Good afternoon. My name is Kyle and I will be your conference operator today. At this time I would like to welcome everyone to Restoration Hardware Holdings' First Quarter Financial Results Conference Call. All lines have been released on mute to prevent any background noise. After the speaker’s monster the question-and-answer session. (Operator Instructions)
I would now like to turn the call over to Cammeron McLaughlin of Investor Relations.
Thank you. Good afternoon everyone. Thank you for joining us for Restoration Hardware Holdings first quarter fiscal 2014 financial results conference call. Joining me today are Gary Friedman, Chairman and Chief Executive Officer, and Karen Boone, Chief Financial Officer.
First, Gary will provide highlights of our first quarter performance and provide an update on the company's value driving strategy. Karen will conclude our prepared remarks with a discussion of our first quarter financial results and our outlook, before opening up the call to questions.
Before I turn the call over to Gary, I would like to remind you of our 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 press release issued today. 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 press releases issued today 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 adjusts 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 10.
A live broadcast of this call is available on the Investor Relations section of our website at ir.restorationhardware.com.
With that I will now turn the call over to Gary.
Thank you, Cammeron. Good afternoon everyone. One of our shareholders made a comment to me recently that I’ve been reflecting on leading up to this call. He said, you might be the most misunderstood company on Wall Street, and I thought to myself, how could it be? We finished last year with comparable brand revenue growth, up 31%, marking our fourth consecutive year comparable brand revenue growth in excess of 25%. In fact, we believe we are the first type of retailer in modern history to accomplish such a seat. Now I’m thinking to myself, how can we be so misunderstood? It reminded me of one of our board members had said to me on several occasions, he said if we go more than six weeks without thinking (ph) up, I feel like I am six months behind because of the pace of innovation at our age is so great. When I stopped and considered those comments, it makes me think that we should also apply the same innovative thinking that has produced industry-leading results to how we spend our time and communicate with our stakeholders. In that spirit, I am going to spend my time differently today. As opposed to regurgitating our Q1 results, I better would use my time to frame for you not just what we have done but rather who we will become. Why we had been able to outperform our industry by such a significant amount year after year, and why you should expect us to continue doing so for many years to come.
When I stop and reflect, I am reminded that we are still in the very early stages of a highly evolutionary brand in business. In many ways, we’re like a $1.6 billion start-up. And while we are all accountable for the discrete quarterly and yearly time measures of being a public company, our effort should really be focused on the transformational stages we are moving through that will define our business and more importantly redefine our industry. Real value has always been created by those who have the courage to lead rather than follow, who are interested in next practices versus best practices, and who are willing to destroy today’s reality to create tomorrow’s future.
Let me start with a question that we believe frames our opportunity, and then discuss the transformational stages we are moving through that will define our business and we believe redefine our industry. First, the question, who is the home brand to the luxury customer? The Nieman, Saks, Barney’s, Bergdorf customer. We believe we are. RH has built the most comprehensive curated collection of luxury home furnishings in the world under one brand. Additionally, we have transformed our entire product platform. We have disintermediated the supply chain by eliminating the wholesale markup and inefficiencies that exist in the highly fragmented luxury market, allowing us to offer unmatched value.
As an example, and probably something not understood, is the fact that we have become one of the largest importers of luxury Italian bedding in the world, offering the exact quality product produced in many of the same factories at half the price of the most well-known Italian bedding brands. We’re also the largest importer of Belgian linen and Thai silk, and I believe we have now become the largest importer of reproduction quality furniture which has previously been limited to both teak factories and small quantity. A point we like to make is this. Furniture of this quality has never been made in these qualities before. In many ways, we have been building a new rail route.
We have developed an exclusive network of artisan vendors who act as an extension of product development merchandizing teams. These are some of the most unique and talented individuals in their respective industries. Many of these businesses were small $5 million to $30 million companies, where we now buy $50 million $120 million of cost receipts from annually and represent 60% to 100% of their production. Over the years we have invested both human and financial capital to enable these partners to scale their businesses and now are enjoying the benefits of having an exclusive product platform that provides us with the unique and very hard to replicate competitive advantage.
Another important differentiator is our RH Centre of Innovation and product leadership. A 120,000 square-foot facility designed to enhance the product development and go-to-market process from product ideation to product presentation. Our investments into designing and building this facility have increased our capability and productivity in excess of 300% while also significantly reducing our cost. I know of no other facility of its kind in the world, and believe this also provides us with a unique competitive advantage. Some of you have been to the center and understand the capability it gives us. And I would encourage those of you who haven’t, to do so. We do request the visitors sign an NDA is the facility design methodologies and processes are all proprietary.
We are also moving through a significant transformational stage in our direct business. We continue to be the pioneer in rethinking the traditional direct model. We have expanded from an 84 page catalogue in 2001 to 1600 pages across six Source Books mailed in 2003, and now to over 3300 pages across 13 Source Books mailed once annually this year. No one has an offering that is remotely comparable nor presentation platform that are similar. Our Source Books are an important part of our multichannel go-to-market strategy as they represent the only current visible manifestation of our brand, and cannot yet be replaced by the Internet, what people overlook is the fact that the web is a very democratic platform. The smallest retailer in the world can look as dominant as the largest retailer due to the fact that we are limited to the same-size store frame.
So for example, RH looks no bigger than Hurley Tom (ph) store on a home page, and it would require a customer to click 10,000 times to understand the assortment size difference, so for now this Source Book play a very important role in communicating the dominant and unique point of view of our brand. While not intuitive, based on the size of our once per year mailing, we have made several changes that are both good for our business and much better for the environment than our previous methodology and those employed by your competitors. We have moved from mailing our Source Book 10 times per year to once per year reducing our pages circulated at the percentage of our sales by approximately 70%.
Additionally, we have shipped all of our Source Book titles bundled together versus separately which is also more efficient and uses less energy. We use only forest certified paper and we are the founding sponsor and only retailer with Verso Forest Certification Grant which provides funding to sustainably manage and harvest forest, we’ve also collaborated with UPS to ship UPS Carbon Neutral. UPS purchases certified carbon offset on our behalf to support reforestation, land field gas destruction and waste water treatment which neutralizes the impact of our delivery. I don’t know of another catalogue retailer scale taking the steps we’re to minimize our impact on the environment.
We do realize that we’re heading in the opposite direction than most in our industry, but believe that we have proven that our methods and decisions have enhanced both our revenue and profitability and base on new thinking and new map. Our approach in the direct channel near our real estate strategy eliminating multiple smaller stores in the market with redundant assortments in favor of one significantly larger store with a dominant author. We believe the new mailing in spring 2014 will again prove to be revolutionary and transformative to our brand and business. Additionally, our online presence will go through equally transformative changes this year as we compare completely re-conceptualize our Web site and greatly enhance our customer experience.
As you know we are in the very beginning stages of what we believe will be one of the most significant retail store transformation in the history of our industry. The retail store is not dead. We believe it is anything but over the past three years we’ve continued to innovate, test and prove that we can build the retail experience that the five conventional wisdom that everything is moving to the web and retail stores are a dying platform. We have proven just the opposite and continued to develop new larger and even more exciting concepts that will create an even more compelling and experiential environment for our customers.
We also learned that we can partner with developers and create a win-win by moving from being a tenant who occupies high cost interior mall or street space to adding value by positioning ourselves as a next generation anchor tenant who can help transform a mall or a neighborhood. This results in unique and dominant location that will range from 25,000 to 60,000 square feet with substantially improved economics and will enable us to unlock the value of our current and future product assortment. We recently opened our newest full line design gallery at the former historic post office in the heart of Greenwich, Connecticut. And the early REITs have been outstanding.
We remain on track to open our new larger full line design gallery on Melrose Avenue in Los Angeles later this year. Our new Melrose location will display 2.5 times assortment of our current Beverly Boulevard location and greatly enhanced our brand presence in this very important market. We will also be expanding our current flat (ph) gallery in New York scheduled to open Friday of next week. We will be adding two additional floors to a top performing store in the Company. Additionally, we will be opening our first next generation full-line design gallery in Atlanta in October of this year.
Atlanta will present more than three times the product assortment of our Houston full-line design gallery and more than seven times the assortment of presented in our current Atlanta store. We believe this new format will generate revenues and earnings that will far surpass any of the previous design galleries we have opened and provide the proof-of-concept that supports our long-term growth objective. After visiting the site recently, I believe that the Atlanta gallery will prove to be our most revolutionary innovation to-date and will demonstrate the true power of the brand we have created.
As mentioned, once our real estate transformation is complete North America we believe we will deliver 4 billion to 5 billion in annual revenues achieved mid teens operating margin and generate significant free cash flow. Let me shift your attention to what is probably the most underappreciated and misunderstood aspect of our transformation our supply chain and system platform. Under the leadership of Ken Dunaj and his team, we’re bringing the same spirit of innovation and disruptive thinking to our supply chain and systems platform. We believe we can significantly enhance the customer experience, reduce our cost and build the platform that can support our long-term growth objectives.
In 2013, we opened our third furniture distribution center near Dallas, Texas adding over 850,000 square feet of capacity to our network. We also completed the 400,000 square foot addition to our Ohio shelf stock facility last year, bringing the center to over 1.2 million square feet. At the end of the first quarter, we operated six facilities in the United States with nearly 5 million total square feet to support our multichannel platform. Additionally, we now have in sourced furniture delivery hubs in our top eight markets, which controlled more than 50% of our deliveries. This year we will be launching our final mile system, which will greatly enhance the customer experience and operational efficiencies of our furniture delivery platform. We will also be piloting our new fully integrated market strategy in Atlanta coinciding with the opening of our new full-line design gallery. We believe there are significant opportunities to localize and integrate our stores, outlet operations, home delivery hub and customer care operations in each high volume market that will result in enhanced service and reduced cost.
Lastly, I would like to speak about our approach to managing and deploying capital and the financial stewardship of our company. One of the benefits of spending almost five years as a private company and a private equity ownership, if you learned the discipline of capital allocation that quite frankly is far superior than what one would learn in a retail career, added to that I believe we work with some of the smartest and most innovative partners in private equity and have developed a mentality of investing that will benefit our shareholders in a greater manner versus others without our experience.
In closing, when I reflect on the comment of one of our shareholders, and maybe think about what is really important, and we believe it goes beyond what we have done but rather who you become. We will become a team of people who don’t know what can’t be done. Will become a team of people who are defined by our values and beliefs, those things we would fight for and value for and die for. So while it is true that we have built one of the most compelling curated collections of home furnishings in the world, developed a proprietary platform of artisan partners that has given us a valuable competitive advantage.
Created entirely in a new direct platform and conceptualized a revolutionary new retail store concept, engineer to fully integrated multi-channel supply chain insistence infrastructure, and become the first type of retailer in modern history to achieve mid-20s comparable brand revenue growth for four consecutive years. What’s the most important is who we are, how we think, and what we believe in. That is why we achieve these results and why we believe we will be able to continue innovating, leading your industry and bringing your future dreams alive. Hopefully, we are a bit less misunderstood. Thank you for your support and interest in our journey.
Let me turn the call over to Karen to review our financial highlights for the quarter.
Thanks, Gary, and good afternoon everyone. I will first take you through our first performance and will then provide our outlook for the second quarter and upwardly revised expectations for the full fiscal year.
We are extremely pleased with our financial growth for the first quarter of 2014. During the first quarter, we delivered net revenue growth of 22% on top of 30% last year and ahead of four awesome expectations. Total revenue increased to $366.3 million driven by 24% growth in our direct channel and 19% growth in retail. Or comparable brand revenue growth which includes our direct business increased 18% on top of 39% growth last year. On a two-year basis comparable brand revenue growth was 57%. We continue to take market share as a result of a dominant assortments and superior position in home furnishing category.
We believe our industry leading growth in the first quarter is especially compelling given the fact that we have not had a Source Book in homes for nearly a year. The first quarter was positively impacted by our strategic inventory investment and continued benefits of our one Source Book strategy. By having better in-stock positions and lower back order, our conversion improved and we were able to ship and deliver products for our customers earlier.
This resulted in additional net revenue growth in the quarter that was a pull forward from the second quarter. Gross profit increased by 22% to $124 million during the first quarter. Gross margin increased 20 basis points to 34% from 33.8% last year. Our overall product margins decreased relative to last year driven primarily by square footage growth and effective inventory management in our outlet channel. However, product margins in our core business were strong relative to last year and relative to our expectations.
Our merchandize margins has expanded meaningfully with adoption of different Source Book and we believe this trend will continue through the balance of the year. During the quarter, we also benefited from improvements in our shipping cost and continue to leverage our retail occupancy cost. We experienced deleverage in our supply chain occupancy cost based on the investments we made in our DC network last summer.
Our total adjusted SG&A expenses increased 13% to a $110.4 million in the first quarter versus $97.3 million in the prior year. As a percentage of net revenue adjusted SG&A expenses decreased by 220 basis points. This decrease was driven by advertising savings resulting from the change in our Source Book strategy, which was levered on other corporate expenses. Our adjusted SG&A expenses excluding impact of a $9.2 million charge recorded in the quarter related to the developments on a significant outstanding legal claim alleging that RH requested and recorded ZIP codes for customers paying with credit cards.
Adjusted operating income increased by 204% to $14 million from $4.6 million last year. And adjusted operating margins expanded 240 basis points. Adjusted net income for the first quarter increased 217% to $7.2 million from $2.3 million last year, and adjusted diluted EPS increased 200% to $0.18. With 40.8 million diluted shares outstanding, and both adjusted net income and diluted EPS were calculated based on normalized 40% effective tax rate.
Turning to the balance sheet; inventory levels at the end of the first quarter increased by 32% to $483.5 million. This increase reflects ongoing initiative to improve our in-stock position and lower back orders and equip new products that will be introduced to our Spring 2014 Source Book and to meet the accelerated growth we expect in the second half. We ended the first quarter with a $149 million in outstanding debt versus $114 million last year, and with $230 million available on our credit facility.
Our balance sheet also reflects the gross sales of approximately $46 million of assets related to the accountings treatment of several of our full-line design gallery leases as build-to-suit leases. Under these arrangements, we're required to record an asset within property and equipment and the corresponding liability within other long-term obligations related to the landlord assets for these buildings. These assets do not impact our P&L or cash flows and are not included in our CapEx. However, similar to the capital lease, under these arrangements, a portion of our rental payments will be classified as interest expense.
Our total capital expenditures were $15.5 million in the quarter and we continue to expect CapEx in the range of $15 million to a $125 million for the full fiscal year as we execute our real estate transformation and build out of our new full-line design galleries and make additional infrastructure investments to support our growth. Our negative free cash flow was $74 million in the first quarter, reflected the timing of several working capital items, including a $30 million increase in our inventory balance since the fourth quarter, 23 million related to the timing of income tax payments and a $20 million change in prepaid expenses which is primarily due to an increase in our capitalized catalog cost for the spring 2014 Source Book.
Turning to our outlook, for the second quarter we expect net revenues to 16% to 19% in the range of $443 million to $453 million. We expect adjusted net income to increase 28% to 32% in the range of $25.4 million to $26.2 million translating into adjusted diluted EPS in the range of $0.62 to $0.64 based on 41 million diluted shares outstanding. We’re also raising our outlook for the full year. We are increasing our 2014 revenue growth target to a range 20% to 22% from our prior expectation of 18% to 20%. This will result in net revenues in the range of $1.86 billion to $1.89 billion. As we discussed with you previous we expect that our revenue growth will accelerate in the second half of the fiscal year as we benefit from the product introduced with our spring Source Books and as we execute our real estate plan.
During the second half, we expect our operating margin expansion to be primarily driven by improved gross margin as our overall SG&A expenses are expected to deleverage due to investments we’re making in new pages and extended product assortment as well as the prospecting efforts with our spring 2014 mailing. We now expect adjusted net income to grow between 33% and 37% to range of $91.9 million to $94.3 million in fiscal 2014 which assumes a full year effective tax rate of 40%. We are providing full year adjusted diluted EPS guidance in the range of $2.24 to $2.30 which assumes 41 million diluted shares outstanding. This compares to our previous expectation of adjusted diluted EPS in the range of $2.14 to $2.22.
In closing, we are extremely pleased with our first quarter performance and are optimistic about our opportunities for the remainder of the year. We continue to take market share, execute against our value driving strategies and feel confident in our ability to deliver a long term growth target and maximize shareholder value. Our long term financial goals remain as follows; revenue growth from the low 20s and adjusted earnings growth in the mid to high 20.
And with that I would now like to open up the lines for any questions. Thank you.
(Operator Instructions) Your first question comes from the line of Daniel Hofkin from William Blair & Company. Your line is open.
Daniel Hofkin - William Blair & Co.
Good afternoon. Congratulations on a great quarter. Just a couple questions. You talked about some let's say pull forward potentially from the second quarter due to higher in-stocks and some of the inventory investment. Do you have any sense for how much that might have been? And if you were to think about the sources of upside in the quarter, how much was that versus just underlying strength in the business? That would be my first question.
Yeah, this is Karen. We think that it’s hard to know exactly how much but we do have expectations for how things would convert and backwards of things and we think that about two points of the growth in Q1 was product that would adjust and that revenue would have been recorded in Q2 and instead that we recorded in Q1.
Daniel Hofkin - William Blair & Co.
Okay. And if I…
[Multiple Speakers] our guidance for Q2.
Daniel Hofkin - William Blair & Co.
Okay. So that’s right, that’s essentially for the first half it’s kind of netted out.
Daniel Hofkin - William Blair & Co.
If I remember correctly, in the first quarter of last year you had a somewhat similar phenomenon. Am I correct about that?
That is correct.
Daniel Hofkin - William Blair & Co.
Okay. And then secondly, maybe you could just comment. Obviously a lot of publicity around the new Source Books, just talk about the impressions that you're hearing from people, positive or questions that you're getting at this early stage. I know they've only been out for a few weeks at the longest.
Yeah, let’s -- this is Gary I’ll just let me take that from Q perspectives; one, we like the response we’re seeing in our business based on the books been in home so to-date if we are performing ahead of our expectations so we like to build that we’re seeing. There is obviously some social media conversions regarding the size of the book and some environmental related comments. We kind of measure social media conversions measuring mentioning Restoration Hardware and when we look at the numbers there is a tiny fraction thus far if you look at the conversations that are talking negatively about the book it’s less than 1/10th of a percent of the books mail. So while we think there is it’s going to be some people that unfortunately we mail a book to that we wish we didn’t who might have bought something in the past then for some reasons didn’t want to receive our books this time we all catch to that. But so far from our point of view from a business perspective the response has been very-very good.
Daniel Hofkin - William Blair & Co.
Great. And then I guess as far as inventory goes, can you discuss sort of going forward should we expect inventories and investment and related to the investment and fulfillment of supply chain to continue to outstrip revenue growth for still a while going forward?
They’re very much like last year in the first half we do grow inventories in anticipation of the drop of the book and then as the back half enters and work through that inventory and that is really best to meet that additional demand once you got the book. By the end of the year we would normally plan inventory to be roughly in line with sales but some of the investments we’re seeing had such a nice payoff with lesser meaning for transportation efficiencies and lower backwards and things, we’re still kind of weighing the present of how much inventory we might want to continue to invest in. So right now I would say we’ll end the year with sales growth roughly in line with inventory growth but that’s something that we’re going to continue to monitor and evaluate.
Your next question comes from the line of Matt Nemer from Wells Fargo Securities. Your line is open.
Matt Nemer - Wells Fargo Securities
Thanks. Afternoon everyone. I just had a couple of follow-up questions on the spring Source Book as well. The first being I think the e-mail follow-up that you're doing is something that we really haven't seen in retail and I think that's part of the fact that you know exactly when it's been delivered to a home. I'm wondering if that is having any impact on conversion. And then secondly, I'm wondering if there's been any unusual opt-out activity versus what is typical when you mail the Source Books.
Sure, Matt the books are still -- as of today were 45, as of today were 45% in home versus I think three weeks of a 100% in home last year. So we’re not looking at an apples-to-apples build and it was a very early stages of reading response, so it’s somewhat too early to get into the details. I think the way we planned our business and the way we planned our business to build and where it should be now. It’s trending meaningfully higher, so the early REITs with 45% of the books in home look to be better than our expectations.
And the email notifications, that gives us obviously more visibility when the books have been received have been delivered by UPS, we also understand what books might have been rejected and not wanted and so on and so forth. So we have better date around that. But nothing else that’s really unusual, our opt out is slightly higher than a year ago, but you’d expect that because the book is twice as big.
Matt Nemer - Wells Fargo Securities
Understood. Then just a follow-up for Karen. You made a comment about the gross margin that you're seeing, the merch margin you're seeing with the new spring assortment. And as we look at the second quarter, you have a very easy comparison. Can you provide a little context on how much of that we could recover in this current quarter?
We don’t want to get too specific but I would just say we do feel very confident about the merchandised margins heading into the second quarter and even in the back half. So it’s a nice compare versus last year as we’ve now anniversaried all the strategic pricing from last year but we also feel pretty good about what’s happening with margins since we dropped the book. So I’d say Q2 we feel good and some of the other components in gross margin are also moving in the right direction, we’re seeing some benefits in shipping. And then occupancy continues to kind of back and forth when we make investment and supply chain for example anniversary but we’ll have some pre-openings rents in the back half on the retail side.
So there is just little piece that’s moving back and forth on occupancy but I think merchandised margins and shipping are going in the right direction.
Your next question comes from the line of Matthew Fassler from Goldman Sachs. Your line is open.
Matthew Fassler - Goldman Sachs
Thanks a lot. Good afternoon and congratulations on a fantastic quarter. My first question is really for Gary, and relates to talking about sort of the newness in the book from a qualitative or quantitative perspective, if you can think about the turnover in product. And also given the number of books you have, I guess you have a lot of different context in which to frame the product. Can you talk about how that's influencing the way you merchandise it, and what kind of response you're seeing for that so far?
That’s a very early data and I think on the new goods and we’re very happy so far with the early response as it relates to turnover in the products in elimination. We probably have a lower turnover or lower elimination rates than most people because we have what’s developing what I call more of a long tail business because of the multi-channel platform and the percentage of our business that really happens in a direct point of view. I mean if you think about our stores, really showrooms for our product and we have developed a direct model it’s a very low cost model. So the hurdle rates for products to be profitable on our model are relatively low which is kind of a new emerging model, so that gives us the opportunity to have a longer tail from a product perspective and a broader assortment. So most of the assortment, newness is incremental and not replacing, discontinued product has -- always some discontinued products but we got -- we're pretty creative in density and how we merchandise and how we drive productivity, as well as the mailing cycle is obviously changed the hurdle rates and return methodology as you think about where you’re investing inventory.
Matthew Fassler - Goldman Sachs
That's very helpful. Just a quick follow-up. If you think about the performance of the direct business in the markets where you've opened the newer and larger design galleries, I know that historically those markets have great market growth on the direct side. If you can just give us an update as to what you're seeing in those five or six markets where you have those stores.
That’s continued to slightly different by markets. Some are better than others but they’re all positives. And we’ve seen on average nothing has changed but the aggregate portfolio, so the early points we’ve made about when we open a big store in the market, it drives greater brand awareness more people purchase with the brand both in retail and direct. We believe we will continue to be a viable part of our strategy.
Your next question comes from the line of John Marrin from Jefferies.
John Marrin - Jefferies
Hi, guys. Thanks and congratulations. So that 18% comp is pretty stellar. I was just hoping maybe you guys could talk a little bit more about what was driving that: comp, traffic ticket, furniture versus non-furniture? And then Gary I was hoping maybe you could update us on your hunt for real estate, and what you're learning about availability and the size of the stores you want to go to market with. And I will go from there.
Unidentified Company Representative
John, we don’t really disclose traffic versus picking average orders prices and things, but I would just say that across the board we’re pretty pleased as you know with the direct and retail channel and I think our comp just demonstrates that people really like our product and we do think we’re taking market share. So again we think it was pretty solid. Our furniture penetration did not grow significantly it has in the past, but seems to be stabilizing out with growing really significant over the four years and now it’s not making as meaningful growth in that one specific category. So we’re pretty happy with that because it does have positive impact on the transportation side though it’s still growing but not to the same percentage.
How is the real estate update -- I think we have great momentum building in the developer community. We have a lot of optionality. We just go back recently from the ICSC the retail RECon conference in Los Vegas, which is the biggest retail real estate conference I think I believe in the world and every major developer there and we that the response to our new concept -- I believe we’re one of the most in demand concepts for developers today and so we’ve got a lot of options. I think the developers are partnering with us, thinking in more creative ways and then they have for probably other retailers.
And in some cases they’re adding this on as an anchor and reconfiguring shopping centers or some cases were you’re aggregating space for us and in some cases where there is street development there we can anchor street or a neighborhood and in development area. So we’re pretty flexible on our side whether we go mall or non-mall. And what’s happening in the non-mall location is because we can bring value to neighborhood and you’ve got people who can aggregate space where we’re able to do very good deals in that way too. I think it’s funny.
I think there is quite a few people at the opening of our Greenwich store and that to see that it got to be opening event and opening party and we’re asking this is the amazing building amazing stores. Something made a comp to me as much because you’re a lot more than you current existing stores and what’s interesting there -- the another what I call partnership win-win development play, we identified that building it was coming up for sale. We found a REIT and some of the partners want to buy that building. We pre-negotiated at least arrangement in that building. So they knew what the arrangement it’s going to be and they knew how much they could buy the building for. We wind up with a space that has three times the exterior space, four times the selling space, three times exterior space at basically the same rent is our 55,000 square stores in Greenwich avenue.
So when you think about -- there is all kinds of good occupancy opportunities for us to create deals where we have significantly more space significantly more dominant locations at significantly reduced occupancy per square foot. In some cases if you’re doing a store that’s three times the size, we might be able to hold occupancy in about the same rate where we’re going to store that might seven times the size and same for our next generation design gallery that we’re seeing occupancy rates that are maybe 30% to 50% higher for six to eight times square footage, so significantly down per square. So we’re very happy to -- we think this real estate model that we’re developing is transformative and revolutionary in the industry. I mean, I -- if you step back and say, when is the last time someone had a luxury, semi-big box kind of play, the last person I can think of that have meaningful play like this was Nordstrom (ph) and that was back in the 80s and 90s. And so we are -- in many cases it is been seen as an attendant in this deals or somewhat M&A pertaining (ph) in neighborhood. So we’re very excited. We’re very excited to get out of the auctions auction space, you know at the middle of the mall, where these auction is based, they we no longer in that situation and we’ve got a very different economic model because of that.
John Marrin - Jefferies
Okay. Great. And I was wondering, if you guys want to share or you have shared another catalog you send out this spring?
We don’t do that.
John Marrin - Jefferies
Okay. All right.
We believe that there’s been competitive information that we’re not going to disclose.
Your next question comes from the line of Brad Thomas from KeyBanc Capital Markets. Your line is open.
Brad Thomas - KeyBanc Capital Markets
Thank you and let me add my congratulations as well on a great quarter. Just a follow-up on that last question about the new Full Line Design Galleries. I think you all alluded to six stores that you've signed already and negotiations for another 25. What do you think the number will shape up to be for 2015, and what's about the maximum that you feel comfortable pursuing in one year?
I believe on the last call we try to transition everyone from thinking about unit growth to square footage growth, because that’s really how we look at it. When you got sizes ranging from 25,000 to 60,000 square feet, we believe it’s the right way to think about the real estate strategy with the square footage growth that we’re going to achieve each year. I think it’s the last, how we guided 30% to 40% square footage growth for 2015. And we’re comfortable with that number.
Brad Thomas - KeyBanc Capital Markets
Okay. Great. And Gary, just a follow-up on some of your introductory comments. It seems that the Company has a tremendous opportunity to source better than its competition and source even better in years down the road. What do you think the benefit to procurement costs could be as you continue to develop the infrastructure?
Yes. There’s really two things, if -- clearly, if you have unique products, you’ve got more blind pricing, the more pricing power in the market place. And two, as our -- as we build this railroad the railroad becomes more efficient right? The more we invest and the greater the platform is the more it can do for us and more leverage we get. So the first five, six years of building that was very, very difficult and not that it’s not still difficult, but we had a conceptualize, can people running a $5 million business becomes a $50 million supplier for us. The first going from 5 to 10 or 5 to 15 or 5 to 20 was shaking in difficult, right because you’ve got a vendor base that was undercapitalized, under resourced, but had the talent to know how and desire to do it. I mean they knowing people that we found it could actually do it, but they had a partner within they are investing them in multiple different ways, every one of our structures was different.
Now, the real business is and is a real platform and a real partnership. Someone was asking me the other. Do you have contracts with all of these people? And I said now we have relationships with all these people. We are deeply connected both from a business point of view and from a value point of view and it’s every bid is much they feel is their company and vice versa. We like to say. We’re shop keepers without factories and our partners are factories without stores and so one needs the other to really win.
But there’s -- obviously as we work together and become more strategic and thoughtful and how we manage that we expect to have more and more efficiencies and whether it’s buying power raw materials, whether it’s leverage on their investments and occupancy, whether leveraging in the amount we buy and then the foot side of having very unique product in the market place. And the pricing power you might get in/. And so one of the things you’re going to see this year is combination pricing power in some of these efficiencies come through in our merchandise margins we feel very confident that, we’re going to have meaningful moving in merchandise margins this year.
And we probably have upside as we look forward. But every time you turn the corner, you see more opportunities, we don’t want committed too much but we have great visibility this year and the early response to the pricing structure that we have in place on both existing the new product will tell us we’re going to have a very good year from a product margin perspective.
Your next question comes from the line of Peter Benedict from Robert W. Baird. Your line is open.
Peter Benedict - Robert W. Baird
Hi, guys. Thank you. Karen, could you spend a minute maybe expand on some of the drivers of the SG&A deleverage in the second half. Kind of what in particular's driving that, you mentioned a couple of things but maybe any more color.
Sure. So we have talked about the first half, we are being continue to benefit the change of the Source Book strategy but as we enter the second half that's when we're going to anniversary those savings. That's also where that significant step change we had in our business, we are going to add on top of that, the anniversary of that that new investments that I mentioned before in the new pages the new assortments as well as the prospecting efforts for the 2014 mailing. So overall, we expect modest leverage in SG&A for this full year in most of our operating margin expansions going to come from the improvements in gross margin. In the first half we had a lot of advertising leverage. In the second half we're going to make those investments. All in all in the year our advertising will be roughly flat as a percentage of sales.
And let me just add to that. I think the way to think about this is we basically doubled the page count, and half of the book, were not yet optimized. Its new product, it’s newly presented, we’re going to learn a lot on all those new pages. We would project that those pages will be less optimal than the existing pages, just because we’ve been able to go back and merchandize those in size and look at density and all the things you’re doing in a direct business to optimize. Any time there significant growth in page count or assortment, you’re never going to have complete optimization in productivity nor will you in inventory investment. So that's why we think we've got to leave ourselves room from an inventory point of view because we’re not going to be optimized with this kind of growth. The other piece here is prospecting. We have increased prospecting as we have very good response rates and we want to continue to build our filings and build our direct business. And prospecting is an investment. You don’t get paid at the same rate of return from a time point of view as you do on a mailing to your house file. So when you think about prospecting, you got a think about an 18 month tail, and in our case, in our business a 24 month tail. So you’re going to have -- initially that’s going to take a while to have the payback, so those two things together in the second half, we’ve positioned, we believe we will have deleverage on advertising; and anybody making a move like this would. But we believe that as we follow up on the next year, there’s opportunity, and optimize that page count - we will start to optimize the prospecting and probably leveraged in the other years.
Peter Benedict - Robert W. Baird
That's helpful. Thanks, Gary. Then just circling back on the merch (ph) margin, Karen you had mentioned that you've seen some improvement here with the new Source Book out there. I know it's early but are there any can categories in particular that are helping drive that? I know you've got a lot of new stuff in there. But just curious what you're seeing from a category perspective.
Yes, we don't disclose that kind of category information, and what is that category, but again we’re just pleased overseeing some far with a drop enough so that, so you guys will feel good about for Q2 and into the back half
And I say, and generally it’s by category, it's responding as we planned. Directionally, it's kind of as expected.
Your last question comes from the line of Lorraine Hutchinson from Bank of America Merrill Lynch, your line is open.
Lorraine Hutchinson - Bank of America Merrill Lynch
Understanding that you're in investment mode right now as you transform the business, I was just wondering how you're thinking about return on capital and when we'll see ROIC and free cash flow really start to accelerate.
I think the real question, right, is as we begin the roll-out and significant capital deployment of the next generation full-line design galleries, the productivity of those galleries, how we wind up, fine tuning the investment in those galleries, and the productivity of the galleries and the effect in the direct business, when you put one of those new galleries in the market, it’s going to really have the biggest determination on that metric. I think I said on the last call, we have been -- we designed the next generation design Gallery and then we had time now to go back and design several of them and start to think about square footage and optimization, whether it’s shrinking the storefront from 200 square feet to a 100 -- I think we’re down to 172 feet, right, and it used to be 110 feet deep. And now it is 89. And so the size of the box gets smaller without changing any product density. I mean the first design, you know the architects designed it somewhat bigger and as we started merchandizing it, planogramming it, we are able to make the box more efficient. The new look at things like, you need all the ceiling heights to be 18 feet clear, they need 18 feet clear in the first floor and to the second floor to be 14 feet clearance, third floor would be 14 foot clearance, how do you optimize, all of that is -- dollars per square foot as far as how many walls you build, or how high you build the walls and what the cost is and how many doors and windows, how you value engineering the doors and windows. I'll tell you exactly what we told our Board a couple of weeks ago. We believe from our initial -- directionally our initial thoughts in our five-year plan that we believe there is an opportunity to reduce the store cost by somewhere in neighborhood of $1 million to $3 million per store on these next generation design galleries.
We’ve got to build the field but we’ve already got early numbers in on value engineering and ordering differently and sourcing differently and optimizing the size of the box et cetera. If you say, hey, you’ve got just the simple math 50 stores and you say the million of box stores that’s $50 million in cash. If you say $3 million a store it’s $150 million in cash. If we gave in smarter -- we can say $4 million a store that’s $200 million in cash, right. So that significantly changes the cash flow of the business and when will get the free cash flow positive, the same things happen on the performance of these stores, right.
And so if you’ve got the stores operating it X dollars per square foot and they do 10% or 20% more than that is going to change through return profile of these stores. And so we’re going to learn a lot with Atlanta and we are already value engineering the build outs of the stores going forward. We’re getting smarter all the time here and then everything in our company beyond that goes through very rigorous capital review and return on capital investment review. We probably have 100 ideas here a year that would we like to -- the people would like capital for and that gets forced strength down to that top 10 or 12 things. And their all forced rank based on two things, one is what is the financial value that the Company what is the strategic value of the Company, and the capital allocation into both financial and human capital gets employed based what the returns are going to be both financially and strategically.
And that’s how we decide to deploy capital and it’s funny because we’re pretty big company. We operate like very little company. And I don’t think anybody spend $100,000 here without coming and sitting in front of the executive committee and talking about where we’re going to invest $100,000 and what we’re going to get for it. So I think we’re as disciplined is any kind of retail company out there I think our five years in the stewardship of private equity ownership that we develop really-really good capital discipline. And I think we all learned a lot here and we’re so much smarter and grateful for that experience. I think about it how it’s changed myself and changed our team. We look at our investments just like probably an inventor look to their portfolio, right.
And where do we think asymmetrical risk? Where do we think we have the most upside? How much we want to invest here? How much we invest here? Then what are the low level things we’re going to see? But it’s -- I think for many times in point in time in history and I’ve been in this business for over 30 year, I think we’re as disciplined capital stewards as any retail company actually.
There are no further questions at this time. I’ll turn the call back over to Mr. Friedman for closing remarks.
Great. Well, thank you everyone, we appreciate your support and interest in our company. We’re very-very excited in private the results that we’ve achieved. I want to thank all of our team members and partners around the world and throughout our stores organization. We couldn’t be more excited about what’s happening in this Company and with this brand. And we’re very excited to talk to you next quarter, so we’ll talk to you soon. Thank you.
This concludes today's conference call. And you may now disconnect.
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