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Restoration Hardware Holdings Inc (NYSE:RH)

Q2 2013 Earnings Conference Call

September 10, 2013 05:00 pm ET

Executives

Gary Friedman – Chairman, Creator, Curator and Co-Chief Executive Officer

Carlos E. Alberini – Co-Chief Executive Officer

Karen Boone – Chief Financial Officer

Analysts

Lorraine Maikis Hutchinson – Bank of America Merrill Lynch

Matthew J. Fassler – Goldman Sachs & Co.

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

Matt R. Nemer – Wells Fargo Securities LLC

John Marrin – Jefferies LLC

Daniel Hofkin – William Blair & Co. LLC

Peter S. Benedict – Robert W. Baird & Co.

David S. Strasser – Janney Montgomery Scott LLC

Operator

Good afternoon. My name is Jeremy and I will be your conference operator today. At this time, I’d like to welcome everyone for the Restoration Hardware Holdings Second Quarter Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session (Operator Instructions) Thank you.

I’d now like to turn the call over Ms. Cammeron McLaughlin, Investor Relations. You may begin your conference.

Cammeron McLaughlin

Thank you. Good afternoon, everyone. Thank you for joining us for Restoration Hardware Holdings second quarter fiscal 2013 financial results conference call. Joining me today are Gary Friedman, Chairman, Creator, Curator and Co-Chief Executive Officer; Carlos Alberini, Co-Chief Executive Officer; and Karen Boone, Chief Financial Officer.

Gary will begin with highlights of our second quarter performance. He and Carlos will then provide an update on the company’s long-term strategic priorities and Karen will then conclude our prepared remarks with the discussion of our second quarter financial results and our outlook before opening up the call to questions.

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

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

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

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

With that I will turn the call over to Gary.

Gary G. Friedman

Thank you Cammeron. Good afternoon everyone. We are pleased to report another quarter of record financial results. During the second quarter, we continued to take market share and deliver industry leading performance posting net revenue growth of 30% marking our 14th consecutive quarter of double digit increases. This is a reflection of our ability to innovate, curate and integrate new products, businesses and services offering an unmatched customer experience.

Our exclusive product dominant assortments and taste and style are resonating with consumers across all channels. Comp store sales increased 26% during the quarter on top of a 31% increase last year, and 17% in the second quarter of 2011. This represents a 98% increase in comp store sales of a three year period in the quarter, as we have dramatically improved our productivity per square foot. Our direct business also continue to scale and accelerate increasing 33% during the quarter on top of 29% growth last year and 21% in the second quarter of 2011.

During the quarter, we expanded our adjusted operating margin to nearly 9% from 7.5% last year and increased our debt to net income by 62% while at the same time continue to invest in our infrastructure and new businesses to support future growth. Adjusted earnings per share reached 49% for the quarter up 48% over last year, and adjusted earnings per share for the first half of 2013 increased by 87% versus a year ago.

As we entered the second half of the year, the demand for our collections remained strong. Due to the strength of our business the continued evolution of our Source Book model and the enhanced ability to connect with our customers through digital and electronic media, we are moving to a once a year mailing of our Source Books. We believe this decision will result in a step change effect to our earnings and cash flow model, allowing us to reach double-digit operating margins and free cash flow positive significantly ahead of our prior expectations. We are eliminating the mailing of our Fall 2013 Source Books and plan to mail an annual edition each Spring.

Concurrently, we are increasing our earnings guidance for the remainder of 2013 to reflect our business trends and the associated cost savings. We do still plan to mail our holiday gift books in late October and the spring 2014 Source Books, we’ll mail at the first quarter of next year.

We have proven our ability to test, scale and roll out new categories and businesses such as Baby & Child, Small Spaces and outdoor. Over the years we have developed these businesses methodically and achieved dominance in multiple categories in the marketplace. This has contributed to significant market share gains and top line growth for our company.

From of our most recent introductions, RH Tableware and RH Objects of Curiosity was launched this past spring and now have a retail presence in all of our galleries to RH Rugs and RH Leather, both of which feature their own unique and innovative Source Books that we’ll mail next spring and RH Antiques & Artifacts and RH Kitchen, which are targeted to be introduced in 2014 and 2015. We have a robust product pipeline to support our long-term growth.

Later this fall, we will launch RH Contemporary Art with an innovative and immersive online experience featuring the works of over 50 international artists and an art journal with articles and features written by well-known art critics and authorities. We will also be opening our first freestanding art gallery in the Chelsea Arts district of New York City. This will be a five floor, 20,000 square foot exhibition space that will give our artwork a physical presence and our brand authority as a true curator of fine art.

The worldwide recognition we received from our first ever art acquisition, the Rain Room, which was exhibited at the MOMA in New York City this summer had the public queuing out for up to 10 hours to view this installation earning RH Contemporary Art credibility at the highest levels of the art world. We believe these efforts and associations also help render the RH brand more valuable and position us as a curator of taste and style. We’re excited about the prospects for this new business and believe we have pent-up customer demand based on feedbacks from our interior designers and associates.

As you know, all of the new businesses and categories, we are pursuing are large $20 billion plus highly fragmented market where we have a customer base and multi-channel platform we can leverage. Over time these can all be meaningful contributors to our growth.

At our core our defining strength is our taste and style and our ability to innovate and curate, which we believe can translate and be leveraged across many businesses and categories. We have long said we believe we can curate a world far beyond the four walls of the home.

Last month we announced RH Atelier, a curated, artisan-crafted luxury apparel and accessory brand based in New York City that will be integrated into our next generation of design galleries. We are also exploring our foray into hospitality and are working on developing the first RH guest house, a boutique hotel and private club which will debut in New York City sometime in 2015 or 2016.

Another example of how we are leveraging our core strength of innovation is how we think about connecting with our customers in creating awareness for our brand and its revolutionary new world at the Internet and new media. Old methodologies of marketing and advertising are quickly becoming obsolete and we have been focusing on developing a new model based on advocacy versus advertising.

It’s about connecting with our customers on a deeper level based on our beliefs as opposed to telling customers what we are selling. It’s about connecting with customers about why we are doing the things we do with M&As from what we believe in and what we love. It’s about truth versus marketing. Hence, we eliminated our marketing department and now have a truth group focused on doing things that reflect the values and virtues of our brand.

We are shifting spending away from traditional advertising into new ways of building awareness and efficacy. One of the examples of this is the creation of RH Music, a new music platform for emerging artists from around the world. We are curating authentic artists that we love, giving them an opportunity to create music that they love. This will be instrumental in their own journey and that is the platform itself, much like the philosophy that our great country was built on for the people, by the people. RH Music will be built for the artists, by the artists.

We are hosting a private concert with three of our founding artists, Larkin Poe, Swampadelic Soul Sisters from the hills of Georgia, The Brixtons, a Brooklyn Pop duo, and British Singer/Songwriter, Edei this Thursday night at the Highline Ballroom in New York City. Our official launch concert is next week, September 20 at the Greek Theatre in Berkeley, one of my favorite music venues in the world where I saw outlay [ph] two years ago.

Tickets for this event are in sale at our RH Music website, rhmusic.com, online at Ticketmaster and in our galleries throughout the San Francisco Bay Area. The concert will also be streamed live worldwide through our website at RH.com and rhmusic.com. We believe the connection we can make with our customers through this form of advocacy versus traditional advertising will create greater awareness of those things we believe in and render our brand more authentic and valuable.

We hope you can join us in person at one of our concerts to experience the taste and style we are curating and witness the energy and inspiration that has been brought to life by the RH brand.

With that, let me now turn the call over to Carlos to provide you with an update on our next generation Design Galleries and other long-term strategic priorities. Carlos?

Carlos E. Alberini

Thank you, Gary, and good afternoon everyone. Regarding our long-term opportunities we’ve remained focused on two key strategic priorities that we believe will create significant value in the future for our company. Our top priority remains the transformation of our current real estate platform into our portfolio of Full Line Design Gallery. This represents the most significant opportunity for revenue and earnings growth as we unlock the true value of our dominant product assortment on new businesses.

The other high priority for us is to continue to build a world-class infrastructure that will provide operating leverage and support our long-term growth. Let me first update you on our real estate transformation initiative. To date we have opened five Full Line Design Galleries in Los Angeles, Houston, Scottsdale, Boston and Indianapolis. We are extremely pleased with our results as every one of this locations continue to outperform our expectations consistently, which provides further validation of our strategy.

Our Los Angeles and Houston stores are in our comp base and comp-ed in excess of 28% during the second quarter outpacing the rest of the fleet. These two stores are highly productive turning to deliver over $300 per selling square foot in 2013.

Our Scottsdale full line design gallery is expected to deliver annual sales per selling square foot of over $1,200 and also are ahead of our expectation. Our most recent full line design galleries in Boston and Indianapolis are expected to deliver nearly a $1,000 in annual sales per selling square foot.

In addition all of these markets have experienced a lift in direct demand anywhere in the range of 30% to 120% since opening. Regarding future openings we are on track to open a 25,000 square foot full line design gallery at the old historic post office in Greenwich, Connecticut and this will happen in early 2014.

We also plan to open a new location in Los Angeles in an amazing corner of Millwork [ph] avenue late in 2014. The new location will have 30,000 square feet, plus an outdoor courtyard and a rooftop park. In addition, we plan to expand our gallery in the Flatiron District in New York City, our strongest market and the top producer and that approximately 17,000 square feet as we opened two more floors in our existing building this will also happen in 2014.

We plan to open our next generation full line design galleries in Atlanta and Chicago. Atlanta will have 65,000 square feet and we will open in late 2014 and Chicago will have 55,000 square feet and we’ll open in early 2015. This larger locations will accommodate the continued expansion of our core assortment, our small spaces collection, Baby & Child as well as all the future new businesses that we are planning. Our negotiations for new locations are progressing very well. We’re currently in discussions for over 30 locations including several anchored tenant type leases and have a LOIs in case for multiple sites. We now see opportunities to be in low over 50 markets in the U.S. and Canada.

The new anchor tenant deals we’re being offered will provide opportunities for higher sales, increased earnings, lower capital investment and higher ROIC than our initial target store economic. We expect that our next generation full line design gallery with an average of 45,000 selling square feet will generate total sales volume of nearly $30 million per location which is 60% higher than our prior store economic target.

These stores are expected to generate 65% higher cash contribution dollars than our previous target store economics. With landlords contributing more capital to this project, our net capital investment is expected to be $200 per foot down 20% from our prior target. As a result we now expect a payback period of 16 to 18 months versus our precious 20 months target. In addition, based on our experience to date if were to include the impact of the direct sales list that we experienced when our Full Line design gallery is open in new markets, the playback period would accelerate further to about 12 months to 14 months.

Our second strategic priority is to build a world class infrastructure that will provide operating leverage and support our growth. During the second quarter we opened our third furniture DC near Dallas, Texas. This building also houses a customer call center. This facility has over 850,000 square feet of capacity to our network.

During the period we also completed a 420,000 square foot expansion of our Ohio shelf stock facility bringing it to approximately 1.2 million square feet. We now operate six facilities in the U.S. with nearly 5 million total square feet to support our multi-channel go-to-market approach. During the quarter we continue to make strides with our in-source furniture delivery initiative and remain on track to have in seven of our top markets by the end of the year, which will represent nearly 50% of our furniture delivery.

We have experienced significant benefits from our in-source activities to-date. We believe our brand stands alone in the luxury home furnishings market. We will continue to expand our offer, disrupt the market and take share. We are developing a real estate platform that will unlock the true value of our assortment, and we have built a full integrated supply chain and infrastructure that is designed to support our growth and maximize profitability.

We have an amazing team of highly passionate leaders completely focused and committed to the continued execution of this strategic priority. We strongly believe this will result in significant shareholder value creation and strong cash flow generation over time.

With that, I would like to now turn it over to Karen to review our financial results and outlook. Karen?

Karen Boone

Thanks, Carlos, and good afternoon, everyone. I will first review the second quarter performance and then spend a few minutes discussing our outlook for the rest of the year.

We are very pleased with our financial performance during the second quarter. Total revenues for the quarter increased 30% to $382.1 million. Our comparable store sales increased 26% during the period on top of 31% comp growth last year. We continue to post industry-leading top line and comp growth even while contracting our store base. We ended the quarter with 70 galleries opened versus 73 last year.

Our direct sales increased 33% to $177.8 million on top of the 29% increase for the same period last year.

Gross profit in the second quarter increased by 22% and reached $139.2 million. Gross margin decreased to 36.4% from 39% last year; the biggest driver of this change was like the strategic pricing on new products, primarily related to new furniture introductions last fall. And as discussed in the last quarter, we did shift the timing of one of our big spring promotions to coincide with the timing of the spring Source Book in Home Day, through our spring savings event selling Q2 this year versus Q1 last year.

Our furniture sales and penetration also increased in the second quarter relative to both last year and the first quarter, which resulted in lower product and shipping margins during the period; offsetting these trends, we leveraged our occupancy costs while continuing to invest in our DC infrastructure.

Our total adjusted SG&A expenses increased 14% to $105 million in the second quarter versus $92.2 million in the prior year. As a percentage of net revenue, adjusted SG&A expenses decreased by 400 basis points, driven by advertising savings and increased leverage of other G&A expenses.

So lower advertising expenses in the quarter was due to a decrease in the circulation of our spring 2013 Source Book as well as the shift in the timing of the book drop and in home days relative to last year. In addition, the net benefit of the change in our Source Book strategy on the second quarter was approximately $0.04 of adjusted diluted EPS. Regarding other G&A expenses, we also experienced significant leverage on our fixed payroll, professional fees, and other corporate expenses.

As a reminder, our adjusted SG&A in the second quarter excludes variables and certain one-time non-cash stock-based compensation expenses as well as legal and professional fees incurred in connection with our recent follow on offering.

Recurring stock-based compensation is included in both adjusted and GAAP net income and EPS. Adjusted net income for the second quarter increased 62% to $19.8 million out from $12.2 million in the prior year. Adjusted net income is calculated based on a normalized 40% effective income tax rate. Adjusted diluted EPS increased 48% to $0.49 during the quarter based on 40.7 million diluted shares outstanding.

Turning to the balance sheet. Inventory levels at the end of the second quarter were $406.6 million, up 48% from last year. We are very pleased with our vendors ability to continue to meet our growing demand. We expect to end the year with inventory growth in line with our expected sales growth. Our capital expenditures were $20.9 million in the second quarter and we continue to expect capital expenditures in the range of $95 million to $100 million for the full fiscal year.

As we have stated previously we anticipate investing more than half of our 2013 capital expenditures on real estate, including the build out of several full line design galleries scheduled to open in 2014. This also includes our immediate plan to convert available backroom storage space into productive selling square footage in several locations. The remainder of our capital spend will come from supply chain and other infrastructure investment to support our growth.

Turning to our outlook. Let me start with our updated fiscal 2013 full year guidance. We are raising our adjusted diluted EPS guidance to a range of $1.65 to $1.70 from a previous guidance of $1.41 to $1.47. This is based on adjusted net income in the range of $67.6 million to $69.5 million and 40.9 million diluted shares outstanding.

We now expect revenue growth in the range of 31% to 32% from our prior expectation of 23% to 27%. Our updated revenue outlook for the year represents growth in the range of 33% to 35% on a 52 week comparable basis.

In the third quarter, we expect the revenues between 35% and 39% to $385 million to $395 million. Based on current trends today, we expect our gross margins to be below last years’ third quarter, but expect the decline to be significantly milder than what we experienced in the second quarter relative to the prior year.

Our adjusted net income for the third quarter is expected to be in the range of $11.2 million to $12 million and assumes an adjusted normalized 40% tax rate. We are providing third quarter, diluted adjusted EPS guidance in the range of $0.27 to $0.29 which assumes 41.7 million diluted shares.

To give you additional context as far as landscape in the remainder of the year, we are also providing fourth quarter guidance today. For the fourth quarter, we expect to grow revenues between 23% and 26% to $490 million to $500 million. Also our fourth quarter fiscal 2012 had an additional week. Total revenue is expected to grow 31% to 34% during the fourth quarter on a comparable basis. Gross margins in the fourth quarter are expected to be relatively inline with last years’ Q4 margin performance.

Our adjusted net income for the fourth quarter is expected to be in the range of $34.3 million to $35.5 million, with diluted adjusted EPS guidance in the range of $0.81 to $0.84, which assumes 42.2 million diluted shares. As a reminder, last years’ 53 week contributed an additional $0.04 of adjusted diluted EPS to the fourth quarter of 2012.

In closing, we are extremely pleased with our second quarter performance. We delivered industry leading revenue, comp and earnings growth, Our business remains strong and we are very optimistic about the remainder of the year. Our current trends in performance gives us further confidence in our ability to deliver on our recently revised long-term financial goals of revenue growth in the low 20s, adjusted EBITDA growth in the high 20s and adjusted earnings growth in the mid to high-20.

With that I’d now like to open up the lines for any questions. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from the line of Lorraine Hutchinson from Bank of America. Your line is open.

Lorraine Maikis Hutchinson – Bank of America Merrill Lynch

I just wanted to follow up on the elimination of the first source book with a couple of question. First, have you been able to test this and perhaps quantify any pressure that we might see on second half sales from eliminating the catalogue?

Gary G. Friedman

Hi Lorraine this is Gary, yes we’ve been testing. We’ve moved to the source book strategy in 2011 as you know when we went from mailing 10 mailings per year to 2 mailings per year and we have tested the tails actually customer segments in measuring the tales on books every drop since 2011 and we’ve seen minimal sales erosion from not remailing a book to a customer. So as we’ve mailed this now for going into the third year of testing these customer segments, we feel very confident that as we’ve migrated this assortment to a kind of venture base, lighting and rug business which are very much considered purchases, an event driven purchases that the remailing of books gives us a very little impact.

Lorraine Maikis Hutchinson – Bank of America Merrill Lynch

Okay and has the Spring Source book been completely expensed at this point so you have no marketing costs in the back half from source books?

Karen Boone

No, this is Karen. We’ve actually – we mentioned that there was a forth set impact that results from we’ve revised our timing with expected benefit of those books through the period that will mail the next books, so in order to better match revenues with expenses, it would be a little strange to not have any advertising costs in the back half. So a lot of those costs that were going to be in Q3 will be in Q3 and Q4, for example.

Lorraine Maikis Hutchinson – Bank of America Merrill Lynch

Okay. And is that what we should expect on a normalized basis for next year as well that run rate?

Karen Boone

Well, actually so in Q3 and Q4 and really this year, we won’t really even I guess benefit from the full impact of this strategy and the step change that we’ve kind of mentioned because this year we will incur certain one-time costs because we made the change and we’re planning to do it from the very beginning of this year. So, we’ll have certain storage costs, we’ve reserved certain printing time. So there’s certainly one-time cost that we will incur in Q3 and Q4, but on an annualized basis they’ll be even more impactful, say in 2014 once we have one source book in for the full year.

Lorraine Maikis Hutchinson – Bank of America Merrill Lynch

Okay. And just one follow-up on gross margins, you talked about some strategic pricing and products. Can you give us a little bit more detail on effects on ongoing strategy and how we should think about gross margins going forward?

Carlos E. Alberini

Yes, Lorraine, this is Carlos. Hi. Yes, I think that we mentioned during the last call that we have followed with a strategic pricing and this has started to happen towards the end of last year and we had anticipated that it would take us couple of quarters to cycle through those pricing strategies and that is why if you’ve heard what Karen mentioned about guidance. We are expecting that our margins are recovering in the third quarter.

We’re still anticipating they will be marginally down from last year, but then in the fourth quarter we expect gross margins to be pretty much in line with last year’s margins and the biggest driver of the margin decline in both the first quarter and the second quarter were the product cost issues that are related to both that topic of strategic pricing and then shipping also impacted the margins because of the mix that we are experiencing with more furniture business.

The great thing is that if you look at the quarter-to-date performance and margins, we are seeing that it is marginally down, I am talking product margin, so we’re already seeing this and now we’re talking about our a month plus couple of weeks of the quarter, so it’s very clear that the margins are recovering pretty strongly.

Lorraine Maikis Hutchinson – Bank of America Merrill Lynch

Okay. Thank you.

Gary G. Friedman

Thank you.

Operator

Your next question comes from the line of Matthew Fassler from Goldman Sachs. Your line is open.

Matthew J. Fassler – Goldman Sachs & Co.

Thank you so much and good afternoon, everybody.

Gary G. Friedman

Hi.

Karen Boone

Hello.

Matthew J. Fassler – Goldman Sachs & Co.

I’d like to follow-up on Lorraine’s question on the impact of the changing in mailing strategy in Canada, I know you’ve already said a lots, if I missed the answer to this question, I apologize. You quantified the impact of the change in the mailing strategy in the third quarter I believe, second quarter $0.04. Can you talk about how much you’re kind of saving net-net for making this decision in the second half, and I guess we need to look not only at the expenses that you’re saving, but presumably that’s offset by some gross profit that you might have captured from additional mailings.

So if you think about the aggregate impact of this decision, not earnings for the second half of the year, would you say it’s up, down or neutral savings are implied in the revised guidance. So you can see that, we’ve not only but that also have lot of other things, so you will see that we took revenue up for the year, but the flow through on that is much better because of the change in the advertising strategy.

We are not providing specific guidance on the exact cost savings by quarter for Q3 and Q4, it’s very easy to calculate what that was in Q2 because the books hadn’t, the fall books hadn’t dropped yet, but there is two things going on, there is the additional cost moving into this quarters, from the spring book but there is the elimination of a full production and mailing cycles with the fall book, but then the cost of some of the – we’re still mailing the holiday book and the Baby & Child holiday book.

So there is still advertising costs and again it’s going to take us probably the cycle to kind of read and see the full benefit, and we’re kind of alluding to understand the and impacting the sales impact but we feel comfortable with the guidance we’ve set forth and those trends and our expectations for the cost savings and the sales impact are included there in.

Matthew J. Fassler – Goldman Sachs & Co.

Understood. Second financial question if I could, very briefly to the extent that gross margin trends have improved meaningful, is that a function of cycling some of the pricing actions that you talked about last fall or are some of the mix and shipping dynamics that you’re seeing today year-on-year different from what you’d seen for the past several quarters.

Carlos E. Alberini

Matt, it’s primarily the first point but also includes some of the second point both are meaningful. One of the ways to think about this as Carlos said, between Q1 and Q2 because there is shipping timing differences based on receipts and furniture shipments between quarter-and-quarter. The best way to look at the first half is to look at in an aggregate spend where gross margins were down about 180 basis points over the six months period, and that end of the Q2 kind of end of the first half cycles strategic pricing impact and because of that it will also impact the mix, right.

So we will have two favorable benefits that start to happen in Q3 and will be even more meaningful in Q4. So we see minimal margin erosion in Q3 from last year and minimal meanings under 100 basis points and somewhere in the range of 50 to 100. And then we believe we can get to flat margins versus a year ago in Q4.

Matthew J. Fassler – Goldman Sachs & Co.

Got it. And then finally, you talked a lot this afternoon Gary about a number of additions to the lineup if you will and really taking the RH brand and case level if you will and imprinting the number of new verticals to make sure music and art and such which are a little less tangible, if you could sort of and thank you obviously talked about before music I think it’s relatively new hospitality as well. If you could sort of talk about that commercialization and monetization of these overtime and then you are clearly expanding the brand to many, many different touch points and many different experiences for consumers, clearly this is a kind of commercial vision here I am sure. Can you talk about how you see that plan, how you see them unified over time?

Gary G. Friedman

Sure. A lot of it comes in and each one kind of has a different role in the overall vision of how we connect with our customers and if you think about our, it’s a very margin fragmented market, there is no real national presence, there is no one in the art business that has leveraged and we believe our taste and style can be leveraged in that category and it does a couple of things; one, it has big meaningful business, $20 billion plus marketplace and we’ve got a customer base that we know for sure is putting a certain percentage of their budget towards art, there is more square footage on the walls of American films than there is on the floors of American films

So we think it’s a big business opportunity but just as importantly being in contemporary art and fine art we believe renders our brand more valuable, and list of perception of the brand in the marketplace and gives us an opportunity to connect with customers especially in the luxury market in a different way.

So as you think about something like the Rain Room exhibition room at the MoMA and what that’s done for our brand in the perception of our brand, we think that’s pretty impactful. We believe that a lot more valuable than ads and magazines where you have deteriorating impact. Also as we look at things and we see a dramatically different marketplace and power in the marketplace shifting to consumer through the Internet.

And if you think about media, 10 years ago and you think about media today and you think about the amount of blogs and the amount of power and what’s happening through social media and other connections and the ability for people to connect and really talk about what they believe in and the brands they believe in, we believe the advertising is becoming, traditional advertising sources are becoming less and less relevant.

We believe the customer as we look at our trying to measure our returns in advertising investments, we believe there is different ways to connect with customers, there is different ways to bring awareness to the brand, if you know we had pretty significant events opening these new galleries in our major markets. When we open these now stores we have usually a music event associated with the store, we have significant turn out, we’ve got significant press through traditional press, but significant press through online blogs and social media. And as you know, I mean we’re not necessarily proud of it, but we had a party in Boston, they got shutdown by the police and probably got more publicity than anything we’ve ever done.

Not that we have a goal of having parties that get shutdown, but the power is in the hands of the consumer today, the ability for consumers to talk about brands that they believe in, the ability for brands to be authentic, and do you think they believe in, we believe connects with customer in new and different ways.

When you think about something like music, one; we believe there is an ability to create a music platform that’s highly viable and commercial, but more importantly, if you think about allocating advertising dollars in a way that connects with customers in a more intimate and a more authentic way, we believe our brand is governed by taste and style.

Our ability to curate and innovate and the ability to curate music and musicians that we love, we advocate for those people, expose them to the world, brings awareness to our brand and we think it make a meaningful connection to the customer. We think there is a long-term business strategy here, but initially it’s shift of advertising dollars.

Matthew J. Fassler – Goldman Sachs & Co.

Thank you.

Operator

Your next question comes from the line of Neely Tamminga from Piper Jaffray. Your line is open.

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

Very good afternoon. Gentlemen, could you help me understand a little bit more specifically what’s going on with your customer file. I think as we guide investor along the way on your story there is always this big question about what the ramp is on customers and how big the hurdles of kind of going to the RH bottleneck as people really trusting themselves for your brand and your lifestyle and what you guys represent. Could you give us any sort of metrics around kind of your new-to-file metrics or kind of how early you think your existing customers are in their filings in terms of how early they are in their spend in terms of their lifetime spend with you? Would you want to share any of those contracts?

Gary G. Friedman

We don’t really disclose that data, but if you think about the broader home market would drive purchases, right, you really have an event buyer where buying is tied to the major events of purchasing a new home, remodeling a home or redecorating a home, and that’s on the customers kind of timeline, not necessarily our timeline.

And we believe the current trends in the industry, we’ve just live through kind of the worst recession that we’ve all seen. And we would expect and through that by the way we’ve had average order growth and we’ve had buyer file growth and that is both of the things happened at the same time. So it’s a big movement towards your brand, big movement towards your product offer.

We expect as the housing market comes off it flows and as it has that we’ll see acceleration in the future and we’re really well-positioned and we would expect both those metrics to increase over time. And the biggest impact though it’s really, as Carlos mentioned, unlocking the value of the company by getting the new real estate into the market, right and by opening the new stores we get the assortment into the marketplace and you have two phenomenon happening.

You have dramatically higher sales in these new galleries with the customer experience and presentation we’re putting in place and then you get the echo effect of the much higher performance in the direct business in the market. So we take market share massively within a marketplace when we open these new galleries and that’s one of the key things to focus on and the other point is the majority of our customer acquisition, new customer acquisition happens in these galleries.

Gary G. Friedman

…in all our galleries.

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

That’s really helpful Gary. Just one little follow up to Matt’s question about monetizing these new verticals that you are going into. Personally if you go to this concert at the Greek, at this point looking at the line up, looks straight, but just wondering when will be maybe see the content kind of repurpose back on to the home page or will we ever see that sort of kind of gathering of all end verticals into a single RH from a digital perspective?

Gary G. Friedman

Yeah, we are working on that, I mean all of this has been, we are working on creating not just a website, but what we call the RH portal, which will integrate all aspects of our brand and if you see in the innovative and immersive kind of digital experience, we are doing at RH, we think it’s world-class and it’s going to revolutionize kind of art purchasing online, as music and other things will also be integrated into this and you will have a more full and robust RH experience, but as we think about all of these investments and all of these businesses, they all have very quick returns on investment, the one with the longest tick would be music, but music again, we are looking at initially is just a shift of advertising dollars.

So when you think about again pretty an experience for getting customers to connect with the brand, if you think about the e-mail that maybe most of you received is about an RH Music and event of the high line if you are on the East Coast or anybody in the West Coast, where we just went into marketing, the event at the Greek Theatre, RH is having a concert at the Greek Theatre, they have these musicians, oh, I can go to the website, I can click on the website, and listen to some of the music.

There will be videos of the artists that’s on the website or I can go to the Greek Theatre, the 7,000 person venue and we expect to sell it out, and you can buy the tickets in our store, think about the excitement that our associates have inside our stores telling the customers about our concert and connecting with the customers about what’s happening with our brand and what we are doing. It’s just a different way of talking about the things you believe in and the things you love and connecting with people in a deeper more meaningful way about many things as opposed to traditional advertising or putting the print out there that we believe doesn’t create the echo effect of doing some of these other things.

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

Thank you so much.

Operator

Your next question comes from the line of Matt Nemer from Wells Fargo Securities. Your line is open.

Matt R. Nemer – Wells Fargo Securities LLC

Good afternoon, everyone. Just a couple of questions, first on the comps, I’m wondering if you could provide a little context on just the change in the cadence of growth over the last few quarters, you did a 26 then a 41 back to 26 all extremely impressive, but just a little color on kind of what’s driving the changes in trend.

Karen Boone

Yeah, Matt this is Karen. One of the things that we try to articulate on the first quarter call is that our strong inventory position in Q1 did allow us to benefit from shipping some of that product earlier. So as Gary mentioned when you really look at the half, we had assessed with the 53rd week and some of the timing of both the book and then the promotion falling Q1 versus Q2 and such it’s really more meaningful to kind of look at the half versus looking at Q1 and Q2.

So that’s the number one thing I would say and then again, from a comp perspective, we truly are channel agnostic when it comes to so much of our product getting fulfilled through the distribution centers that for us, we love it we have a strong comp, we love we have a strong direct growth as well. So and again, if you look at it on the half, it’s more balanced.

Carlos E. Alberini

Matt, this is Carlos, I would like to add a couple of things to Karen’s comments. The risk if you look at what drove the comps, the levers that drove the comps during the second quarter, we have identified that the productivity of our interior design new team is significantly higher and that represents about a third of the comp increase that we saw, which of course drove significant value as a result of that because the expenses that we incurred to drive that type of growth were drive a lot of productivity and therefore [indiscernible].

The other big thing is what we expect for third quarter. I am sure that this didn’t escape you, that we’re guiding revenues, growing in the 35% to 39% year-over-year and that is a pretty significant revenue growth. So the same phenomenon that you saw in the first quarter that we are guiding you too to look at it as a first half is in a way happening in the third quarter again.

So, meaning that we’re going to be shipping a lot of products in the third quarter, that is going to drive a lot of that growth in revenue. So I think the same comments that apply to the first half, you could say this is a business that is a business where revenues are driven by shipment and you cannot always anticipate exactly when that demand is going to be paired with the shipment of product.

Matt R. Nemer – Wells Fargo Securities LLC

Okay. That’s helpful. And just a quick follow-up to that, which is the interior design team, when do we anniversary the changes, I mean is that primarily something that’s just happened recently?

Carlos E. Alberini

Well, we started building that team about a year and a half ago and we have said that by the end of the year we expected to have interior design services across the chain. That is still our plan, but the great thing about this is that this is not a one-time thing. What we are experiencing is that interior designers are cultivating significant relationships with the customer and that is driving more volume as we continue to evolve in that relationship.

So it’s not okay now. I have a group that is producing pretty significant numbers and then we’re up against those numbers. It’s more about how much more this group can develop as they interact with customers on an ongoing basis. So and they have reached that relationship and also brought new ideas for customers to think about expanding their home furnishings with our lifestyle. So we think that this is going to continue to accelerate.

Matt R. Nemer – Wells Fargo Securities LLC

Okay. And then just lastly, given the change in the Source Book strategy, is there a need for a step function change in your investment on the digital side, whether it’d be a new platform or a lot of additional hires on the digital side of the business or anything we should be aware of coming there?

Carlos E. Alberini

Yes. Actually Gary just referred to our investments and for our Contemporary Art platform and we have invested this year and actually we have also invested in our infrastructure for the entire web operation and we will continue to do so.

We believe strongly in having a worldwide infrastructure figure and that impacts every area of the operation and of course this is a big one. As you know, our direct business is a pretty significant part of our business and we’ll continue to support that to always be ahead.

Gary G. Friedman

And I would say there is no planned step change in investment on the direct to website. We don’t foresee any shift of the spending per se based on the elimination of the Source Book to the digital side of the business. We believe this is really purely cost savings as we kind of focused on finding what is the optimal model for this company and for this business.

If anything, I’d say just as we went from 10 million a year to 2 million a year and we saw significant savings and optimization of the model by going from 2 million a year to 1 million a year we are going to see another step change in optimization of the model. It’s really learning here what is the right model and how to allocate our investments to drive the highest return on investment.

Matt R. Nemer – Wells Fargo Securities LLC

Okay, great. Thanks. Congrats.

Gary G. Friedman

Thank you.

Carlos E. Alberini

Thank you.

Operator

Your next question comes from the line of John Marrin from Jefferies. Your line is open.

John Marrin – Jefferies LLC

Great. Thanks, guys. Congrats on a great quarter. So just for clarification, next year’s opening in Los Angeles, is that a new unit or a relocation?

Carlos E. Alberini

Yeah, it is a new unit and a relocation of our Beverly Boulevard location. Today, as you know at the time this was a location that we opened. It was available and we are very pleased that we took that because this is the least that is under market in a pretty significant way and in fact we negotiated for this new location. It’s going to be on Melrose Avenue. It’s a fantastic corner and also it will give us the opportunity to open a much larger house for our assortment. So we’re going to have over 30,000 square feet less [ph] rooftop park courtyard. It’s just going to be phenomenal.

Gary G. Friedman

Yes. It’s the change. We have about 15,000 feet of interior selling space at our current location in Beverly Boulevard, and we will see moving to 30,000 square feet of interior space at our new location. So it’s a significant expansion of the assortment and again at first time Beverly Boulevard was our very first one and we’re still kind of moving up and stepping up and trying to understand what is the right size and we’re a large market.

John Marrin – Jefferies LLC

And then the New York story, you said it is expanding two floors. Was that to 17,000 or from 17,000?

Carlos E. Alberini

No, no. We will add 17,000 square feet. You may recall if you will in our last call, we did mention that we were with plans to remodel and expand one of our locations, but at the time we are in the middle of negotiations. We don’t want to disclose the location now we are.

John Marrin – Jefferies LLC

Okay, great. That’s great. And so help me to focus a little bit on Indianapolis just for a moment. In the last call, I think you said that sales in our market were up 2x. I think Carlos you mentioned something about 30% to 120% in the new stores that you built in maybe Indianapolis. I think it’s sort of plays where Indianapolis is in that range now and maybe add some color about anything that that market and what store is teaching you about your entry with Full Line Design Galleries in small markets.

Gary G. Friedman

Yes. Actually, I have to say we are very impressed with the performance. It’s interesting that you’re at about that one. Indianapolis is up over 150% lives today in terms of revenue and demand growth. And we think that this is saying a lot about what those middle markets can offer in terms of opportunity for the brand. In addition to that, I mentioned that our direct business for all the five Full Line Design Galleries were in a range of 30% to 120%.

Indianapolis happens to be the one that is over 120%. And so that’s why just thinking about the type of productivity that we can get in a market like this when you think the type of real estate deal that we are accounting for a secondary market like that you can imagine the type of returns in them and profitability that we can achieve. So we’re very pleased with this.

We think that we have said that now we believe that the North American market offers an opportunity to open more than 50 Full Line Design Galleries. We think that we could be well north of that number based on this type of experience.

John Marrin – Jefferies LLC

Great. Thanks guys.

Gary G. Friedman

Thank you.

Operator

Your next question comes from the line of Daniel Hofkin from William Blair & Company. Your line is open.

Daniel Hofkin – William Blair & Co. LLC

Good afternoon. Very nice quarter.

Gary G. Friedman

Thank you, Dan.

Karen Boone

Thanks, Dan.

Daniel Hofkin – William Blair & Co. LLC

Just circling back on a couple of topics as it relates to the change in the sourcebook strategy. I know this was asked about in a previous question. As I recall maybe in years pass there were times when changes in timing or number of mailings may have had a greater than expected impact on the businesses. It sounds like now you are able to sort of fine tune that better, I guess is that just a matter of sort of a more scientific approach to the house file or what’s driving that more targeted approach.

Gary G. Friedman

It’s a very scientific approach to the mailings I believe and we say when we move from 10 mailings to 2 that was a very scientific approach and new sort of approach from improving our return on investment from an advertising point of view, and just as we said earlier we have been measuring this since every quarter since 2011, we’ve held out customer segments with whatever we haven’t remailed in fall of 2011, spring of 2012, fall of 2012, and based on those tails, those customers and those customer segments that we are not re-mailing the book.

There is a minimal impact and doesn’t warrant the cost of re-mailing the books. And again, you’ve got a very long buying cycle here. You’ve got an event buyer here and this is no longer a catalog business. I mean, you can’t really compare us to Pottery Barn or Crate and Barrel or any of these other businesses anymore. They’ve got a huge seasonal assortment. They have got a huge kind of accessories business and other businesses that are impulse businesses that rely on mall foot traffic, that rely on multiple catalog mailings, and we don’t have a business like that.

And nor should our model look like that, and I think the challenge that people have is, with a lot of things we’ve done in the last four years, honestly it’s trying to say, wait a minute nobody else does that.

And from 2008 when everybody went after value and lowered quality and took prices down and we went the other way and raised quality and prices up nobody understood it, and from going to 10 mailings to 2 mailings everybody was just like wow, gee that doesn't make sense from going from small stores to big stores, the industry was saying like, well, gee that’s not what everybody else is doing, and what we’re doing is trying to do what’s right and what maximizes productivity, profitability and return on invested capital in our business, and we think this is a step change to the positives in the right direction is going to move us much more quickly to double digit operating margins and much more quickly to free cash flow positive.

Carlos E. Alberini

Yes, I think, I would like to add, really a couple of years ago when we tested the Source Book strategy for the first time, at a point we didn’t know exactly what to expect. We had a very strong theory about the fact that our customer was becoming very much an event driven customer and therefore we knew that and we believe that make a lot of sense. But today I really see almost no risk in what we are doing because we have proved, we have been seeing the behavior of this far now for over a year and a half and it’s very clear and especially because we have tested not mailing customers that have been part of the prior mailing and we continue to see acceleration in their purchasing behavior.

So it really that we know that after seeing that for six months we didn’t e-mail our customer and that customer continues to interact with the brand and now we’re talking about in some cases over a year and we continue to see that acceleration, and we believe that in the numbers that we are providing today and the guidance that we are giving, there maybe a nice size of conservatism because the one question mark here is what type of revenues if any, we are forfeiting.

We have assumed a pretty conservative size of revenues based on our current trends, so we feel that we are now they are getting to pretty solid grounds here and I think we are going to be looking back and say wow, how is that we have been able to move this operating model in such a rapid pace and with the type of cost structure savings that we will experience.

Daniel Hofkin – William Blair & Co. LLC

Thanks, that’s very helpful. I guess one maybe just brief follow-up on the gross margin, and then on the guidance in the second quarter versus kind of how you expect things to play out, was some of that, was any aspect of the promotional pricing incremental relative to what you expected going into the quarter and then as it relates to the second half, I heard your answer earlier, would it be fair for us to conclude that the stronger sales guidance and the profit flow through just from that alone is a bigger factor than the Source Book strategy adjustment?

Gary G. Friedman

No, actually the expectations for margins when we were sitting here three months ago, talking about the first quarter performance, we had pretty much the kind of expectations that became real of our gross margin and we tried to kind of give direction to you guys and so overall this performance was ahead of our expectations based on some other levers, including a little bit of revenue growth over and above the guidance that we provided.

Daniel Hofkin – William Blair & Co. LLC

Okay, yes, that was just my question because it seemed like if there was it seems like it flow through to some incremental top line and that as it relates to the second half?

Gary G. Friedman

Yes, as it relates to second half, we are providing the most accurate guidance that we can provide. Again, keep in mind that we are always going to be conservative and we’re trying to help you look at how we see the landscaping taking place in the second half in both third and fourth quarters, trying to be as transparent as we can that’s what we decided to provide fourth quarter guidance so that you can see where every piece is going to fall or how we anticipate it’s going to fall.

Daniel Hofkin – William Blair & Co. LLC

Okay, all right. Thank you, very much. Best of luck.

Gary G. Friedman

Thanks, Dan

Karen Boone

Thanks, Dan.

Operator

Your next question comes from the line of Peter Benedict from Robert W. Baird. Your line is open.

Peter S. Benedict – Robert W. Baird & Co.

Hey guys, thanks. Most of my questions has been asked, but just I guess Gary you talked about achieving the double-digit operating margins sooner than previously planned, do you want to go further and say how long you think it’s going to take it to get there?

Gary G. Friedman

Yes, not at this time, we’re not disclosing that, but I think we’ve largely given you guys long-term guidance and goals about growth and where we thought we could be. I think we would say that this change and this debt change not only will move us to double-digit operating margins sooner, it gives us line of sight to higher long-term operating margins than we previously expected.

Peter S. Benedict – Robert W. Baird & Co.

Okay. Fair enough. and then, Karen just on D&A, can you help us with that? Your outlook has been growing about 2% to 3% over the first half of the year. Does that start to step up materially in the back half? It’s becoming a little lighter where we’ve been modeling it, but just what can you tell us about the outlook for D&A? Thank you.

Karen Boone

Yes. So CapEx, if you saw on the start of the CapEx because that’s what eventually drive it. The number one thing I’ll point out you will see this when the Q comes out is even though the year-to-date six month CapEx number is only about $30 million, there was $13 million or so of accrued capital expenditures. So they basically already been incurred, but they just haven’t been paid for yet. So we’ll provide that disclosure in the 10-Q, so you can see what we truly are for the half.

We’re not giving specific guidance for depreciation. The one thing I’d say is that capital that’s being deployed is for much of it is for Full Line Design Galleries that aren’t going to open until 2014. So where you might be office work, if we’re coming below where you’re thinking. It’s because those assets haven’t been placed in the service yet with the DC opening in the Dallas and the Ohio shelf stock facility opening about Q2 things.

So those are replaced in the service in Q2 and then again some of the retail stores that’s when the big dollars will be placed in the service in that depreciation kick in. So that gives you a little bit of color. So again we’re not giving specific guidance on depreciation.

Gary G. Friedman

So, I hope, we already have time for one more question.

Operator

And your last question comes from the line of David Strasser from Janney Capital Markets. Your line is open

David S. Strasser – Janney Montgomery Scott LLC

Thank you very much. Appreciate it. One bigger longer picture longer-term question, I mean you talked about some of the sales per square feet, the 2,300 from some of the newer galleries at 1,000 or so give or take around Indianapolis, the small market in Boston. When you kind of look at your longer-term guidance, the numbers are well below that. I think you’re 650 in sort of the most recent guidance that you put out. I’m just trying to get a sense of that conservatism. Is there a reason, I know the galleries get bigger, but is there a reason that the numbers would come down that much as you kind of look out over multi-year basis?

Carlos E. Alberini

Well, again we’ll try to always be conservative. Yes, $650 is more representative of the total volume that we have allocated to the larger books. Frankly we don’t have any experience yet. And yes, we believe based on the early results that we have achieved that that number may prove to be very conservative, but we’ll take one step at a time here. The great thing about this is that with $650 the model delivers amazing returns at a very fast payback and by the way that payback is further enhanced with the impact of the direct business and the lift that we are seeing there. But we will continue to monitor this if we see that there is an opportunity to take that number out of course we will.

David S. Strasser – Janney Montgomery Scott LLC

And just one follow-up on that, you talked in the press release about and I think on the call as well about potentially 10 or more galleries coming, if you kind of go out two years. As you think about your infrastructure, how many do you think you can open from an infrastructure standpoint putting aside sort of timing around real estate and zoning and all of that type of stuff, what would you add to infrastructure?

Carlos E. Alberini

I think this question was asked during the last call and the way we look at this is we start with, okay, how big is the opportunity and what is the right thing for the company to do and how fast do you want to move. Once we achieve the answer, then we build whatever we need to build to achieve those goals and based on what we are seeing everything that we can do to really move really fast here is the best thing for the company and the shareholders, so we are mobilizing our team to build whatever capabilities we need to build and we have made great progress on that to really be prepared to open those 10 plus locations per year starting in 2015.

David S. Strasser – Janney Montgomery Scott LLC

Thank you, very much.

Carlos E. Alberini

Thank you.

Operator

And there are no further questions at this time. I’ll turn the call back over to Mr. Friedman.

Gary G. Friedman

Great. Thank you, so much everybody for being on the call with us today. We look forward to talking with you next quarter. Thank you.

Operator

And this conclude today’s conference call. You may now disconnect.

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