q4 and her holiday assortment and why they feel good about Q4, but, you guys, we're out at 0 to 2% comp.

And the drivers of that are going to come out of Willams-Sonoma and Pottery Barn Kids which have proven to be strong all year.

Howard can speak to Willams-Sonoma assortments and he mentioned in his prepared remarks the exclusivities that we have been able to negotiate with our vendors this year, we're very excited about them.

So we feel very competent that the comp guidance absent of further deterioration of the macro is conservative.

Laura, could you please speak to Pottery Barn for Q4 as you come into holiday?

Sure.

This Christmas, you know, we're building on the strength of what we saw last Christmas and then also taking into account what we're seeing from the customer right now and feel really well poised both in our decorating and our gift giving strategies for all channels.

And so last year you may recall that we ran out of some important holiday goods a little early last year so we have the opportunity to maximize those lost sales.

And the other key thing that I feel very good about is that we have been a little out of stock on our dining tables because we've oversold a few collections in particular.

And we will be getting back in stock and have very strong marketing for this category as we go into the time of year where our customer tends to buy a lot more dining tables in preparation for holiday get togethers.

And then Howard, would you like to speak to Willams-Sonoma as we enter their big holiday season which is actually Q3 and Q4?

Well, yeah, Sharon, as I mentioned in the earlier comments, you know, we have some exclusive goods this fall, which we're really excited about.

I think a lot of the visual presentations and the activities, the cookbooks and those things that I spoke about are going to be better this year than they were the year before.

The visual initiative that I've talked about for the last two years, we will have touched by the end of the fourth quarter almost all of the mid-size and small stores.

And we are seeing increased performance across the brand in those stores after those conversions have been made, so that's encouraging.

I think that that's going to be a big plus for us this fall.

So we have a lot of new products, a lot of new holiday food, which is a big driver for our gift business in the fall on the floor, we will have.

And new colors in a lot of our appliances, in our electrics business, our coffee business, particularly our high-end espresso machines have been a very strong category for us for the last year or so, and I expect that to continue to be so during this fall as an important part of our gift giving.

So I'm actually pretty excited about William-Sonoma, I think we're going to have a good fall.

The last thing, Chris, that I'd just like to mention and I know all of the analysts on the call are familiar with this.

We also have an extra day this year before Christmas, which for us, especially in the Willams-Sonoma brand, is really significant.

You pick up one shopping day in the quarter before Christmas and then, of course, you lose it afterwards.

But the net impact of that is comp points in our Company because Sonoma has such a significant ramp as does Pottery Barn, but it's much more significant in Willams-Sonoma and that's a really important factor when you look at that Q4 comp because you are picking up that day before Christmas.

Thank you very much.

And we'll go next to Scott Chiccarelli with RBC Capital Markets.

Hey, guys, how are you?

Had a question about the sales trends in the quarter.

I mean you guys revised your expectations with about three weeks left and then it looks like you kind of came in at the low-end on a total sales basis and a bit short on the comp.

Can you just help us understand, was there a significant falloff throughout July or were you expecting some sort of rebound that didn't occur?

Can you just help us understand the trends a little bit better?

Absolutely.

When we gave our guidance in July we had not yet set our fall floor set in Pottery Barn in the retail stores and the catalog was not in home.

Those did not go in home until about, that those two dates were around the 15th to the 20th of July.

So we had no visibility to the fall season in Pottery Barn at the time we gave guidance.

We did, in our guidance at the time in July, put a better trend than we had seen on the summer assortment because we really believed that what we saw in summer was related to some of the issues we felt were executional in the part of Pottery Barn.

So the big surprise to us, and it came pretty fast in the last couple of weeks of the quarter, was the fact that the consumer response was much softer than we expected to Pottery Barn's fall, both retail and direct to customer.

And actually in direct to customer, both channels.

So did you actually see the trend deteriorate further or you just didn't catch the rebound that you expected once you made the new mailing?

We actually saw the trend deteriorate.

It got worse.

Okay.

Thank you very much.

Next to Jack Murphy with William Blair & Company.

Morning.

Morning, Jack.

Just on the furniture component I wonder given the fact that your furniture has held up so well if you could just touch on why you think such a high average ticket category is doing relatively better in the Pottery Barn brand?

And then given what you've seen and how you feel about the macro impacting Pottery Barn, how you're viewing furniture in that business in the next, let's say, couple of quarters?

Okay, Jack, I'm just going to talk a little bit more broadly and then I'm going to let Laura discuss furniture in the Pottery Barn brand specifically because that's where it's so significant.

I think that as Howard mentioned and Laura mentioned earlier, what we have seen in our business consistently is that our high-end assortment is what is selling.

If you listen closely to Howard's comments about Willams-Sonoma, what has been strong, his cookware and cutlery, our high-end electrics have done well, then you look at Williams-Sonoma Home.

As I said earlier, furniture was strong.

Laura comes in and she's selling strong furniture in all three of her brands.

So what we have seen is a very high resilience to the high average unit sales that we, you know, the higher price point items.

So now, Laura, could you please address furniture specifically in Pottery Barn and how you're thinking about that for the back half of the year?

Sure.

First let me just clarify in Pottery Barn, furniture, although strong, is softer than it was before from a growth perspective.

It is still a very strong category for us, but it's not accelerating like it was four months ago.

So that's important to know.

In Kids it's more consistent with where we've seen it from a sales growth year-over-year.

Furniture, I believe is holding up better, first of all, it's a considered purchase and, as Sharon said, it's a higher purchase that's being made by our customer.

And you know, I think because our very strong vertical structure it's extremely difficult to compete with us on price and quality.

We've made a lot of investments here in the supply chain both on the customer service delivery as well as the quality of the furniture and building it to last and really having a differentiated line from anyone else in the marketplace.

And I think it's really clear to our customer, that value proposition in furniture and so they continue to come to us even though they may be spending less overall because I think we're positioned better.

And I speak for all brands when I say that in each one of their different market niches, I believe that we are positioned better than the competition.

You think that there are two distinct demographics of Pottery Barn shoppers and that the higher end part of the Pottery Barn shopper is still buying furniture but the low-end is not?

Well I think there's that, and we can see that from the stores, you know, we have, looking at which stores are doing better than others, but also, you know, again, it's not an impulse product.

Usually, you need a dining table, you need a dining table, you're buying one.

You can probably live without the bedding that you might have replaced more frequently before.

And so I do think that that also has a lot to do with it.

Final question just, Sharon, anything on potential markdown risk given some of the, you know, the weaker overall performance on the top line?

Well I think if you look at the details of our guidance, you'll see that we took down substantially our gross margins both in Q3 and Q4.

And those were taken down specifically to reflect the risk of markdowns in the Pottery Barn business.

So I feel that we're well covered there, Laura feels we're well covered there and I think we recognize that we're going to sell the inventory it's at what price.

Okay.

Thank you.

And to Elizabeth Armstrong with Alliance Bernstein.

Thanks.

[Inaudible] talked about with West Elm, could you just update us on the trends there?

Yes, I will let Howard speak to that.

Howard, could you speak to West Elm?

Sure.

Thank you.

Well, West Elm in the quarter, we saw strong business performance pretty much across the board.

We saw it in furniture, textiles, decorative accessories, the frames, the assortment continues to get better.

The fall assortment was just put in the stores a couple of weeks ago and I think it is a material step forward from the last assortment that we had in the stores.

It's just, just demonstrates the progress from a merchandising standpoint that we continue to make.

But keep in perspective that we only had 14 stores operating through the end of July and only six of these have been open for a year.

Those six stores, Brooklyn, Chelsea in New York, Oak Brook, Illinois, Corte Madera, San Diego, and Portland, Oregon, are all exceeding pro forma expectations.

Of the remaining eight stores, which have been open for less than nine months, I believe, we believe that they, too, on average as a group will meet or exceed our pro forma expectations in their first full year of operations.

So we're quite pleased.

We just opened, particularly good news to us, I think, we just opened a store in Henderson, Nevada, which is in Las Vegas, in the north side of Las Vegas, and it appears as though, I mean the first week, it's only been open a little over a week.

The first week, Sharon, what was it in the whole chain?

It was 11th or 12th or something like that?

Yeah, it was in our top 15 stores in the country.

Top 15 stores in the whole chain which was materially above the kind of opening that we expected given the research and kind of looking backward on openings of other stores, of the other 14.

So we were really excited about that, the store's continuing to perform at a very high rate.

So we're quite encouraged with West Elm.

The challenge for us is, as I've mentioned before, is finding the proper real estate, you know, in the right neighborhoods and in the right sort of hip, if there's such a thing, strip malls, but not the non-traditional malls.

So the space is just not as plentiful and it's more difficult to find, but we are aggressively looking for it.

But I think that in 2007 we'll probably be closer to ten stores that the 22 or 23 that we have talked about previously due to the real estate.

But not -- while our enthusiasm for the brand is higher than it was before.

Thank you.

And next to Mark Rowen with Prudential Securities.

Thanks.

I had a couple of follow-ups on Pottery Barn.

Number one, given the fact that your furniture was better than you expected, Laura, in that business, can I assume then that the average ticket at Pottery Barn was up and traffic was down more significantly than the sort of flat comp?

And then second, have you looked at the housing data regionally where, you know, for instance, California's been weaker than the rest of the country, although the whole country has been negative, and can you find any relationship between that and weakness regionally at Pottery Barn?

Thanks.

I'm going to let Laura address your question.

Laura, could you please take Mark's question?

Sure, Mike.

Yes you are absolutely correct that the average ticket continues to be higher.

And although we don't have traffic counters, you know, obviously the trends would therefore be lower.

In terms of correlating housing with stores, you know, we haven't really done that.

You know we could look at that, but I actually, you know, in just thinking about what you just said, I don't believe we'd see that dramatic of a correlation there, although, certainly, we are, as I said earlier, we are seeing in [inaudible] more affluent markets that we are doing better.

Okay.

Thanks.

And we'll go next to Rex Henderson with Raymond James.

Good morning and thanks for taking my call.

A couple questions.

I think they're related.

First of all the inventory at the end of the quarter what the makeup of that was and whether you sold through that at this point and whether there's still some inventory you'd like to clear out?

And secondly, on the gross margin guidance, can you kind of break out for me how much of that lower gross margin guidance represents merchandise markdowns, how much represents mix, how much represents logistics costs and deleverage there?

Kind of give me some idea of why that is as low as it is?

Okay.

Rex, as far as the inventory goes, as we said, when you look at our guidance for the second quarter and you look at where we actually came out, we were only $4 million above that guidance.

When we have issues or things we need to move, we take the markdowns and we move through the inventory and we are very clean right now in, really, all of our brands as far as summer goes.

So we do not believe we have any big risks associated with summer.

As we look at fall, we clearly have, within the guidance, played in a more conservative estimate of what we might need to do with markdowns because our margins have been very strong this whole year across all of our core brands.

I said it in Q2.

We have strong margins with lower cost of merchandising across all core brands.

In the guidance for Q3 and the back half of the year, if you're talking about the year-over-year variance, which I assume you are, because the only change in my gross margin guidance for the back half of the year as it related to the rate was due to the sales changes that we made.

There were no significant businesses issues, it was the sales changes and the reflection of the possibility of markdowns.

On the year-over-year question, the drivers of the year-over-year gross margin deleverage are coming from the retail rollout of the emerging brands and then we also have seen significant core brands occupancy increases, and the last would be in order of magnitude, the higher cost of goods sold due to the markdowns, which we expect in the guidance.

So those would be the way that you should think about the impact of those.

But we are starting with very strong initial margins and we feel like our guidance currently reflects the risk associated with the markdowns we'll need to take to clear the inventory.

Okay.

Thank you.

And next to David Magee with SunTrust Robinson Humphrey.

Yeah, hi, good morning.

A couple of quick questions.

First, I remember back in July, you all seemed pretty excited about the Pottery Barn look for the fall and I know you think that most of the issue is macro, but if you had to do over again with the launch of the fall book at Pottery Barn, what would you do differently there?

I'd like Laura to take that question, Dave.

It's a good question.

I think things change very rapidly and as I said, we we're seeing a greater price sensitivity than we've seen in the past and we're seeing some of the things that worked in the past not work as well and we are adjusting aggressively based on the changing consumer trends.

It's hard to, you know, you always wish you knew today, you know, you wish you knew everything that was going to happen.

It's harder to do that.

But now that it has shifted, what we're doing is we're focusing more on, you know, our value proposition, our differentiated design, and the things that we've always -- that have always been our core competency.

And truly, just executing extraordinarily well in a tough environment is going to be so important because as long as we do better than our competition, we are going to gain market share in this tough time.

So, you know, we're looking at just doing everything better than we've ever done it before and being very flexible at the same time to adjust based on what our customer is telling us.

And they vote every day on what we sell and how we present our merchandise.

And Howard said, and I believe it very strongly, that as long as, you know, we need to focus on visual merchandising, customer service, and all of these things that are so very important to our consumer.

And then, secondly, could you talk a little bit about the Willams-Sonoma Home direct to consumer business and what you'd have to see there to be more excited about it?

Pat, could you please discuss the Williams-Sonoma Home DTC business?

Absolutely, Dave.

We have taken and adjusted our page counts a little bit and revised the design in the William-Sonoma Home catalog.

And on the 11th of August, we introduced the Web site, the Willams-Sonoma Home Web site, which has had a very strong reaction from our customers.

We had been getting a lot of requests for the Internet presence more than we had expected and we've taken the last year to really design a Web site that we think responds to how the customers want to shop that concept and we're very excited about it.

Thank you.

Good luck.

Thank you.

And we'll take our final question from Neely Tamminga with Piper Jaffray.

Great.

Thanks for taking my call.

The question I have is really just Laura, maybe for Pat, as well.

Can you guys, switching gears a little bit, can you talk a little bit more about what's going on in bridal business as a sign or a symbol to you that it is not in fact not an issue with the brand but just an issue with the consumer?

Have you seen any trend changes there over the last six months?

And then similarly whether it's at Williams-Sonoma Home or the core Pottery Barn business, do you see in any changes in the professional decorators, the interior designers and how they're trafficking with you?

Pat, would you take that question for Neely?

Sure I will.

Neely, we have a very strong reaction in Willams-Sonoma Home from the design community.

It's one of the things that we've been working on to reach out to them and we have a whole program around it and that is actually increasing in terms of its interest from the design community.

On the bridal business, we have a stronger bridal business in Willams-Sonoma than we do in Pottery Barn, as you know, and we're very excited about the opportunities there.

And you'll see some changes that we're making on the Willams-Sonoma side here at the end of the year as we begin to launch some advertising specifically directed at brides to be.

It's a big opportunity for us.

Great.

Thanks, and good luck.

Thank you.

Thank you.

That is all the time we have for questions today.

I would now like to turn the conference back to Mr. Howard Lester for closing comments.

Thank you, operator.

Well, I'd like that thank all of you for joining us for our second quarter 2006 conference call.

We appreciate your time and we look forward to speaking with you again next quarter.