Williams-Sonoma Inc (WSM) 2009 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the Williams-Sonoma Inc.

first quarter 2009 earnings conference 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 call over to Steve Nelson, Director of Investor Relations at Williams-Sonoma, Inc.

to discuss non-GAAP measures and forward-looking statements.

Good morning.

This morning's conference call should be considered in conjunction with the press release that 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.

Our press release and this call contain non-GAAP financial measures that exclude the impact of unusual business events.

For the remainder of today's call, we will be discussing our first quarter 2009 results, our fiscal year 2009 guidance, and our 2008 results, 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 as to why these non-GAAP financial measures are useful and how they are used by management are discussed in exhibit one 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, growth plans and prospects of the Company in 2009 and beyond, and are subject to 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 the Company's Form 10-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 today.

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 Vice President for the Williams-Sonoma, Williams-Sonoma Home and west elm brands.

I'm going to begin today with an overview of our first quarter 2009 results and our outlook for the balance of the year.

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

While the home furnishings sector continued to be under significant macro pressure in the first quarter, a realistic sales plan and aggressive cost actions allowed us to deliver better than expected results in an extremely difficult environment.

During the quarter, revenues stabilized at the October/November two-year trend, and we substantially exceeded our expense reduction and cash flow targets by optimizing advertising cost, managing promotional activity, expense reduction, and tightly controlled inventories and SG&A.

In the first quarter, net revenues declined 22% versus last year, resulting in a non-GAAP loss of $0.14 per diluted share.

During the quarter, comparable store sales declined a better than expected 21% and selling margins were above expectations.

In our core brands, net revenues decreased 23%.

This decline was driven by 27% decrease in the Pottery Barn Kids brand, a 26% decrease in the Pottery Barn brand, and an 11% decrease in the Williams-Sonoma brand.

What those numbers don't yet reflect is the significant progress we've made in the Pottery Barn brand, both in merchandising and retail execution.

We've been working on this initiative for some time and feel confident that our current merchandising strategies, combined with our superior service in our stores is the best we've seen here in several years.

In our emerging brands, which include west elm, PBteen and Williams-Sonoma Home, net revenues decreased 17%.

While the top line continued to be a challenge throughout the quarter, we made significant progress on several of our key initiatives.

During the quarter, we continue to focus on exclusivity, perceived value, and accessibility of price points across our merchandise assortment.

We're making meaningful progress in this area, particularly in our Williams-Sonoma and Pottery Barn brands, and are expecting substantially greater penetration in the back half of the year.

In direct marketing, we continue to move forward with our catalog circulation optimization strategy, which, combined with catalog production savings, drove a 30% reduction in advertising expense during the quarter.

These savings were net of a 25% increase in online marketing, which resulted in the eCommerce channel being our best performing channel on a two year trend basis.

We continue to believe there is significant opportunity in the refinement of the balance between catalog circulation and online marketing.

And we'll be evaluating these opportunities as the year progresses.

In the supply chain we saw both customer service and financial benefits from our ongoing returns, replacements and damages initiative.

This is a key initiative for us, and we believe there's still significant opportunity to further reduce our costs, as we assume greater control over our Asian furniture operations and consolidate our remaining large cube home furnishings inventories into our regional hubs.

We've also made significant progress on our inventory reduction initiative.

At the end of the first quarter, year-over-year inventory was down a better than expected $166 million, or 23%.

As we look forward to the balance of the year, we're guiding revenues to remain in line with the October/November trend, and the promotional environment to potentially accelerate based on ongoing competitor announcements of store closings, inventory liquidations, and bankruptcies.

As this is consistent with our previous view, we are reiterating the quarterly guidance we provided in March, but while this guidance may be reflective of the current environment, we remain committed to changing the outcome.

Therefore, we're focused on the things we can control, and are committed to delivering against the following initiatives for the balance of the year.

Capturing market share through innovative merchandising, superior customer service, and a greater emphasis on opening price points.

Continuing to optimize our advertising spend through refinements and catalog circulation and Internet marketing.

Driving efficiencies in our supply chain including the continuation of our returns, replacements and damages and worldwide sourcing initiatives.

Developing an aggressive plan to reduce fixed occupancy costs where possible.

Including the closure and lease renegotiation of underperforming retail stores, and the elimination of excess distribution and corporate office space.

And maximizing profitability and cash flow through aggressive cost reduction, inventory management, and capital spending initiatives.

All of these actions will improve our bottom line, strengthen our balance sheet, and position our brands to emerge stronger when the economy improves.

While we recognize that our business is being significantly impacted by economic issues far beyond our control, people's homes are still one of their most material assets, and they will invest in them over time.

And when they do, our brands will be well-positioned to capitalize on the opportunity.

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

Thank you, Howard.

Good morning.

Before we discuss our first quarter results, I want to remind you that certain financial comparisons are on a non-GAAP basis as described by Steve earlier in today's call.

These non-GAAP results exclude a $0.04 per share impact from charges associated with underperforming retail stores in the first quarter of 2009, and a $0.05 per share benefit related to an early lease termination incentive that we received in the first quarter of 2008.

Despite the ongoing top line challenges that we and the home furnishing sector overall continue to face in the first quarter, our performance substantially exceeded our expectations, and confirmed for us that the aggressive actions we have taken to adapt to this new economy were the right ones, from both an operational and financial perspective.

The highlights were as follows.

On a non-GAAP basis, our first quarter loss per share was better than expected at $0.14, versus a profit of $0.05 in the first quarter of 2008.

The favorability versus our expectations was driven by strong execution, including better than expected selling margins, advertising costs, and operating expenses.

Net revenues in the first quarter decreased 22% to $612 million.

Retail net revenues decreased 18%, including a comparable store sales decline of 21%.

Direct-to-customer revenues decreased 27% on circulation reductions of 17% and 23% respectively, for catalogs and catalog pages.

Internet revenues decreased 23%.

Non-GAAP gross margin as a percentage of net revenues decreased 540 basis points to 30.1% in the first quarter.

This decrease was primarily driven by the deleverage of fixed occupancy expenses due to declining sales and an increase in cost of merchandise sold, including the impact of increased markdowns.

Occupancy deleverage contributed over 75% of the 540 basis point year-over-year margin decline.

Non-GAAP SG&A expenses as a percentage of net revenues decreased 40 basis points to 33.9%.

This decrease was primarily driven by reductions in total advertising costs, including the benefits from our catalog circulation optimization strategy, but were partially offset by the deleverage of employment costs due to declining sales.

In dollars, we decreased non-GAAP SG&A by $61 million, or 23% to $207 million, in line as a percentage of sales with our revenue decline.

Significant year-over-year working capital variances at the end of the first quarter were as follows.

Cash and cash equivalents increased $69 million to $96 million, with no outstanding borrowings under our $300 million revolving line of credit.

At this time, we do not anticipate accessing this line at any point during the year.

Merchandise inventories decreased a substantially better than expected $166 million, or 23%, to $548 million.

The primary driver of this decrease was a reduction in units across all brands and all categories.

Prepaid catalog expenses decreased $17 million or 31% to $37 million.

This decrease was primarily driven by reductions in catalog circulation.

Accounts payable decreased $47 million or 27% to $130 million.

This decrease was primarily driven by the lower inventory purchases.

I would now like to briefly discuss our fiscal year 2009 guidance, which for comparative purposes excludes the impact of unusual business events in both 2009 and 2008.

From a revenue perspective, we are continuing to base our 2009 guidance on the assumption that the sales trend we saw in October/November 2008 will continue on a two-year basis until we anniversary it in the last month of the third quarter of 2009.

This is consistent with our results since that time, except for the impact of seasonal spikes and the aggressive fourth quarter 2008 inventory reduction program, which we will not be repeating this year.

Accordingly, we are reiterating our quarterly net revenue guidance for 2009, and adjusting the full year to reflect our actual results in the first quarter.

Annual net revenues are projected to decline in the range of 13 to 16%, with comparable store sales projected to decline in the range of 12 to 16%.

From an earnings per share perspective, we are reiterating our remaining quarterly guidance for the year but are increasing our annual guidance to reflect our substantially better than expected results in the first quarter.

As such, our revised fiscal year 2009 earnings per share guidance is as follows.

Non-GAAP diluted earnings per share are now expected to be in the range of negative $0.07 to positive $0.11 and GAAP diluted earnings per share are now expected to be in the range of negative $0.11 to positive $0.07.

From a balance sheet perspective, we are also reiterating our capital spending guidance in the range of $90 million to $100 million and our inventory guidance in the range of $480 million to $510 million.

Consistent with our strategic initiative to enhance shareholder value, we remain committed to driving growth, profitability, and cash flow, despite the challenges we face in this difficult economic environment.

I would now like to turn the call over to Dave DeMattei, to discuss the Williams-Sonoma, Williams-Sonoma Home, and west elm brands.

Thank you, Sharon.

Good morning.

The performance of the Williams-Sonoma brands in the first quarter significantly exceeded our expectations, and we continue to be encouraged by the brand's relative economic resilience, especially at higher price points.

Driven by innovative and exclusive product introductions, electrics and cookware were two of our best performing categories.

We also saw renewed energy in our food and houseware categories, due to new product introductions and a strong visual presentation.

During the quarter, net revenues declined a better than expected 11%, driven by a comparable store sales decline of 15%, offset by a better performance in the direct-to-customer channel.

Selling margins in the brand were also above our expectations and are only slightly below last year, due to a stronger than expected full price selling.

As people are eating out less and entertaining more, we believe we can continue to attract customers to the brand, despite current macro pressures.

As we look forward to the second quarter and the balance of the year, we are doing so with the same cautious outlook with which we entered the first quarter.

As such, we are executing against those initiatives that we believe will drive traffic to our brand and be relevant in the lives of today's customers.

These initiatives will also keep us well positioned in the current retail environment, as well as put us in a position of strength when the economy improves.

These initiatives include partnering with key vendors to introduce innovative and exclusive products that are unique to the marketplace.

Leveraging Williams-Sonoma's cooking authority to develop an exclusive food offering that can capitalize on current trends in home cooking.

Emphasizing value through set pricing and key price points.

And expanding eCommerce marketing in the areas of paid and natural search.

Customized e-mails, product reviews and remarketing.

We believe that even in this difficult macro environment, our strong merchandising, innovative marketing and superior customer service will continue to differentiate the Williams-Sonoma brand as a destination of choice for high end cooking and entertaining essentials.

In the Williams-Sonoma Home brand, the first quarter remained very challenging, as the luxury consumer continued to retrench.

As such, we focused during the quarter on those initiatives that in the near term prioritize profitability over growth.

These initiatives include lowering our inventory, which was down over 37% at the end of the quarter, reducing our catalog circulation which was down over 30% during the quarter.

And refining our product assortment to cater to our best customers.

While we believe that all of these initiatives will improve profitability in 2009, there is still tremendous fixed cost pressure in our underperforming stores that we are working aggressively with our landlords to address.

We are also continuing to assess the brand's overall market potential in this reset economic environment.

Although revenues in the west elm brand declined significantly in the first quarter, west elm continued to be one of our least impacted home furnishing brands on a two-year comparable store sales basis, despite having a large percentage of stores located in the housing impacted areas of the country.

During the quarter, we opened three new stores, one in Manhattan, one in Northern California, and one in Arizona.

Like other brands, west elm focused on several initiatives during the quarter to align inventories and expenses with sales levels.

We are particularly pleased with the progress we have made on our catalog circulation optimization, replacement and damages and inventory turn initiatives.

We will continue throughout the year to assess the tradeoffs between tighter inventories and sales in this brand as we gain more experience in this new retail environment.

From a merchandising perspective, our best performing categories were those in which the customer could make easy updates to their home decor at a great value.

Our weakest performing categories were those were higher price points like furniture.

As we look forward to the second quarter and the balance of the year, our focus in west elm will be on continuing to expand the reach of the brand and improving profitability, despite our expectation that sales will continue to be negative.

To expand the reach of the brand, we are opening one additional store in Austin, Texas later this year.

We are also developing a new opening price point merchandising strategy and emphasizing the west elm value proposition through brand marketing.

To improve profitability, we are refining our product mix toward higher margin categories, optimizing our vendor base through factory consolidation, improving packaging to further reduce returns, replacements and damages, expanding the penetration of our catalog circulation optimization strategy, including investing in higher productivity eCommerce opportunities, and improving the four wall contribution of the retail channel by evaluating opportunities for underperforming stores.

We believe our good design at great prices in west elm will prove relevant in these trying times and provide a significant competitive advantage over the long term.

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

Thank you, Dave and good morning.

First I'll start with the Pottery Barn brand.

While first quarter net revenues declined 26%, including a 23% decline in comparable store sales, the result was encouraging because it was in line with expectations for the first time in several quarters.

As such, our results this quarter are the first positive indication we have that there may be stabilization in our business, which, if sustainable, could provide opportunities as we progress through the year.

These results also give us affirmation of the success we are having with our new merchandising and customer service strategies, as it is those initiatives that are leading our recovery.

Also encouraging during the quarter was the significant progress we made on improving our post downturn selling margins, optimizing our advertising costs, and reducing our inventories.

Strategic promotions and strong operational execution drove substantially better than expected results in all of these areas.

From a merchandising perspective, our focus on the product line and value coupled with a shift in marketing to private label credit card programs, and online advertising, resulted in renewed momentum in bedding and furniture, both of which were among our best performing categories during the quarter.

Connecting with our customer from both a style and value perspective is particularly critical now as the economic downturn changes fundamental consumer behavior.

From an operational perspective during the quarter, we continued to improve profitability through our supply chain initiatives, including reductions in returns, replacements and damages and post downturn cost of merchandise sold.

We also continued to drive down our inventories in both units and dollars, which contributed to improved selling margins in the quarter.

As we look forward to the second quarter and back half of the year, although we are gaining confidence in our projections, we are cognizant of the fact that the retail environment is still fragile.

Therefore, despite our better than expected performance in the first quarter, we are remaining cautious in our outlook from both a top line and a selling margin point of view.

As a result, we are focusing on our brand strategies for the balance of the year that will drive profitable incremental growth and improve operating margins.

These opportunities include a clear and consistent merchandise strategy in every category, a shift in our value proposition through an increase in opening price points, category promotions and enhancements to our third party private label credit card program, increased marketing of opening price points across all channels, differentiated services, including interior design, [clienteling], and in store events and a shift in marketing spend out of the catalog into eCommerce as we continue to focus on the significant opportunity that the Internet represents.

Now I'd like to talk about Pottery Barn Kids.

Although our results for the first quarter in Pottery Barn Kids were in line with the October/November trend, it was a difficult quarter on both the top and bottom lines.

During the quarter, net revenues decreased 27%, including a 25% comparable store decrease and selling margins remained under pressure as we continued to reduce inventory weeks on hand and exit the apparel category.

At the end of the quarter, brand inventories were down over 34%.

From a merchandising perspective during the quarter, better than average performing categories were textiles and decorative accessories due to exclusive product introductions and promotional activity.

Higher price point discretionary categories like rugs and occasional furniture were our most challenging categories.

From an operational perspective during the quarter, we continued to share the same success in supply chain as Pottery Barn.

We also spent considerable time on our store real estate portfolio and successfully closed two underperforming stores during the quarter.

As we look forward to the second quarter and back half of the year, we will continue to focus on opportunities to maximize sales in the current environment, while protecting our strong competitive presence.

These initiatives include providing a wider range of opening price points in all categories, marketing our third party private label credit card and loyalty programs, increasing exclusive premium brand licensing arrangements, shifting our advertising spend from catalog to eCommerce in the areas of customized e-mail, affiliate marketing, paid and natural search and remarketing, and improving the four wall contribution of the retail channel by continuing to examine underperforming stores and removing our least productive categories.

I would now like to talk about Pottery Barn Teens.

Net revenues in the PBteen brand declined a better than expected 17% versus a 29% increase in the first quarter of last year.

This decline was significantly better than expected.

Selling margins were also ahead of expectations.

And while we are disappointed with any decline, PBteen continued to be our best performing home furnishings brand and the best performing brand in the Company on a two year trend basis.

From a merchandising perspective, the best performing category in the brand was textiles, due to new product introductions and strong merchandising.

While furniture was our most challenging category, we expect to see a stronger performance in the back half of the year as we introduce new value into this category.

As we look forward to the second quarter and back half of the year, we will continue to focus on extending the reach of the brand and maintaining its position as a top of mind destination for home furnishings for teens.

These initiatives include expanding our merchandise assortment across a wider range of price points to address the consumer's sensitivity to value.

Building upon the robustness of our eCommerce experience through improved site usability and greater customer interaction.

And, testing PBteen merchandise within the four walls of two Pottery Barn Kids stores and in a small showroom in New York.

We continue to be excited about the long-term growth potential of PBteen, as it solidifies its positioning in the Pottery Barn portfolio of brands.

I would now like to open the call for questions.

Thank you.

Thank you.

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

(Operator Instructions).

We'll pause for just a moment.

And we'll take our first question from Budd Bugatch from Raymond James.

Good morning, Howard.

Good morning, Sharon.

Good morning, Laura.

Good morning, Dave.

And congratulations on better than expected performance in the quarter.

My question relates to the fact that DTC sales decline was greater than the retail decline and yet you profess some optimism on the catalog optimization program.

How do we know that that's working?

What metrics can you give us?

I know you gave us the catalog pages reduction and reduction in catalogs.

But sales are dropping at a bit of a faster rate.

Can you kind of describe how you look at that and how we should think about it?

Absolutely.

Pat, would you please take Budd's call, question.

Absolutely, Budd.

On the Internet side of the business we were up against a much tougher compare with first quarter revenues up almost 9% last year so on a two year basis, we were down about 14% on a two year basis, which we are very pleased with.

Remember that a lot of our catalog sales -- our Internet sales are driven by the catalog sales.

Our catalog optimization strategy involves analyzing those marginal catalogs that would not have been profitable had we mailed them.

We're very confident, because we've been into this for almost 15 months now, that the circulation we cut would not have been profitable in terms of meeting our standards for customer profitability over an extended period of time.

We'll take our next question from Alan Rifkin from Banc of America-Merrill Lynch.

Just following up on Budd's question, with respect to the catalog circulation optimization program, how much of the benefits now that you're 15 months into the process, do you believe are behind you as opposed to still opportunities going forward?

I realize that it's an iterative process.

Any sort of qualification along those lines could be given, that would be great.

Then my second question relates to the distribution capacity.

Curious where you thought from an efficiency standpoint you were with respect to eliminating some of the excess distribution and when might we see one or more call centers or DCs possibly closed going forward?

Thank you very much.

Pat, could you follow up on his question on catalog circulation and what is in front of us related to future opportunities there?

I will, Sharon.

Alan, we started the catalog optimization initiative really at the end of the first quarter last year but we continue to see opportunities.

We're going to see circulations down in the high teens this year and page counts down a little bit more than that.

Pretty consistent across all the brands.

The second part of the optimization strategy involves our ability to use versioning.

That is, to mail smaller books to certain segments of our file, particularly those in retail trade areas and we've had considerable success there.

We continue to extend it, particularly in the Williams-Sonoma brand.

And we've successfully now implemented it in west elm.

So we continue to see opportunities there.

And where there's marginal dollars that we're able to save, we're spending more of that in Internet advertising across a number of areas that Laura pointed out in PB Kids, including customized e-mail, page search, affiliates, and remarketing which are proving to be very effective for us.

From a distribution perspective, we anticipate by the end of this year that we will have reduced distribution capacity by approximately 20%.

We have about 1.2 million square feet that we, based on our successful inventory initiatives, are going to be able to get out of.

We'll be consolidating that into our other facilities and at this time we are not looking at any additional call center activities.

We'll take our next question from Joe Feldman with Telsey Advisory Group.

Hi, guys.

I have a question about leases and the lease negotiations update.

I recall last quarter I think on the call you had mentioned of the 600 plus stores that you guys operate, around 15 or so you were able to negotiate some lower leases.

I just wanted to get an update on where things stand and how you're thinking about stores in the future.

Howard, would you please speak to that?

Well, this scenario, we're spending an awful lot of time on, visiting with our major landlords and really all our landlords across the country and as we said in the call, we continued our underperforming stores that have become underperforming stores as a result of this economy, we're being very aggressive with, trying to close them where we can.

We're trying to work with our landlords.

It's a difficult problem for all of us.

Certainly as renewals come up, we're able to negotiate much better lease terms than we had before.

So it's an ongoing process that we're working at.

It's a major both problem and opportunity for us as we look forward, trying to figure out how to deal with what I think of as the reset in this new world as to where the sales are going to be, starting entering 2010.

And where we go from there.

And obviously we've got to bring our occupancy cost in line with our sales.

It's something close to historical levels and that's our goal and there's several ways to get there.

We would prefer to get there by keeping our current store base and readjusting our expense structure.

If we can't, then we'll have to get there by closing some of our stores and driving those sales into the remaining stores in those markets.

So we'll see how it plays out over the next few months to a year.

And we'll take our next question from Matt Fassler from Goldman Sachs.

Thanks a lot.

Good morning.

One follow-up on the expense side and then a quick one on comps.

I'll ask them both at once.

On the expense front, you did seem to beat your fourth quarter -- rather your first quarter expense dollar plan.

You left your expense guidance for the rest of the year unchanged.

I guess I'm curious, did you make incremental progress in the SG&A run rate, broadly speaking, in the first quarter versus where you were in Q4?

My second question, just relates to the comp progression during the quarter, do you have any insights about the state of the consumer and the state of the consumer vis-a-vis your categories based on changes in the February through April.

Matt, I'll take your question on the expense guidance for the balance of the year, we did make substantial progress in virtually every category in the first quarter and in no way are we trying to send a message that we expect to see any different performance in expense in the back half of the year.

The only area, the biggest piece of our SG&A, the second biggest piece to employment is of course our advertising expenses and as you heard in all of our prepared remarks earlier, we are very aggressive about the Internet at this time and we're leaving some flexibility in our marketing expenses between now and the end of the year to take advantage of opportunities that present themselves.

We think we're extremely well positioned there.

We think this is the time to jump on it, as Howard said.

We're not going to sit back even though the things we can't control, we're aggressive about it.

We left some money in there in the advertising area to ensure that we've got ourselves covered for the back half of the year.

Matt, it's Howard.

On the second part of your question, with regards to what we're feeling about the consumer, as we said in our remarks, we're cautious.

I don't think we -- I think we said at the last time we spoke with you, that we would certainly need to see the end of May and perhaps June and July before we could have a sense of how to protect with more confidence the balance of the year, because of the mixed calendar in the first quarter, the lateness of Easter and et cetera.

So I would characterize May for us, as particularly as we focus on the two year trend as somewhat encouraging.

think we feel like there's a little more confidence out there.

We feel like we're going to get a breakthrough.

We are getting modest improvements with some of our brands.

That seems to be consistent, but it's not enough to be able to reforecast it into our numbers for the balance of the year.

We are -- that's particularly true with Pottery Barn.

I would say that as we said earlier, we think we've made a lot of improvements in Pottery Barn.

I think personally the stores look the best they've looked in many years here.

And our field organization, we've revamped.

The programs that we put into place.

We are seeing some improved results in Pottery Barn.

And we're seeing those every day fairly consistently, so the bias would be if we kind of characterize our feelings, the bias would be, yeah, I think it's getting a little bit better and I think we're on the right trend but then we have a breakdown in California or something that kind of sets us back.

So it's just not clear yet but we're feeling a little bit more hopeful.

And Matt, I would say that as a general rule, it's consistent with what I said in Q1, is that the two areas where we believe that we have remained cautious in this guidance is in Pottery Barn and in the expense base and if we beat the numbers, I think that that will be in those two areas and the selling margin as well.

We certainly don't know what the competitive landscape looks like, but from an internal point of view, therein lies our opportunities to this guidance.

And our next question comes from Colin McGranahan from Bernstein.

Good morning.

Just to first follow up a little bit on Matt's question, that does sound like you're getting a little bit more confident here just in the stabilization.

Are you seeing any kind of a change in traffic trend, or is that more driven by some of the improvements you talked about for instance in the furniture business in Pottery Barn and how much of what you're seeing do you think is your own marketing efforts, and I know again you mentioned some improvements in the private label credit card.

So if you could maybe provide a little bit more color on the traffic trends through the quarter, what you're seeing in traffic and ticket and then big ticket versus small ticket.

And then as an aside, an ancillary question, you mentioned uncertainty around the competitive environment and competitive exits.

If you could just provide a little bit more color on one, what you've seen so far and two, what you're expecting or hoping to see through the course of the year from the competitive standpoint.

Since Howard spent quite a bit of time with the landlords, I'll let him take the first question which is how are you seeing traffic and things like that and then more specifically where you asked about Pottery Barn, we'll let Laura speak to the Pottery Barn business.

So Howard?

Well, mall traffic is certainly down, and our best guess is that it's down somewhere in the mid-teens.

That's -- we don't have true counts from all the malls and the International Council of Shopping Centers and so on.

But our best guess in the malls that we're in is that we're running somewhere in the low to mid-double digits, 15, 12, 15%.

So I think the traffic in our -- a couple of our brands, particularly in Williams-Sonoma, is probably down less than that.

What we're finding, though, is that the consumer, they're not spending as much, which has been the trend that we've seen for the past couple years.

That's particularly magnified I think on the Internet.

Pat, you might comment on this, but our traffic has been up but our conversion has been down.

We think that's a result of people shopping more for prices or just shopping and not buying.

So I think we're in that world that I tried to describe earlier where people I think want to shop.

They just haven't quite -- they just haven't quite got to the point that they're comfortable doing it, either economically or emotionally.

Laura, I don't know, you want to add something to that or -- ?

Sure, Colin, to your question about big ticket versus small ticket.

Overall we're seeing the easy updates get the most traction.

We're seeing renewed interest in textiles, particularly bedding.

We've seen this great pillow uptick for a while.

We've been very focused on what we call world domination of pillows.

But we're also seeing that spill over into our bedding business and some of the decorative accessory area where you get a lot of update for your money.

However, I will tell you that there are some furniture categories that are also picking up, and it is because of our focus on high quality, great style, and unbeatable price, a great example being our PB Comfort Sofa which hit all those categories and was sustainable at $999 that we market on the cover of our catalog.

So we're seeing some signs of life in both some high ticket and lower ticket across the brands.

Dave, I think in your prepared remarks you did speak to the higher price point selling in Williams-Sonoma and cookware and electrics but you do have three brands that hit different demographics so could you speak to the performance and your feeling about that in those brands?

Sure.

Like I said in my prepared comments, in Williams-Sonoma where we have exclusive innovative products like the new Calphalon Unison line that we just introduced, it's a new technology of non-stick, tremendous, tremendous response to that.

The new food processors from Cuisinart that we are introducing, which there has not really been any development in that area for probably 20 years have been a huge seller.

In fact, we're chasing the inventories there to get in that product, and then moving to the furniture brands, like Laura, we see the easy updates in textiles and pillows and throws, those performing better than average in our categories.

Price isn't always the determinant in west elm where we have product like our storage bed that has great function and serves a need that the customer wants, we see great selling on those things.

So it really depends on the product but price is usually not the determinant but really textiles have been more dominant.

Just to follow up on Colin's comment about site traffic, what we're seeing, what Google is telling us and what we're seeing from some of the focus groups we've done is the consumer is much more considerate.

They're visiting the site more before they buy, and they're looking around more, so while traffic is up, they're taking a longer time to make their purchase decision.

And our next question comes from Janet Kloppenburg with JJK Research.

Good morning, everyone.

Good morning, Janet.

I had a couple of questions.

The first is it seems like your cut in advertising spend is pretty commensurate with the decline in the direct revenue line, direct to consumer revenue line and I'm just wondering what you think will be the catalyst to make sales improve there as those advertising dollars continue to decline.

And Laura, I wondered if you could talk a little bit about the credit card push, we're in a period of very constrained consumer credit and I'm wondering why you think this is the right time to make a push there?

And lastly, Howard, I was wondering if you could comment on the outlook for rent renewals at the Pottery Barn stores.

I know the big push of expansion was about 10 years ago when mall rents were substantially lower and I'm just wondering as these come up for renewal, what the opportunity would be for more advantageous leases?

I'm actually worried that the leases could actually spike a bit, the lease costs.

Thanks so much.

Okay.

Pat, could you speak to the cut in spending being consistent with the DTC decline and those things we're working on as catalysts for -- ?

Yes, I can.

Janet, what we're doing with catalog optimization is closely analyzing the marginal part of our circulation, and to the best of our knowledge, the books that we're cutting would have had ad costs that are close to 100%, so clearly those are the ones that we would want to cut.

We are seeing a decline in spending on the books we are mailing as we are seeing a decline in the sales in our stores, but we're very careful about how we're cutting circulation and the two numbers may be close, but they're not necessarily correlated, and we are taking a lot of effort to really, as both Sharon and Laura indicated, redirect some of our advertising spend into the Internet, which is proving to be more effective with some new programs that we've launched.

And then Laura, could you please speak to her question regarding the push in private label credit card within your brands?

Sure.

On our credit card program, it is a third party supported program and we actually haven't seen a decline in our approval rates so far, and we were on a store visit trip and we had been talking to a lot of our store associates about things we could do to drive our business, and they encouraged us to help the customer make the decision to purchase the furniture to do a delayed payment, 12 months, no payments, and then also to make the rewards program more robust, matching some of the other retailers in the market because ours was under -- the discount was under what the competition has done and we really listened and thought it over carefully, and put it into place and we have seen that it's not the thing -- it's not the only factor that makes them purchase, but it is one of the important parts of the consideration set to get them to feel more comfortable buying high ticket products.

And we've also seen one of the things that's very advantageous about the credit cards, it's bringing in a lot of new customers to our brand that haven't shopped us before and we're very pleased with that, and then also we are seeing great uplift on the rewards that we send out.

When we send them out, they come in and they spend substantially over the value of the rewards.

So there's a lot of great benefits to the program.

We are continuing to look at it on a regular basis and re-evaluate whether it's the right thing forever, but right now, we feel like it's a very important part of our strategy.

And actually the brand that has the greatest penetration on the private label credit card is west elm and Dave, would you like to speak to how you use the credit card in west elm as well?

Yeah.

We were pretty much one of the first to make the push with the design dollars that Laura just talked to, where there's kind of an incentive to bring the customer back into the store and remarket to them, and we do see a huge uplift in those design rewards, and we get a very good loyalty program going based on that.

And then Janet, your last question was the outlook for rent renewals as we go forward.

You pointed out that the store openings in our brands kind of coincided with about 10 years ago and Howard, could you please speak to this issue?

Janet, you're right, we started building the design stores in Pottery Barn in the fall of 1994.

I think we built our first four.

And so we are starting to see now or we have been seeing some of those leases starting to come up for renewal.

Usually, we have been historically, a couple years out in front of the natural expiration of the lease, and as you know, because business was so robust at Pottery Barn, many of those stores after eight or nine years we remodeled them and enlarged them and renewed the lease.

So we could cover the new depreciation schedule, new investment, that we had.

But we do have starting in -- well, I mean, there were a few this year, a few more next year, and then they accelerate through the next three or four years, all those renewals, they'll be coming up.

I think this whole area is one that is, as I said earlier, is very complex.

If in fact the world is off for these two years entering 2010, something like 25%, which is what I tend to think it is, or will be for the two years, then those rents that we were paying on the previous lease in my view have to go down 25%, our occupancy expense, or something close to it.

And we, as I said earlier, we've got to find a way to get it there.

Existing leases, we don't have any real leverage to force the landlord to lower the rent.

I mean, and he's got a contract, and he would expect that he would get his rent stream, and pretty much our landlords with a few exceptions, are holding to that, but as renewals come up, we're being very aggressive and we're expecting something in the order of what I've talked about to bring rents back into line.

Now, we have other -- the whole issue is a very large issue.

We'll have a certain percentage of our leases where we will have what's called a co-tenancy failure, and that would be where we've written into our leases certain requirements for the landlord in terms of other tenants that they've guaranteed that will be there, department stores or other specialty stores, and if they violate that covenant, then we have certain rights, sometimes those rights allow us to kick out of the lease totally.

Sometimes they allow us to reduce our rent quite substantially.

So there's a lot going on here.

This is a really complicated world, and we're spending an inordinate amount of our time.

I've just, the last I think weeks ago, our real estate team and myself flew around the country, visiting with our major landlords.

We continue to do that.

We've got more meetings where Dave and I are out visiting stores this week and his team next week.

The following week, I'm visiting with two of the major landlords again in follow-up meetings to try and think through how we're going to do business in the future.

Because it's a challenge for the whole community, both the real estate and REIT community as well as the retailers.

So stay tuned.

(Operator Instructions).

The next question comes from David McGee with SunTrust Robinson.

Yeah, hi, good morning, everybody.

Good morning.

Good morning.

Just a quick question on container costs.

Was that a significant benefit in the first quarter and what are your expectations that you've got kind of baked in with container costs over the balance of the year?

Well, as the industry has declined in the neighborhood I've heard numbers 20 to 35%, depending on the level of importing, now, that all began about this second quarter time frame.

So that cost is going to go into your inventory, Dave, and then it goes into your average cost and then it will flow through, through the balance of the year.

And the first quarter we saw no benefit from it, and quite frankly, I don't anticipate seeing any significant benefit from it until we get into closer to Q3, by the time we receive in the inventory and selling it.

We will see a substantial reduction in cost in the back half of the year related to container costs.

Next question comes from Anthony Chukumba from FTN Equity Capital Markets.

Good morning.

I had a bit of a follow-up question in terms of real estate.

You made some remarks about working with your landlords and upcoming lease renewals and also how many leases you have with co-tenancy agreements.

I guess I was just focusing on -- wanted to focus on the co-tenancy agreements.

What percentage of your leases have these co-tenancy agreements in them, that would allow you to potentially get rent reductions or close the stores without a penalty, if one of the big co-anchors closes in the shopping center?

I'm not sure of the exact percentage.

Somewhere around 25 or 30%, probably, of our leases have some form of co-tenancy requirement in them.

I could be -- Sharon, do you have a better number?

I think that's right in the range.

I think that's pretty close to the range that we have.

Somewhere around 25 or 30%.

Anthony, they're different.

Each lease in and of itself is very different, and it may be a co-tenancy kick-out.

It may be a -- what we call a co-tenancy failure or kick-out rights, a sales threshold issue, so there are several different attributes.

It may or may not be about a named co-tenant.

But Howard's percentages are absolutely correct.

Let me say this.

Anthony, at the end of the day, we and the retail specialty business, or department stores, any of us, we're partners with the landlords and the major REITs out there and the small real estate guy who built a lifestyle center in some middle sized city.

We're all partners and we're in this together.

And I believe that while we have a very difficult problem, in that this economy has just dropped a significant notch, and we're going to have to deal with that, the end of the day we're going to have to deal with it as partners, and we look for leverage where we could get it.

Right now, they've got it because they've got leases, but what we're trying to do in our meetings with our landlords is convince them and it's not hard to do at all, it's very clear, that we are pretty much the best of class in our categories and that we're going to survive this.

We're going to be here when it's over.

And if they want to have a home strategy in their properties, then we need to work together you now to assure that we're healthy and we're there and we're doing it in a way that works for both of us going forward.

And so, it's an issue that's going to take some time.

It's a grind.

We're both trying to get to the same result.

But it's going to take a little time.

But it's a major problem for the retail bricks and mortar retailer in general.

What we're particularly encouraged about our business, which I think is what's fundamental to strengths right now, is the fact that 40% of our business, approximately, isn't coming straight from retail.

The direct business, you can see it in the SG&A leverage, to be 100% retail right now would be extraordinarily challenging but the direct piece and the variability of that piece has been extraordinarily beneficial for us.

Let me just add to that.

I know we've had several questions about productivity in the direct side and the catalogs and the ad costs.

In fact, this quarter, advertising expense in the direct side is sort of like analogous to occupancy expense in bricks and mortar part of our business.

And in our retail business, we've adjusted everything else that we can.

I mean, our margins are strong.

Merchandise margins.

We've adjusted our service levels.

I mean, so that we think that they're as good as they've ever been, but we brought our costs down to our 2003 levels, so they're about as good as they've ever been as a percent to sales.

Our general expense, all the other expenses in the store we've adjusted but we haven't had the ability to do that with occupancy expense.

Where in the direct side, we have.

Our sales were down in DTC in the first quarter I think 23% or 21 or 23% and our advertising expense was down 31.

And that's in an environment where people are spending less.

Our best catalogs are not as productive, obviously, as they were a couple years ago.

I think we've had a very good result there.

Our biggest issue is fixed occupancy expense that we have to somehow deal with going forward.

And our next question comes from Neely Tamminga from Piper Jaffray.

Just a question here for Laura related to fall and holiday.

Clearly you are seeing some upticks and improvements in the decor, these are budget-friendly updates, the value furniture.

Just wondering if the assortment will be distorted enough towards those categories, naturally through the mix, for that decor side, that would play right into some of these strengths.

As well any sort of update you could give us on outdoor, and historically, has a good outdoor boded well for holiday?

Entertaining for entertaining, could you give us some feel on that.

Thanks.

Sure.

You know, it's a great point.

The strength we're seeing in textiles and some of the easy updates is going to -- should play well into the natural shift into holiday and gift giving and those areas where you spend more time decorating your home and you have more people in your home and we have also in addition to that really you'll see in fall and holiday in kids and Pottery Barn and teen, even more great new introductions where we built the value and the great quality into the product from the get-go.

So more things like the PB basic and more planned promotions.

On the planned promotions, we're really focused on driving the margin dollars and different than last year, we are planning them versus taking them because of inventory clearance, and so we're very cognizant of where we can make money by doing that and bring new customers into the brand, and so those strategies are totally in place for fall and holiday.

I'm very optimistic as a result of them, and the results we're seeing now.

On outdoor, it's very interesting you asked that question.

Outdoor, when we started the outdoor season, all of our competition came out with sale prices, right from the get-go.

And we started at regular price and we are now 20% off, and doing quite well at 20% off and particularly as the season gets warmer, we're seeing it gain momentum.

It started out tougher.

It's gaining momentum.

We're also seeing strength not just in the furniture but the outdoor entertaining and the accessories there.

So we still have the rest of June to go on outdoor and there's big sales that happen then.

So it's too early to call it.

But we're excited also because we bought it to the weeks on hand left.

We bought it to the weeks -- the amount of weeks that we have left and we don't anticipate that we're going to have to go any further on the markdowns, which is fantastic.

But what that means for Christmas, I don't know.

I don't know if I've ever seen a correlation between outdoor selling and the Christmas assortment but I know this: We are extremely well set up for fall and holiday with the assortments that we have planned, focusing on high quality, great style, unbeatable prices and really relevant marketing.

And our next question comes from Laura Champine from Cowen.

Good morning.

I just had a follow-up question on your gross margin performance because I'm not sure you broke out product margins specifically but it seems like they might have been better than expected, driven by your inventory cleanup and maybe better sell-through of new products.

Why would you not see the same kind of benefits drive upside in gross margins the next few quarters of the year?

Laura, I'll take that question.

In Q1, in our prepared remarks, we said that of the margin deleverage in Q1, 75% of it was driven by fixed occupancy.

The balance, actually by markdowns, promotions, with the private label credit card, remember, there are fees associated with the loyalty program and the 12 month same as cash program so those are like markdowns.

So that affects the margin.

As we look forward to the back half of the year, we had played in improvement in our margins, but Howard mentioned that we continue to be cognizant of the fact that we have competitors closing stores, liquidating inventories, the inventories of many of our competitors are still too high and we are seeing bankruptcies.

That inventory gets flooded on the market and we may have to react to that.

So within our guidance, for the balance of the year, we have left a significant cushion related to having to deal with those issues, if we need to.

Like I said earlier, when you think about where we believe that we will beat this guidance, if we beat it for the year, it will be in the performance of Pottery Barn, better selling margins, and on the cost side where we're still seeing great controls in those areas.

So that's how we're looking at it.

Thank you.

That is all the time we have for questions today.

I will now turn the call over to Howard Lester for closing comments.

Well, thank you for joining us today, and we'll be talking to you in another quarter.

Thank you for your support.

Good morning.

And this does conclude today's conference call.

Thank you for your participation.