Williams-Sonoma Inc (WSM) 2018 Q2 法說會逐字稿

Welcome to the Williams-Sonoma, Inc.

Second Quarter 2018 Earnings Conference Call.

(Operator Instructions) This call is being recorded.

I would now like to turn the call over to Elise Wang, Vice President of Investor Relations, to discuss non-GAAP financial measures and forward-looking statements.

Please go ahead, ma'am.

Thank you.

Good afternoon.

This call should be considered in conjunction with the press release that we issued earlier today.

Our discussion today will relate to results and guidance based on certain non-GAAP measures.

A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP financial measures and our explanation of why the non-GAAP financial measures may be useful are discussed in Exhibit 1 of our press release.

This call also contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which address the financial conditions, results of operations, business initiatives, trends, guidance, growth plans and prospects of the company in 2018 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 release and SEC filings, including the most recent 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 Laura Alber, our President and Chief Executive Officer.

Thank you, and good afternoon, everyone.

On the call with me are Julie Whalen, our Chief Financial Officer; Felix Carbullido, our Chief Marketing Officer; and Yasir Anwar, our Chief Technology Officer.

Today, we're announcing another quarter of strong results with top line growth at the high end of guidance, gross margin significantly above last year and a substantial EPS outperformance.

Our powerful multichannel, multibrand platform, together with our strong execution of our strategic initiatives in digital leaderships, product innovation, retail transformation and operational excellence, are having a positive impact on all parts of our business.

Given the results from the first half and the momentum our initiatives are creating, we are raising our full year guidance for net revenues, comp revenue growth, operating margins and EPS.

Let's discuss in more detail our second quarter results.

Net revenues and comp growth for the second quarter were towards the high end of our guidance at $1.274 billion and 4.6%.

Growth was broad-based across all of our brands, with the Pottery Barn brands comps continuing to improve year-over-year.

West Elm delivered another quarter of double-digit growth and a sequential acceleration in comp growth to 9.5%.

Williams-Sonoma also had a solid quarter with a comp growth of 1.6%.

Our emerging brands, Rejuvenation and Mark and Graham, continue to gain scale, growing double digits during the quarter.

Now moving on to some highlights of the progress we've made against our strategic priorities.

First, digital leadership.

We are unlocking the power of our cross-brand platform through cross-brand initiatives and technology.

This quarter, our cross-brand loyalty program, The Key, continued to gain momentum.

Since we re-platformed this program in Q1, enrollments have been tracking at 4x the pace of that of last year, with customers spending on average 5x the value of their Key rewards.

We will continue to improve the user experience and member benefits to capture the substantial growth opportunity we see in this cross-brand loyalty initiative.

In technology, we continue to make strong progress on our integration of Outward, which culminated in the launch of our photorealistic space-planning experience [Ensemble] early this month.

It's currently live in all of our West Elm and Pottery Barn stores.

We'll be making a customer-facing version of the experience available online in September and will be adding the other brands before peak.

Built off Outward's proprietary 3D asset platform, Ensemble is the first photo-realistic customer-facing space planner in the industry, allowing us to create an interactive shopping experience that spans across product discovery, customized product visualization and space planning.

Customers will be able to build their own floor plans, browse our product assortments cross-brand and drag and drop photo-realistic pieces to furnish their homes with more confidence and accuracy.

Also in Q2, we significantly improved the digital customer experience through content creation.

We updated our shop pass with more engaging content that is inspirational and drives conversion.

We materially enhanced our product information pages and are impressed by the results, particularly in the Pottery Barn brand, where we introduced editorial content.

The focus is on product quality and reasons to buy.

We also introduced a multi-image visual layout for shop-by-room pages and revamped the homepage to better communicate the story of the season and breadth of assortment.

The West Elm brand also continues to pioneer digital innovations that focus on customer-centric solutions and dynamic personalization.

In Q2, we created, deployed and iterated on a new algorithmic recommendation engine for frequently bought-together products.

This tool is driving increased revenues per visitor and will be rolled out across brands.

We also released our guided shopping tool, which leverages our machine learning algorithms and image recognition to create personalized product recommendations based on the customer's individual style.

In the Williams-Sonoma brand, we are in the process of an overhaul of our Williams-Sonoma home website.

Among the enhancements, we redesigned the homepage to better showcase our inspirational lifestyle imagery.

We also integrated Outward's technology to help customers visualize the product alongside other items from our assortment and in different settings.

Another major shift across the company is our marketing mix.

We are optimizing catalog mailings to focus on higher ROI digital channels to drive more reach more efficiently.

Our digital customer growth accelerated double digits in the quarter, the fastest pace we've seen in over 2 years, with new customers up even more.

These results demonstrate the success of our digital advertising investments and product innovation strategies over the past year.

We're also becoming more efficient with our advertising spend as the majority of our digital marketing is now managed in-house, helping us drive cost savings and better performance.

Looking to the balance of the year, we will continue to partner with large digital players to design and test lifestyle ad units that focus on relevancy and inspiration to drive customer acquisition and strong profitable growth.

We're also gaining strong traction in our strategic priority of retail transformation and excellence by pruning the fleet of underperforming stores and selectively investing in new stores, remodels and relocations while elevating the store experience.

Our stores are a key part of our multichannel strategy as they provide an incomparable experience to our customers to engage with our products in real life.

We opened a total of 9 stores this quarter and added 4 more locations of Williams-Sonoma Home, bringing its total to 69 retail locations.

We plan to open another 4 stores in Q3, including a new store in our Rejuvenation brand, which continues to expand in the high-end lighting and hardware market and is on track to becoming a significant multichannel lifestyle brand.

Our new stores are performing better than the fleet, generating strong profitability with a payback of just over 1 year.

Our fleet of remodeled and relocating stores -- relocated stores are also outperforming, averaging double-digit growth in annualized sales over the prior stores.

Our retail strategy's been particularly successful in Pottery Barn with new, remodeled and relocated stores driving above-average sales growth and profitability over the prior stores.

Given these results, we are planning for 4 more remodels in Q3.

In Williams-Sonoma, our remodeled stores are also performing and we have plans for 2 more next quarter.

And in West Elm, we opened a new format store in Santa Monica, California, that is off to a strong start.

This next-generation store has an expanded outdoor living area that displays a wide range of outdoor collections and more open space for community engagement.

To further optimize our fleet and expand profitably, we closed 4 underperforming stores as part of our planned store closures for the year.

In addition, we've been aggressively pursuing the early closure of the subset of underperforming stores which we announced at the beginning of the year.

In Q2, we successfully terminated the lease for 2 of those stores and we impaired an additional 5 stores.

This resulted in noncash impairment expenses and early lease termination charges.

The closures of this entire list of underperforming stores, when complete, would generate an additional 20 basis points in annual operating margin expansion.

Now I'd like to talk about product innovation, which is another key differentiator for our company.

We continue to lead the market this quarter with exclusive designs, high-impact collaborations and category expansions.

In the Pottery Barn brand, we had a strong summer season with new merchandise offerings and we are seeing a strong start to fall.

We've also built incremental businesses, including PB Apartment, which continues to grow double digit and attract new customers.

Our Pottery Barn children's business is also gaining momentum.

We launched the successful cross-brand collaboration between West Elm and Pottery Barn Kids that is driving strong incremental sales as well as new customer growth.

And more recently, Pottery Barn Kids unveiled Pottery Barn Modern Baby, a high-style curated collection with 5 distinctly new design aesthetics to better meet the needs of parents seeking nursery decor that reflects their modern contemporary style.

The Pottery Barn Modern Baby collection is also crafted with the commitment to safety and quality that we know our customers value.

All wooden and upholstered furniture in the collection are GREENGUARD certified and all cotton bedding is 100% organic.

The initial customer response has already surpassed our expectations.

We have plans to expand both collections over the coming quarters as we see substantial opportunity in the children's home furnishings market for products that are modern and contemporary in design, also high quality and sustainably made.

In West Elm, we launched new products in opening price points, and at the same time reduced our inventory and overstocks.

Our core furniture business remains strong, and growth in our decorating categories continues to accelerate, driving new customer acquisitions and entry points to the brand.

We have a compelling pipeline of product assortments in core and new categories for the balance of the year, which should position us well to deliver another strong holiday season.

In our Williams-Sonoma brand, our exclusive products and collaborations, along with our digital marketing efforts, are driving strong customer growth in e-commerce, which has accelerated over the past 4 quarters to double digits year-to-date.

This quarter, our collaboration with Aerin Lauder and Instant Pot were particularly successful.

We've also broadened our Williams-Sonoma branded products with further additions to the tools and food businesses.

We continue to see this line as a sizable growth opportunity and an important driver of new customer acquisition.

In our global business, we are pleased to see another quarter of double-digit growth in our company-owned operations.

We continue to make strong progress on our Pottery Barn Kids launch in the U.K., with both the website going live and the shop in shops in the John Lewis Oxford Street flagship launching in Q3.

Our franchise partners continue to add locations, with 6 locations opened around the world during Q2.

Looking ahead, we will continue to focus on operational improvement to drive profitability in all of our businesses and execute on our multichannel entry into large-sized markets in Asia and Europe.

And lastly, our commitment to operational excellence.

This quarter, we continued to make substantial progress against our inventory initiative.

We successfully reduced overstocks and clearance in stores, bringing our total inventory growth down to 2.5% while revenues grew 6.1%.

Inventory management remains our single biggest opportunity to reduce costs and improve profitability.

Tighter inventory controls allows us to be more aggressive in reducing our promotional activities.

We're driving regular price sales through compelling digital marketing and inspiring store displays and innovative product.

This is resulting in higher selling margins.

We'll continue to focus on managing inventory more effectively in the second half, including better in stocks, more in-time inventory and frequent flow from our overseas vendors and our multiyear transitions to one inventory that will substantially improve our DC efficiency.

In addition to inventory management, we drove further cost reductions across the supply chain, including efficiency improvements in our personalization operations and our domestic upholstery manufacturing facility.

We have also reduced our damages by 20% year-to-date.

We are encouraged by these results and we have identified further opportunities to drive supply chain innovation and improve customer service.

Our focused execution on these opportunities will also enable us to further cut costs.

In summary, these results reflect the powerful advantage of our multichannel, multibrand platform, along with the important progress that we continue to make on our strategic priorities.

The combination of inspiring content, compelling products and lower clearance levels are driving strong sales as well as higher selling margins.

Together with our aggressive optimization of the retail fleet and supply chain, we are able to deliver strong top line growth, gross margin expansion and EPS outperformance this quarter.

Our strong execution in the first half sets us up to deliver on the important holiday season and long-term future growth.

Our cross-brand launches, including Ensemble , our innovative product pipeline, our new and remodeled stores, our improved inventory positions and our supply chain optimization, gives us confidence in our performance over the balance of the year, and as a result, we substantially raised our full year guidance today.

Now I'd like to turn the call over to Julie to discuss our Q2 financial results in detail.

Thank you, Laura, and good afternoon, everyone.

We are excited to report another strong quarter with top line results at the high end of our guidance, selling margin expansion and occupancy leverage, driving increased operating income and flat year-over-year operating margins, resulting in EPS exceeding our expectations.

This performance reflects the success of our strategic initiatives and the benefit they continue to drive across our business, including strong profitable growth in all of our brands, e-commerce revenues outpacing to another historical high and inventory growth substantially below revenue growth.

These results also demonstrate our long-standing commitment to financial discipline and to generating consistent returns for our shareholders.

Before I review our performance in more detail, I would like to remind everyone that our second quarter 2018 results include the financial impact from the implementation of a new accounting standard associated with revenue recognition.

The primary impact is associated with the reclass of other income from SG&A into net revenues, which resulted in an approximate 100 basis point improvement to revenue and a 60 basis point swing in margin improvement from SG&A into gross margin.

The remaining impact is primarily associated with the timing of our revenue recognition for certain merchandise shipped to our customers, which is dependent upon our performance during the last week of the quarter.

Now I would like to review our second quarter results in more detail.

Net revenues in the second quarter were $1.274 billion for a year-over-year growth of 6.1%, and comparable brand revenue growth was 4.6%, an increase of 180 basis points over last year.

Growth was broad-based, with all brands delivering another quarter of positive comps.

Comp growth for the Pottery Barn brands, on a combined basis, accelerated more than 300 basis points year-over-year, which includes Pottery Barn at a 2 comp and our Pottery Barn Kids and Teen business accelerating from the first quarter to a 5.7% comp.

We also saw another quarter of strong revenue comps in West Elm, where comps also accelerated sequentially to 9.5% and total revenues continue to grow double digits.

Our newer businesses, Rejuvenation and Mark and Graham, as well as our global company-owned operations, all delivered another quarter of double-digit growth.

And in Williams-Sonoma, strength in e-commerce and the continued success from our exclusive collaborations drove a 1.6% comp on top of a 1.9% last year, resulting in the strongest second quarter 2-year comp the brand has generated in many years.

By channel, revenue growth in both e-commerce and retail continue to accelerate versus last year.

E-commerce net revenues grew year-over-year by 8.8% to a record high of 53.8% of total company revenues compared to 52.5% last year.

This growth was a significant acceleration over last year's growth of 5.2% and represents the highest second quarter e-commerce growth rate we have seen over the past 3 years.

We are pleased to see that our investment to drive increasing customer counts and traffic are continuing to fuel our top line momentum.

In our retail channel, net revenues increased 3.1% with particularly strong results in Pottery Barn and West Elm.

This demonstrates the continued success of our high-performing store remodels and relocations as well as the success of our other retail transformation initiatives to further differentiate our customer experience, including the financial benefit we are seeing from our cross-brand design services and our expanding cross-brand loyalty program.

Moving down the income statement.

Gross margin for the second quarter was 36.5% compared to 35.2% last year.

The substantial year-over-year improvement of 130 basis points was driven by higher selling margins and occupancy leverage, which includes the overall margin benefit from the reclass of other income into revenues from the implementation of the new revenue recognition standard.

Occupancy costs in the quarter totaled $170 million or 13.4% of net revenues as compared to $168 million or 14% of net revenues.

Our selling margin improvements resulted from higher merchandise margins across all brands.

Our successful merchandise margin expansion this quarter reflects our emphasis on relevancy and inspiration rather than promotions.

We have been streamlining our promotions and refining our promotional messaging across all brands.

And we are pleased to see that we were able to deliver strong top line performance while expanding our selling margin.

SG&A for the second quarter was 29.7% this year versus 28.4% last year.

This 130 basis point deleverage was primarily associated with general expense deleverage, predominantly driven by the reclass of other income into revenues from the implementation of the new revenue recognition standard as well as deleverage from higher digital advertising and increased hourly wages from the reinvestment of tax savings, which we announced earlier this year.

This was partially offset by further catalog advertising optimization.

Operating income continued to grow year-over-year, up 5.8% to more than $86 million, and our operating margin for the second quarter was flat to last year at 6.8%.

We are pleased that we're able to deliver another quarter of operating income dollar growth that was relatively in line with revenue growth.

By channel, the operating margin in the e-commerce channel was 20.6% versus 21.4% last year.

This 80 basis point deleverage was primarily driven by our reinvestment of tax savings into digital advertising and increased hourly wages.

This is partially offset by catalog advertising optimization and higher selling margins.

The operating margin in the retail channel was 6.6% versus 6.1% in 2017.

This 50 basis point leverage was primarily driven by higher selling margins.

Corporate unallocated expenses as a percentage of net revenues were 7.4% in the second quarter of 2018, which is relatively flat to last year.

The effective income tax rate in the second quarter was 24.5% compared to 34.8% last year.

The lower year-over-year tax rate primarily reflects a reduced federal tax rate associated with the 2017 Tax Cuts and Jobs Act.

Second quarter 2018 diluted earnings per share were $0.77 compared to $0.61 last year, representing growth of 26.2% year-over-year and a $0.07 outperformance to the high end of our guidance.

Moving to the balance sheet.

Cash at the end of the quarter was $175 million versus $103 million last year.

In the second quarter, we invested $46 million in the business and returned $173 million to stockholders through share repurchases and dividends, comprising of $137 million in share repurchases and $36 million in dividends.

Merchandise inventories at the end of the second quarter were $1.100 billion or 2.5% growth on last year, which is once again significantly lower than our revenue growth.

And excluding inventory that is in transit for the fall and holiday season, inventory on hand and available-for-sale was up only 0.3%.

As we said at the beginning of the year, we expect this trend to continue over the balance of the year as we focus on the execution of our inventory optimization initiatives to further bring down our inventory levels while improving the level of in-stock inventory and backorder rates and overall customer satisfaction.

Now I'd like to discuss our third quarter and fiscal year 2018 guidance.

Given the continued strength across our business and our strong execution year-to-date, we are confident in our outlook for the second half of the year.

Therefore, we are pleased to be raising our fiscal 2018 full year guidance for the second time this year, with a top and bottom line rate that reflects our full year-to-date beat versus our guidance.

We now expect net revenues to grow to a range of $5.565 billion to $5.665 billion from our previous guidance range of $5.495 billion to $5.655 billion.

We expect comp growth to be in the range of 3% to 5% compared to 2% to 5% previously, and operating margin to be in the range of 8.4% to 9% compared to the previous range of 8.2% to 9%.

We are also raising our diluted earnings per share by $0.11 to a range of $4.26 to $4.36 compared to a range of $4.15 to $4.25 previously.

All other financial guidance within the press release remains unchanged from the previous guidance.

For the third quarter of 2018, we expect to grow net revenues to a range of $1.355 billion to $1.380 billion, with comparable brand revenue growth in the range of 3% to 5%.

And we expect diluted earnings per share to be in the range of $0.90 to $0.95.

Our guidance does not reflect any potential impact from the imposed China tariffs.

We estimate that approximately 15% of our cost of goods sold would be subject to the China tariffs as currently proposed.

But given the timing of their potential implementation, we expect there to be minimal financial impact on our fiscal year 2018 results.

However, it's difficult to quantify with certainty their impact as these tariffs have not been finalized.

As we closely follow this topic, we are aggressively working to mitigate the potential impact of these tariffs on our financial results while maintaining our customer value proposition.

We believe we are well positioned to do so, given our vertically integrated, multicountry supply chain, where we design and contract manufacture almost all of our products.

And finally, from a capital allocation perspective, we remain committed to utilizing our strong operating cash flow to first invest in the business in those areas that will fuel our growth and provide the highest returns and to return excess cash to our shareholders in the form of share repurchases and dividends.

In summary, we are proud of our team and all of their hard work in driving our outperformance in the first half of the year and the broad-based momentum we are seeing in our business.

With our top line growth, selling margin expansion and our continued occupancy leverage driving the improved operating income and EPS outperformance, we are confident that our strategic initiatives are working.

And this, combined with our long-term growth opportunities and our unique competitive positioning, including a portfolio of strong, well-known brands with proprietary products, a vertically integrated supply chain that gives us unparalleled flexibility on sourcing and control over quality and cost, a leading multichannel platform with almost 54% of our business already transacted online, a world-class customer service model, a strong balance sheet, operating income and cash flow, along with our commitment to operational excellence and a proven track record of strong financial discipline, give us the confidence that we will be able to continue the momentum we are seeing in our business and to deliver long-term sustainable growth and financial returns for our shareholders.

I would now like to open up the call for questions.

Thank you.

(Operator Instructions) We'll take our first question from Peter Benedict with Baird.

So I guess my first question is just around Outward, and you brought it up a few times in the script.

And it sounds like it's playing a nice role in the business, but you bracket out of the adjusted numbers.

I'm just -- can you remind us what the thought process is there?

And is there a plan to kind of put them -- put that business back into the numbers at some point down the road?

This is Julie.

So what you have to remember is the biggest component of the piece that we are backing out is associated with the amortization or the accrual of the costs as part of the acquisition.

So for example, there's the amortization of the intangible assets and then there is the accrual of the earnout piece based on our probability of reaching their metrics.

And so that, to us, is associated with the transaction and so that is backed out.

As far as the actual operations of the business, they're currently in the ramp-up stage, and so we probably estimate that in a year to 2 years, they'll be back into our business.

Okay.

And then my other question was just around the one inventory view.

Can you give us a little more color on your progress there?

And when are you going to get there?

And what that's going to do for you once you achieve that milestone?

Sure, Peter, this is Laura.

There's a lot of this that is confidential, but let me tell you that what we're putting together.

First is the furniture aspect of it because we're shipping that directly to the customer, anyway.

They don't pick it up in the stores.

And that really allows us to optimize the inventory, be better in stock but also not have the excess in individual channels because currently, we hold it both separately electronically but also physically, so we're putting that together.

The further piece of the CMO business, which is the conveyable mail order business, is to common.

We have a lot of factors to consider before we make that decision.

We're focused right now on putting the furniture together for the balance of the year.

We'll move next to Michael Lasser with UBS.

Can you give us a sense of how the selling margin was ex some of the accounting adjustments in the quarter?

And what have you prospectively assumed for the impact of the accounting adjustment in your guidance in the third quarter and what's implied for the fourth quarter as well?

We haven't disclosed per se how it plays out by line except to say that it is the largest component -- selling margin expansion is the largest component out of the 130 basis point expansion on gross margin and then next is occupancy.

But the proximate 60 basis points that we said was associated with the largest piece of the accounting change, is exactly what we estimate will continue in the guidance.

We've been saying it's going to be about 60 to 70 basis points of shift between gross margin, SG&A, and about 50 to 100 basis points on the revenue line, and that's exactly how it came out this quarter.

Okay.

And do you expect that for the next 2 quarters as well?

Yes.

We'll move next to Matt Fassler with Goldman Sachs.

My first question relates to shipping costs, shipping expenses.

We didn't hear a lot about that today which, I guess, is good news.

If you could talk about why that seems to have faded as a challenge, whether it's the environment, whether it's efficiencies that you're seeing, whether it's the sales volume that's helping you overcome any headwinds associated with that.

Matt, it's Julie.

We still had pressure from shipping costs.

I don't think we should give the wrong impression there.

I think the difference is that we had supply chain efficiencies that completely offset it, and so the emphasis in the gross margin on why it expanded was selling margins and occupancy leverage.

And so we're still feeling pressure.

As we said, we just lapped the flat rate shipping costs in Q2 with West Elm.

We've been now lapping in Q3 the UPS contract, but there's still ongoing cost pressure from a shipping perspective, especially given the mix of what we sell.

The more that we sell towards oversized for UPS, for example, or more furniture, there still will continue to be pressure on the shipping line.

But what we're pleased about is that with the supply chain efficiencies that we've been able to generate and the incremental ones we've identified that we are going to be able to offset that.

Got you.

And then just a very quick follow-up.

You gave a very crisp explanation of the impact of the accounting change on gross margin this quarter.

I think it was 60 basis points to gross margin.

Given that there was so much disclosure in Q1 and you changed that a bit, can you just give us the equivalent number in Q1?

Was it also 60 basis points or was it a different number?

I think it was around 70 basis points, but we can circle back with that.

(Operator Instructions) And we'll move next to Steve Forbes with Guggenheim Securities.

Maybe regarding BOPIS.

I think we talked about this last quarter, but can you discuss how that offering performed during the second quarter within the Williams-Sonoma brand and then maybe just update us on the scheduled rollout to the other brands within the portfolio?

Yes, sure.

It's working well in both Williams-Sonoma and in PBK and driving footsteps and also customer experience because it's very convenient.

They really like it, the feedback is great.

We wanted to leverage our learning from Williams-Sonoma and PK before we scale to Pottery Barn and West Elm to make sure that we -- that our customers receive the best experience possible.

And currently, the West Elm rollout is planned for October, well ahead of the peak season.

We'll move next to Greg Melich with MoffettNathanson.

I'll keep it with one.

You mentioned, Julie, at the end about tariffs and sourcing and your flexibility there.

That 15% of COGS, is that direct or indirect that you're importing?

I assume that, that is China and that's what the current $200 billion that are proposed?

Yes, associated with China is based on the $200 billion, but it's based on our total direct and indirect estimate as to what is coming from China, to total company.

Got it.

And if it was -- could you help us with how much is imported from China if it went from $200 billion to that -- the broader tweet of 500?

We have not analyzed that as to how much will be actually impacted by the goods that we sell from China.

So I'll get back to you on that.

Next we'll move to Chuck Grom with Gordon Haskett.

Just on the guidance, in order to back in the $0.90 to $0.95, looks like you're expecting about 100 basis points of operating margin compression on a similar compare to a year ago.

And obviously, in the second quarter, you were roughly flat.

First quarter, you were up a little bit.

So I'm just wondering what the drivers are for that deceleration.

And if you could break it out between gross and SG&A, that would be very helpful.

Sure.

The biggest drivers are within SG&A and there's 2 things that are driving it: one, last year at this time in Q3, we had lower incentive compensation expense associated with performance-based compensation that we didn't earn.

And so this year, we have -- given our outperformance year-to-date, we have higher incentive compensation that's running through.

The other piece is the incremental reinvestment of our tax savings that's coming into Q3 associated with our hourly wages and in digital advertising.

The hourly wages, we have had a full quarter of the retail.

Last quarter, we had a little bit of distribution center hourly wage impact.

This quarter, we'll have in Q3, a full quarter of the distribution center impact, plus you have to realize as we start to hire seasonal hires for both retail and distribution, they are typically hourly, and so they'll also have that impact of the higher wages, and so it is purely a function of our reinvestment and the prior year lower compensation expense.

I wouldn't read anything else into it.

We still have the same expectations from a selling margin and gross margin perspective, and the health of the business.

Okay.

So I guess, just as a quick follow-up, obviously, there's a little bit improvement in the cadence of your merchandise margins, selling margins here in 2Q relative to 1Q, so you'd expect that to continue in the third quarter?

Yes, I don't know if I'd peg it exactly to the cadence delta between Q1 and Q2 and assume that cadence goes forward.

But we feel very comfortable that the initiatives that we're working on to drive expanded selling margins should be sustainable.

We move next to Kate McShane with Citi.

Just when looking at your guidance today, what do we need to see to get to the high end of the top line?

I ask because it looks like the beat in the first half is the driver of the increased guidance.

And it seems like from an execution standpoint and a macro standpoint, demand is accelerating.

So could you maybe walk us through what could -- what scenario gets us to the higher end of your top line guide?

Are you talking about the revenue side?

Yes.

Well, I think the one thing you have to keep in mind is as we bring down our inventory levels especially towards the back half of the year, we're going to have less clearance inventory to be able to drive clearance sales.

And so we're being very thoughtful in how we set that revenue guidance in light of that.

Now obviously, that will help with selling margins and expansion there, but we're being thoughtful about where we set that guidance.

Now on the flip side, if you look at the guidance we set on revenue for Q3, it's relatively in line with where we've been, especially at the high end.

And on a 2-year basis, it's accelerating and same thing with the Q4 implied guidance.

We have -- Q4 last year, you may recall, was one of the highest Q4s we've had in 5 years and was driven by Williams-Sonoma had the biggest piece of that in Q4, and they had one of the highest Q4s in 8 years.

And so just if you look on a 2-year basis, we are seeing acceleration.

Next we have Simeon Gutman with Morgan Stanley.

I have a question on Pottery Barn.

The business is stabilizing and improving.

I wanted to ask if it's consistent with what you expected.

And if you're being purposeful about promotions or discounts in it so that you're not overstimulating sales in favor -- well, you're not pushing it more in sales and favor profit.

Yes, absolutely.

Pottery Barn is really -- the team has done so much good work, both in product but also in the presentation of the product, both in-store and online.

As I mentioned, our new Pottery Barn stores are performing better than we expected.

Our online experience has dramatically changed, and it's allowing us to reduce the amount of overall promotions but also streamline them, make them clear and have less of them and also at the same time, clearance is being reduced.

And so absolutely, we are favoring the regular price sales, the higher-margin sales versus competing just on price.

And right now, I believe strongly that the Pottery Barn momentum is going to continue because the product, the strategies going forward are all incremental to what we're seeing today and what we're seeing today is working.

So we're quite optimistic and really proud of the team and all of their hard work and vision.

And next we have Christopher Horvers with JPMorgan.

So I wanted to follow up on the selling margin question.

If you look at it, it looks like selling margins were sort of flattish in the back -- in the first half of '17 and then with the EPS and finishing the roll at a flat rate, they looked like they were down over 100 basis points in the back half of '17.

So was it all the UPS in the rollout of the flat rate?

And as you think about an environment where it looks like you're optimizing your promotional posture, it looked like free ship days were down year-over-year, why shouldn't we assume that those selling margins, which were up in the second quarter, see a substantial step-up in the back half?

Well, so the biggest driver before, going back to 2017, was both shipping and merchandise margins.

And so as we move through the year, we still have the shipping pressure and we're starting to see the merchandise margins, as you can tell from Q1 to Q2, a substantial change in expansion.

But I wouldn't assume that, that same acceleration to that degree, which was my point earlier on the other question, that you can assume that cadence as we move throughout the year.

But we are very optimistic about where we landed on Q2 and our ability to drive the top line and expanded merchandise margins that we should be able to see that continue.

So then it comes down to a function of all the other pieces within selling margins to determine where that plays out.

Understood.

And then I just have one quick follow-up.

If you think about Sonoma being really important in the fourth quarter, as you mentioned, Sonoma did decelerate.

Was there something on the merchandising side, a certain category?

Do you think maybe in a way they eclipsed you in the second quarter or something like that?

And what gives you the confidence around the fourth quarter on that brand?

Sure.

It's Laura.

We saw in Sonoma in Q2, actually, on a 2-year basis, one of the strongest comps we've seen.

And summer season is the one that's most different because of the outdoor cooking element.

A full 100 basis points of the comp was that last year we did some Williams-Sonoma Home sell-off that we did not anniversary this year, and that resulted in higher margins in our Williams-Sonoma Home business, which was a great thing, but we obviously didn't comp those sell-off of those items last year.

So we're very optimistic about the back half.

We have some opportunity to get better in stock in some of the runaway products, and so we know that, that's going to happen based on our inventory flow.

We had some out of stocks in some key areas this quarter in Sonoma, which should not continue.

And the other thing that gives me a lot of confidence is the customer count, which we mentioned is always an indicator of what's to come.

And the customer counts are very strong, and our digital marketing efforts are really driving that business.

Felix, you want to make a few comments about Sonoma in the back half in the margin strategy?

Sure.

As Laura mentioned, we have not seen this momentum for a few years in terms of heading into the back half in Sonoma.

Our customer counts are up double digits, especially in the direct channel.

Or as Laura said, we see continued growth there.

So our marketing mix as well is geared more than ever as we head into third and fourth quarter towards where we see our greatest source of acquisition, which is more digital than ever.

So we're very excited about what is ahead for Sonoma in the back half.

(Operator Instructions) We'll move next to Seth Basham with Wedbush.

My question is on the furniture category broadly.

How did that outperform this quarter relative to recent quarters?

And on a related note, I believe you guys increased flat rate delivery fees for furniture earlier this year.

What kind of elasticity did you see with that move?

We haven't broken out furniture.

I will say that based on looking at the numbers that are published industry-wide, we are gaining share and we're doing it more profitably than most.

And that's very exciting.

We all know that the macro, the consumer's been in better shape but we are also seeing that our strategies are really working and gaining those customers to our brands, and that's evidenced by what Felix just said about the new customer growth.

We're bringing them in on the lower ticket and they're converting to furniture.

And we're also improving as we talked about earlier, our in-stock and reducing our overstocks, which is great.

In terms of the shipping fees, I think we tested a lot of different things, which is what you might be seeing but there wasn't any recent change, though.

Next we'll move to Cristina Fernández with Telsey Advisory Group.

I wanted to ask on real estate.

Could you update us where you are in your negotiations with landlords as far as the 80 stores you identified earlier this year for potential closure or favorable lease terms over the next couple of years?

And related to the topic, with the strong performance you are seeing under remodels for Pottery Barn, adding Williams-Sonoma Home to the Williams-Sonoma stores, do you see the potential to accelerate those remodels going forward?

So first of all, I think you mentioned 80 stores.

80 stores was the number we gave associated with store closures or potential store closures over the next 3 years based on a population of 250.

We have 30 that's planned for this year and those are on target.

Those aren't early lease terminations, they're just regular terminations.

And then we made progress, as what Laura alluded to in her prepared remarks, on some of the early store closures that we're aggressively going after, with the shutdown of 2 stores and then the impairment of 5 other stores.

And so we're pleased with the progress.

Obviously, there's still quite a bit more to do on that, but good news is that we're making progress.

As far as the remodels, those are phenomenal and we are moving faster on those as we continue to see that they are doing really well from a profitability standpoint and a top line perspective.

So you'll continue to see more of those.

So we like to do those when we re-up the lease, so that we have the longest life possible on these stores.

And we have time for one last question and that will be from Jonathan Matuszewski with Jefferies.

The spend in The Key reward members is really impressive.

Anything you can share there regarding the profile of this customer group?

Is the greater spend driven by frequency of visit or higher ticket or both?

And any updates on how many members are enrolled within the program?

Sure.

Thanks.

This is Felix.

Well, I'm excited for that question.

We don't disclose the number of members as of yet.

We believe The Key is a competitive advantage from a program structure perspective.

But what I can share with you is they are 3x more likely to shop across our family of brands.

We think there's a material opportunity in terms of customers shopping across our 7 brands, especially during holiday.

So we know that they shop more brands and they spend more than our average nonmember.

So this is a very healthy customer during these stages of The Key.

And we know that for fourth quarter, we see a tremendous opportunity to get them shopping across our brands and as they start to shop for the holidays.

That concludes our question-and-answer session for today.

I'll now turn the conference call back over to Ms. Alber for any additional or closing remarks.

Yes.

I want to thank you all for joining us.

Thank you for your support and a big thank you to our team who's worked so hard to produce these results and who will continue to.

Look forward to talking to you next time.

Thank you.

And that does conclude our conference call for today.

We thank you for your participation, and you may now disconnect.