Restoration Hardware Holdings' CEO Discusses F4Q12 Results - Earnings Call Transcript

| About: Restoration Hardware (RH)

Restoration Hardware Holdings, Inc (NYSE:RH)

F4Q12 Earnings Call

April 18, 2013 5:00 pm ET

Executives

Cammeron McLaughlin – Vice President, Investor Relations

Carlos Alberini – Chief Executive Officer

Gary Friedman – Chairman Emeritus, Creator and Curator

Karen Boone – Chief Financial Officer

Analysts

Lorraine Maikis Hutchinson – Bank of America Merrill Lynch

Matthew J. Fassler – Goldman Sachs & Co.

Daniel Hofkin – William Blair & Company, L.L.C.

David A. Schick – Stifel, Nicolaus & Co., Inc.

Neely J. N. Tamminga – Piper Jaffray, Inc.

Matt Nemer – Wells Fargo Securities LLC

Justin Kleber – Robert W. Baird & Co. Equity Capital Markets

Operator

Good day, ladies and gentlemen, and welcome to the Restoration Hardware Holdings Fourth Quarter and Fiscal 2012 Financial Results Conference Call. My name is Keith, and I’ll be your operator for today. At this time all participants are in a listen-only mode. Later on we will conduct a question-and-answer session. (Operator Instructions)

As a reminder, today’s conference is being recorded for replay purposes. And with that I’d now like to turn the conference over to your host for today, Ms. Cammeron McLaughlin, Investor Relations. Please go ahead.

Cammeron McLaughlin

Thank you. Good afternoon, everyone. Thank you for joining us for Restoration Hardware Holdings fourth quarter and fiscal 2012 financial results conference call. Joining me today are Carlos Alberini, Chief Executive Officer; Gary Friedman, Chairman Emeritus, Creator and Curator; and Karen Boone, Chief Financial Officer.

Before turning the call over to Carlos, I’d like to remind you of our standard legal disclaimer that we will make certain statements today that are forward-looking within the meaning of the Federal Securities Laws including statements about the outlook for our business and other matters reference in our financial results press release.

These forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please refer to our SEC filings as well as our financial results press release for a more detailed description of the risk factors that may affect our results. Please also note that these forward-looking statements reflect our opinions only as of the date of this call and we undertake no obligation to revise or publically release the results of any revision to these forward-looking statements in light of new information or future events.

Also during our call today, we will discuss a number of non-GAAP financial measures including adjusted operating income, adjusted EBITDA, adjusted net income and adjusted earnings per share. These measures are just our GAAP results to eliminate the impact of certain items. You will find additional information regarding these non-GAAP financial measures, and a reconciliation of these non-GAAP to GAAP measures in today’s financial results press release as well as a reconciliation of adjusted P&L items on pages 11 and 12.

A live broadcast of this call is available on in the investor relation section of our website at ir.restorationhardware.com.

With that I will now turn the call over to Carlos.

Carlos Alberini

Thank you, Cammeron. Good afternoon everyone and thank you for joining us. We have many exciting things to share with you today. I’ll start with an overview of our business performance and touch on the progress that we have made on our key operating initiatives on long-term strategy. Then Gary will provide an update on the RH brand and key products and business initiatives. Karen will then wrap up our prepared remarks with a discussion of our financial results and our outlook for 2013. After that we will open the call for your questions.

We are very pleased with our fourth quarter performance, which drove record financial results with adjusted net income growth of 24% and an adjusted diluted EPS of $0.64 for the period closing the best year ever for our company. On behalf of our leadership team, Gary and myself, I want to thank every member of Team Resto for all of the hard work and tremendous accomplishments this past year.

In the fourth quarter, we delivered industry leading sales growth with a net revenue increase of 30% on top of 19% increase last year. Excluding the 53 week, net revenues increased 23% year-over-year. This performance marks our 12 consecutive quarter of double-digit net revenue growth. During the time, when we have contracted our store base from 95 locations in 2009 to the 71 locations that we had at year-end. In fact, during this three year period RH achieved compounded revenue growth of 24% per year, essentially doubling the size of the Company from $625 million in net revenue in 2009 to $1.2 billion this past year. We believe that this 24% CAGR significantly outpaces the home furnishing market.

And now our peers; the home furnishing market in the U.S. has grown at 12% CAGR over the three years, while our set top peers have generally grown at less than a 10% CAGR over the same period. We believe that it is clear that we are disrupting this highly fragmented marketplace and have been gaining share consistently. While, all of our categories are experiencing strong growth for us. Furniture is leading the way, producing a lower margin mix, but resulting an industry leading sales result and market share gain.

We are thrilled with this evolution of our business. We believe that we are creating significant brand awareness and are becoming a destination for furniture nation wide, which should support our growth to sustainable long-term market share gains and margin expansion.

Gary always had a clear vision for the RH brand and our business. Today, we believe we have the most dominant luxury home collection in the marketplace. What he and the team have accomplished with the transformation of our assortment is simply outstanding. What is most exciting to me is the fact that, we are very early in this transformation, and we see tremendous opportunities for further expansion in multiple product categories.

The home furnishings market is very large at over $143 billion in the U.S. alone, and we represent less than 1% of that market today. The expansion of our assortment has enabled us to drive significant growth, but less than 20% of our current assortment is displayed in our retail galleries today. Less than 15%, if we include our bath, Baby & Child product.

The bottom line is this, today we have an assortment with revenue potential that could be more than three times as large as our business today, but the assortment is flat in our undersized real estate portfolio.

The real estate transformation into our full line design gallery concept is the key to unlocking the value of our assortment, and it remains our highest priority. Our first three full line design galleries showcase a larger percentage of our assortment, and continue to outperform our expectations.

Our LA and Houston galleries have achieved store demand cum growth in excess of 25% since their first anniversary. Our new full line design gallery in Scottsdale has delivered store demand growth in excess of 90% since its opening last November, and it continues to gain momentum each month.

Both LA and Houston are delivering annual sales per selling square foot of over $1500, while Scottsdale is tracking at over $1000 per square foot. The increasing profitability in this market is at anywhere from 80% to 300% in the first year of operation.

We recently opened our newest full line design gallery in the former Museum of Natural History in Boston. This gallery is our best expression of the RH brand to-date and represents the next evolution of our customer experience. While we are excited to open last week end, the recent events in Boston have been devastating to our team, to the city and to our country. We want to express our sincere sympathy and concern for all those impacted by this terrible tragedy. While the Boston gallery was temporarily closed following this event, it has now reopened for business.

We plan to open our next Full Line Design Gallery in Indianapolis in a few weeks and will be breaking ground in Greenwich, Connecticut and Atlanta, Georgia very soon. We have also identified and on negotiations for Full Line Design Gallery sites in over 20 markets including New York, Chicago, Miami, Denver, and San Diego, just to name a few.

The next generation Full Line Design Galleries will be larger to accommodate our small spaces collection, expanded furniture assortments and Baby & Child products. The new lease fields that will generate reflect more favorable economic and the concept has now been proven. Landlords have embraced our new galleries with high enthusiasm and are currently offering RH leases has an anchor tenant for some of the best retail shopping centers in the country.

We believe that we can structure these types of anchor tenant deal in a number of locations throughout the country and we expect this leads us to result in a more productive of timing, higher developer contribution to our build out and lower rent, all of which should drive higher profitability and minimized execution risks. The combination of our improved performance in the new galleries and better deal economics should result in improved returns in our invested capital above what we have previously expected.

This is an important fact, as most of our capital spends over the next several years will be directed towards the execution of our real estate transformation and we are in the very early stages of this process. We’ve remained confident that these galleries will allow us to drive sustainable growth for many years to come. We recognize the importance of investing in our operating infrastructure and platform to support our rapid sales growth. During the year, we make good progress with our key initiative in this regard.

First, we executed in our inventory strategy and close the fiscal year in a much stronger inventory position. We are very pleased with our vendors ability to scale and meet the growing needs of our business. During the quarter, we improved our in-stock positions, which contributed to better customer service, lower by quarters and higher delivery. This trends are also positively impacting our business in the first quarter of this year.

Regarding our supply chain infrastructure, we are on-track to open our fourth DC near Dallas, Texas. And, expand our shifting Ohio’s shelf stock facility. In addition to provide an increase capacity, we estimate that the addition of the Dallas DC to our furniture network will reduce the average transit time to our customers by 25%, enabling us to reach a higher percentage of our customers even sooner.

The Dallas facility also has our new customer service call center, allowing us to reduce our reliance on outside providers and support our growth in an efficient and cost effective manner. We’ve also made progress with our in home delivery initiative with the recent conversion of the Houston market we now have six in-source hubs, which give us more control over the quality of the customer experience. While also yielding lower returns and damage rate.

In 2012, we delivered 38% of our furniture through our in-source hubs, up from 19% in 2011. By the end of 2013, we’ll have 8 in-source market and almost 50% of our furniture deliveries will be controlled through our internal network. We have never been more confident in the strategic directions we have chosen for our company. We have a disruptive and powerful business model that we believe will drive significant market share gains and support our financial goals for many years to come.

We believe we have dominant product assortments and exclusive products across all categories and are offering tremendous value and superior service. We have significant real estate opportunities with very attractive lease economics. We have made investments in our infrastructure that will continue to leverage as we grow. Each of these attributes positions us for strong top line growth, operating margin expansion and improved ROIC.

I’d like to turn now the call over the Gary. Gary?

Gary Friedman

Thank you, Carlos, and good afternoon everyone. As mentioned in the press release, our ability to innovate, curate and integrate new products, businesses and experiences has driven our industry leading results and continue to distinguish us in the marketplace.

Our growth in 2012, and indeed our growth since 2009 was driven by a combination of new products, new categories, new businesses and the re-conceptualization of both our retail and direct platform.

We believe we are building not only an innovative and proprietary product offering, but also a completely new platform or eco system to experience our collections. Both these factors are producing industry leading sales per square foot in our galleries, and with continued refinement, we’ll also produce what we believe will be one of the most compelling and productive multi-channel experience in the retail.

As Carlos mentioned, with only four of the top 50 markets having been converted, many of our new and developing businesses have been just introduced, and others being launched this spring and into the future. We are at the very early stages of our growth story.

Most recently, our growth is driven by new collections and finishes in furniture, lighting and textiles coupled with an expanding bath and child offering and the introduction of small spaces.

Looking forward, this spring, our collection will be presented across six Source Book titles totaling over 1,600 pages and represents the most dominant and authoritative assortment in a luxury home furnishings market.

Our Interiors and Small Spaces Books include the addition of new furniture collections and finishes, the expansion and presentation of color across our upholstered furniture and textiles collections, and dramatic new lighting. The new furniture which includes an antique top and white painted finishes, we believe will open up an entirely new market for us.

In addition, we are introducing two new businesses this spring, RH Tableware and RH Objects of Curiosity, which we believe represent significant long-term growth opportunities for the Company. Each of these new businesses are being presented in their own distinctive catalogs and represent what we believe is an un-served market from an aesthetic point of view.

As we have traditionally approach new businesses, the product for each of these will be tested and direct and rolled out at retail over the next several quarters and into next year. Our newest business RH Contemporary Art has acquired the Rain Room by Random International, arguably one of the most admired pieces of modern art in recent history as evidenced by the three to five hour wait times while an exhibition at the Barbican in London during the past several months.

We are actually the first in the world to purchase the Rain Room and it will make its U.S. debut in collaboration with the Museum of Modern Art in New York. The exhibition is part of EXPO 1 and will be presented in a freestanding structure in the parking lot adjacent to MoMA ordering the entrances on 53rd and 54 Street. The launch will coincide with the opening of the Frieze New York Art Fair this May and will be on exhibition at the MoMA until August.

Clearly this association adds creditability to our position as a new entrant into the world of contemporary art. We plan to open our first freestanding RH Contemporary Art gallery in the Chelsea Arts District in New York City, and be live with our online platform this fall post the exhibition

With that let me now turn over the call to Karen.

Karen Boone

Thanks, Gary and good afternoon everyone. I will first take you through some of the financial details of our fourth quarter and 2012 performance and will then provide our outlook for both the first quarter and 2013 full fiscal year.

First, as Cammeron mentioned with several unusual non-recurring items, so we’ve excluded from our adjusted earnings in the fourth quarter and full fiscal year. Due to adjustments include the items we discussed on our third quarter earnings call as well as the charge from an anti-dumping exposure related to purchases from a supplier in China dating back to 2011. Further details regarding all these adjustments have been included in our press release.

We’re extremely pleased with our fourth quarter performance. Total revenue for the fourth quarter increased 30% to $398 million. Retail sales during this period increased 22% to $210 million. And, our comparable store sales increased 26% and this is on top of the 22% comp store sales growth we experienced last year. We also operated fewer stores with 71 galleries opened at the end of the fourth quarter versus the 74 we had opened at the end of last year.

Our direct sales increased 41% to $188 million on top of a 23% increase for the same period last year. Top line growth across all of our channels was primarily driven by the expansion of our assortment. As we’ve strong performance in the new black and brown furniture finishes, lighting expansion and new items in our Small Spaces and Baby & Child collection.

Adjusted gross profit in the fourth quarter of fiscal 2012 increased by 26% and reach the $148 million. Adjusted gross margin decreased to 37.3% from 38.5% last year due to increased shipping costs and a reduction in product margin based on changes in product mix. With higher furniture sales during the period, partially offset by improvements in our occupancy costs.

Strategic pricing on those new furniture introductions and existing collections has allowed us to take market share, this resulting in lower product margin. Increases in our furniture sales also result in higher shipping costs. We believe that the value we offer through our competitive pricing is resonating with our customers and is contributing to significant market share gains.

During the fourth quarter we also continue to see occupancy leverage despite new costs related to expansion of our Baltimore furniture facility and a full quarter of free opening rent for our Boston gallery without the corresponding revenue.

Turning to expenses, our total adjusted SG&A expenses were $107 million in the fourth quarter versus $83 million in the prior year. The increase in SG&A dollars was primarily driven by increase in employment costs, the majority of which relates to variable store and distribution center labor, which was in line with our sales growth as well as increased advertising and catalog costs related to our expanded page catalog circulation.

As a percentage of revenue adjusted SG&A expenses decreased by 40 basis points to 26.9% versus 27.3% of net revenues in the prior year. This decrease was due to increased leverage on fixed payroll and other corporate expenses, partially offset by increased advertising and catalog cost.

Adjusted net income for the fourth quarter increased 24% to $24.2 million, up from the $19.5 million in the prior year. Adjusted diluted EPS was $0.64 during the quarter with the 53rd week accounted for approximately $0.04 of our Q4 adjusted EPS. This performance closes out our best year ever for the Company. In 2012, our net revenues increased 25% and reached almost $1.2 billion for the year, surpassing a significant milestone for our business.

Comparable store sales on a 52 week basis increased 28% on top of the 25% comp growth in fiscal 2011. Direct revenues also increased 30% on top of the 27% increase last year with our direct sales in 2012 representing 46% of our overall revenue.

The full year adjusted gross margin as a percentage of revenue was 36.9%, a decline of 30 basis points from last year. Similar to the fourth quarter, this decrease was driven by changes in our product mix, strategic pricing and higher shipping costs, partially offset by occupancy leverage. Adjusted operating income increased 40% during the year with adjusted operating margins expanding to 5.8% from 5.1% last year as we continue to leverage our overall occupancy costs and SG&A expenses.

We’re extremely pleased with our progress this year, especially when we consider all the investments we made in our infrastructure to support growth, our new businesses and in our real estate transformation. Adjusted net income for the year increased 43% and reached $37.7 million or $1.01 per diluted share based on approximately 37.2 million diluted shares outstanding.

Turning to the balance sheet, inventory levels at the end of the year were $353 million, up 44% from last year. This increase was in line with the inventory strategy we’d outlined previously as we work to improve our in-stock positions, reduce backorders and drive higher sales.

Through the third quarter of 2012, our sales growth had outpaced our inventory growth, and as Carlos mentioned, inventory receipts in the fourth quarter allowed us to close out this year in a much stronger inventory position and it positively impacts our performance as we began the 2013 fiscal year.

With respect to our credit line, we ended the year with $82.5 million outstanding on our $400 million credit flexibility. Following our IPO in November, we utilized a portion of our proceeds to maintain the $75 million on this stability and fully repaid our $50 million term loan. Our total capital expenditures for the year were $49 million, representing investments in both new galleries and infrastructure to support our growth.

Let me now address our guidance heading into 2013. We’re very pleased with our fourth quarter trends, which have accelerated in the first quarter and remains strong even when our spring source that will be enhanced a month later this year. We continue to see very strong consumer demand for our products including our new furniture offering, lighting assortment and Baby & Child products.

Based on our current trends, we expect to grow revenues between 28% and 31% to $280 million to $285 million for the first quarter.

We expect gross margin trends in the first quarter relative to the prior year to be consistent with our fourth quarter performance and expect SG&A trend to improve considerably.

We are assuming a 40% tax rate for the quarter and net income in the range of a loss of $1 million to breakeven. We’re providing first quarter diluted EPS guidance in the range of a loss of $0.02 to breakeven, which assumes 38.8 million diluted shares outstanding.

With respect to the full year and 2013, we expect the revenue growth to be between 19% and 22% and reach $1.42 billion to $1.45 billion. Our fiscal 2013 revenue outlook represents growth of 21% to 24% on a 52-week basis.

As we think about quarterly revenue, the majority of our Spring Source Books will be in home in the second quarter of 2013. While we expect this change to benefit our second quarter business, based on the (inaudible) purchasing patterns, we anticipate this shift will impact our third quarter business in an even more meaningful way.

We expect net income to grow between 35% and 43% to a range of $51 million to $54 million at fiscal year 2013, also assuming a 40% tax rate. We’re providing full year diluted EPS guidance in the range of $1.29 to $1.37, which assumes 39.5 million diluted shares outstanding.

With respect to inventory levels, we’re trying to close the year with inventory growth commensurate with our planned sales growth. In the first half, we are planning inventory levels higher than our sales growth in line with our recent efforts to improve our overall in-stock position.

We planned capital spending to be between $95 million and $100 million, excluding certain allowances and over half of the spent will be invested in our real estate transformation with the remaining expense invested in infrastructure including our supply chain and other initiatives.

In closing, we’re extremely pleased with our record performance this year. We delivered industry-leading revenue growth and increased earnings at an even faster rate, driving operating margin expansion. We remain confident on our growth strategy and ability to consistently deliver long-term revenue growth in the mid to high teens and earnings growth of approximately 20%.

With that I would now like to open up the line for any questions. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from the line of Lorraine Hutchinson with Bank of America Merrill Lynch. Please go ahead.

Lorraine Maikis Hutchinson – Bank of America Merrill Lynch

Good afternoon. My first question was around gross margin. I know there is a lot of mix shifts going on with the increase in the furniture penetration. How should we think about that over the long-term? Should we continue to see that decline on a multiyear basis, given the focus that you are placing on furniture or are there offsets that we can look for in the out years to offset that?

Carlos Alberini

Yes, Lorraine how are you? Let me take that. Let me start by saying that, we are very, very excited and thrilled with the evolution that the business that has taken and how we continue to gain markets in the business that is so critical to our long term strategy. And I am talking about furniture specifically. You are correct that that business has impacted our mix negatively. We are modeling our long term with a very stable margin. We do see that the trends are somewhat similar in the first quarter as Karen indicated and that would impact our first quarter margins as well. We have seen some promotional activity and we believe that we have winning formula with the very strong dominance over it and very exclusive products.

So we feel that long term, we will have pricing power. As you know, at the core of our strategy we want to win disruptive marketplace and continue to gain market share and I think we are doing just that.

The great thing about the model is that we do see operating margin leverage as we further lever our cost structure and infrastructure and SG&A overall and occupancy with the new deals that we are seeing. So we feel that we can continue to drive this market, share gain remain very competitively priced and continue to win in the marketplace.

Gary Friedman

Yeah, this is Gary. Lorraine, let me build on a couple of key points. We are going to start to see growth from new businesses, particularly Tableware, Objects and Art. As the businesses start to grow, you’ll see a stabilizing of the furniture growth in the product mix. The other thing that we’re seeing is with the growth in furniture is leading to the better pricing with our vendor base. So there are deficiencies that our vendor base has, that are being passed along to us. So that will become a positive as we start to see it in the later half of this year. And the other thing to consider is Baby & Child is now just starting to reach a level where our orders are getting to a scale that we’re going to start to get leveraging or buying the Baby & Child. And so that business, because it was in its infancy with somewhat of a margin drag, and that will start to normalize and lift up margins also.

Lorraine Maikis Hutchinson – Bank of America Merrill Lynch

Great. And then, on your new store opening cadence, what’s a good run rate for us to think about longer term, how many of these do you think you can digest in the course of a year, and is the $100 million a good CapEx number to use as a run rate?

Gary Friedman

Yeah, let me address that too, we are very excited about what we are seeing in terms of the enthusiasm that we see that landlords are taking with our new Full Line Design concept. I think that there is a big opportunity here to grow the square footage in a pretty significant way, probably even more than what we originally thought because when you are concentrating on some of this shopping retail centers with anchor tenant deals, there is an opportunity to grow much faster than if we are just looking for one building here are they are now, of course there is going to be opportunity for single buildings like the ones that we found in Boston or the post office building in Greenwich, but this gives us a model that it will enable us to grow significantly faster.

In terms of the number of units, it depends on the complexity, but we have been modeling our long term growth with numbers anywhere between 5 and 10 locations, I am talking about 3 to 5 years out.

Lorraine Maikis Hutchinson – Bank of America Merrill Lynch

And CapEx?

Carlos Alberini

In terms of CapEx if you think about that type of number assuming that we are going to be building locations that are larger than what we have built so far just to accommodate the expansion of some of the product categories as I mentioned in my prepared remarks you have to think that this $100 million will be probably spend in a different way, there is a considerable amount of spending this year for infrastructure, primarily supply chain, we are opening a new DC, and we are expanding one in a pretty significant way that is very costly, but which we do not anticipate that we’ll have that type of investment every year.

So but I think $95 million to $100 million in terms of overall capital is a good annual run rate doesn’t probably mean that we will spend exactly that amount every year there could be some years where we may spend more than that. But I think the $100 million range is a pretty good benchmark.

Lorraine Maikis Hutchinson – Bank of America Merrill Lynch

All right, thank you.

Gary Friedman

Thank you

Operator

Your next question is from the line of Matthew Fassler with Goldman Sachs. Please go ahead

Matthew J. Fassler – Goldman Sachs & Co.

Thanks a lot and good afternoon, congratulations on the holiday season. The first question I’d like to ask relates to a little more detail on the impact some of the emerging businesses on the fourth quarter, I know that some of them that hit the Source Book, and the stores thereafter. Any color you could give, what your early reads are on their impact on the business?

Gary Friedman

Matt, you’re talking about the books that are just now being dropped

Matthew J. Fassler – Goldman Sachs & Co.

Well, I guess I am talking about some of the new initiatives Gary that impacted Q4?

Gary Friedman

Yeah, well that’s a good one, if you stand back and think about it right, we have multiple business investments that we believe will lead to longer-term growth and leverage on our operating margins, but that provided de-leverage rate in the last couple of quarters. And so specifically those are Tableware, Objects of Curiosity and Fine Arts where we have no sales being generated, but we have teams working on building those businesses. And we’ll start seeing sales in Tableware and Objects of Curiosity in the next. We’re starting to see sales now, because we just brought up online the books are just starting to getting own.

And then small space basis of Baby & Child, where we’ve had significant work being done on the assortment. But you’ve got businesses here when you think about it that there are in their infantile stage even Baby & Child, we have such a small retail presence, but we have a full assortment, I mean we opened a 7,000 square feet of selling in Santa Monica, California and needed every bit of that, and actually is performing quite well, we got I think industry leading dollars per square foot in all of our Baby & Child locations that we have.

So when you think about starting to roll that out in retail you’re going to get big leverage there, same thing with Big Style small spaces. The small faces category, think about it as a start-up catalog, it is really in its first year we’re testing, refining. We’re optimizing circulation, optimizing page count and density. You’re going to see good leverage there.

And then the third thing, I’d mention is we made circulation investments to test the depth of our file in the second half of last year. And we knew, as a private company we wanted to get a feeling for how big that market looked and made some investments that now we will start to optimize that circulation, and I think we would have expectations of better leverage from an advertising point of view going forward.

Matthew J. Fassler – Goldman Sachs & Co.

And Gary, if you think about Big Style and small spaces in particular, which I realize is very much emerging, but still did have a presence for a number of months during last fiscal year. Any read on its promise and its contribution in the quarter that we just saw?

Gary Friedman

Yeah, we’re very enthusiastic about the reads on it, very enthusiastic. In fact, as Carlos alluded to we are going to size up the box on our new design galleries to incorporate a retail presence of big style small spaces. Yeah.

Matthew J. Fassler – Goldman Sachs & Co.

Second question just on real estate; I realize that demand growth is a relevant metric, I guess, it encompasses direct and other things, but if you kind of take maybe a more traditional metric to same store sales on the retail box for the galleries that you saw for namely LA, in Houston, can you give us a color on how those numbers attract?

Gary Friedman

Yeah, that’s actually what Carlos referred to is basically the demand of retail.

Carlos Alberini

Yeah, normally you would see complete correlation Matt, inventories away, you’ve talked about demand is because we were comparing to a much smaller type of business, so really if you don’t do it, based on demand. You would get, you would on the delivery of…

Gary Friedman

Ship product yes…

Carlos Alberini

At the beginning of that, so, the same store sales is pretty much tracking the numbers that I spoke about for eastern close location.

Gary Friedman

That demand growth is same store demand right?

Matthew J. Fassler – Goldman Sachs & Co.

Spaces (inaudible) business if you will as opposed to…

Carlos Alberini

Exactly.

Gary Friedman

Exactly.

Matthew J. Fassler – Goldman Sachs & Co.

That’s a clean retail member.

Gary Friedman

That’s a clean retail member.

Matthew J. Fassler – Goldman Sachs & Co.

Got it, that’s great. And then my final question.

Gary Friedman

I’m actually Matt, let me just add that if you add the impact of that this galleries have in each of those markets in our direct business, which was something that we were not counting on when we made those decisions to invest in this Full Line Design Gallery. The impact is significantly accretive to each of those markets as well on the direct business.

Matthew J. Fassler – Goldman Sachs & Co.

Great, and then my final question, Karen you spoke in your comment on Q1 about SG&A trends improving considerably. I just want to make sure that are we thinking about versus the fourth quarter run rate versus the fourth quarter year-on-year in other words do you expect to see a lot more leverage in Q1 than you saw in Q4, I just to get clarify on, what precisely…

Karen Boone

Yes, it’s the leverage, we see the leverage in Q1 seeing better compared to what we saw in Q4.

Matthew J. Fassler – Goldman Sachs & Co.

Great. Thank you so much guys.

Carlos Alberini

Thank you, Matt.

Operator

Your next question is from the line of Daniel Hofkin with William Blair. Please go ahead.

Daniel Hofkin – William Blair & Company, L.L.C.

Good afternoon. Very nice quarter.

Gary Friedman

Thank you. Hi, Dan.

Daniel Hofkin – William Blair & Company, L.L.C.

I guess just a follow-up a little bit on maybe in the intermediate term and the gross margin you have talked about the first quarter outlook. It sounds like that’s kind of go in hand in hand with the stronger sales, particularly in furniture. As you get out for the year as a whole, do you expect the gross margin drag is smaller than in the first quarter alone, given the sort of?

Gary Friedman

Yeah, completely. That’s exactly what we expect. We see opportunities as we go into the second half of the year for significant improvement over the trends that we saw.

Daniel Hofkin – William Blair & Company, L.L.C.

Not necessarily up year-over-year, but you are saying smaller rate of degradation.

Karen Boone

Yes.

Daniel Hofkin – William Blair & Company, L.L.C.

Okay, got it. And then…

Gary Friedman

A bit smaller, a fraction of.

Daniel Hofkin – William Blair & Company, L.L.C.

Got it. And then I guess just on the real estate for, maybe if I could just ask about the Chicago market, I know the couple of locations, the smaller locations have closed, is that just sort of in preparation for an eventual large format gallery or what’s sort of the specific strategy there if you can share that?

Gary Friedman

Yes. Dan, this is very similar to and consistent with how we have approached every market. Every time we decided to close a location is based on that one investment decision and so if we decided to close it, because there was a significant return opportunity in every case, but that being said, you are absolutely right, we are searching for the appropriate location to represent us in that market and it’s a big market for us and a great opportunity for our Full Line Design Gallery and we have been negotiating and talking about one specific location we are very excited about.

Daniel Hofkin – William Blair & Company, L.L.C.

Great, and then I guess my last question relates to the new store performance, is there anything you would call out in terms of, is it certain classification, certain collections of furniture that are driving especially get upside so far in I guess the three newest stores

Carlos Alberini

What I would say is Dan, I think that something that we said before, if we continue to confirm every time that one product is display at retail we experience that sell list in the 50% to 150% range, and that is consistent and of course this full line design galleries are displaying much more of our assortment and that is how we are seeing that significant lift. And that has being complete consistent in everyone of this locations we have been really surprise in a great way, was that Scottsdale just delivering some amazing numbers and we continue to build the two locations and thoroughly fully burdened in Houston, just continue to really accelerate relative best of this lead if you exclude Full Line Design Gallery even on the second anniversary. So it’s all great like Gary said before we do see an opportunity to relieve or represent more of the assortment we know that’s the way to win.

Daniel Hofkin – William Blair & Company, L.L.C.

All right, thank you very much.

Carlos Alberini

Thank you, Dan.

Operator

Your next question is from the line of David Schick with Stifel Nicolaus. Please go ahead.

David A. Schick – Stifel, Nicolaus & Co., Inc.

Hi, good afternoon and I’d add the congrats on the quarter on the continued strength, and I think I have to just for sake of comedy talk there is something profound about Baby & Child being in its infancy right that we talked about.

Carlos Alberini

We like to think that is co-added.

David A. Schick – Stifel, Nicolaus & Co., Inc.

I think yes, we’ve got our title starting to form for the note, so if we could go and sort of think on a comp basis you got a lot of comp drivers, but then how much is new customers, you’ve talked about growing you catalog a little bit, but new customer versus existing customers growing their business with you, if you could talk about that, and then sort of overlying as well, transaction count growth versus the size of the transaction our units for transaction or whatever you think about it.

Carlos Alberini

Clearly we are selling more to our existing customers and as we expand the assortment and we move in new category so we would expect the majority of table top to sell to our existing customers that have been in that category same with Objects of Curiosity, same with where we’re seeing the growth in outdoor or Baby & Child or even in our existing furniture lines. I think the addition of small spaces starts to open up a new market, it makes our brand even more accessible and that’s what we are so excited about the small spaces concept into a retail format, because if you think about it, you got a couple of ways to make the brand more accessible; one is we make the product smaller, there is less input cost into the product so it can happen with a lot of retail, but also shipping it here you get more in the container so that gives you a lot of retail, so we’re not taking any quality or any design out of the product, but by sizing the product differently, we believe that’s gong to open up the market, not just from a youth point of view, but from an acceptability point of view.

So we start to see how that is opening up the market and then the other key part here, one of the hardest way is to grow a business, it’s just through a direct channel as far as awareness right? Because the deeper you circulate them the more expensive it is and it’s hard to hit those targets. The best way, once you have a proven format, is to put that assortment into the retail channel and make it accessible and make it visible. So the biggest opportunity you have here for new customer acquisition is really by transforming the real estate and opening the new galleries and that by far is going to be the biggest deal in this company and we’re going to see really good growth.

We’re excited about tabletop, we’re excited about Objects, we’re excited about many, whether it’s expanding our right business to (inaudible) business and we have many more bullish loaded in the gun that you’ll hear about it coming down the pipe. But the big deal here, is as Carlos said, is if you really looked at this assortment, if you looked at these six tiles, 1,600 pages and you put that assortment into the retail marketplace that changes everything and that is the key.

We have spent years building this assortment. We have spent years adding in it, figuring out how to present it in the direct channel and now we’ve proven that we can put it into the retail channel and keep returns that are multiples of our current real estate locations at a occupancy cost level that’s significantly lower that our current locations and the other thing I’d just say, I want to reinforce what Carlos said, the fact that and it just happened in the latest quarter that we have now found ourselves in a position to actually cut what’s called anchor tenant deals.

For someone like Carlos and I who have spent our careers paying mall rents, and this is nothing against our landlords who are running the shopping centers who might be on this call, this completely changes the game for us. It changes the game for us. It changes the game for us from what we had previously thought we’re going to be. The rents we are going to be paying in the model, which would give us a great return. It’s ever seen significantly different rent deals, which allows to decide the box and put excel, small spaces out there to put Baby & Child out there and not a 2,000 square foot footprint, but a 6,000 or 7,000 square foot footprint. To add more categories and more of our assortment in the marketplace and do it on significantly less rents and significantly bigger tenant improvement, tenant allowances.

We thought we’re going to have to go off the mall to get these kind of real estate deals. In fact, we can stay in the mall. The fact that you’re going to soon hear about a location where Saks Fifth Avenue vacated and we’re taking Saks Fifth Avenue and fake the street and many other locations like that completely changes the game for us. So we couldn’t be more excited about what’s going to happen here as you think about the accessibility and the impact and help customers. You’re going to proceed the brand. You thought we were excited about Houston, waiting to see what’s coming next.

David A. Schick – Stifel, Nicolaus & Co., Inc.

Well, thanks. That’s very helpful. Sort of for me to think about it, it sounds like you’re saying the business today has been driven by more, really more your exciting customers growing what they are buying and it’s mixing towards a more even mix as you grow your footprint and accessibility. Is that the right way to think about it?

Carlos Alberini

If we grow footprint, I think we’re going to…

David A. Schick – Stifel, Nicolaus & Co., Inc.

I mean change that. Yeah, change that.

Carlos Alberini

But I think, the one thing I would add to that Dave is that like Gary said before, we’ve made a significant investment in the circulation and [going] significantly deeper this past year. And so, we are talking to new customers as well and we are seeing that the impact on the return on that investment is very desirable, so.

David A. Schick – Stifel, Nicolaus & Co., Inc.

Great.

Karen Boone

And on the cost side, you might hear it from all of that. This is Karen. On the comp, the other thing I would add is towards the latter part of 2012, we saw an acceleration and the impact of our interior design services we are having on our call. We are not having more and more designers in our stores. We closed the year with 39 designers in 25 of our galleries, and those individuals are so much more productive, and they have a longer relationship with these customers and more and more customers are coming and shopping for multiple rooms at their home overtime. So we are really pleased with that initiative and by the end of 2013, we expect to have these services available in all of our galleries, so we think that’s going to be a good driver for the comp in the future as well.

David A. Schick – Stifel, Nicolaus & Co., Inc.

Thank you so much. Anything you would share then on average transaction size growth or anything like that, any metrics?

Karen Boone

Not at this time. We are not going to share those.

David A. Schick – Stifel, Nicolaus & Co., Inc.

Okay, thank you.

Operator

Your next question is from the line of Neely Tamminga with Piper Jaffray. Please go ahead.

Neely J. N. Tamminga – Piper Jaffray, Inc.

Great. Good morning, and let me also add my congratulations to the team.

Carlos Alberini

Thank you Neely.

Neely J. N. Tamminga – Piper Jaffray, Inc.

So I just wanted to get some just clarity around particularly the Big Style small spaces and table tops. Gary, is there currently right now in all galleries of 73 year or so of them representation of some form of the added of this product in stores or just the 25 or so, I mean just trying to get a sense of where it is?

Gary Friedman

It is from small spaces and table tops, there is no assortment out there. There is a little bit in the second floor New York in the basement like there is basically no representation of small spaces in the company and then ultimately table top the book is just getting to drop in the product key rolling out to retail stores over the next several months, and as it tested, we get more clarity how it’s performing we will make bigger investments into the retail presentation.

Neely J. N. Tamminga – Piper Jaffray, Inc.

By the end of the year would you expect to at least maybe 10% of the galleries to have some format added or 10% of the product to be in all the gallery something to that effect?

Carlos Alberini

Not in small spaces, in table top I would say by the fourth quarter we’ll be in all galleries with table top.

Neely J. N. Tamminga – Piper Jaffray, Inc.

Okay, excellent, okay cool. Thank you for that clarity, and then just a couple of more questions here on outdoor furniture, I know that Minneapolis is not the center of the world, but I am currently staring at a snow storm today just wondering and somewhat dramatic what we’ve seen across at least in mid-west from the sort of spring, could you comment as to how outdoors perform for you guys, and then whether or not Q2 contemplate or Q1 and into Q2 contemplate some sort of acceleration in that business for pent up demand just help us understand the importance of outdoor.

Gary Friedman

Two things; one, our outdoor business is positive year-to-date and we’re happy with the performance of outdoor, and one of the things that if you think about our limited retail space a lot of it deals with, not only the time when we drop the book, but when do we switch out into our product off the floor and put outdoor product on the floor in our retail stores. And we’ve been studying that art, if you will carefully and which perfectly left into our product on the floor longer this year because we believe we have a better arbitrage in that and so we’re just now going to start to see some outdoor furniture on the floor in the retail stores.

So I think we are excited about our store and we think we have one of the coolest new collections, Aspen collections which you will see in the front of the book and across magazines, designed by Soren Rose from Copenhagen is I think one of most innovative outdoor collection, it’s really viable for mountain homes and places like Aspen, and Sun Valley and log cabins and things like that and we’ve done lot outdoor expect a very good season so.

Carlos Alberini

And what I would add is I think you probably heard the comment that Gary made that the books are dropping later than they where a year ago, so and that also includes outdoor, so the fact that the business has been tracking so strongly relative to a year ago with that change in our strategy, I think it’s pretty meaningful and significant.

Neely J. N. Tamminga – Piper Jaffray, Inc.

It’s an excellent point thanks Carlos, and then I just have two follow-up model questions for you Karen. First, do you specifically give where the circulation plan is this year relative to last year? I know that you have been a significant investment in last year. But, what does the 2013 circ plan?

Karen Boone

We’re not sharing the specifics of that I’ll just, will say that we do try and optimize that in few leverage in 2013, but we’re not really guiding to a specific at cost or numbers or percentages.

Neely J. N. Tamminga – Piper Jaffray, Inc.

Okay, and then, in terms of depreciation, have you given some sort of depreciation guidance for this year, for the quarter?

Karen Boone

We didn’t give that, but I’ll just say planning at roughly similar to what we saw in 2012 will be a good estimate.

Neely J. N. Tamminga – Piper Jaffray, Inc.

Similar, are you mean by the rate or the actual whole dollars could you clarify just little bit?

Karen Boone

The rate.

Neely J. N. Tamminga – Piper Jaffray, Inc.

Okay, Thank you very much and good luck to you guys.

Gary Friedman

Thank you Neely.

Operator

Your next question is from line of Matt Nemer with Wells Fargo Securities. Please go ahead.

Matt Nemer – Wells Fargo Securities LLC

Good afternoon, everyone. Sorry for the background noise. So, I just wanted to follow-up on the Full Line Design Galleries that you’re making larger in terms of small spaces in Baby offset by the anchor tenant deals that you’re getting. How does that impact the returns and the payback on this next batch of stores versus the math you provided in the IPO?

Carlos Alberini

Well, we think about the next batch of stores. We have a couple of deals that we did prior to some of the things that we’ve learned recently, but all are what we call are accretive deals versus our current performance and ended performance currently. So, would you think about things like Greenwich and Atlanta and so on and so forth. Some of the deals that are in the pipeline I’d say there is a model for more, towards the guidance that we gave at the IPO. And then many more of the deals that you’re going to see happening, obviously with the exception of things like New York and some major metropolitan areas, where you’re not going to go into a mall in Manhattan. But we expect the majority, vast majority of the deals going forward to be accretive to the expectations that we laid out of the IPO.

Gary Friedman

You know what I would add Matt is that there were a few things that were very different when we were during the Roadshow, when we talked about this topic and I think the good news is that all the changes are more positive and beneficial. So the first one is, the fact that at the same we had some expectations about the performance of the Full Line Design Galleries, which we have been exceeding free and they’re actually the ones that we have. So that is definitely impacting our returns in a positive way. The second one is that we had anticipated our plan that our total occupancy cost we’re going to be similar on a per square foot basis to what we’re paying that’s the way we modeled our financial plan. And what we are seeing now is that with this anchor tenant deals that we can see a pretty significant improvement of what we’re paying. So that is the second big thing combined with the capital utilization, which we again think that could be a big positive.

The fact that we are dedicating more space to this category that Gary mentioned it’s all good news. We see based on our experience in Baby & Child, Gary mentioned the Santa Monica location is delivering some pretty impressive performance and we know that everyone of the markets where we are planning to open our space for Baby & Child, our markets are doing very well with the direct business for Baby & Child. So we already have accessed we know what we expect, it has worked it in every market where we did open Baby & Child. And we believe that small space is a big opportunity as Gary said. So we haven’t read down the numbers in terms of what to expect in terms of return, but it’s going to be better all around.

Matt Nemer – Wells Fargo Securities LLC

Great, that’s helpful. And then just secondly in terms of services you mentioned that you ended the year with 39 designers where from that number go by the end of this year and just overtime does that going to the 100’s or just give us a sense for how a guess, what you guess?

Gary Friedman

In order to be present in all 70 galleries like Karen mentioned, you’ll be looking at number in the 90.

Matt Nemer – Wells Fargo Securities LLC

Okay. And then lastly I know it’s pretty early because it hasn’t been online that long, but any early read on tabletop and just early read from what customers are kind of talking about and blogging about? Thanks.

Carlos Alberini

It’s too early and the books aren’t really in home yet and we went online with the books and we’ve gotten some. The comments are all positive, like, in generally, they are. I mean, our people are enthusiastic about it. That’s great. The first few transactions around tabletop, we’re seeing people buying not just items. We’re buying like full collections [outfitting and second home]. So we’re very, very encouraged by it. I think if you take our table top look and you try to take other look at anybody else who has got tabletop and a catalog and just put him side by side on a table, I think it is a completely different presentation and assortment of how tabletops represented anywhere in America today. And we have been wisely think it’s better. Our people are excited about it and we’re relatively positive we’re going to be happy with the outcome. I think that you could say same thing with Objects of Curiosity. If you say to yourself where do you buy product like that, where is it presented in a way that you can understand it.

If that category even exist in the marketplace today, I would argue that the category not really merchandised anywhere in a meaningful way and that would grow with creating a new category with Objects of Curiosity. And I don’t know if you guys have gotten the books yet or if you’ve seen them online, but again these are businesses. When you think of the Tableware and Objects of Curiosity, these are products that our customers need and want, right. Need and want. You need to finish excess writing you home. You need tabletop in everyone of our customers’ homes and they want the level of quality, the level of taste and level of style that we provide and we’re proving that in other category. So logic says, survey says it should work. But we don’t have any real numbers to get out there and get too enthusiastic. So this is our tempered enthusiasm.

Matt Nemer – Wells Fargo Securities LLC

Thanks for that detail and congratulations on a great quarter.

Carlos Alberini

Yeah, thank you.

Operator

And your next question is from the line of Peter Benedict with Robert Baird. Please go ahead

Justin Kleber – Robert W. Baird & Co. Equity Capital Markets

Hey, guys. This is actually Justin Kleber on for Peter. Thanks for taking the question and congrats on the quarter. Just in terms of books dropping later, was that an internal decision on the part of you or is there some other rationale behind it, is it just lead times associated within those assortments or something else driving that decision?

Carlos Alberini

It’s a combination of things. We felt it was the optimal way to maximize our business and [life of] efficiencies in the way we did it. So, listen we learn all the time here right. So we’re constantly fine tuning and tweaking and like I talked earlier about the arbitrage between indoor and outdoor furniture, there is a lot of things you can fine tune here in the direct business and the direct modeling and this is [one way] that we’re testing.

Gary Friedman

I would add that this was a strategic decision and we are very happy with the decision we made. Let me put it that way.

Justin Kleber – Robert W. Baird & Co. Equity Capital Markets

Okay, thanks. And then, Karen, just on the gross margin, going back to the fourth quarter, could you discuss the impacts from product margin, supply chain cost and occupancy, maybe perhaps in basis points at least relative magnitude?

Karen Boone

Yeah. When we think about those three components that we’ve been speaking about in the past, the product margin, the shipping cost and the occupancy costs. The product margin and shipping costs are impacted by the mix and it really do vary based on the timing of new product introductions and seasonality. We’re not going to be giving the same level of detail that we’ve given in the past down to the basis point by each area and then the occupancy cost leverage is going to fluctuate from period to period and in Q4 as I mentioned we did have investments and frankly in ’12 and then going into ’13.

We expanded our flux revenue both from furniture facility and we expanded that another 600,000 square feet. in Q4, we have in Ohio shelf stock facility that we are expanding coming in the 2013 year and another DC in Dallas that we are opening, that really are critical investments to support our growth, and a lot of the growth that we see coming and being sustained, so the timing of those investments are going to change the timing of the occupancy leverage that we see over time, for Q4 specifically again we don’t want to get into a lot of the details, but I will say that that the product piece of that was less than what we saw early in the year in Q3 and then the occupancy was less.

So the magnitude that you saw in some of the earlier quarters with big swing, a lot of way in big swing, the other way, we still have some of those offsetting factors, that they won is great.

Justin Kleber – Robert W. Baird & Co. Equity Capital Markets

Okay I appreciate the color and then just lastly on any closings we should expect through out 2013, I think you only have the one full line design gallery planned and just any visibility on additional closures?

Gary Friedman

As you know we closed the two Boston locations that we had this year, that happened in the first quarter so when you think about start activity that is going to impact that and depending on when we open Greenwich, that could trigger the closure of the existing location or not we are still thinking about those things, we also closed one store in New York in January.

Justin Kleber – Robert W. Baird & Co. Equity Capital Markets

All right thanks guys. Best of luck.

Gary Friedman

Thank you very much.

Karen Boone

Thank you.

Operator

And ladies and gentlemen that is all the time we have for questions today, I’d like to turn the call back over to Mr. Carlos Alberini for some closing remarks.

Carlos Alberini

Well thank you so in closing we are very confident and excited about our strategy. We have a constructive and very powerful business model and we believe that we will continue to drive market share again, in addition we believe we are in the very early stages of our real estate transformation and we see significant opportunities to unlock the value of our assortment, which I think is absolutely dominant in the marketplace.

We have invested in our infrastructure to support future growth and we are well positioned for operating margin expansion as we look into the next few years. Thank you all for taking the time this afternoon and we look forward to sharing our progress with you in next quarter. Have a great evening.

Operator

Ladies and gentlemen that will conclude today’s conference. Thank you very much for joining us and you may now disconnect. Have a good day everyone.

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