Williams-Sonoma Inc (WSM) 2010 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the Williams-Sonoma Inc.

first quarter 2010 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, 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.

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

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 why these non-GAAP financial measures are useful, are discussed in Exhibit One of the press release.

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 2010 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 for more information on these risks and uncertainties.

The Company undertakes no obligation to update or revise any forward-looking statements to reflect circumstances or events that may arise after 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 next CEO, Pat Connolly, our Chief Marketing Officer, and Sharon McCollam, our Chief Operating and Chief Financial Officer.

I'd like to begin today by sharing with you my perspective on the strength of our operating results in the first quarter, and then I'll turn the call over to Sharon and Laura for more details on the quarter and the balance of the year.

Before I begin, I'd like to take a moment to thank all of you who have supported us here at Williams-Sonoma over the past 30 years.

As I approach my retirement next week, I could not help but reflect on the contribution that so many have made to our collective success.

First and foremost, I want to thank our associates who have dedicated their careers to building our dreams and serving our customers.

I'd also like to thank our supply chain partners, our landlords and our service providers, for all they've contributed as well.

And then of course, there are all of you, our shareholders.

What's amazing to me now is that, as much as it has been a joy and an honor to lead this great Company, I'm finding equal joy in watching the people who have been crucial to building it over the past decades take the helm.

While it is so bittersweet to step away, I'm doing so at a time when our management team, led by Laura, has never been stronger, and our future has never been brighter.

There's no better evidence of this than our first quarter results.

On revenue growth of 17%, non-GAAP diluted earnings per share increased $0.37 to $0.23, versus a $0.14 loss last year.

This is our highest first quarter non-GAAP diluted EPS in history, and our operating margin is at peak levels as well.

It represents what's possible when a strategy is well-executed, and entered on the Company's most -- and centered on the Company's most important asset, its customers.

While cost containment and inventory management were critical, there was equal focus on our brand proposition and the customer experience.

Collectively, these initiatives transformed our business, and we are now a structurally more profitable and efficient Company, as demonstrated by these results.

And the momentum is continuing.

As such, our guidance has been increased to reflect the upside.

Revenue growth for fiscal year 2010 is now expected to be in the range of 6% to 9%, and diluted earnings per share in the range of $1.39 to $1.48.

We really have to commend the entire management team for having the ability to drive the performance that we've seen over the past several quarters.

But particularly, Laura and Sharon for their extraordinary leadership during these unprecedented times.

I could not be more proud of what these teams have accomplished.

I'll now turn the call over to Sharon to discuss the details of the first quarter.

Sharon?

Thank you so much, Howard.

Good morning, everyone.

Our first quarter performance once again substantially exceeded our expectations.

The P&L highlights were as follows.

Net revenues increased 17% to $718 million.

Retail net revenues increased 15%, including a comparable store sales increase of 17%.

Direct to customer net revenues increased 20%, despite catalog and page circulation reductions of 3% and 4%, respectively.

Internet revenues were up 24%.

Non-GAAP diluted earnings per share were $0.23 versus a loss of $0.14 last year.

These results were above both the high end of our guidance and the FirstCall consensus estimate.

Stronger than expected sales and greater than expected full-price selling drove these better than expected results.

GAAP diluted earnings per share were $0.18, including a $0.03 charge associated with underperforming retail stores, and a $0.02 charge associated with CEO retirement expenses.

Non-GAAP gross margin increased 770 basis points to 37.8% in the first quarter.

This improvement was driven by reduced markdown activity, sales leverage of fixed occupancy expenses, a 40 basis point improvement in replacements and damages expense, and an actual decrease in occupancy expense dollars.

For the quarter, our non-GAAP occupancy expense was the lowest in four years and we have increased our permanent store closings this year from 14 to 18.

And finally, non-GAAP SG&A expense decreased 200 basis points to 31.9%.

This decrease was primarily driven by sales leverage of fixed SG&A expenses, partially offset by increased incentive compensation, Internet advertising, and other general expenses.

From a balance sheet perspective, first quarter year-over-year highlights were as follows.

Cash and cash equivalents increased over $300 million to a Q1 record of $405 million.

Merchandise inventories decreased $46 million, or 8%, to $502 million.

As a historical comparison to put this reduction in perspective, on a similar revenue base to Q1 2005, we are operating with 4% less inventory, despite having 58 more stores and 29% more retail leased square footage.

Prepaid expenses decreased $23 million to $38 million, primarily driven by a reduction in prepaid income taxes.

And accounts payable increased $48 million, or 37%, to $178 million, primarily driven by the timing of merchandise receipts late in the quarter.

I would now like to briefly discuss our second quarter and fiscal year 2010 guidance.

Based on our strong first quarter results, and the ongoing momentum we are seeing today, we are incorporating all of the upside we saw in the first quarter into our full year guidance.

We are also conservatively increasing our second quarter guidance.

In the second quarter, net revenue growth is now expected to be in the range of 9% to 12%, versus previous guidance of 4% to 7%.

And non-GAAP diluted earnings per share is expected to be in the range of $0.16 to $0.20, versus previous guidance of $0.08 to $0.12 per share.

For the third and fourth quarters, we are waiting to update our guidance until our next earnings release in August, so that we have more visibility to the sustainability of the trends that are driving our results today.

We continue to believe that there is risk of volatility in the economy over the next several quarters, as consumer spending begins to compare against significantly higher numbers in the back half of 2009.

So in total, our updated full year guidance will be as follows.

Net revenues are now expected to increase in the range of 6% to 9%.

Non-GAAP diluted earnings per share are now expected to be in the range of $1.39 to $1.48 per share, versus $0.95 last year, and that includes $510 million of occupancy expense.

And, GAAP diluted earnings per share, including $0.06 of unusual business events, is now expected to be in the range of $1.33 to $1.42, versus $0.72 last year.

From a balance sheet perspective, we're maintaining our fiscal year-end inventory guidance in the range of $470 million to $515 million, and holding our annual capital spending guidance at the high end of our previous range, at $75 million.

I'd now like to turn the call over to Laura to discuss the performance of our brands.

Thank you, Sharon.

Good morning.

As Howard said earlier, the momentum we are seeing in our business today is very encouraging.

In our core brands, net revenue in the first quarter of 2010 increased a better than expected 19%.

Pottery Barn saw the greatest improvement, closely followed by Pottery Barn Kids.

In our emerging brands, including West Elm, Pbteen, and Williams-Sonoma Home, net revenues increased 11%.

In the Williams-Sonoma brand, net revenues increased a better than expected 8%.

Comparable store sales increased 11%, and selling margins continued to rebound towards historical levels.

From a merchandising perspective, we saw strong growth across several categories, with particular strength in cookware, cook tools and electrics.

We also saw a better than expected consumer response to our seasonal assortments for Valentine's Day and Easter.

As we look forward to the second quarter and balance of the year, we will continue to execute against those initiatives that are driving momentum in the business today, including new and exclusive product introductions, strategic price points and targeted promotions, and innovative marketing strategies, particularly in the areas of eCommerce, social media and in-store events.

All of these initiatives are driving new customers to the brand, and affirming the brand's authority as the premier destination for high quality cooking and home entertaining essentials.

In the Williams-Sonoma Home brand, we continue to make progress on the restructuring and, as expected, we are successful in reducing the brand's year-over-year non-GAAP operating loss by approximately $0.01 per diluted share in the first quarter.

Aggressive inventory management and strong expense controls drove these improved results.

Remaining assets on the balance sheet at the end of the first quarter were $13 million, including $8 million of inventory.

In the Pottery Barn brand, net revenues in the first quarter increased a better than expected 25%, versus a 26% decline last year, with ongoing momentum in both the retail and direct to customer channels.

Comparable store sales increased 23%.

From a merchandising perspective, all key categories, particularly furniture, textiles and decorative accessories delivered strong growth.

We also saw a robust consumer response to our seasonal themes.

From an operational perspective during the quarter, gross margin continued to improve, due to the cumulative benefits of our inventory management and supply chain initiatives.

We are particularly encouraged by the success of our Asian sourcing initiatives, as we improve quality, develop exclusive designs and partner with our vendors to control costs.

We see this as a significant competitive advantage and barrier to entry for the competition.

In the direct to customer channel, we have continued to shift our investment from marginal catalog circulation to Internet marketing, which is driving incremental growth and new customer acquisition.

Our new eCommerce platform continues to deliver significant benefits, as we gain more expertise in utilizing its flexibility in site merchandising, optimizing natural search and further engaging the brand in social media.

As we look forward to the second quarter and the balance of the year, we see great opportunity to gain market share by capitalizing on the initiatives that have raised our performance to the levels we are seeing today.

As such, we will continue to provide great products at a great value and expand into merchandising categories where we see opportunities in the marketplace.

We will also continue to improve the customer experience through in-store clienteling and enhanced functionality on the website.

ECommerce is our fastest growing and most profitable channel across all brands, and as a Company we are identifying new opportunities to build brand awareness and customer engagement through search, e-mail modeling, affiliate programs and enhanced functionality.

Now I would like to talk about Pottery Barn Kids.

During the first quarter, net revenues increased a substantially better than expected 21%, versus the decline of 27% in the first quarter of 2009.

ECommerce sales were particularly strong, but were offset by a 9% reduction in retail leased square footage.

Comparable store sales increased 23%.

From a merchandising perspective, all key categories, particularly textiles, furniture, and decorative accessories, and the all-important nursery category, delivered strong growth.

We also saw a significantly better than expected consumer response to our newly introduced entry price point assortment and value messaging initiative.

From an operational perspective during the quarter, a strong inventory management and promotion strategy, coupled with significant cost reductions in the supply chain, drove a substantial year over year improvement in gross margins.

We also saw a significant improvement in our store operating expense structure, due to strategic store closings and benefits associated with labor scheduling.

As we look forward to the second quarter and the balance of the year, the foundation of our growth strategy is great product at a great value, and we are continuing to expand this assortment to attract new customers to the brand.

We are also leveraging the late 2009 launch of our new eCommerce platform and database marketing tools to enhance the relevancy of our customer interactions and make social community an intrinsic part of our online experience.

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

Pottery Barn Teen continues to be the best performing brand in the Company, as net revenues increased a better than expected 22%, versus only a 17% decrease last year.

Selling margins were also ahead of expectations.

From a merchandising perspective, we saw high teens or better growth across all major categories, and new entry price point products continue to be both top sellers and new customer acquisition vehicles.

As we look forward to the second quarter and the balance of the year, we will continue to drive profitable growth through the introduction of entry price points, expand our assortments, and make social community a key aspect of the brand experience.

Finally, I would like to talk about West Elm.

During the first quarter we saw a substantial improvement in the performance of West Elm, on both the top and bottom lines.

And we continue to be encouraged by the impact we are seeing from small changes in the areas of merchandising and visual presentation.

All key product categories, particularly textiles, furniture and table top, delivered strong growth during the quarter.

A strong consumer response to early roll-out of our value and promotional strategies also contributed to these better than expected results.

As we look forward to the second quarter and the balance of the year, there are several strategic and tactical initiatives that we believe can meaningfully accelerate the growth and profitability of the brand.

These initiatives include broadening the aesthetic to appeal to a wider range of customers, increasing the penetration of opening price points, expanding the non-furniture assortment to rebalance the product mix, and enhancing customer engagement through warm and inviting multi-channel lifestyle marketing.

We will also continue to take advantage of the opportunities to rationalize our retail footprint.

While our long-term strategy for this brand is to expand our retail store base, we have locations that have been greatly impacted by the recession that continue to be a challenge, and as such, we are expecting to close an additional two stores between now and the end of the year.

We believe all of these initiatives will allow us to improve our competitive positioning, and profitably grow the West Elm brand over the next several years.

Before I open the call for questions, I would like to congratulate Howard on his retirement.

It is his vision and inspiration that have made this Company great, and the strong culture that he has built that will keep it vibrant.

I would now like to open the call for questions.

Thank you very much.

(Operator Instructions).

Our first question today will come from Matthew Fassler with Goldman Sachs.

Thanks.

It's actually Robert Higginbotham in for Matt.

A question on merchandise margins.

I may have missed it.

Forgive me if I did.

But could you give us a sense of what your merchandise margin improvement was for the quarter?

As part of that, maybe let us know if that was above, below plan.

And as you look at that result, does that change at all your kind of longer term expectations for operating margin potential?

Thank you.

Robert, our improvement in the gross margin, this is selling -- you're talking about the selling gross margin, I assume.

And that was an approximate 250 basis point improvement.

It was clearly -- the reduction in markdown activity was significantly better than we expected.

The reasons we beat this quarter was two-fold.

It was the stronger top line sales and then secondly, the selling margin was better than we hoped.

It's still not yet -- as we look at the year, we still don't see the year at peak levels but we're getting -- in Q1, we are getting very close to peak levels or exceeding those for different reasons, most of it comes from supply chain.

So we are feeling very good and very confident in our ability over time to recover our historical selling margins.

This is the first quarter where we've really seen this level of improvement and it's very encouraging for all of us.

Our next question will come from Matt Nemer with Wells Fargo Securities.

Good morning, everyone.

I just wanted to ask about the Internet sales growth.

Could you comment on whether that's coming from traffic or conversion?

And then as a follow-up, can you remind us what your plans are to integrate the web sites with the stores, i.e.

ship to store, return to store, et cetera.

Thanks.

I'm going to let Pat take that question.

Pat, would you like to speak to the Internet, please?

Matt, we've had good success across all aspects of the web, both traffic and conversion.

In terms of -- and we're very pleased especially with some of the Internet marketing efforts that Laura alluded to in her prepared remarks.

We see continuing opportunity ahead of us there.

And we are looking at a number of initiatives regarding how we can further integrate the web with our stores, and utilize our customer data to help our associates do a better job of serving our customers.

We've already got some of these initiatives in place, and we're seeing some very good results from them.

Next we'll hear from Alan Rifkin, Banc of America Securities.

Yes, thank you very much.

This is Vincent Sinisi in for Alan.

Congratulations on a nice quarter.

And Howard, best of luck to you.

My first question is dealing with the customer improvement that you're seeing, both from basically across the board, Sharon, do you have any color whether those customers are coming from existing accounts, are they coming from your house file, or are you seeing new customers entering the stores?

They're coming from both, and I'd like to let Laura speak to the strength of the growth of our house file, because it is -- we've had some very impressive numbers.

So Laura, would you like to speak to that?

Sure.

We have been extremely focused on our customers, both new customers, retained customers, reactivated customers, and we've put a lot of strategies in place to drive these results and we are seeing improvements, particularly in the Pottery Barn brands, with all metrics.

But across all brands we are also seeing new customers come both into retail and our direct to consumer channels.

And it's great, it's just great news for the future, because the more customers we have on the file, the better able we are to profitably mail them in the future.

Budd Bugatch with Raymond James and Associates has our next question.

Good morning, everyone.

This is actually TJ filling in for Budd.

Congratulations on the excellent quarter.

Two parted question here.

First is to the inventories.

I know last quarter we talked about how there was a shift going on from furniture to non-furniture categories.

I think Laura, you had talked about that a little bit in your prepared commentary.

How far are we through that process?

And how much further is there to go, is one question.

The other question is on the direct channel and the catalog business, looks like you took up the guidance for the catalog circulation for the second quarter.

What was it that caused that change?

Have you cut into a little muscle here with some of the recent reductions, and any comments you have there.

Let me speak first to your question, TJ, about the furniture to the proportion of our total sales.

Actually, we have not seen a significant change in that, as a percentage of total Company.

We've been running around 29%.

We are just slightly above that, getting closer to 30%.

But we're in that 29% to 30% range.

So there is not a shift, as far as our total Company revenues, away from furniture.

I think when you go back to the prepared remarks that we had in Q1, or in the fourth quarter, that the comment that Laura made is that we are not wanting to grow the mix of furniture.

It is not that we are seeing the furniture that we currently offer to the customer become less proportional as a percentage of of our mix.

So -- as a total Company.

So then -- I'll let Laura speak to the strategies of catalog circulation, because a majority of those changes are actually in the Pottery Barn brands.

Sure.

We had a very robust and thorough process to look at each mailing, every single month, and the earlier comments I made about new customers and better customer performance allows us to mail more catalogs profitably, and it's very exciting.

We're also seeing great response to our smaller mailers.

We put in the mail stream some smaller mailers, the PB Dorm, the Gear Guides, and those allow us to reach more customers more profitably, and we're very, very excited about the long-term potential of that strategy as well.

TJ, it's important to note that when you're looking at paid circulation which is what we guide -- I'm sorry, catalog circulation, we don't guide paid circulation per se, and you've got to remember that every one of those books we put in home gets treated as a catalog and all catalogs are not equal.

Next is Kate McShane with Citigroup.

It's Oliver Chen on behalf of Kate McShane.

Congrats, Howard, and congrats on a great quarter, guys.

Our question was about the near term global macroeconomic events and the stock market volatility.

Do you think it will have an adverse impact on future spending patterns and the psychology of your customers, and if there's a correlation in your view.

And our follow-up question was related to gross margin for the back half.

Other companies are speaking to potential sourcing transportation inflation, and it looks like you're up against 500 basis points of a tougher comparison versus guiding to around 400 in second quarter.

Is there anything we should know about modeling, that in the back half will occupancy dollar declines, which are very impressive, be able to decline a potential offset?

Okay.

Let me speak to our perspective on the macro environment.

As we said in our prepared remarks, we do continue to believe that as we come up against the higher consumer spending -- the consumer confidence numbers in the back half of the year, and -- which equated to higher consumer spending in the back half, we are continuing to be cautious.

We put this cautious guidance out there in March and we're holding that guidance for the very reasons that you are speaking to.

This volatility in the stock market, what's going on in Europe right now, it's weighing on people's minds.

It's infiltrated in the news.

It's everything you see and what you hear about.

So we in no way are taking what we are currently seeing and saying that we believe that the consumer is all better.

So we want to continue to maintain our cautious outlook.

We have done so in this guidance.

And obviously I think what we are proving is that where there is opportunity for higher sales, that our inventory management, our chasings of inventory, et cetera, are effective in allowing us to capture those sales.

So we feel very good about our strategy toward remain cautious, chase into it, keep the profitability moving forward.

As it relates to the margin improvement in the back half, you were speaking to the fact that we had a high margin, a big margin improvement in 2009, and now we've got guidance out there and it indicates some improvement coming into it.

I'm going to let Laura speak to this, because working on the supply chain issues and with vendors has been a key priority for her and the supply chain team.

And Laura, why don't you talk about it, because we've had so much success there and I'd like you to share some of the things we've done and how you're feeling about the back half.

Sure, Sharon.

Just to go back a little bit, over the last 18 months we have been very focused on driving strategies that are customer-centric, to engage our customers, to give them better value, to give them better quality, to give them differentiated designs.

And it's clear that, despite the recession, people are noticing the differences that we've made and they are responding to us, I think a lot better than they are responding to others in the same business that we're in.

And so we're going to continue on that focus and our -- we're very cognizant, as Sharon said, about what's going on in the macro environment, and we're staying really on top of all these issues.

Competitive pricing, making sure that in our stores we have the best service, that we engage our customers every time we speak to them, whether it's on the phone or in our stores or online, in the relevant tone that appeals to them in this tough environment.

And with that, we've really spent a lot of time sharing our concerns and our strategies with our vendors, and working through how do we together offer the customer a great value.

Because they do well when we do well.

And so they really see that we have reduced our prices in a lot of cases and are enjoying reorders.

Now they are seeing increasing costs in raw materials and labor in a lot of markets, and we are talking about that as partners and how do we combat that and continue to give our customers great prices, because we know that the customer does not want to pay more in this environment.

So it is a real issue.

Where we're able to offset it is we're working on a big packaging initiative to reduce the inefficiencies of overpacking.

It's very important that the product gets there safely, but in some cases we probably overdid it.

So Dean Miller and his whole team have been working very closely to look at where are there opportunities to improve packaging and reduce costs.

We are also continuing to see improvement in returns and replacements, which helps us reduce the costs that potentially may be increasing in raw materials.

And there's a whole myriad of other initiatives that we are working on our supply chain that are making a big difference.

We're moving into our new building in June, which is going to give us efficiency.

We're doing a better job with cartonization, so that we reduce our carton pricing out the door and to our retail stores.

And we've really -- all this work we've done on our hubs and taking control of our supply chain and looking for opportunities to reduce costs while improving service are really paying off.

So we are cognizant that we have an uphill battle on costs, particularly out of Asia, and those are the different things that we are doing to make sure that we continue to give the best value to our customers.

We would like to remind participants to limit themselves to one question at a time.

Once your question has been answered, you may rejoin the queue by pressing star one.

Next we'll hear from Brad Thomas, KeyBank Capital Markets.

Thank you.

Good morning, and let me add my congratulations as well.

Wanted to follow up about margins and just try and look at it from a bit of a bigger picture standpoint.

In the past, you all have been very helpful at putting the margin outlook into context.

When we look at the first quarter results, by my estimates it looks like you're just only 20 basis points shy of your historic first quarter peak numbers, from a margin standpoint.

Given this backdrop where sales seem to be accelerating, there seems to continue to be more opportunities to selectively reduce costs or improve supply chain, how should we think about that margin potential going forward, and could we surpass peak margins later this year?

That's a great question, Brad.

Let's just get Q1 in perspective.

We still have this substantial occupancy deleverage coming from our peak years.

What are you using as your peak year, when you say 20 basis points versus your peak year?

Because we're not within 20 basis points of our peak margin, selling margin ever.

So -- that's beside the point.

As we look at the occupancy, we still have about 300 basis points of deleverage in occupancy.

And obviously we know how the model works.

We're working on it coming from two sides, increased sales of course leverage that rate.

In addition to that, we're also working on continuing to lower the occupancy.

So we are working on that and coming from both ways.

So as we continue to make progress there and, as I mentioned in my prepared remarks, we are being successful in reducing our number of stores.

We do have 58 more stores than the peak year that we operated, and all of those have inventory and all of those have occupancy.

So we're working through that and we'll continue to work through that.

We would like to work through it by going with -- the sales side is working very nicely for us.

We prefer that.

But we'll continue to optimize the store base.

And that will be helpful as well.

And the cost of goods side, even in Q2 if you look at the guidance, it is conservative.

And no one's said it yet, but I know you're all thinking it, and we agree with you.

The margin that we saw in Q1, we did not guide into Q2, that kind of benefit.

We do think that we need to stay cautious and we do think that we need to recognize that there are bumps in the road.

You guys have your big bump, 1,000 basis point bump, and we are conscious of the fact that that -- this news with Europe and everything is affecting the consumer.

So we're just going to stay cautious, keep doing what we do, and we think that there is absolutely runway in front of us to improve.

It will come this year.

Laura mentioned it.

These supply chain benefits that we continue to execute these strategies, the benefits continue to come quicker than we anticipated.

Whether you're talking about Asian sourcing, or you're talking about cartonization, the benefits from the regionalization of separate ship, or the in-sourced hubs, every one of those is delivering better than expected and more rapid than expected benefits than we guided originally.

So those will offset some of these costs that are coming, and we feel very, very good about the guidance that we have out there right now, and do agree and understand why some you would believe there would be upside.

And next we'll hear from Chris Horvers, JPMorgan.

Thanks, good morning.

Congratulations, Howard.

You must be very proud.

Following up on the margin question, Sharon, can you talk about the relative margin or flow-through of a sale -- dollar of sales in retail versus DTC, and then how that may shift as you think about an Internet sale, inclusive of advertising costs?

Well, the retail model, in the life cycle of the retail model, right now on a retail sale it's different between stores.

Some stores you have percentage rent, and in some stores you're operating at minimum payroll already which means that you don't have incremental payroll for increased sales, and then at times you are over the minimums which means you have to add payroll.

So when you think about a retail sale, it actually -- I know you would like a simple answer.

You would say it can just flow through to the bottom line.

Generally there will be, on average, some additional cost that comes from rent and from payroll in the stores.

That would be your general consensus.

In the case of the Internet, it depends on how that sale is derived to the Internet.

But in general, you can pretty well assume that the cost on the back end is the same as any other sale, but it's the acquisition cost that is lower.

So it is going to be by far your most profitable sale.

But at this point, what we're focused on is capturing market share.

What channel the customer buys in is their choice.

We want it to be their choice.

We prefer, of course, the Internet sale because it's so much more profitable.

But as we go forward, we want the customer to pick our brands and capture market share, and that's what we'll focus on with our advertising dollars.

And next we'll hear from Neely Tamminga with Piper Jaffray.

Great.

First let me just congratulation Howard on his retirement, and just thank you for your leadership, and your talent cultivation over the years.

Clearly the results of that continue to come to fruition here in the story, so congratulations.

Sharon, could you -- similar to Chris' question, you know, in your Qs and Ks you guys are really good about giving some segment profitability.

I'm just wondering if we could get a sneak peak as to what that might look like on the EBT basis for retail, versus direct to consumer, before unallocated -- It's almost like the numbers we saw today are implying maybe double-digit -- low double-digit profitability on that basis, for those two divisions.

Am I barking up the right tree?

Neely, we generally wait until we actually issue the Q to put out those numbers.

So what I'd like to do is just give us a couple weeks to get all the allocations put out there, and we'll release it in the Q.

But I understand the nature of your question and, going forward I think it's something we should think about getting to you guys earlier, because I know your models have now been broken down by channel, many of you.

So we'll make sure that we do that going forward.

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

Yes.

Hello.

Good morning, and congratulations.

My question also has to do with the Internet.

As you look forward over the next several years, that part of the business has grown so much, so fast.

How do you get your arms around what the potential will be for that over, say, a three year period?

Pat, would you speak to that, please?

David, we see a lot of potential over the next several years.

Forester and others have said that home furnishings in our segment is under-penetrated, compared to other merchandise categories.

And they're forecasting that Internet sales of home furnishings and related products, online, will go from about 9% to almost 14% by 2014.

We certainly want to get our share of that.

Internet Retailer has us at about 24% market share now, so we see a big opportunity there.

We mentioned earlier, and Laura and Sharon have both alluded to the marketing efforts, and we think that we are very strong competitively in terms of our Internet marketing.

But I would also not -- it would be good to point out how strong the back end of our process is.

We can get the sale, but we have some really differentiating advantages in our supply chain in terms of getting that merchandise, which is frequently bulky, to our customers.

We've got our East and West Coast DCs.

We have a 25-, 30-year heritage in terms of filling direct orders, which I think will further allow us to differentiate ourselves from others in the market, in the years ahead.

And next we'll hear from Joe Feldman, Telsey Advisory Group.

Hello, guys.

Also congratulations on a terrific quarter and to you as well, Howard, for all your service.

Can you guys talk a little bit about what you've been doing lately to drive the reduction in the returns and damages?

I mean, that was a really terrific result, Sharon, with that 40 basis point improvement there, and maybe you could give us a little update as to what's going on there?

The key to it is the quality benefit that we are receiving -- we are deriving from our Asian sourcing.

The second thing that we are seeing is that the regionalization of separate ship is allowing us to not have to move the inventory so frequently.

Therefore, we're seeing incremental benefit from that.

I think we had talked about that a lot at your conference, about how by not moving the inventory so many times we can improve the quality.

The in-sourcing of our hubs has been another major source of this.

When we are handling the furniture inventory, all the way up until the point it's put on the delivery truck, it is -- the numbers are just really so compelling.

And that's why we are doing so much in-sourcing.

So those three areas are really the primary areas that we are seeing those benefits.

I think that culturally, I think, Joe, honestly, that every single step in our supply chain is being engineered for returns replacements and damages.

And we just keep taking one piece at a time, taking small steps, implementing it, perfecting it, then taking the next step, and because of that it is sustainable and it continues to be incremental.

Next we'll hear from Scot Ciccarelli, RBC Capital Markets.

Good morning, guys.

This is Austin Paul, sitting in for Scot today.

You mentioned that payrolls are at base levels in some of your stores.

As the momentum in your business continues to get better, is there a point at which you will think about increasing your in-store spending to accommodate the higher traffic levels in your stores?

Absolutely -- yes, and no.

I want to be clear, and I'm going to let Laura speak to this.

The answer is yes, where you're running minimums, we run our payrolls as a percentage of sales, but we have to say that we've made some major structural changes and we received great benefit from labor scheduling tools that we gave to our stores, and as a result of that, we substantially lowered our payroll versus the 2005, 2006 time frames.

Now, Laura, would you speak to the strategy as it relates to store payroll, please?

Sure.

As Sharon said, we gave the store managers new tools to help them better plan their payrolls.

But it is still totally within their responsibility which makes it so great, because they're thinking about the customer and running their store like a shop keeper.

They are looking at their sales trends.

They are looking at what's going on in their local community.

And putting on payroll where they see opportunity.

You know, of course, there's the minimum amount, and then incremental sales don't cost as much as just staffing the store to the first time.

So you get more leverage on the upside than -- you get more leverage on the upside.

But they do such a good job in a very entrepreneurial way and making the bet.

We reward them for it.

We encourage them to always service the customer.

And I think it's one of those things that we did differently than others.

We cut the payroll but we didn't cut the service.

We actually added events in the stores, and we have a culture -- a very, very strong culture -- in supporting our stores and giving them great tools to do the right thing.

And we're seeing that really pay off.

So rest assured, we're very aggressive and supportive of our store teams in adding payroll, as we see traffic levels improve.

Our next question will come from Christian Buss with Thomas Weisel.

Yes, look, congratulations on a great quarter.

Thank you, Christian.

Wondering if you could provide an update on the DC initiatives you have under way, and if you could quantify the benefits that is providing, I'd appreciate it.

Laura, why don't you speak to the DC initiatives that we have happening currently, and then --

Sure.

We mentioned earlier, you know, we are looking at everything in our supply chain from transportation, distribution, you know, our furniture, upholstery manufacturing, our call centers, our packaging.

And in every single area we are -- we're seeing improvements and we are putting together strategies to continue those improvements beyond this year, into the future.

And we're lowering the costs and we're improving sales.

So Sharon mentioned some of them.

We've in-sourced our hubs.

We've improved our cartonization and our CMO building.

Our cartons are actually down 9%.

We have driven retail freight savings due to this consolidation.

We're doing a better job with shrink across our distribution centers.

We're consolidating buildings.

You've heard about us getting out of square footage and consolidation, and the consolidation gives you better quality.

Because as Sharon mentioned, you don't need to move the goods as frequently.

Our Sutter Street furniture upholstery factory is producing record numbers, which is driving returns down and improving the value equation to our customers, and we continue to see just acceleration in that plant.

Our call centers are doing a great job, not only servicing the customer when they call in, but doing outbound sales driving calls, and we're generating incremental revenue because we're being more assertive and just more customer-friendly as well, in calling customers back and letting them know when we have something that we know that they would like to buy.

And then I mentioned earlier, and I'll say it again, our packaging cost reduction initiative, we're looking at SKUs across all of our brands to redesign, and we believe that we'll continue to see savings based on this initiative into the future.

Our next question will come from Avery Sheffield with Bernstein Research.

Hello, this is Avery filling in for Colin McGranahan.

Congratulations on a great quarter.

Before you mentioned that some stores have a portion of rent expense tied to sales.

I'm curious if you could provide any insight regarding the general percentage of stores that have that clause in the rent contracts and how that impacts the seasonality of occupancy cost trends through the year, and most importantly how much better than expected top line could impact expected occupancy costs and full leverage for the year?

Avery, we don't release the details regarding our rent arrangements with our landlords, which we believe is appropriate.

We have said historically that we do not see major changes.

As far as your models go, there is not a major, major change in our occupancy expense by quarter.

You of course get bigger in Q3 and bigger in Q4.

But it is not so material that it is something that we feel that we need to call out, or something that I think you need to majorly change your model over.

So there's some cost there but not -- it's not huge.

It's not going to change your forecasting within a range.

Let me put it that way.

Michael Lasser with Barclays Capital has a question.

Hello, this is Tiffany Witt on for Michael Lasser.

My question is about the sourcing initiatives.

I'm wondering if you can talk about where you are in terms of these initiatives across the brands, which ones might have the most opportunity left and perhaps what the timing is around these improvements?

Sure.

You said sourcing.

Yes.

Yes.

Great.

It's Laura.

We've been looking at opportunities in all of our brands.

The one that has the most future opportunity is West Elm.

We have just begun our initiatives to give better value in West Elm to our customers.

And we are in the process of re-engineering, redesigning, repricing, our products in Asia and so you'll still -- you'll see the biggest improvement there to come.

In the Pottery Barn, in the Kids and Teen brands, we ask ourselves this question, you know, how much more is there?

How much more is there?

We know this.

We know our customer knows great value.

And a large percentage of our sales are coming from our opening price points.

And so you're going to continue to see us add opening price points, beautiful products, well-designed, you know, that the customers are inspired to buy, but with great prices that they can afford.

And so you are going to continue to see us add more in Pottery Barn and Pottery Barn Kids and Teens, even though we've made a lot of progress so far.

Next we'll hear from Laura Champine, Cowen and Company.

Good morning and congratulations on your sales momentum, and we clearly see that in the comp as well as the DTC business.

Also, I'm cognizant of your cautious, more macro outlook, but what are you seeing right now in the malls, not just at your stores but in those locations in general?

Is the customer mood and traffic trends improving or decelerating so far this year?

Laura, would you like to speak to that, please?

Sure.

You know, I think good retailers are doing better.

People who have exclusive, engaging, inspiring product lines are doing better and those that didn't make the adjustments are not.

And so we are seeing in our stores that the customer is very inspired to come in and -- recession, no recession -- they love their homes.

And we give them an environment, when they come into our stores, to make them feel happy and to help them, whether it's throwing that dinner party or redecorating their family room, or setting up a new home office, you know, we've given them inspiring products to meet their needs.

And as we go to malls, you see some stores that are really busy and you see some that are ghost towns, and I think it's all dependent on how assertive the management has been in addressing the changing needs of the consumer.

And I think that, Laura, when you think about the quarter last year, this is the quarter where the consumer's confidence started building.

So if you are asking us at this very moment, based on our current momentum and trends, we absolutely are seeing a very strong business right now.

And in order to deliver the guidance that we have out there, what we are assuming is that we're going to come up against tougher numbers in the next two months of the quarter and that we would see a tougher compare.

Therefore, we would see a deceleration.

That's how we planned it.

If it continues, this is where we get into the question about the conservatism of the guidance.

It all does depend on what you believe about the macro.

From an execution point of view, and from a consumer response to the assortment that we have out there, our numbers should be fantastic.

The question is, what happens with the consumer as we come up against these tougher numbers and that's why the more conservative guidance.

Next we'll hear from Jennifer Milan, Sterne Agee.

Hello.

Good morning.

We've been hearing other retailers talking about -- it sounds like this didn't happen in your business -- about kind of a falloff at the end of April, and some of the others in your space talking about, with respect to seasonal product, some pull-forward from the 2Q, and I was wondering if you could talk a little bit about your performance of the seasonal product and to what extent you might think that might be the case, and also how you're thinking about the elimination of the homeowner's tax credit going forward or later in the year.

As far as our business goes, you know, the April issue, coming off of April, you know, you have the issues with the Easter shift and we've heard a lot of this, and honestly, we think that you have to look at the business on more than a four week basis, and that's why we don't release monthly comps.

But as far as the business is going, like we said, we are still seeing that momentum at this current point in time and we have not seen the trends that you're referring to.

That is not something that we're currently seeing in our business.

And different than apparel, you know, we have Easter but then we introduce our outdoor furniture in a big way and we are seeing great response to our outdoor furniture collections, which is really exciting and carries us through the summer.

And all the holidays and themes, that the customer is really celebrating the holidays again.

They're very important to them and we have great assortments for the -- we had great assortments for Easter, and we are going to have incredible assortments for the back half as well.

Sharon, do you want to talk about the elimination of the homeowner's tax credit and the impact to our --

The elimination -- the homeowner's tax credit, of course, is inspiring turnover in the home, in the home markets.

And it's hard for us to predict what that will look like.

A lot of those tax credits, however, are going to first-time home buyers, or buyers that have not bought homes in an extended period of time.

Therefore, that is probably a -- there is certainly a customer that would be shopping our brands that might be benefiting from that, but in general I would suspect that a lot of those sales are going to some of the lower end home furnishings retailers, as opposed to coming into our brands.

And that does conclude our question-and-answer session.

I will now turn the conference over to Laura Alber for any closing or additional remarks.

Thank you.

Thank you for joining us for the Williams-Sonoma first quarter fiscal 2010 earnings conference call.

We appreciate your time and continued support and we'll talk to you next quarter.

Have a great day.

And that does conclude our conference call.

Thank you for your participation.