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Williams-Sonoma (NYSE:WSM)

Q1 2013 Earnings Call

May 23, 2013 5:00 pm ET

Executives

Stephen C. Nelson - Vice President of Investor Relations

Laura J. Alber - Chief Executive Officer, President, Director and Member of Incentive Award Committee

Julie P. Whalen - Chief Financial Officer, Principal Accounting Officer, Executive Vice President, Corporate Controller and Treasurer

Patrick J. Connolly - Chief Marketing Officer, Executive Vice President, Director and Member of Incentive Award Committee

Analysts

John Marrin - Jefferies & Company, Inc., Research Division

Peter S. Benedict - Robert W. Baird & Co. Incorporated, Research Division

David Gober - Morgan Stanley, Research Division

Laura A. Champine - Canaccord Genuity, Research Division

Daniel Hofkin - William Blair & Company L.L.C., Research Division

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

Simeon Gutman - Crédit Suisse AG, Research Division

David G. Magee - SunTrust Robinson Humphrey, Inc., Research Division

Joseph I. Feldman - Telsey Advisory Group LLC

Mark Friedman

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Williams-Sonoma Inc. First Quarter Fiscal Year 2013 Earnings Conference Call. [Operator Instructions] This conference is being recorded.

I would now like to turn the call over to Steve Nelson, Vice President of Investor Relations, to discuss non-GAAP measures and forward-looking statements. Please go ahead.

Stephen C. Nelson

Good afternoon. This call should be considered in conjunction with the press releases that we issued earlier today. Our earnings press release and this call contain non-GAAP financial measures that exclude the impact of unusual business events. A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures and an explanation of why these non-GAAP financial measures are useful are discussed in our earnings release.

This call also contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which addresses the financial condition, results of operations, business initiatives, trends, guidance, growth plans and prospects of the company in 2013 and beyond, and are subject to risks and uncertainties that could cause actual results to differ materially from such forward-looking statements. Please refer to the company's current press releases and SEC filings, including the 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, to discuss our first quarter 2013 results and our outlook for the remainder of fiscal year 2013.

Laura J. Alber

Thank you, Steve. Good afternoon, and thank you, all, for joining us. With me today are Julie Whalen, our Chief Financial Officer; and Pat Connolly, our Chief Marketing Officer.

In March, we reiterated our strategic long-term initiatives to grow our existing brands, launch new businesses and expand globally. We also communicated that we will drive profitability by investing in our supply chain and in the technology supporting all of these initiatives to further enhance our leading multichannel business.

I am happy to report that in the first quarter, we made progress against all of these objectives, particularly with respect to global expansion. We are most excited that we opened our first company-owned retail locations and fully transactional e-commerce sites in Australia. We also continue the expansion of our franchise operations in the Middle East. Looking forward, we will further expand our retail footprint in Australia, with an additional West Elm location in Melbourne later this year. And as announced today, we are extending our global footprint into the United Kingdom with the opening of our first West Elm store in London.

As we have discussed, we are taking a very disciplined approach to our global expansion. We know that attractive real estate economics are critical to the profitability levels we are committed to achieving. Our team has made great progress finding locations that meet our criteria earlier than expected, as we had not previously anticipated being able to open stores in Melbourne and London in fiscal 2013.

Last week, I was in Australia following our store openings, and we have been literally overwhelmed by the initial response to our brands, and are pleased with the sales at both our retail stores and our e-commerce sites. Most importantly, the execution of our launch in Australia exemplifies the competitive advantages of our multi-brand, multichannel model, and the strength of our team.

From our global strategy team to our merchants, inventory planners, supply chain experts and our information technology team, I am so proud of what we have accomplished. The simultaneous launch of our 4 new retail stores in the Bondi Junction suburbs of Sydney, together with our 4 branded e-commerce sites with fulfillment operations in-country, is a significant milestone in our global expansion strategy.

Also in the first quarter, we achieved our supply chain objective, including the further in-sourcing of our foreign agent structure throughout Asia, and we are on track with our DC consolidation.

In addition, during the first quarter, we continued our investments across a number of initiatives that leverage the Internet and our e-commerce platform to enhance the customer experience across all channels. Specifically, we relaunched our Williams-Sonoma registry, which features significantly improved usability and integration with the e-commerce site. We also implemented several enhancements that improved the customer experience and drive increases in revenue per visitor across all of our brands.

And now I would like to provide additional detail on our performance in the first quarter. We delivered non-GAAP earnings per share of $0.41, a 21% increase over a year ago. Net revenue growth for the first quarter was 8.6%, with comparable brand revenue growth of 7.2%. The revenue mix by channel was 47% for the direct channel and 53% for the retail channel. All brands had positive comparable brand revenue growth in the quarter. We believe that we continue to take market share and are positioned for further growth in our category. Our primary focus is on our customer, and these top and bottom line results demonstrate our ability to successfully operate in a retail environment that continues to be promotional.

I would now like to update you on Pottery Barn, our largest brand, which represents approximately 43% of our business on an annual basis. In the first quarter, Pottery Barn comparable brand revenues increased 7.6%. Our mission is to turn our customer's houses into dream homes. We are focused on product innovation, and we saw particular strength in furnitures, textiles and tabletops in the first quarter. Prints and pattern collections are both a core strength and a hallmark of the brand, and expanded aesthetic in outdoor contributed to strong performance. We continue to increase our in-home design services, which deepen relationships with our customers.

At we enter the second quarter, we are inspired by our fall assortments and the marketing we have planned to support these collections. We are committed to providing an exceptional customer experience across all channels, and we continue to expand our retail experience and our focus on driving increased profits with our upcoming store openings and remodels. We will continue to offer our customers home furnishings that are exceptional in comfort, quality, style and value and deliver an unparalleled customer experience, and elevate our service levels at every touch point.

Pottery Barn Kids comparable brand revenue grew by 6.9% in the first quarter. Performance in the brand was driven by a positive merchandise response and a stronger in-stock position. We are particularly pleased with our furniture, nursery and seasonal businesses. We've also seen a very favorable response to our bedding collections, featuring prints and patterns that remain relevant to children as they grow up.

In the second quarter and through the balance of the year, we'll continue to focus on those initiatives that are driving customer acquisition, customer engagement and strong multichannel growth. These include delivering an exceptional personalized customer experience in all channels and enhancing our connection with our customers through social media.

In the second quarter, we'll launch our biggest ever back-to-school gear assortment, with a compelling offering of backpacks and lunch for kids of all ages and stages. We'll also launch our fall collection for kid and baby, with new and exciting bedding, furniture and decorating solutions for kid space.

I would now like to talk about PBteen. PBteen comparable brand revenue increased 16.1% in the first quarter. We have strengthened our furniture business and our textiles, between bright, preppy and graphic designs. As we look forward to the second quarter and the rest of the year, we are focused on delivering innovative products that allow teens to express their own unique style. We are excited about the broadening [indiscernible] and PB Dorm launches. In addition, we'll be expanding our partnership with Burton, adding new collections and building on the excellent results we experienced last fall.

Connecting with our customers in new and exciting retail experiences, such as design centers and pop-up stores, continues to be a key strategy for PBteen, and we are thrilled to be opening our Thousand Oaks, California pop-up store in early June. This will bring the total number of stores featuring PBteen merchandise to 12.

I would now like to discuss the Williams-Sonoma brand, which represents approximately 24% of total net revenues on an annual basis. In the first quarter, comparable brand revenues increased 1.9%, a significant improvement over 2012. Comparable brand revenues include both Williams-Sonoma and Williams-Sonoma Home, of which Williams-Sonoma Home represented 30 basis points of this increase. Product innovation, marketing and customer engagement drove the results in cookware, electrics and tabletop in the first quarter. The first of a series of new product introductions contributed to these results. We're encouraged, as our strategies are taking effect.

We're also continuing to go after new business opportunities in the direct channel. We took steps this quarter to strengthen our product offering and our lifestyle marketing around Agrarian and Williams-Sonoma Home. Stand-alone catalogs were mailed for each of these businesses, and they received a strong consumer response.

In the retail channel, our first store in Australia opened and features a cooking school. This school has been met with great consumer response and marks the beginning of a new customer engagement program, which we believe could be a significant opportunity. Our vision is to be the preeminent resource for the cooking and entertaining enthusiasts. We are committed to establishing a distinctive, consistent and more relevant voice that speaks to this customer, and to continue to introduce new and exclusive product offerings.

We will leverage our authority through our marketing and in-store sales expertise, to increase sales to our existing customers and attract new ones. The promotional landscape persists, and we are focused on executing against our initiatives that are driving the business today. We continue to identify significant execution and marketing opportunities throughout the brand, but particularly in the retail channel.

Finally, I would like to discuss West Elm. West Elm delivered record revenue and profitability in the first quarter. Comparable brand revenues also had a double-digit increase for the 13th quarter in a row, growing 11.8% on top of 22.1% last year, with total brand revenue growing 18.3%. Brand growth continues to be driven out of all categories, including furniture, textiles, decorative accessories and lighting.

From products that mixes material to make a statement to simple and sophisticated pieces, from whimsical wears found in your local market to rich textiles found in the global souk, from multifunctional solutions to everyday basics and from designer collaborations to item color runs, West Elm is providing a broad palette of products that reflects our customers' varied tastes. As we continue to expand these assortments into new areas, including West Elm market, we see a positive response from both our core customers and new customers. West Elm Market is currently available online, in 2 freestanding locations in New York and Vancouver, and in 18 shop-in-shops in West Elm stores across the country.

We also continue to focus on the seamless customer experience, aligning promotional activity, seasonal instructions and key marketing statements on and off-line through e-commerce, catalog and in-store activities. As mobile engagement increases, our additive efforts in social communities continue to be more localized and store specific. In-store, we continue to focus on an engaging customer experience with locally relevant visual display, assortment, workshops, classes and events.

In addition, the brand service offering continues to expand. Customers can now partner with our home stylists on design projects in any of our West Elm locations. All of these efforts continue to accelerate sales, customer acquisition and deepen our relationship with our customers. As we look forward to the rest of 2013 and beyond, our strategy is to continue to profitably grow the West Elm brand by engaging with and attracting a broader base of customers, while maintaining a compelling value proposition.

We'll also continue to aggressively seek retail expansion opportunities worldwide. We have plans to open 11 West Elm stores this year, which include our first location in French-speaking Canada in the Griffintown neighborhood of Montreal, our Melbourne location and our recently opened Sydney store. And today, we're excited to announce that we recently signed a lease on Tottenham Court Road in London. The London location will be our first West Elm in the U.K., marking our continued steps in the brand's global expansion strategy. It is now expected to open in late 2013.

We believe all of these initiatives will continue to differentiate West Elm in the marketplace, and allow us to capture additional wallet share and drive growth in this brand. We're confident in achieving our goal of building West Elm into a billion-dollar brand.

Another key initiative for the company is new business development. We're investing in our brand extensions, West Elm Market, Williams-Sonoma Home, Agrarian, PB Dorm, as well as making improvements in product line and marketing in Rejuvenation and our newest launch, Mark and Graham. While these businesses are small, we continue to see growth and long-term opportunity in all of them.

Now I will turn the call over to Julie to discuss our financial results and the outlook for the balance of the year.

Julie P. Whalen

Thank you, Laura, and good afternoon. We are very pleased with our first quarter results and the outperformance we saw on both the top and bottom line compared to our expectations for the quarter. Let me begin with our first quarter results.

For the first quarter, net revenues increased 8.6% to a first quarter record of $888 million, with comparable brand revenues increasing 7.2%. All brands had positive comparable brand revenue growth, including Williams-Sonoma at 1.9%. Net revenues in our direct-to-customer channel grew 11.9%, driven by high-teen growth in e-commerce, which represents over 91% of our total direct-to-customer revenues. And our retail channel revenues increased 5.8%.

Q1 2013 non-GAAP diluted earnings per share grew 21% to $0.41 from $0.34 last year. Gross margin during the quarter was 37.6% versus 37.8% last year. This 20-basis-point decrease resulted from lower selling margins, partially offset by occupancy leverage. Occupancy leveraged 30 basis points, with occupancy costs at $133 million in Q1 2013 versus $125 million in Q1 2012.

While our gross margin slightly decreased versus last year, non-GAAP SG&A improved to 30.1% in Q1 2013 versus 30.9% in Q1 2012, primarily driven by lower advertising costs, resulting in a first quarter non-GAAP operating margin of 7.5%, which exceeded last year's record operating margin by 60 basis points. This improvement in operating margin was driven by a 210-basis-point increase in the direct-to-customer channel from 20.8% last year to 22.9%, and was partially offset by a 50-basis-point decrease in the retail channel to 7.3% and a 30-basis-point increase in corporate unallocated expenses.

The improvement in the direct-to-customer channel operating margin was across all brands, and was primarily driven by greater advertising leverage and improved selling margins. The decrease in the retail channel operating margin was primarily due to lower selling margins and the upfront investment costs associated with entering into our new global retail locations in Australia that opened at the end of the quarter, partially offset by lower employment-related costs. Increase in corporate unallocated expenses was primarily driven by higher employment-related costs as we invest in top talent to drive growth.

From a balance sheet perspective, merchandise inventories increased $75 million or 12.8% to $662 million. This inventory level reflects our stated goal to improve our in-stock inventory positions, to drive sales and to support our growth initiatives. The largest increase in merchandise inventories was in West Elm.

Cash at the end of the quarter was $253 million versus $376 million last year. Over the past year, while generating $325 million in operating cash flow, we returned $222 million to shareholders through share repurchases and dividends, including $63 million in cash to our shareholders this quarter alone, through $41 million in share repurchases and $22 million in dividends.

I would now like to discuss our Q2 and fiscal year 2013 guidance. We are on track for 2013 to be another year of record revenues and earnings, while at the same time, investing in our future growth. For Q2 2013, we expect to grow net revenues to a range of $920 million to $940 million, with comparable brand revenue growth in the range of 4% to 6%. Diluted earnings per share are expected to be in the range of $0.43 to $0.46, and we expect our operating margin to be slightly below last year's rate.

Our Q2 operating margin this year is partially impacted by the timing of expenses related to the 53rd week calendar shift, the financial impact on the quarter from our capital investments in 2012 and our investments in our accelerated global expansion associated with our new West Elm locations in Melbourne and London that are not expected to open until late 2013.

For the full year, we are raising our revenue and diluted earnings per share as a result of the outperformance we saw in the first quarter. As a result, we now expect to grow net revenues to a range of $4.22 billion to $4.3 billion, with comparable brand revenue growth in the range of 4% to 6%, and we now expect fiscal 2013 non-GAAP diluted earnings per share growth at the high end of the range. This revised diluted earnings per share guidance raises the range by $0.02 after including the impact of a financial investment in our accelerated global expansion.

From a capital allocation perspective, consistent with our March discussion, we plan to make capital investments in the range of $200 million to $220 million as we continue to invest in our long-term initiatives. We will also return capital to shareholders under our 3-year $750 million share repurchase authorization and our recently increased quarterly dividend of $0.31 per share.

We are confident that the strength of our brands, combined with our strategic long-term growth initiatives, will allow us to meet our long-term commitments to our shareholders for future growth and shareholder returns.

I would now like to open the call for questions. Thank you.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from John Marrin with Jefferies.

John Marrin - Jefferies & Company, Inc., Research Division

I was hoping, Laura, if you could spend a little more time talking about the Pottery Barn comp. You had a nice sequential acceleration there both on 1 and 2 year. I know you gave us some color before. I was hoping you could tell us like what it was that was driving the strength in furniture and tabletop and why you did so well in outdoor.

Laura J. Alber

Yes, I mean, the outdoor business is very strong for us and it's particularly encouraging, given that I know it hasn't even warmed up in many parts of the country yet. And so we can see that we're clearly taking share there. We offered more styles this year and also built new SKUs on additional successful styles in outdoor and our home furnishings, outdoor [indiscernible] are really popular this year with our customers. And in the indoor business, we continue to build a lifestyle vision for our customers that allows them to decorate and see their whole room come together. And the furniture business, which is the real foundation of the brand, is very strong across both upholstery, but also the other rooms of the house. And we know that customers -- people out there love their homes. And we're not sure whether there is truly a housing recovery that's going to be sustainable yet, but we are seeing that they are spending money to redecorate. And we are speaking to them in a relevant voice, and we're using all of our channels to make it easier for them to come to us and decorate whole rooms, including whole houses. So I'm very encouraged by what we're seeing in our largest brand, and that it continues to grow stronger than the home furnishings industry, clearly, taking share and a very powerful brand. As we went overseas, and I told you I was just in Australia, it was just really amazing to hear how much familiarity there was around our brands and, in particular, Pottery Barn. And people were so excited to come and touch and feel it, and also experience this high service level that we offer that is really not something that they've ever seen before in their country. So I'm confident in the domestic strategy, but I'm also just very excited about the global opportunity for the Pottery Barn brand.

John Marrin - Jefferies & Company, Inc., Research Division

And one quick follow-up for Pat. Direct had another great quarter, and Laura seemed pretty pleased with the direct growth at the Williams-Sonoma brand. Can you just talk about the factors that are driving sales in that band, in particular, online, and maybe touch a bit on how it's doing relative to that 12% for the total company?

Patrick J. Connolly

The Williams-Sonoma brand just did very well in the first quarter, John, and we're just executing very well there. We've made a number of improvements to the site. Actually, we've made a number of improvements to all of the sites, I might add, and that's what drove the high teen -- that's really what drove the high-teen sales. I'm just really pleased with our DTC business. And 23%, I think we're -- which is a record, I think we're the most profitable e-commerce company in America. And at the same time, we grew from #25 up to #22 in the Internet retailer ranks and had the 19th highest growth rate. I think Williams-Sonoma and all the other bands have benefited from very efficient e-marketing. We're very disciplined. Our vendors that we work with say we're one of the more disciplined, or maybe the most disciplined that they work with. And we made some progress really in improving revenue per visitor. This is in Williams-Sonoma and in our other brands. It's a key metric that we look at. We drive quality traffic to the site. And then we've made enhancements in 3 areas: one is search, the second is content management, and the third was shop path enhancements. And these are investments we started making last year when we talked about our e-commerce investment. And our web analytics team has been working with the brands, and those have come to fruition. A lot times, people talk about basis point increases they're getting from their investments. We're getting percentage point increases, so I'm really proud of that.

Operator

And our next question comes from Peter Benedict with Robert W. Baird.

Peter S. Benedict - Robert W. Baird & Co. Incorporated, Research Division

Just -- I think, Julie, you said the second quarter EBIT margin is going to be hurt by the timing of some expenses, I guess, related to calendar shift with last year's 53rd week. I'm just curious, did the first quarter benefit from that shift? And if so, by how much?

Julie P. Whalen

No, it's actually a shift coming out of Q3. So there'll be expenses moving into Q2 that would have normally been in Q3. So no, Q1 did not benefit from that, and we're not quantifying it.

Peter S. Benedict - Robert W. Baird & Co. Incorporated, Research Division

Okay. No, that's helpful. And I mean, look, you guys beat the high end of your range in terms of earnings by about $0.05, and you raised the full year high end by $0.02 so you've got that net of $0.03. Are we to understand that, that $0.03, is that the accelerated global expansion, the costs related to that? Or are there other changes kind of to the balance of the year that we need to be aware of?

Julie P. Whalen

Look, we're very pleased with our Q1 results. But you have to remember that it's only the first quarter, and it's very early in the year. And what we have seen is that the retail environment out there continues to be choppy, and we just don't want to get ahead of ourselves. Additionally, we have so many new opportunities ahead of us, particularly in global, which, in the short term, put pressure on earnings, as you guys know. So for example, we announced today the acceleration of our global expansion, where we're entering a new country, the United Kingdom, and expanding our reach within Australia, both of which will not be opening until late 2013. And there could be more of these opportunities this year. With that said, we do feel confident in our 2013 outlook and, therefore, have raised the fiscal year guidance by $0.02, which at the high end, represents low double-digit EPS growth at 10%, consistent with our 3-year outlook. And given the initial response that Laura spoke to, and of all our brands in Australia, this really reinforces our belief and the worldwide opportunity we have to double our business and gives us further confidence in our 3-year outlook. And we just couldn't be more excited.

Peter S. Benedict - Robert W. Baird & Co. Incorporated, Research Division

Fair enough, totally understand it. One more, if I could, just on capital allocation. If you look at your 3-year plans for buyback and the dividend, it does look like you'd probably have to dip into the cash balance and/or go into the revolver. Can you just talk about your willingness to take down some of the cash balance, how low would you be willing to go, and then if you would be willing to go into that revolver balance?

Julie P. Whalen

Sure. I think -- thanks for the question. There's a couple of things I want to make sure that everybody gets on the call. First, the thing -- first, you'll see that we're actually at $250 million in this quarter, and that's where we relatively expected to be. And we'll continue to dip into the balance throughout the year, especially with Q3 is typically our lowest cash level. Q4, as you guys know, is about 50% of our earnings, so the cash comes back into Q4. So we will not be holding around $300 million throughout the year. It'll be below that. With that said, the $300 million is a target at which anything above that, we believe, should not be accumulated. It should be returned to the shareholders. So the $300 million, there's no magic to that number. It's basically the double where our line of credit effectively is. And so if we need to be below that, if we need to be at $200 million, we'll do that. With that said, if we need to use the line of credit, we would also use that as well. But first and foremost, we're going to fund the business, and we're going to make the right decisions for the business and continue to return cash to our shareholders through share repurchases.

Operator

[Operator Instructions] And the next question comes from David Gober with Morgan Stanley.

David Gober - Morgan Stanley, Research Division

Just wanted to touch on gross margins for a second. I was wondering if you could dig a little bit into either the drivers of the March margin declines or -- I know, Pat, you've talked in the past about some of the trade-offs between promotions like free shipping that might reduce the March margins but help you save on SG&A costs. Is that what you're seeing in the business? Is that why advertising costs are down in the quarter?

Laura J. Alber

I'm going to let Julie start that, and then I'm going to add a few comments about the environment.

Julie P. Whalen

Dave, it's Julie. So yes, our gross margin, as you see, is 20 basis points down. It's primarily due to lower selling margins in the retail channel, and that was partially offset by occupancy leverage. I think one of the key things to know is that in the DTC channel, product margins, selling margins, which also includes shipping, and gross margins, which also includes occupancy, were all improved year-over-year, and substantially on a sequential basis from Q4. But as we want everyone to remember, we have, and I think we spoke to you about it, we have a different model than most retailers. As a multichannel retailer with a DTC business that's almost 50%, this allows us to leverage our SG&A such that, for example, our slight deleverage in gross margin this quarter was more than offset by our 80-basis-point SG&A leverage, resulting in a record Q1 operating margin of 7.5%, which was 60 basis points better than last year's record operating margin. Laura, do you want to provide more color on what drove that?

Laura J. Alber

Well, I just -- I want to comment on the promotional environment out there. We have continued to say that we are prepared to compete on price, and we have set ourselves up to do that well, both through our history of having a large direct business but also planning promotions and planning -- and using all of our digital expertise to be able to drive more business online, which is the more profitable channel. But when you go out there, there's broad-based discounting, both in the specialty retailers who are direct competitors with us, and you can see, particularly this weekend, Memorial Day, broad-based discounts, and then also, of course, in the department stores. And we know that we are positioned to take market share and also to drive really profitable sales. There are others out there that drive sales, but they're not nearly as profitable as ours. And our -- the strength and the health of our business gives us confidence in our strategy this summer and also into the fall. We are building on the categories that are working, and we're seeing the results happen in each and every one of our brands.

David Gober - Morgan Stanley, Research Division

That's really helpful color. And Laura, just if I could have a follow-up about the environment. We've heard from a number of different retailers across various different categories that the quarter started off slow, improved throughout the quarter and, as you noted, as the weather warmed up, maybe there are some weather-sensitive categories that have benefited. Are you seeing that as well? And I guess, is there anything that would give you pause, that the momentum in the business that you're seeing today isn't going to follow through for the rest of the year?

Laura J. Alber

[indiscernible] weather. So I mean, I guess, we're very lucky that our business isn't as seasonal and you don't wear your house, so the weather doesn't affect what you buy for as much. You generally don't change it seasonally, other than buying outdoor furniture in the summer. So the weather effects is when there's natural disaster, but it doesn't affect us -- the heat and the cold doesn't affect us as much. In terms of cadence through the quarter, we don't generally like comment on that. We try to be as long term as we can. And we just see -- we see a strong business in our brands, and we see a very competitive marketplace externally, where there's a lot of people competing on price. And the retailers who are going to do well are the ones who are going to have innovative products that are well priced and if the service is high touch. I know that the customer is really responding to all the things that we're doing in our stores, and there's a great appetite for experiential retail. And so in each and every one of our brands, we have a different version of that, and we think that, that is a huge competitive differentiator.

Operator

And the next question comes from Laura Champine with Cannacord Genuity.

Laura A. Champine - Canaccord Genuity, Research Division

Could you comment on the impact on margins of in-sourcing some of that business that you import, and then also the impact on margins of shipping promotions?

Julie P. Whalen

Okay, I'll take the agents. And then, Laura, you want to take the shipping promotions? So in-sourcing the agents is a huge initiative for us, as you know. It's still probably too early to really see that in the numbers, other than the fact that our return rates are now consistently lower than they've been in the past. But we're going to continue to see benefit from this initiative. They're only, I call it, maybe halfway through completing this whole process of in-sourcing all of our agents, so there's still more to come. But I think one of the biggest benefits is going to be the fact that they're going to be in the factories much more regularly. They're going to be our employees, and they're going to be able to do everything from ensuring that we're picking the right raw materials, we're negotiating the right price, we're making sure that the damages are found early on in the process before it gets all the way shipped back out to us at our DCs. And so we think this is a huge advantage.

Laura J. Alber

Yes. And then on shipping, the customers are very smart and they're always looking at the total price offered, including shipping. And other retailers sometimes embed the shipping in the retail price. And generally speaking, their product price is higher than ours. The customers come to us for a complete value and they expect that, and they love when they receive great service on furniture deliveries. And what we have done is we've really spent the last 10 years perfecting our in-home delivery, and it's a key advantage to us. I mean, we actually completed over 750,000 over-the-threshold item deliveries last year, and we don't think any of our competitors can do this as efficiently as we can.

Operator

And the next question comes from Daniel Hofkin with William Blair.

Daniel Hofkin - William Blair & Company L.L.C., Research Division

Just, I guess, following up a little bit on Williams-Sonoma between direct and retail. Maybe, I don't know, you touched on it a little bit last quarter, but talk about what you see as some the biggest opportunities to particularly improve either service levels or content within the stores. And a slight follow-on to that as it relates to the online penetration within the Sonoma brand. As I recall, that is below -- maybe noticeably below your corporate average. Where do you think that could get to over time? Do you see that as an opportunity to increase the online percentage within the Sonoma brand?

Laura J. Alber

Thanks for the question, Daniel. We see opportunity both online and in retail, and we're confident in the future of this brand. And you are going to see gradual and incremental improvement. One of the most exciting highlights of the first quarter was the great response that we got for the new collection of Williams-Sonoma Home goods. And we brought in 3 new collections that we mailed a larger format catalog to great response, which we can measure and see that, based on the mailing we did, we have more opportunity. And we -- in fact, we just put back on press the same catalog and would be remailing it to a new group of customers this month. It's really a growth vehicle because high-end home is white space in the marketplace. And when you think about all of our brands across demographics, we have Pottery Barn upper middle, we have West Elm more entry. And there's room for us at the high end. In the cooking business, we've seen strength continue in electrics and tabletop. But we're particularly pleased to see the strength in cookware this quarter. And there are other categories where we still have a lot of opportunity, so we're working hard on cook's tools and food. Another online opportunity has been our Agrarian launch. And bringing new customers to this brand is very important, and the Agrarian product is very relevant. And we sent a stand-alone catalog this season for that, and it also exceeded our expectations. In our stores, we mentioned how important we believe experiential retail is. And the cooking school in Australia represents, we think, a pretty good opportunity for us, both domestic and internationally. We think we probably really have something there. The response to it was quite strong. In fact, I just learned today that we had to open up our August classes already because we're sold out in Australia. And our first expectations were that we'd only fill about 30% of the classes and it would be an experimental lab. And we've seen just incredible response. So that is something that -- it's early. We're talking about how do we bring that to our stores in the United States and whether we test it in a few here. And then also if we don't do it in full form like we did in Australia, with a full cooking school, how we can replicate what we're doing there, because there's such a huge appetite for it. In Australia, it's interesting. As many of you know, it's a big food culture. There's a lot of chefs there and a lot of -- there are a lot of other cooking schools. And so it's not that it's a completely open market, it's that what we are doing is so appealing and differentiated.

Daniel Hofkin - William Blair & Company L.L.C., Research Division

That's great. And then if I could just -- if you look in the U.S., excluding West Elm, which is clearly adding footage, what do you see for the 2 larger brands in aggregate going forward? I know you're selectively relocating and whatnot, but just in aggregate for Sonoma and Pottery Barn.

Laura J. Alber

We see great runway in our core brands domestically, and it's not -- we are actually looking at the digital opportunity and realizing how many stores we would have had to build to get the same sales. And it's just -- we see opportunity both in product lines, brand extensions, as we've talked about, but dimensional extensions, size of the furniture, aesthetics. And some of the businesses there are not very well known. There's opportunity to do a better job, to move the customers along life stages better, and that's something we're always working on and looking at how do we use our house file and our data analytics to even more specifically target and personalize communication. And that's one of the key drivers of our digital strategy. So we don't count it by stores. We think about the opportunity to furnish people's homes and teach them how to cook and entertain.

Operator

And the next question comes from Matthew Fassler with Goldman Sachs.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

I'd like to ask a quick question sort of related to macro and sales drivers. I know you get some questions on the economy and the cadence of business. I guess my question relates to what you saw in terms of ticket and traffic, both online and in-store, and how the interplay between those factors drove the comp, if that interplay was any different from what you've seen in recent quarters? And related to that, to what degree you could trace some of the pickup in sales to some of the explicitly housing-sensitive businesses, or businesses that tend to do well when the housing market is particularly robust?

Laura J. Alber

Sure. We don't generally comment on ticket and traffic, I apologize for that. On the macro, there's a lot of mix reports out there, and you can read anything you want. But consumer confidence is good. Housing indicators have been favorable. Employment for the most part is better. But there's mix reports on other retailers, and I was surprised to see how low the government home furnishings numbers were. I think the real question for us is, is the housing recovery going to be sustainable? But as I said before, we're focused on taking market share regardless of the economy. And we're focused on relevant product for renovations and people who move. We know that you spend more money on your house in the 18 months after you move than any other time. And so while we don't have a housing recovery baked into our numbers, it certainly would be good for us. We realize also that when you first buy a house, you probably don't buy the furniture until you remodel it. So there's a different life cycle on how it could benefit our business than, you could say, a Home Depot. So you'd imagine that you might see a natural lag. But we are seeing some nice lift in some categories that, I believe, are based on people being very interested in their homes again. Whether they're moving or not, it's time to get some new stuff in your home after a period when, I think, people didn't feel comfortable spending money on their homes. We're going to be right there for them with relevant assortments.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Got it. That's great. And a quick follow-up for Julia, if I could. You're actually now seeing, I think, faster footage growth, still modest, but faster footage growth than you've had in the business in aggregate for a while, such that modeling the productivity of that space is actually going to be a little more important for thinking about the sales trajectory of the business. As we think about -- and most of that unit growth, I guess, is coming from West Elm. So if we think about the productivity of a West Elm store versus the stores that you're closing, which are, I guess, largely Williams-Sonoma, how should we think about the relative productivity of those units, just for modeling purposes?

Julie P. Whalen

We obviously don't give out our hurdle rates, but I can say they're very high. As far as your correlation to the increase in square footage, that's correct. I mean, it's around 2% this quarter, but that's not where we expect to land necessarily at the end of the year. And that is due to the West Elm brand. And as we've said many times, given the success of that brand, that if we can open up more real estate locations, we will.

Operator

And next will be Brad Thomas with KeyBanc Capital Markets.

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

Wanted to ask another follow-up on the international side of things. The company has obviously been very deliberate with the steps over the last few years that it's taken to lay the groundwork for this international growth, and it sounds like you're pleased with the initial results in Sydney. But could you just remind us what the overall P&L impact is going to be from these investments in international? It seems like that's primarily on the expense side of the equation. And as we look forward, I mean, what are the return metrics that you hope to see? You may not give out a rate, but what kind of time frame would you hope to start getting a payback on these international investments?

Julie P. Whalen

This is Julie. We obviously have decided not to give out the amount of our investments by quarter, by year anymore. We're now a growth company for sure, and we're going to be having investments in our base and going forward. With that said, clearly, especially with retail global expansion, you obviously have costs ahead of the sales. And so initially, as what happened with Australia, you have anything from rent, which hits gross margins. You have payroll, hiring individuals ahead of time, which is SG&A. You've got advertising, et cetera, that hits SG&A. So it sort of hits across the board and then you, so to speak, turn the lights on and have sales that come through. So there's a ramp that has to occur as you start to roll out these international locations. And keep in mind, obviously, 4 stores isn't going to move the needle on a $4.5 billion company. So it's incremental. And over time, you'll start to see the results as each and every one of these stores and e-commerce starts to layer on top of one another. And so that's why we have said, within our 3-year outlook, especially the outer year, that you start to see that momentum.

Operator

And next question comes from Gary Balter with Credit Suisse.

Simeon Gutman - Crédit Suisse AG, Research Division

It's Simeon Gutman for Gary. A quick question on SG&A, which looked pretty well-managed, especially considering some of the international growth. Can you talk to if that's more a function of some of the positive channel shifts that are happening in the business or there's also some more efficiency on the core business?

Julie P. Whalen

I would say it's both. It's certainly the fact that we had more sales on the DTC side. We get incredible leverage, clearly, from that, but we definitely have lower advertising costs. And we have strong financial disciplines in place to manage our costs, so that's where it's coming through.

Simeon Gutman - Crédit Suisse AG, Research Division

Okay. And then a follow-up on inventory growth. When does or when should the inventory growth become in line with sales? Or I guess, in other words, when should we start to cycle the higher in-stock levels that's been part of the strategic plan?

Julie P. Whalen

Yes, I think one of the key things to make sure that you're aware is, yes, merchandise inventories are up 12.8%. But we've got inventory that we're building for global expansion, new stores and new businesses. So actually, if you exclude that, inventory is in line with sales growth. And other important piece is that, due to the timing of receipts, a substantial portion of this inventory increase is currently in transit and, therefore, will be available to support our future sales growth, which we feel great about, given we've learned that being in-stock is critical to our sales growth. So the overall health of our inventory is good. I would say it's in line with our sales growth, and so you may not see it that way at the end because we've got all these additional new businesses and global expansion that we're building up for.

Operator

Moving on to David Magee with SunTrust.

David G. Magee - SunTrust Robinson Humphrey, Inc., Research Division

I guess I want to ask a question about the international expansion. When you opened the stores and you opened sort of the DTC effort at the same time, I'm curious as you go forward, will you be able to have as much intelligence about where to put stores as you have domestically over time, where you've had sort of the DTC before the stores opened?

Laura J. Alber

It's a great question. We really believe in going into market with both channels, and that is what we did. The power of going in with all 4 brands in 1 building and the fully integrated e-commerce platform was really something we want to replicate as we go further. With that said, oftentimes, you can't find them together. And so we used a bunch of different qualifiers to identify Australia. And it was a combination of cultural similarities, i.e., gift giving, larger homes, food culture, entertainers. And then, of course, it's easier to do business since it's English-speaking, so Australia and U.K. make sense as primary markets. And we see a vision of multichannel business with beacon stores, and a real opportunity to change the way people think about decorating their homes and entertaining.

Operator

And next question is from Joe Feldman with Telsey Advisory Group.

Joseph I. Feldman - Telsey Advisory Group LLC

I wanted to go ask another question about international. I was curious, especially like in the London launch, that you would go with West Elm to start it off as opposed to, say, a Pottery Barn or the core William-Sonoma brand. And I was curious as to maybe what was behind that decision, especially given that West Elm has so much more potential here in the U.S. still.

Laura J. Alber

We want to do all of it. That particular location we thought was best suited for West Elm, but we're actively seeking locations for Pottery Barn and Kids. And West Elm has a great appeal to urban people, and it's a very global brand. It's doing quite well in Australia. Despite the fact they knew Pottery Barn better as a brand, they love West Elm. So we think they both have great runway, so I wouldn't read too much into that.

Joseph I. Feldman - Telsey Advisory Group LLC

Okay, got it. And then just to stay on the real estate theme. I guess, coming off of the big recon event from ICSC, any trends that you guys kind of picked up on there? I mean, are you seeing rents going up a little? Are you still seeing good availability of space for your concepts, and just on the real estate side, closure opportunities, things like that?

Laura J. Alber

We have a very rigorous process of retail real estate review. The A locations have always been really tight. There's not a lot of room in them ever, and that's where we tend to be. With that said, they love having us there. We bring good merchandise mix to their malls, and so they find great real estate for us. And they -- in particular, they love the fact that we'll take down a lot of space because of our multiple brands and, I guess, it's leverage. And then we're always looking at where we should close and prune off stores as they come up for expiration and push the sales into more profitable stores. And lastly, in each of our brands, we are always looking for the next format that will drive profitability, and we're very careful to test before we roll out. But there's pieces and parts of each brands that's highly competitive, that we've been testing, that are very productive, and that, as we do smaller remodels or larger remodels, we'll be putting into the new stores.

Operator

And we have time for one last question from Marni Shapiro with Retail Tracker.

Mark Friedman

It's Mark Friedman subbing for Marni. Laura, Pat, I guess I was wondering on the mix between direct and bricks-and-mortar. With you launching e-commerce in Australia, and it sounds like eventually in the U.K., how should we be thinking about the shift over time, both as a total and then your ability to continue to drive it higher in the U.S. and what impact that has in the stores. And then I was curious about the catalog trends and what you're doing there in the future to drive business.

Patrick J. Connolly

Thanks. That's a good question, Mark. I think we've said and Julie's been pretty clear in her guidance about the fact that we expect DTC to be over 50% in the next 2 years, so that's sort of on the domestic side. And the catalog remains a very powerful vehicle. It's over half of our advertising spend, and it will probably continue to be, even though we're continually increasing our e-marketing spend. What we've seen is that the catalog drives such high revenue per contact. When we mail a catalog, the revenue per book is much higher than virtually anything anyone can do in terms of you marketing with a contact, so it's a great way to extract as much lifetime value from that customer. And the catalog is also a great expression of the brand. And when we launched in Australia, we mailed catalogs and we circulated a lot of catalogs. And actually, the ones we gave out in our stores, which I thought would last 6 months, we got rid of and -- I mean, they were gone in 2 weeks. So even though the catalog business is not a huge business in Australia, we've seen more positive reaction than I would expect, and our e-commerce there is stronger as a percent of the total, too. So I think that gives us a lot of promise as we move to other countries in our global expansion.

Operator

And that does conclude 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.

Laura J. Alber

Thank you. I want to thank you all for your support and for joining us this afternoon. We appreciate your time, and we'll speak with you again next quarter.

Operator

Thank you. And that does conclude our conference call for today. We thank you for your participation. You may now disconnect.

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