Williams-Sonoma, Inc. Q2 2009 Earnings Call Transcript

Aug.26.09 | About: Williams-Sonoma Inc. (WSM)

Williams-Sonoma, Inc. (NYSE:WSM)

Q2 2009 Earnings Call

August 26, 2009 10 am ET

Executives

Stephen Nelson – Director Investor Relations

Howard Lester – Chairman, Chief Executive Officer

Sharon McCollam – Chief Operating Officer, Chief Financial Officer

Laura Alber – President

Pat Connolly – Chief Marketing Officer

Analysts

Matthew Fassler – Goldman Sachs

John for Laura Champine – Cowan and Company

Neely Tamminaga – Piper Jaffray

Alan Rifkin – Banc of America/Merrill Lynch

[Dana Chelsey – Chelsey Advisory Group]

Anthony Chukumba – Ftn Capital Markets

Christopher Horvers – J. P. Morgan

David Magee – Suntrust Robinson Humphrey

Ivan for Scot Ciccarelli – RBC Capital Markets

Janet Kloppenburg – JJK Research

Operator

Welcome to the Williams-Sonoma, Incorporated second quarter 2009 earnings conference call. (Operator Instructions) I would now like to turn the call over to Steve Nelson, Director of Investor Relations at Williams-Sonoma Incorporated to discuss the non-GAAP measures and forward-looking statements.

Stephen Nelson

Good morning. This morning's conference call should be considered in conjunction with the press release that we issued earlier today. I would first like to discuss the non-GAAP financial measures that are included in this morning's press release and today's conference call.

Our press release and this call contain non-GAAP financial measures that exclude the impact of unusual business events. For the remainder of today's call, we will be discussing our second quarter 2009 results, our 2009 guidance and our 2008 results excluding the impact of these items and we'll refer to these results as non-GAAP.

These non-GAAP financial measures are provided to facilitate meaningful year over year comparisons. A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures and an explanation of why these non-GAAP financial measures are useful and how they are used by management are discussed in Exhibit One of the press release.

I would now like to discuss our forward-looking statements. The forward-looking statements included in this call constitute forward-looking statements within the meaning of the Private Securities Litigation Reform of 1995. These statements address the financial condition, results of operations, business initiatives, guidance, growth plans and prospects of the company in 2009 and beyond and are subject to risks and uncertainties that could cause actual results to differ materially from such forward-looking statements.

Please refer to the company's current press releases and SEC filings including the company's Form 10-K and most recent Form 10-Q for more information on these risks and uncertainties. The company undertakes no obligation to update or revise any forward-looking statements to reflect events or circumstances that may arise after the date of this call.

I will now turn the conference call over to Howard Lester, our Chairman and Chief Executive Officer.

Howard Lester

Good morning and thanks for joining us. With me today is Laura Alber, our President, Pat Connolly, our Chief Marketing Officer and Sharon McCollam, our Chief Operating and Chief Financial Officer.

I'd like to begin today with an overview of our second quarter 2009 results and our outlook for the balance of the year, then I'll turn the call over to Sharon and Laura for further details.

While the home furnishing sector continued to be under pressure during the second quarter, innovative merchandizing and appealing value proposition and the delivery of a superior customer experience drove strong top line results and better than expected selling margins.

Throughout the quarter, revenues trended at the high end of expectations. Both margins, excluding occupancy improved over last year and we exceeded our expense reduction cash flow target. In the second quarter while net revenues declined 18% we delivered a non-GAAP profit of $0.05 per diluted share and ended the quarter with over $165 million in cash.

Comparable store sales during the quarter declined 15% which was an improvement from the first quarter and better than our expectations for the second quarter. In our core brand, net revenues decreased 17%. This decline was driven by a 25% decrease in the Pottery Barn Kids brand and 19% decrease in the Pottery Barn brand and a 9% decrease in the Williams-Sonoma brand.

In every brand, second quarter results were better than the first quarter, but what's most encouraging about these results is that they still do not reflect the full impact of the revitalization initiative we have underway, particularly in the Pottery Barn brand.

Equally encouraging is the fact that there is still a significant amount of change to be introduced in the back half of the year which combined with less competition should drive significantly increased sales and margin with little incremental cost. Laura will talk more about these initiatives when she addresses the Pottery Barn brand later in this morning's call.

In the Williams-Sonoma brand, we continue to see the same economic resilience that we've seen all year. During the second quarter net revenues declined 9% including a comparable store sales decline of 11% and although gross margins were slightly below last year, our tight inventory position and seasonal shift in product mix in the back half, leave us optimistic that we will be able to deliver a full year gross margin increase by the end of the year.

Execution in the Williams-Sonoma brand has been exceptional this year and our focus on innovation and exclusivity continues to drive the business.

In our emerging brands which include West Elm, PBteen and Williams-Sonoma Home, net revenues decreased 22%. Williams-Sonoma Home once again faced significant top line challenges. As such, we are prioritizing cost ability over growth and continuing to assess the brands' long term market potential until the luxury home furniture sector becomes clearer.

In the West Elm brand, the declines in net revenue while consistent with our other home furnishing brands were partially impacted by vendor related production issues which led to a low in stock position in a few key furniture categories. As these issues are currently being resolved, we are optimistic that we will see a pick up in West Elm front line performance in the third and fourth quarter since more than half of the brands' business is driven by furniture related sales.

Through all brands we remain focused on the initiatives that we believe are critical in gaining market share in this environment. Through superior customer service, innovative merchandising and a strong value proposition we're making meaningful progress in all of these areas and are optimistic that the increased penetration of exclusive products at accessible price points in the back half of the year will attract new customers to the brand and drive increased traffic in all channels.

In direct marketing we continue to move forward with our catalog circulation optimization strategy. During the quarter year over year advertising expense declined 26% net of a 34% increase in on-line marketing. We continue to believe that refining the balance between catalog sales and on-line marketing is a significant opportunity and we will be participating in a strategic test with Google at the end of the month to test this initiative at the next level.

In the supply chain, we continue to regionalize our large queue of inventory and expand our agent furniture sourcing base. We also continue to see both customer and service and financial benefits from our ongoing returns, replacement and damage initiatives. Each of these initiatives is driving increased margin dollars as is our strong inventory management strategy.

At the end of the second quarter, year over year merchandise inventories were down by better than expected $140 million or 21%.

We also continue to make progress on our occupancy cost reduction initiative including increasing 2009 store closings from nine to 16 and positioning ourselves to eliminate 1.2 million square feet of excess distribution capacity and 80,000 square feet of excess office space in San Francisco during Q3.

As we enter the third quarter we're encouraged by the sales and margin trends we're seeing today particularly in the Pottery Barn brand. As such, we are increasing our revenue and earnings guidance to reflect the upside.

In revenue, we are increasing guidance by $10 million to a range of $660 million to $700 million and would expect to be near the high end. In earnings, we are increasing non-GAAP diluted earnings per share guidance from a loss of $0.02 to $0.08 to a profit of $0.01 to $0.05, and while we have no reason to believe that our current performance will not continue into the fourth quarter, we believe maintaining a cautious outlook is prudent in this reset economy.

As such, we are reiterating our fourth quarter guidance, but are optimistic that the initiatives that are driving our business are sustainable and will carry us through the balance of the year.

Additionally, we'll be working closely with the M.H. Alshaya group to open our first four franchise stores in the Middle East in 2010. While this has no immediate financial upside, it is a strategic step towards the longer term international growth plan.

I will now turn the call over to Sharon for more details on the quarter and our guidance.

Sharon McCollam

Good morning. Despite the ongoing challenges we continue to see in the broader home furnishings market in the second quarter, our financial results once again significantly exceeded our expectations. The highlights were as follows: on a non-GAAP basis, our second quarter diluted earnings per share were $0.05 versus $0.9 last year.

This was $0.14 above the first call consensus estimate and $0.13 above the high end of our guidance due to better than expected selling margins and lower occupancy and operating expenses.

On a GAAP basis, second quarter diluted earnings per share were break even including a $0.05 per diluted share charge associated with under performing retail stores and the exit of excess distribution capacity.

Net revenues during the second quarter decreased 18% to $672 million. Retail net revenues decreased 14% including a comparable store sales decline of 15%. Direct to customer revenues decreased 24% on circulation reductions of 19% and 25% respectively, for catalog and catalog pages mailed. Internet revenues decreased 21% but on a two year trend basis, e-commerce was our best performing channel.

Non-GAAP gross margins decreased 180 basis points to 32.2% in the second quarter. This decrease was driven by approximately 275 basis points of fixed occupancy de-leverage due to lower sales partially offset by reductions in freight costs and lower replacements and damages.

Non-GAAP SG&A expenses decreased 180 basis points to 30.9%. This decrease was primarily driven by reductions in total advertising costs including the benefits from our catalog circulation optimization strategy and company wide reductions in other SG&A expenses.

Significant year over year balance sheet variances at the end of the second quarter were as follows; cash and cash equivalents increased $127 million to $165 million with no outstanding borrowings under our $30 million revolving line of credit. This is the second highest ever cash balance at the end of the second quarter and we do not expect to need to access our revolving line of credit this year.

Merchandise inventories decreased to better than expected $140 million or 21% to $517 million. This decrease was across all brands and all categories. Accounts receivable decreased $22 million or 36% to $40 million, reflecting the planned reduction in lease incentives at our company's this year reduced store construction program.

Pre-paid catalog expenses decreased $11 million or 22% to $39 million. This decrease is primarily driven by reductions in catalog circulation. And accounts payable decreased $30 million or 19% to $130 million. This decrease was primarily driven by lower inventory purchases.

I'd now like to briefly discuss our 2009 guidance. As we look forward to the balance of the year, we are continuing to guide revenues in line with the 2008 October/November trend with the exception of the third quarter where we have seen increased revenues and have increased our revenues to reflect the better than trend performance we are currently seeing in the Pottery Barn and Williams-Sonoma Kitchen brands.

Also in the third quarter, we have increased our gross margin to reflect the consistent upside we have seen all year in selling gross margins. As such, we are raising our non-GAAP third quarter EPS guidance to a range of $0.01 to $0.05. We will however, incur a $0.04 per diluted share non-GAAP charge in the third quarter related to the exit of distribution capacity that we discussed previously.

For the fourth quarter, we are reiterating our previous guidance because we continue to believe that we need to be cautious about the promotional environment that could accelerate in the holiday season due to competitor store closings, inventory liquidations and bankruptcies.

For the full year, based on our better than expected performance in the second quarter and our increasing guidance for the third quarter, we are increasing our 2009 P&L guidance as follows; net revenues are now expected to decline in the range of 12% to 15%. Non-GAAP diluted earnings per share are now expected to be in the range of $0.19 to $0.31 despite approximately 200 basis points of occupancy de-leverage and GAAP diluted earnings per share including $0.13 of unusual business events related to store impairments and the exit of excess distribution capacity are now expected to be in the range of $0.06 to $0.18.

From a balance sheet perspective, we are reiterating our inventory guidance in the range of $480 million to $510 million but lowering our capital spending guidance to the range of $90 million to $95 million.

We continue to believe that the actions we have taken to adapt to this new economy from both an operational and financial perspective were appropriate and we remain committed to optimizing growth, profitability and cash flow despite the economic challenges we believe we will continue to face.

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

Laura Alber

Good morning. First I'll start with the Pottery Barn brand. Net revenues in the second quarter declined a better than expected 19% including a 16% decline in comparable store sales. We are very encouraged by these results because not only do they demonstrate a sustaining trend of gradual top line improvement, but also, an affirmation that our strategies to re-invigorate the business are resonating with our customers.

From a merchandising perspective, our focus on style and value resulted in renewed momentum in all key categories including furniture. From an operational perspective during the quarter, we improved profitability through our supply chain initiatives including reductions and replacements, damages and transportation.

We also continued to reduce our inventories in both units and dollars which contributed to improved selling margins in the quarter. We also continue to make progress on our catalog circulation optimization strategy which resulted in significantly lower advertising costs from both a dollar and percent to sales perspective.

As we look forward to the third and fourth quarters, we are very encouraged by the positive consumer response we are currently seeing to our fall merchandise assortment and the overall strategies we have implemented to drive our business including a compelling merchandise strategy in every category, a shift in our value proposition through opening price points, category promotions and private label credit card offerings, differentiated services including interior design, planned selling and in-store events and a shift in marketing spend out of the catalog into e-commerce as we continue to capitalize on this significant opportunity we believe the internet represents.

Now I would like to talk about Pottery Barn Kids. During the second quarter net revenues declined 25% including a 22% decline in comparable store sales and a $3 million negative impact from a voluntary product recall. Inventories at the end of the quarter however, were down approximately 27% with selling margins strengthening as the quarter progressed.

From a merchandising perspective during the quarter, our best performing categories were those where customers could make easy updates at accessible price points. New product introductions, including our exclusive premium brand licensing programs supported by targeted promotional activity contributed to the stronger performance of these categories.

From an operational perspective during the quarter, we achieved significant cost reductions in returns, replacements and damages. We also spent considerable time on our retail occupancy cost reduction strategy which resulted in an increase in 2009 permanent store closings from three to six by the end of the year.

As we look forward to the third and fourth quarters, we will continue to protect our strong competitive presence through the marketing of our value proposition including a greater penetration of opening price points and the enhancement of our retail service model.

We will also continue to shift our advertising spend from catalog to e-commerce as we capitalize on the new functionality in customized e-mail, affiliate marketing and search.

To date, we are extremely pleased with the initial consumer response to our new fall assortment and based on early reads, the impact of these initiatives is exceeding our expectations.

I would now like to talk about the Pottery Brand Teen brand. Net revenues in PBteen declined a better than expected 22% during the second quarter versus a 25% increase last year. Selling margins were also ahead of expectations, but while any decline in revenue is disappointing, PBteen remains the best performing brand in the company on a two year trend basis.

From a merchandising perspective, new product introductions at a great value, continue to be our best performers and the initial consumer response to our new fall assortment is strong. As we look forward to the back half of the year, we will continue to focus on expanding the reach of the brand and maintaining our position as a top of line destination for home furnishings for teens.

These initiatives include expanding our merchandise assortment across a wider range of price points to address the consumer's sensitivity to value, increasing our investment in e-commerce to attract new customers to the brand and drive increased customer interaction, and continuing to test PBteen merchandise within the four walls of two Pottery Brand Kids stores in a show room in New York with the objective of establishing a boutique retail presence for PBteen and enhancing retail productivity in Pottery Brand Kids.

I would now like to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Matthew Fassler – Goldman Sachs.

Matthew Fassler – Goldman Sachs

Congratulations on the strong performance here. I wanted to try to get a sense from you as to the magnitude of the merchandise margin recovery. We ran some numbers and it looked to be in the neighborhood of 100 basis points or better year on year. If you could give us some color on that, we'd really appreciate it.

Sharon McCollam

I provided you in the prepared remarks with the occupancy de-leverage during the quarter which was 275 basis points, so that will back you into the number you're looking at. So I think that will help you with your model.

Matthew Fassler – Goldman Sachs

Color on the reception that you're getting from consumers to the extent that you've moved price points down a bit, how that is going vis a vis consumer reception and also what the implications are on margins if any.

Sharon McCollam

I'm going to let Laura take that question because the majority of those changes have come in the Pottery Barn brand, so Laura could you speak to that please.

Laura Alber

We're very excited to see our customers responding so positively to our improved quality at great value, and it's across many categories where we have started to make significant quality and also value enhancements to the product line. And it's clear that as money is tighter for consumers, this is very important to them, and it's helping them to be really inspired to purchase and re-decorate their homes.

Howard Lester

Let me make in addition to that too, this is not just a price story. The merchandise changes that Laura and her team have been working on in Pottery Barn over the last two years is just really coming into fruition. So it's a combination of much improved merchandise that's resonating with the customer; better quality, better price points and a combination of all that is really starting to get some traction.

Operator

Your next question comes from John for Laura Champine – Cowan and Company.

John for Laura Champine – Cowan and Company

Last quarter you said, just based on the math you gave us that you're buying and occupancy was de-leveraging about 20 bits per negative point comp. It's now running about 18. Can we expect that to continue going forward? Is that baked into your guidance?

Sharon McCollam

Yes. I also provided, this is new information that we've put into the prepared remarks. By the end of the year what you can expect in this range of guidance is somewhere in the range of a 200 basis point de-leverage in occupancy costs.

John for Laura Champine – Cowan and Company

Even with the store closures, we won't expect to see the basis point de-leveraging recover so to speak or get better.

Sharon McCollam

The stores will close at the end of this year, so you'll have the occupancy cost associated with those stores throughout the year.

John for Laura Champine – Cowan and Company

Any update on Dave DeMattei successor planned going forward?

Howard Lester

Dave DeMatttei's successor, I think we're going to probably change our organization around just a little rather than replace Dave directly. You may recall that prior to Dave coming here, Richard Harvey, a 25 or 26 year veteran had been running the Williams-Sonoma Kitchen brand and doing a superb job of it and was reporting to me at the time, and we had had some problems. That's when we had the big turn around in the Williams-Sonoma Kitchen brand.

And then subsequently after Dave joined, I think we added to his responsibility the kitchen brand. So that will revert back to reporting to me and we won't miss a beat. Richard has really been running that brand for several years now as I said, at least seven or eight, and just doing a great job and continues to perform at the best level of all of our brands, so that's not an issue.

We were looking for a full time President to reside in New York if possible prior to Dave's resignation, and that search is continuing and we would hope to have a resolution to that in the next few weeks and an announcement hopefully will be forthcoming.

During the past year, we have basically merged Williams-Sonoma Home with the Williams-Sonoma Kitchen brand from a standpoint of day to day management. We have a wonderful fellow who is running Williams-Sonoma Home and that will continue, so I don't see any change there.

So we will be announcing a new President for West Elm but will not be doing anything further at this time with respect to a replacement for Dave DeMattei.

Operator

Your next question comes from Neely Tamminaga – Piper Jaffray.

Neely Tamminaga – Piper Jaffray

Laura, just looking through the books that came into homes this week and I noticed a couple of things. One, baskets on the front I think are always tremendous and amazing for its value price point but also kind of the old adage when baskets are working well, home is working the category. And secondly, the book looks and feels a little bit bigger. Are you picking back up your page count? Is there a change in strategy that I'm picking up on or maybe you could walk us through how this was representative of what you're going to do from a merchandising perspective in the back half.

Laura Alber

We love the baskets too, so thanks for that comment. It's just getting in homes this week, so we'll see. We're optimistic, but we'll see.

Page count, no it's not going up. We continue to be very focused on productivity in the catalog and we are also continuing with our version strategy.

Operator

Your next question comes from Alan Rifkin – Banc of America/Merrill Lynch.

Alan Rifkin – Banc of America/Merrill Lynch

Sharon, you said that your increase in full year '09 guidance is predicated on a fourth quarter that is essentially in line in October '08 trends. It appears that at least relative to that point in time, trends today are significantly better. Can you maybe provide some color on your ability to address in the fourth quarter the fact that if the trends continue at current levels how your inventory position, how your preparation for the holiday season will unfold?

Sharon McCollam

For the fourth quarter, what we continue to be conscious of is the fact that it could become a promotional environment at that point because of the competitor store closings, inventory liquidations, etc. So we are being cautious from that standpoint.

The merchants, the inventory teams are watching the trends every day and chasing inventory where we need to chase and obviously as we all know, furniture would be the most difficult to get back in stock on a short term basis, but other things that we do, we'll keep our finger on that tightly.

As it relates to fourth quarter though, I do want to point out that that is the 2008 October/November trend. That is what the revenue guidance is predicated on. But in addition to that, if you believe that, then you would say then it should be flat because the fourth quarter occurs after the "October/November" time frame.

The reason that it is not flat is because as it was same for Q1, because we have reiterated the guidance we have reflected in there the fact that we had a significant amount of inventory last year that we liquidated in the fourth quarter and we do not expect to buy into those mark downs. That really hit our margin as you know, and we've talked about that, so I won't take time on our call today to go through that, but we'd be happy to offline.

So that's what we see for the fourth quarter. But I obviously, if these trends continue into the fourth quarter, there is no question that we would be taking up our fourth quarter guidance both on the top line and on the bottom line because as Howard said in his remarks, that increased sales in this environment, flow through at very little incremental cost.

Operator

Your next question comes from [Dana Chelsey – Chelsey Advisory Group]

[Dana Chelsey – Chelsey Advisory Group]

You talked a little bit about the real estate environment. What are you seeing in terms of, is the incentives, are they what you expected? Is there changes being made? And you upped the store closures a little bit. Is there more coming? How are you looking at it?

Sharon McCollam

I'm going to let Howard speak to that. I would just start out by saying that it's a partnership with our landlords. We're not going to be discussing in great detail on the details on the negotiations that we're having with our landlords, but Howard, would you please take that question.

Howard Lester

Let me characterize kind of the world that we're dealing with out there. I would say from the last time, we're making some progress. It's still slow. Of our major half a dozen landlords, we've got about a third to a half of them that are more willing than the others to work with us and to try to find creative solutions that will work for both of us both short and long term.

So in that regard, we are making some progress with some. Others are more difficult and haven't been willing to get to that point yet. So we just keep working. You notice that each quarter we've got a little bit better results to report there, more closings and what we're not reporting on I think as much is leases that we're re-negotiating that are giving us better, rather than close the stores, we're getting a better occupancy expenses and are able to bring more stores back close to their historic contribution level.

So we've got a long way to go, but I would say that we are making progress and while I'm somewhat encouraged with as I mentioned a third to a half of our major landlords, I'm still disappointed with the other half.

Operator

Your next question comes from Anthony Chukumba – Ftn Capital Markets.

Anthony Chukumba – Ftn Capital Markets

I had a quick question in terms of the catalog circulation optimization effort. Your catalog circulation if I wrote these numbers down correctly, catalog circulation declined 19% and your catalog pages declined 25%, but year over year your direct to customer business was down 24%. I guess what I'm wondering is do you feel comfortable that you haven't cut back too much on your catalog circulation? In other words, it strikes me as a little bit out of line that you're direct to customer sales be down even more than your catalog circulation. It sort of implies that some of the circulation you got rid of wasn't necessarily marginal kind of dead beat circulation.

Sharon McCollam

A substantial piece of the reductions were in the Pottery Barn brand, so I'll let Laura speak to the specifics related to Pottery Barn and their strategies, and then I'm going to let Pat talk about the broader catalog circulation optimization strategy. Laura could you take this specifically related to the Pottery Barn brand where you're doing a lot more versioning?

Laura Alber

We have been actually, this is a very important question for all of us and we continue to have a lot of discussion and research done on the subject and we look at it monthly and go through and look at where there are opportunities and make adjustments, and it's a very productive process.

We do have less promotions than last year, so as Sharon said earlier, there are sales that we drove last year that weren't as profitable as they should have been and weren't good for the brand longer term, and that is part of what you're seeing with the direct to consumer decline that's worse than the catalog circulation cut.

Howard Lester

And just to extend that a bit across all of our brands, the techniques, we're in our 23rd year of using the sophisticated regression analysis to rank our file when we go to mail it. And over the growth years, we were looking at how we could use this to find the next best prospect.

In this environment, we're able to use these techniques to identify those people who would most likely not buy and not mail them, and we have done a number of control groups and are very confident that the circulation we've cut would have produced minimal sales compared to the cost of having mailed those catalogs.

The other point that Sharon brought out earlier, and Laura mentioned, is that we're able to divert some of our catalog spend to on-line digital marketing that is producing more attractive results and we are very optimistic about our opportunities here especially in the back half of the year across a wide range of digital marketing efforts from e-mail, to affiliates to re-targeting to paid search and also the initial results of Google's new caffeine algorithm which tends to favor brands and pushing up our page rankings.

Operator

Your next question comes from Christopher Horvers – J. P. Morgan.

Christopher Horvers – J. P. Morgan

Maybe you could provide a little more color on August. I sounds like Pottery Barns is having a pretty good start here to 3Q. Should we think that you're running better than the down 8% to 13% comp overall. And as a follow up, Laura maybe you could talk about the unit versus dollar comp trends, because I know you've taken price down over the past year and it sounds like the units are really responding.

Sharon McCollam

Absolutely the comps that we are seeing coming in for the third quarter are better on a one year basis and on a two year basis. So we are encouraged about the initial consumer response to the fall assortment across all the Pottery Barn brands. We're very pleased with Williams-Sonoma's performing right now. So I'll turn it over to Laura and let her respond to your more detailed question related specifically to Pottery Barn.

Laura Alber

As Sharon said, we are seeing some better trends. It's early, but we are optimistic that the strategies that we have put in place, it looks like we got it right. As you know, it's very competitive right now and so I hesitate a little bit to give you more information than we have because it is early, and it is competitive.

Operator

Your next question comes from David Magee – Suntrust Robinson Humphrey.

David Magee – Suntrust Robinson Humphrey

The question I have is to do with the gross margin again. Just looking historically, the numbers between the first and second quarter have been usually flattish on a sequential basis, and this year you're up roughly 200 bips second quarter over first quarter. Is that a function of just becoming more aggressive on shipping costs or what's going on there so far this year from first and second quarter?

Sharon McCollam

I think it's just, we can take it offline when we get into our discussion later this morning, but I would say that all the things that we have been doing are gradual and incremental and each quarter we build on what we have accomplished from the prior quarter. So as we start seeing momentum, the thing that you're going to see, and I don't think that you should go back and discount all of our history, because what you're seeing is the strong consumer response to merchandising that started to come into play.

We said it in May when we had our call that we were starting to see better than the October trend. Now we're seeing that go further. We're seeing these stronger selling margins in Q1. We hadn't seen that yet. There was still a lot of competitor inventory being liquidated on the market. We were competing with that.

Our inventories were still being brought down and stabilized, so I think it is a combination of so many things. As you're modeling in the future, I think you should not model it that way because we expect where we have all those years of such strong performance, I would expect our business to run similarly.

But I think in an environment where you're making such dramatic change so consistently, that it will build on itself over the next several quarters.

Operator

Your next question comes from Ivan for Scot Ciccarelli – RBC Capital Markets.

Ivan for Scot Ciccarelli – RBC Capital Markets

Congratulations on a solid quarter. I was hoping you could provide a little bit of additional color just on your venture in the Middle East. I was just curious why you had chosen that particular area. Are there any other regions that you are contemplating, and just as a follow up to that, would the mix be similar in terms of the retail versus direct to customer? How should we think about the prospects with regard to that?

Sharon McCollam

The first four stores that we're opening are in the Pottery Barn and Pottery Barn Kids brands. I will let Laura speak to the current strategy with Pottery Barn as it relates to the deal that we've done with Alshaya.

Laura Alber

We are so excited to go forward with our new partner, the Alshaya Group. They are excellent operators as you all know, and our plans are to operate stores in the Middle East in the same way we operate them here. We are going to be, as Sharon mentioned and Howard mentioned, opening two stores in Kuwait and two stores in Dubai this coming year and have plans to open stores subsequently throughout the Gulf.

We're excited because not only does it expand the reach of our brands internationally, and offer those customers the same opportunity to shop overseas as they have here, but also gives us a new revenue stream.

Sharon McCollam

And from a geographic region perspective, as many of you know on the call, some of the greatest growth that is currently occurring in retail is in the Middle East, and there are outstanding partners like Alshaya that we believe can reflect the essence of our brands better than probably anywhere in the world and we are very excited.

Howard would you like to add anything to this?

Howard Lester

I think the reason that we, the primary reason that we selected that region to begin and the best global expansion strategy was that Sharon and Laura both have mentioned, it's very much like America in one sense in that it's mall based and they're very much Americanized. They operate in copies of malls that we have in America.

They also have operators there that you could partner with that are very accomplished and that was important for us because we didn't have the resources to field our own team from scratch really in any part of the world, and we wanted to test the expansion of our brand before we even considered how we would address the balance of the world, if in fact we had a global opportunity.

So those were the primary reasons. And there's a lot of money there. People are shopping at high rates. The stores show very high productivity in sales per foot even with the down turn that's occurred in Dubai particularly.

So we have as Sharon and Laura said, we've got outstanding partners. We have a very satisfactory financial arrangement and we think it's an excellent test for our brands, initially our Pottery Barn brands and then subsequently Williams-Sonoma brand. So we're very excited about the store openings next year and we'll see what happens.

You also asked the question will the mix be similar to America in terms of retail and direct. Initially no, it will be almost all retail because that's the way the region operates, but we would be hopeful that eventually the direct business would be equally strong there.

Operator

Your next question comes from Janet Kloppenburg – JJK Research.

Janet Kloppenburg – JJK Research

I was wondering if Laura could spend a little time talking about the time line for Pottery Barn in terms of executing on the new product assortments with the focus on delivering more value, how much has been done, how much more can we expect, and if someone could comment on that for the Williams-Sonoma brand as well.

Laura Alber

We have been studying every single category in our business over the past several years and our competitive set to look at where we need to increase our value offering both because of the reset economy but also to attract new customers into the brands. You're going to see with every season new offer that is at the same great quality and design as we've always been but better value.

The way we're able to do that is to really just be very focused on building things smart, doing things different, and we have great partnerships with our vendors who are really helping us execute this. So we're very excited about the future.

We believe there is still a lot of room and many more categories than we've touched and even further depth in the categories that we've already addressed.

Sharon McCollam

On the Williams-Sonoma brand, it's a different theme and I'm going to let Howard speak to it. Their focus is on exclusivity. Their focus is on innovation and brand ideas. But Howard could you speak to the evolution in Williams-Sonoma that's occurring?

Howard Lester

The strength of that brand has always been newness and exclusivity and style and quality and all of those things that we've tried to be all these years. However, Richard and his team have had a strong focus the last year or so on trying to develop with our vendor community products that have equal value but that are more attractive price points. They've done an excellent job of that and that will continue. So without being specific about products that are in the works or products that we're going to be announcing, that's an important part of their strategy going forward.

Operator

There are no further questions. I will now turn the call back to Howard Lester for closing comments.

Howard Lester

Thank you very much for being with us this morning. We're particularly pleased with our quarter and I just want to say that I'm so proud of our team. We've all worked hard and results are showing the extent of our efforts, so we are just very excited about where we are and we're looking forward to continued improvement. And we'll talk to you next quarter. Thank you.

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