Williams-Sonoma Inc (WSM) 2008 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the Williams-Sonoma Incorporated second quarter 2008 earnings call.

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

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

This conference is being recorded.

I would now like to turn the conference over to Steve Nelson, Director of Investor Relations at Williams-Sonoma, Incorporated to discuss non-GAAP measures and forward-looking statements.

Please go ahead, sir.

Good morning.

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

I would first like to discuss the non-GAAP financial measures that are contained in this morning's press release and conference call which exclude the impact of unusual business events.

For the remainder of today's call we will be discussing our second quarter results and 2008 quarterly and fiscal year guidance, excluding the impact of these items and will refer to these results as non-GAAP.

These non-GAAP financial measures are provided to facilitate meaningful year-over-year comparisons.

A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures, and an explanation of how these non-GAAP financial measures are used by management are discussed in Exhibit 1 of the press release.

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, and prospects of the company in 2008 and beyond, and are subject to risks and uncertainties which could cause actual results to differ materially from such forward-looking statements.

Please refer to the company's current press release and SEC filings, including reports on forms 10-K, 10-Q and 8-K for more information on these risks and uncertainties.

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 Howard Lester, our Chairman and Chief Executive Officer.

Good morning and thank you for joining us.

With me today is Laura Alber, our President, Pat Connolly, our Chief Marketing Officer, Sharon McCollam, our Chief Operating and Chief Financial Officer, and Dave DeMattei, our Group President for the Williams-Sonoma, Williams-Sonoma Home and West Elm brands.

Let me begin today with an overview of our second quarter 2008 business results, and a high level outlook for the balance of the year.

Then I'll turn the call over to Sharon, Dave and Laura for further details.

During the second quarter, much to our disappointment, we continued to see significant deterioration in the macroeconomic environment, resulting in progressively declining comparable store sales throughout the quarter.

To put this in perspective, comparable store sales declined 8.6% in May versus 14% in July.

Due to this deterioration in trend, our second quarter net revenues decreased a greater than expected 4.6%.

However, despite this top line pressure, we focused on the aspects of our business that we could control including the successful execution of several key cost reduction initiatives and delivered diluted earnings per share within the range of guidance at $0.17 per share.

That included a $0.09 benefit related to the sale of our corporate aircraft.

Excluding this $0.09 benefit, non-GAAP diluted earnings per share were $0.08.

In our core brands, net revenues decreased 7.6%.

This decline was driven by an 11.5% decrease in the Pottery Barn brand and an 8.1% decrease in the Pottery Barn Kids brand, partially offset by 1% increase in the Williams-Sonoma brand.

In our emerging brands, which include West Elm, Williams-Sonoma Home and PBTeen, net revenues increased 15.9%, despite the softening in the overall economy.

In direct marketing, we continued to implement our catalog circulation optimization strategy and the results to date are affirming that the circulation decreases we have made are accretive to earnings.

Therefore, we'll continue to look for ways to expand this strategy over the next several quarters.

In our supply chain, we continued to see significant benefit from our returns, replacements and damages initiatives, including a 40 basis point reduction in replacements and damages expense, and a 100 basis point reduction in our sales return rate.

This has been a key initiative for us and we are currently taking additional steps to further reduce our cost in this area by assuming a greater level of direct control over our Asian furniture operations.

As we look forward to the third and fourth quarters, we're increasingly concerned about the downward trends we've seen in the macroeconomic environment and more importantly, in our brands.

Due to this concern, it's difficult for us to predict how the consumer will respond in the back half of the year.

Despite our confidence in our overall merchandising strategies, while this is difficult to accept, the downturn we've seen in the last 30 to 60 days across all brands has been significant.

Therefore, the most prudent outlook for us for the back half of the year is the assumption that these trends will continue.

With the exception of the Williams-Sonoma brand, where we believe that seasonal relevance will drive improved sales, despite a weak economy.

The impact of this assumption is reflected in today's updated guidance.

Specifically, we are projecting revenues for the year on a 52 to 53-week basis to decline in the range of 7.8 to 9.5%.

And diluted earnings per share to decline in the range of 34.7% to 41.5% to $1.03 to $1.15 per diluted share.

While we are extremely disappointed with these projections, we believe they are reflective of the current macro environment.

Therefore, during this time, we will be focused on driving profitable growth while maintaining a strong balance sheet.

Including reducing inventories and capital expenditures.

We'll also be focusing on further reducing costs to the extent that it does not affect service levels to our customers.

As I said in June, our approach in this environment is not and will not be business as usual.

And we are not expecting a equipment turnaround.

Consistent with our economic perspective on 2008, we are looking forward to 2009 with a very cautious outlook.

Accordingly, decisions we are making today are reflective of that sentiment, particularly in the areas of retail leased square footage growth, capital spending and inventory.

Therefore, in 2009, we are currently targeting the following: A reduction in retail leased square footage growth from 7% in '08 to 4 to 5% in '09.

A reduction in capital pending from 200 to $220 million in '08 to 145 to $170 million in '09, and a continuing reduction in inventory levels through managed receipt flow and turn optimization initiatives.

We are, however, remaining flexible in our plans, and are prepared to respond if we see any improvement in the macro environment.

Therefore, this year we have consistently focused on improving our merchandising, our inventory planning, our marketing efficiency, and our supply chain operations, all of which leave us well-positioned to accelerate our business when the opportunity presents itself.

We believe that we're in a cycle, somewhat like the '80s and early '90s.

But like those cycles, we believe it will pass, and people's homes are still their most material asset, so they're going to want to continue to invest in them.

We also believe that it's only a matter of time before housing demand catches up with supply, and when it does, there will be a revitalization in the home furnishings market again.

So while this is a difficult time for home furnishings retailers overall, it is creating an opportunity for the strongest retailers to gain market share and we plan to capitalize on that.

I'd now like to turn the call over to Sharon.

Thank you, Howard.

Good morning.

I would now like to talk about second quarter results.

In the second quarter of 2008, GAAP diluted earnings per share decreased $0.06 to $0.17 per diluted share, versus $0.23 in the second quarter of 2007.

Excluding a $0.09 net benefit associated with the gain on the sale of our corporate aircraft, non-GAAP diluted earnings per share were $0.08 per share.

Throughout the quarter, the success of our operational and cost containment initiatives allowed us to deliver operating results that were within our range of guidance.

Net revenues in the second quarter decreased 4.6% to $820 million.

Comparable store sales decreased 11.7%.

Retail leased square footage increased 11% and catalog circulation, consistent with our optimization strategy, decreased 20.5%.

Page circulation decreased 31.1%.

This compares to catalog and page circulation increases of 8.6 and 9.2% respectively in the second quarter of 2007.

Gross margin expressed as a percentage of net revenues was 34% versus 37.2% in the second quarter of 2007.

This 320 basis point year-over-year decrease was primarily driven by an increase in cost of merchandise sold including the impact of increased markdowns, the deleverage of fixed occupancy expenses and an increase in inventory-related reserves.

These increases were partially offset, however, by a 40 basis point decrease in replacements and damages expense.

SG&A was $253 million or 30.9% of net revenues, versus $277 million or 32.3% in the second quarter of 2007.

Excluding the approximate $16 million pretax benefit from the sale of the corporate aircraft, non-GAAP SG&A was 32.9%.

This 60 basis point year-over-year increase was primarily driven by the deleverage in employment cost, partially offset by a reduction in advertising costs due to the successful roll-out of our company's catalog optimization strategy.

The effective income tax rate was 27.1%, versus 40.2% in the second quarter of 2007.

This decrease was primarily driven by certain favorable income tax resolutions during the second quarter.

I would now like to discuss significant year-over-year working capital balance sheet variances at the end of the second quarter of 2008 versus the end of the second quarter of 2007.

Cash and cash equivalents at the end of the second quarter were $39 million, a decrease of $19 million after returning $145 million to our shareholders through share repurchases and dividends over the past 12 months.

Merchandise inventories increased $5 million, or approximately 1% to $657 million, which is better than our expectations.

This increase was driven by a $33 million increase in the fixed investments in new and remodeled stores, an $8 million increase in the Williams-Sonoma brand due to cost increases and a mix shift impact offset by lower units, and a $36 million reduction in the Pottery Barn brand, due to lower units, partially offset by cost increases and mix shift impact.

Inventories in the emerging brands, excluding new stores, were virtually flat at the end of the quarter.

Prepaid catalog expenses decreased $19 million, or 27.9%, to $50 million.

This decrease was primarily driven by a significant reduction in catalog circulation related to the catalog circulation optimization strategy partially offset by cost increases in paper and postage.

Accounts payable decreased $46 million or 22.2% to $160 million.

This decrease was primarily driven by the timing of payments at the end of the quarter, due to the 52 to 53-week calendar shift.

Reductions in inventory receipts during the quarter, and lower catalog advertising costs.

I would now like to discuss our fiscal 2008 guidance.

As a reminder, fiscal year 2008 is a 52-week year, versus fiscal year 2007, which was a 53-week year.

The 53rd week added approximately $70 million in revenue and $0.05 in diluted earnings per share to our 2007 results.

As we look forward to the third quarter and back half of 2008, as Howard mentioned, we are increasingly concerned about the downturn we have seen in the economy and the home furnishings sector overall.

Therefore, in our updated guidance today, we have assumed that our sales trends over the past 30 to 60 days will continue with the exception of the Williams-Sonoma brand, which has not run a negative comp for the fourth quarter at any time in recent history.

Based on this assumption, we have reduced our fiscal year 2008 guidance by $166 million, to a range of $3.57 billion, to $3.64 billion, and our GAAP diluted earnings per share guidance by $0.42 to $0.43 to $1.03 to $1.15.

On a non-GAAP basis, our diluted earnings per share has been reduced to a range of $0.89 to $1.01.

In response to these lower sales trends, we are reassessing our infrastructure and implementing changes where appropriate, including a reduction in our capital spending guidance of an estimated $15 million, and our inventory guidance in the range of 12 to $16 million.

We are also ensuring that the plans we are putting in place for 2009 are reflective of economic environment that we believe is going to continue for the foreseeable future.

Accordingly, as Howard shared earlier, we are reducing our 2009 year-over-year retail leased square footage growth by 2 to 300 basis points, our capital spending by 50 to $55 million, and our inventory to the extent it does not negatively impact customer service.

Beyond this, we are continuing to identify new business opportunities that can further benefit us as we move forward through the balance of the year and into 2009.

As we have said, we are leaving no stone unturned and are continuing to strategically invest in those initiatives that will enhance our competitive position and allow us to emerge stronger when the economy begins to rebound.

I'll now turn the call over to Dave DeMattei, to discuss the Williams-Sonoma, Williams-Sonoma Home, and West Elm brands.

Thank you, Sharon.

Good morning.

I would like to begin with Williams-Sonoma.

Despite an extremely difficult macro environment, net revenues in the Williams-Sonoma brand increased 1% in the second quarter.

Comparable store sales, however, decreased 4.5%, but were more than offset by incremental revenues from new and expanded stores and higher traffic and E-commerce.

What drove the business was the successful marketing and merchandising of seasonal events, like Mother's Day, Father's Day and 4th of July, which is encouraging, as we enter the highly event-driven back half of the year.

From a merchandising perspective, the key growth drivers during the quarter were electrics, seasonal hard lines and cookware.

These were substantially offset, however, by traffic dependent categories like housewares and food that have been weak all year.

As we get ready for the third and fourth quarters, we are increasingly concerned about consumer trends, but believe the Williams-Sonoma brand with its seasonal relevance and gift-giving focus will be more resilient than our other home furnishings brands.

For that reason we are guiding comparable store sales to be down only low to mid single digits during this period.

But we'll be disappointed if we don't do better than that due to a high level of confidence in this year's holiday assortment.

Our execution will be critical and we are focused on the following initiatives to capitalize on the brand's authority.

Expanding our gift giving assortment to feature a broader range of options and price points, strengthening our marketing message to draw attention to new and exclusive offerings, leveraging the functionality of our new E-commerce platform, and maintaining a superior level of customer service, while balancing the cost pressures of a softer top line.

We continue to believe that despite the macro environment, the Williams-Sonoma brand is the premier retail destination for high end cooking and entertaining essentials and with strong execution can continue to outperform the industry in the holiday season.

In the Williams-Sonoma Home brand, second quarter net revenues were in line with expectation and we continued to make progress on our brand-building initiative.

From a merchandising perspective, we continued to see strong growth in home furnishings and newly introduced table top.

This was more than offset by an ongoing softness in furniture and textiles.

As we look forward to the back half of the year, we are doing so with a cautious outlook, but believe like Williams-Sonoma, that Williams-Sonoma Home will be more resilient than our other home furnishings brands due to its target demographic and relatively small store base.

As such, we will continue to focus on the following initiatives that we believe will take the brand's performance to the next level.

Building brand awareness by leveraging the strength of the Williams-Sonoma kitchen brand, including cross-branding catalogs and testing a store within a store in New York City.

Optimizing catalog circulation and E-commerce marketing, and continuing to reengineer the supply chain to ensure a premium level of quality while at the same time working with our vendor base to optimize merchandise margins and inventory turns.

All of these initiatives have been top priorities this year and we are pleased with our progress to date, particularly in the catalog circulation and returns replacements and damages.

In West Elm, net revenue growth in the second quarter was driven by incremental sales from new stores and increased traffic in E-commerce.

This was partially offset, however, by weaker sales in existing stores, of which approximately 30% are located in the housing-affected markets in Florida, Nevada and California.

During the quarter, we opened three new stores, ending the quarter with 32 stores versus 23 last year.

From a merchandising perspective, growth was driven by expanded categories within furniture, textiles and decorative accessories.

We continue to believe that our design-driven merchandise offering is resonating with the customer and is providing a significant competitive advantage in this difficult macro environment.

As we look forward to the third and fourth quarters, we again are doing so with a cautious outlook.

But are optimistic about our merchandise assortment, and focusing on the things we can control, including expanding the reach of the brand by opening our five of 10 planned stores for the year, including our first in Canada, Significantly enhancing our E-commerce functionality, including greater search capabilities and an easier checkout path and refining our merchandise assortment to drive increased traffic and build broader brand appeal.

We are focused on reducing costs of goods sold through Strategic Sourcing and enhanced quality assurance program as we build toward sustainable, long-term profitability.

I would now like to turn the call over to Laura to discuss the Pottery Barn brand.

Thank you, Dave.

Good morning.

First, I'll start with the Pottery Barn brand.

Second quarter net revenues decreased 11.5% with declining trends throughout the quarter.

Of this decrease, approximately 250 basis points were driven by reductions in catalog circulation as expected, and approximately 70 basis points by a voluntary product recall.

And while we are generally encouraged by the consumer response to overall newness in the brand, it was not strong enough to offset the significant deterioration in the overall macro environment.

Retail was particularly challenging.

With comparable store sales decreasing 16%, and July at negative 18.6% was noticeably weaker than other months in the quarter, a trend that is continuing in August.

From a merchandising perspective, we saw year-over-year sales declines across all major categories.

Interestingly enough, however, no one category was significantly better or worse than another, with the exception of furniture, which benefits from the success of new product introductions and a strong upholstery business.

On the operational side of the business, we had another great quarter, delivering better than expected savings from both our catalog circulation and returns, replacements and damages initiatives.

We also delivered a strong inventory performance as we reduced units on-hand, despite a significant sales shortfall.

As we look forward to the third quarter, and the balance of the year, we are assuming that the macroeconomic environment is not going to improve.

And as such, we are guiding high teens negative comps and a similar trend adjusted for circulation decreases in the direct to customer channel.

Our focus is on execution and the things we can control, including pricing strategies, catalog circulation and discretionary spending, all areas where we have a proven track record of success.

We are also focused on reducing inventories through managed receipt flow, transfers between channels and the utilization of our outlet stores and E-commerce web sites.

From a merchandising perspective, we'll be focusing on expanding our assortment in the areas where we are seeing consistent trends of consumer appeal, which are consistently proving to be where we have stayed true to the authentic casual style of core Pottery Barn, but updated for current trends in color and functionality.

Quality and value are the key.

The customer is looking for great products at a great price.

We are also focusing heavily on E-commerce, a channel where we continue to see positive growth and a significant opportunity.

Over the past several months we have made significant progress in the areas of site navigation, and natural search, both of which we believe can be important sales drivers in the third and fourth quarters.

The successful execution of all of these initiatives is the sole priority of the entire Pottery Barn team as we strive to achieve a balanced focus between growth and profitability in these extremely difficult times.

Sales at any cost is not our strategy.

Our goals today are simple.

Mitigate the earnings I'm impact of macro driven sales losses without sacrificing customer service or brand image and optimized cash flow through aggressive inventory management and lower capital spending.

Now I would like to talk about Pottery Barn Kids.

Second quarter net revenues in Pottery Barn Kids decreased 8.1%.

Of this decrease, approximately 150 basis points were driven by reductions in catalog circulation, as expected.

And while these results were better than anticipated, due to a strong performance in E-commerce, we continue to believe that the macroeconomic environment is having a significant impact on this brand, particularly in discretionary categories like textiles and decorative accessories.

Categories like nursery and core furniture, which fill life-stage needs, continue to deliver better results.

Retail was particularly challenging, which comparable store sales decreasing 13.5%.

And like our other brands, retail performance did get worse between the beginning and the end of the quarter, but was less pronounced.

We have, however, seen further deterioration in August and therefore, in the back half of the year, we are guiding the brand at negative mid-teen comps.

From an operational perspective, Pottery Barn Kids, like Pottery Barn, delivered better than expected savings during the quarter from both catalog circulation and returns, replacements and damages.

Inventory units on hand were also substantially reduced during the quarter, which is an initiative that we will continue to drive as we progress through the year.

Despite the macro environment, however, we believe there are opportunities that can drive sales in the back half.

These include leveraging the capabilities of our new E-commerce website, including the benefits of enhanced natural search.

Expanding our assortment in licensed programs and enhancing our gift assortment to include a broad range of price points.

While we believe the children's home furnishings category will continue to be impacted by macroeconomic issues in the third and fourth quarters, like Pottery Barn, we will continue to manage the aspects of the business we can control, while at the same time protecting our strong competitive presence.

I would now like to talk about Pottery Barn Teen.

Net revenues in the Pottery Barn Teen brand increased 25.1% during the second quarter, delivering the best year-over-year growth in the company.

All key merchandising categories saw strong growth, particularly furniture, textiles and decorative accessories, but even PBTeen saw a deterioration in their growth rate between the beginning and the end of the quarter, as the macro environment began to soften.

Therefore, as we look forward to the third quarter and balance of the year, we are being significantly more cautious in our outlook, by continuing to drive initiatives that will improve the teen's customer experience and extend the reach of the brand.

These initiatives include leveraging the August launch of our upgraded E-commerce website, Testing PBTeen merchandise for the first time at retail in one Pottery Barn Kids store in November, and expanding our selection of holiday gifts to serve a broader range of teen interests.

We continue to be excited about the long-term growth potential of Pottery Barn as it solidifies its role among the Pottery Barn portfolio of brands.

I would now like to open the call for questions.

Thank you.

Yes, certainly, ma'am.

The question-and-answer session will be conducted electronically.

(OPERATOR INSTRUCTIONS).

We will pause for just one moment to assemble the queue.

We'll take our first question from Matt Nemer with Thomas Weisel and Partners.

Hi, good morning, everyone.

Hey, Matt.

My first question is if you could just talk to your brand positioning and merchandising, if this malaise that we're in lasts for another year or two or three years and customers are turning towards discounters and coupon usage, does it make sense -- is there anything you could do to the marketing or merchandising to have more of a value message, or do you think that that would damage the brand longer term?

One quick question, follow-up question, on SG&A, I guess it was down about 11% per square foot.

Can you give us any clarity on how much of that is coming from retail marketing or corporate, et cetera?

Matt, I'm going to let Howard take your first question on how he sees the larger macro, if it was an extended period of time.

Howard, will you please take that question, then I'll come back on the SG&A.

Matt, I think none of us know how long this is going to last or the extent of it.

So I would think at this point in time that we should keep doing what we've been doing here for 50 years in building these brands.

And value is part of that.

I mean, I think if this worsens or gets deeper, we're not going to be unaware of the fact that the customer is looking for value, but I wouldn't do it to the extent that it changes the premise of the brand.

So I think we'll just kind of measure that day-to-day.

That could have some effect on, on merchandising trends and how we react to those, and we'll react to what the customer's saying to us.

But I don't think we're thinking about a material change in the brand, if that answers your question.

And the second one, Sharon, I'll turn that back to you.

Matt, were you referring to the third quarter or the full year?

Sorry, I was actually looking at the second quarter.

Oh, at the second quarter.

The drivers in the second quarter were ad cost, that was the big driver, and then where we're seeing additional SG&A reductions are virtually in all of our headquarters and corporate departments.

Those would be where they see -- you're going to see the majority when you get segment reporting coming in the direct to customer channel and then the corporate non allocated.

(OPERATOR INSTRUCTIONS).

We'll move on to Dana Telsey with Telsey Advisory Group.

Good morning, everyone.

Definitely a challenging environment.

As you look at each of the three brands and preparing for this holiday season, I believe there had been some discussion of more in-store events, more direct contact with the customer.

How do you see that playing out for each of the brands going forward?

And as you plan for next year, pricing, product flows, is there any change or difference and how does that impact the gross margin?

Thank you.

Laura, will you the take that for the Pottery Barn brands, Pottery Barn Kids and Pottery Barn and Dave you'll take that for Williams-Sonoma, please.

Let me take the first part, Dana.

For the Pottery Barn brands, both right now and the holiday season, right now we've been running very successful decorating events in our Pottery Barn stores and we continue to invest in our sing-alongs and story time and some very special Star Wars events that are coming up that we think will literally pack the house and really delight our customers and create a create a great environment in the mall for our customers in our stores.

And we will continue those through the holiday season and make that investment in our stores.

On the direct side, we are very focused and have been methodically going through our e-mail and direct marketing messaging to send highly targeted, relevant messages to our customer based on both shopping behavior and also the change that we're seeing in the environment and recognizing that people are not refurnishing entire homes to the same extent they were last year.

They are, though, redecorating, replacing, and they will celebrate the holidays this year, and we are really fine-tuning our messaging to them to really show them that we understand and that we stay relevant.

Hi, Dana.

As you know, in Williams-Sonoma, we have really developed our technique classes in an increasing manner, and actually have merged that into our catalog marketing and our retail versioning which has been highly successful for us, and as you know, our versioning continues to increase as a percentage of our circulation.

We will continue to do that.

We are increasing our demonstrations in our stores ongoing and that's a major focus for our field organization.

As you know, when we taste products or when we demonstrate products, we have great success with that, especially in making a much more interactive environment in our stores and so we will continue to do that.

That is a big focus for us.

In terms of our e-mail marketing, as Laura said, Williams-Sonoma too is doing segmentation of of their e-mail files and really trying to send out more targeted messages.

The conversion of those e-mail increases.

In terms of holiday and beyond in terms of merchandising, we are working very, very hard on our food strategies going forward, not only from a product standpoint, from a marketing and in-store presentation standpoint.

In fact, Howard and I were in Corte Madeira yesterday where we had set up some new things where we're seeing great results on that and we're working on some organizational changes to impact our table top areas and we feel very strong about that.

Our housewares business that I've talked about for the past year of being down, we have a new strategy that will go into place, partially at holiday and in September to impact that.

So we're feeling very confident that we're on the right track to push our business forward.

On the second your part of your question, Dana, about next year's pricing and product flow, interestingly enough, some of the strongest parts of our business are not the lowest ticket.

We're seeing better strength in more considered purchase across the home furnishings brands and furniture, particularly, and our customer comes to us for great value and that is not necessarily related to lower prices.

It's that the price reflects the value and the quality and the design that goes into it so that we're offering product that you would usually find at the higher end in our stores and our best-selling product right now reflects that.

So we are not making a sea change on the pricing strategy for next year.

As it relates to the product flow, people are buying closer in on seasonal products and we're very conscious of that in giving them relevant products in all of our channels at the right time.

So we're making adjustments to that effect.

And I really don't have anything to add to either what Laura said or what Howard said.

We continually merchandise into trends.

That's what we do every day and as Laura said, the lowest selling price is not always the best selling good but it's great to have a broad assortment of price points and that is what we're merchandising into and we watch trends constantly and make adjustment to our assortment.

We'll take our next question from Matthew Fassler with Goldman Sachs.

Thanks a lot and good morning to you.

I would like to focus on inventory for a moment.

You talked about taking some higher inventory reserves.

Obviously the inventory came in below your plan.

You seemed to keep up with the sales shortfall.

So how much of your reserves were anticipatory and what kind of provisions -- what's your expectation in terms of markdowns for the second half of the year, given where the environment is?

We definitely -- Matt, this is Sharon, I'll take that question.

When you look at the components of our inventory that I gave you in our prepared remarks, we said that when you look at -- we just had a $5 million increase and $33 million of that is in new stores, new and expanded stores and Sonoma was only up 8 and that was versus last quarter when they were up 20 and that was the net of lower units, but then a higher mix shift impact, shifting to higher cost products and then of course cost increases in Sonoma, a lot to do with the Euro.

Then in Pottery Barn, they are down $36 million, and that is units and then partially offset by increased cost and a little bit of a mix shift.

So when you look at the inventory in total, we are extremely pleased with how it is coming down and how it's rationally coming down.

On the inventory reserves, we are definitely in a good -- we think we're in a good place.

We have our -- if you look at our policies on inventory, we have some aging issues and when they hit the aging, of course we take the reserve.

That is our policy.

So we don't see any big exposures there.

Now, when we look at our gross margin as we go into the fourth quarter and for the year, we do expect that one of the biggest contributors, the biggest contributor is actually going to be deleverage of occupancy if we run those comps.

We're not quantifying it, per se, but we have taken into account an expectation of higher markdowns in all brands.

Moving on to our next question from Budd Bugatch with Raymond James.

Good morning and thank you for taking my question as well.

You had indicated, I think, Laura, that furniture was better than -- the hard lines was better than the soft lines.

Any help you can give us in quantifying that, on giving maybe color on average ticket versus traffic, particularly at retail and the second question, maybe for Howard and longer term, with a reduction in square footage going forward, what's the persistence of that and which brands might that reduction most affect?

Howard, would you like to take the question?

The second part?

Yep.

Well, I think it would affect our Pottery Barn brands the most, because we're doing the worst there, so we'll be more cautious there.

As we have opportunities for Williams-Sonoma stores, where we're highly confident that they're going to make our pro forma and at the brand average or better, we'll certainly continue to do those.

West Elm, we're probably a little more cautious on, just because of the potential of the environment having a more adverse effect on those stores.

But we are continuing to open West Elm stores in those locations where we feel highly confident that they're going to work.

So that's kind of the way we're going to be thinking about that.

But I think, you know, the overall thing that I was trying to say is that in this kind of environment, we're just not -- we're not too keen on opening stores.

We're trying to focus on getting all of our current businesses really working, and unless the real estate transaction is pretty compelling, we probably won't be doing them until we see some real change in the economic environment.

And Bud, in the actual numbers that we put out there for next year, about half of that square footage is in West Elm.

Your first question, about furniture versus the other categories, furniture is also down but it's only down singles versus double digits and kids is stronger, even than in Pottery Barn, and we've looked at this every which way to understand what could possibly be going on and the thing that makes the most common sense to us that is the customer is more careful and they're making investments in things that will last longer and they're not doing as much of the -- if you think about all the purchases you make when you move, whether -- a lot of our business has been fueled by you buy a bigger house, you have more bedrooms, you have more bathrooms and you redo those entire rooms.

As people stay put more and redecorate, they replace their family room sofa, they replace their media cabinet.

They don't just replace all the windows in their house every year like they used to, or their bedding.

You can kind of shut that door in your house and people don't go in there as much.

So furniture is down, but not to the same extent, and we're careful on that because it's a big key for us and it's a big inventory investment but we're also very aggressive at our merchandising strategy there and looking at what's selling and building on that and we have some great programs that are very beautiful and different in the marketplace, and really true to who we are in our current assortment in our stores, and you're going to see us expand those from a simple dining room table to a coffee table, to a media cabinet, and that's what we've always done and I'm really pleased that we have some new programs that we can build on like that because that gives us some more stability into the future.

And also, I think it's particularly pleasing, given how promotional the environment is on furniture and we haven't done the sweeping promotions as other competitors have and I think we're holding up pretty well comparatively.

And we'll move on to Alan Rifkin with Merrill Lynch.

Yes, thank you very much.

Howard, you mentioned that your emerging brand revenues are up 15.9%, yet it looks like square footage growth is almost double that, north of 30, which would imply negative double-digit comps at the emerging brands.

Can you maybe just, first of all, verify if in fact our math is correct.

And then secondly, as you look at the longer term potential for emerging brands, are you still as euphoric over the long-term opportunity for West Elm today as you were years ago?

Let me take home first and then we'll come to West Elm.

Home is actually having a pretty good year from a comp base.

I think, what are we, Dave --

We were flat.

We're basically flat.

I think it's down one, up one.

So Home is actually -- we've made a great deal amount of progress and I think the reason for that is is that they're up above the people who have been reacting the most negatively to this economic environment we're in.

It's a much more affluent customer that's probably shopping Home and of course it's a smaller group of stores.

With respect to West Elm, first of all, just our comps for the year are low to mid single digits down.

But when we look at the -- and we've got some stores in there that we did early on that we know were bad, not the best locations for us, not the best choices for us.

So those are having an adverse effect.

I'm getting a lot of information here.

Those are having an adverse effect on us.

And then, of course, in Florida, which is one of the places that's really been hit, particularly South Florida, where we have three now really strong stores for us that were very big volume stores for West Elm.

They've been hurt down there more than the norm and so that's had a big impact on us.

On the stores that we're watching, where we now have kind of zeroed in and learned from our real estate learnings, really, over the past four, five years of opening these stores, we're particularly pleased with those stores.

I mean, our Chelsea store in New York is phenomenal.

Really, there's other word for it.

And it's growing every year.

We'll be opening a second store in Manhattan in the spring.

So up on Broadway near the Time Warner building, across the street there.

And in our stores, like Dallas and various locations around the country that come to me, we're doing very well.

So pretty much we've been hurt there in those locations which kind of follows Pottery Barn, where the housing market has been the worst.

So that would be places like Southern California, Nevada, South Florida, Georgia, to some extent in Atlanta, although that's improving recently.

And we had a concentration of stores in those markets so it's kind of skewed those numbers that way.

But I would say overall, on West Elm, we're feeling pretty good and I think the brand is getting better.

Our team in New York is a terrific team of merchants and product development people.

I think every season the merchandise gets better.

So we're really quite pleased with West Elm.

And then, Alan, I would only add to that that when you're taking those metrics, you've got to keep in mind the direct to customer businesses in both West Elm and in Home and in Home particularly, our catalog circulation optimization strategy was put into Williams-Sonoma Home and so they made a deliberate decision to cut circ and sales.

So that is another reason for that number to be lower and that's the other side of it.

So when you're looking at the whole brand and just trying to divide it by square footage when these brands are so much smaller than the other brands, that math is a little bit challenging.

We'll take our next question from Michael Lasser with Lehman Brothers.

Good morning.

Thanks for taking my question.

With the decision to retain the promotional and merchandising strategies, how do you think about the risk that you might be losing out on a portion of your customer base in a structural way such that you won't benefit when the market rebounds, folks will -- who have been going and finding different price points at other merchants might be fearful or might be less apt to come back once conditions improve.

Secondly, can you talk about how -- with regards to the deterioration that you witnessed throughout the quarter, did that -- was that consistent with the broader trends in that from a hard line goods held up relatively well and it was the deterioration was more pronounced in the traffic-driven categories?

Ask and then finally, if I really quickly could, once you get through the circulation optimization program and the benefits from reduced returns, are there other cost-saving strategies on the horizon that you can begin to talk about?

Absolutely.

Laura is going to start out addressing your question regarding pricing strategy for the Pottery Barn brands.

Then Dave will take it for Sonoma and then we'll move on to the other question.

So Laura, would you take, that please.

Sure, Sharon.

Michael, I want to first clarify we are more promotional than last year and that's because we're very aggressive with our inventory management and sales are slower so you have to take more markdowns.

We're taking them where we need to take them and we're not overbought.

So we don't have the sweeping markdowns that you see in other brands that I think are in much worse shape and that's hard to compete with.

However, taking big sweeping markdowns in some of these lower margin goods is not really a sustainable strategy.

We will take them where we have products that don't sell.

And we are seeing this from that.

I don't think it becomes a competitive disadvantage.

I actually believe that it's really important not to just have sales as I said at any cost but to have a model that is sustainable and we will continue to take the markdowns that we need to take to clear inventory, seasonally and to bring in merchandise that will sell better.

You asked a second question about deterioration throughout the quarter and it really was across all categories equally.

The one noticeable difference is transactions are down a little bit more than AUR, but it wasn't that obvious.

So it's really across the board and kind of leading us to the conclusion if you look at all the brands also on a map, and where the brands are down more, it seems to be a very similar trend to where we see the housing markets most difficult in the country.

The only thing I can add to that, Michael, is that we constantly merchandise into our trends and we are very confident in our merchandising strategies.

We take appropriate price action where we need to.

We manage our inventories, manage our receipt flow and merchandise the store, so we're constantly looking at that and making adjustments and refinement refinements to merchandising to merchandising to trends.

Pat Connolly is going to talk about additional opportunities in direct to customer advertising costs.

We have a couple of things that we're really focusing on particularly in electronic direct marketing.

We're really focusing on both our search engine marketing in both turns of SEM, paid search, and in natural search.

Our SEM revenue is up significantly this year.

We have implemented a new e-mail delivery platform that Howard and Laura and Dave have talked about in terms of more personalized messaging and we're really seeing double-digit increases in the returns there and we're really just getting started.

Lastly, we're beginning to work more in affiliate marketing and we're very selective about the affiliates we work with, but we have not participated in that to a great degree and in many companies it's 8% of their E-commerce revenues so that represents an opportunity for us as well.

And all of those have ad costs associated with them that are significantly lower than catalog advertising costs.

The final question was, and then are there other opportunities that we have from an operating margin expansion point of view and the answer to that is yes.

In our returns, replacements, damages and sourcing areas we have made some substantial investments.

Also in transportation.

The 40 basis points that we saw in replacements and damages, we see continuing to expand that number, this 100 basis points in returns.

We are not satisfied with 100 basis points and we are going to continue to push that number and have plans in place and can already see it happening.

So those are two areas that on the transportation side we are doing additional in-sourcing of our furniture hubs, which is allowing us to be able to reduce our transportation cost and at the same time reduce the damages that are occurring and lastly, we, with our focus on inventory turns as we go into 2009, we have already this year gotten out of one of our distribution centers, East Coast distribution centers which was an offsite facility and as we continue to do that, that will allow us to better leverage our occupancy costs.

So as I said in my prepared remarks, there are no stones being unturned and we already have traction on all of these initiatives.

We'll take our next question from Chris Horvers with JPMorgan.

Thanks and good morning.

First, a follow-up question on the SG&A side.

How much -- presumably some of your stores hit minimum staffing levels on the Pottery Barn side during the tough months.

How much do you need to flex up payroll into the seasonality in the back half?

Is it different from trend, presumably?

And then as a follow-up, it sounds like the markdowns were more severe on the Pottery Barn side of the equation.

How much do you think that could be representative of this competitive encroachment, the design and the fashion has been mimicked for years and you've sped it up to try to stay ahead of it.

Is there anything to think about there?

Laura, will you speak to Pottery Barn payrolls and Dave you can speak to it in your brands and Laura you can take the markdowns for Pottery Barn.

Why don't you take that.

On the payroll side, we run payroll as a percent of sales.

We predict our sales trends by store, by week and almost by day and then we adjust up and down based on trend.

So as you go into Christmas, it's a matter of putting in the right numbers for your volumes and then working on what that looks like from a staffing perspective.

And we are only at minimums in a couple Pottery Barn stores, more in kids, and we're very careful not to cut our service.

So we're balancing that but making sure that we have our best teams on the floor during peak hours and that we're really using that payroll efficiently and also cutting back on the workload that's non-selling for our stores, to manage it, so that we can focus on our customer because we really know, and we believe strongly that service is one of our key competitive advantages in this time where many retailers are cutting back so severely on their payroll that the service in the malls is really deteriorating.

This is a great advantage for us.

Payroll management is something that our field organization does every day.

We have a great field organization in all of our brands.

And we basically in Sonoma, seasonal is a major component of our business and we will gear up to that accordingly, and as Laura said, We look at our sales trends, our management and we hire accordingly.

The great thing about Sonoma is it has a very loyal customer base and a very loyal employee base.

We have a lot of part-timers who come back to us and are very flexible in the holiday season.

This is something we've done for years.

I was just going to add that you have to remember here, our store volumes are significant enough that on a per store basis, we don't run into the minimum question as much as others who would have a much lower average sales per store.

We may have as Laura said, just a handful of those where we're challenged, particularly in Kids.

But other than that, we don't run into that.

Sometimes we have to do a little surgical work with the management group in the store when we've run negative comps for a while.

But it's not a huge challenge for us.

On your second question, Chris, you know, our sales are not what we forecast so we have more markdowns to reflect the sales not selling at regular price.

From the more strategic question, about the product aesthetic and the knock-offs in the market, it's clear that there has been a lot more Pottery Barn knock-offs in the market and we have clearly identified our need to differentiate ourselves and we introduced new products, new marketing and a new floor set strategy and we know that there's probably some fine-tuning to make to the adjustments that we've made in the fall season but we're sticking with our longer vision to own the American home furnishings market in America, by offering relevant, well made, casual home furnishings through our three channel strategy and that's what we're doing.

We're really focused on it, steady as she goes and every month we're evaluating what's selling and how we adjust our product lines to better take advantage of that and where we miss we take markdowns.

And then the question, Chris, that you didn't ask and I think it's something that we're particularly proud of is that we also have another very large payroll base which is in our distribution centers and our call centers, and they too have very sophisticated labor scheduling and a tremendous amount of flexibility built into their model.

So as a result of that, each quarter so far this year where the sales have been obviously below our expectations, they have been able to come in and improve productivity in the distribution side or in the call centers, able to adjust that payroll.

Those two payrolls are a significant piece of our payroll as well.

That does conclude today's question-and-answer session.

I'll turn the call back over to Mr.

Lester for closing remarks.

Well, I just want to thank all of you for joining us this morning for the second quarter earnings conference call and we appreciate your time and support and patience.

Particularly as we work through this difficult period and we'll talk to you again next quarter.

Have a great day.

And that does conclude today's conference.

Thank you for your participation and have a wonderful day.