Williams Sonoma, Inc. Q2 2007 Earnings Call Transcript

Sep.18.07 | About: Williams-Sonoma Inc. (WSM)

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Williams Sonoma, Inc. (NYSE:WSM)

Q2 2007 Earnings Call

August 29, 2007, 10:00 AM ET

Executives

Stephen C. Nelson - Director of IR

W. Howard Lester - Chairman and CEO

Sharon L. McCollam - EVP, COO and CFO

David M. DeMattei - Group President, Williams-Sonoma, Williams-Sonoma Home and West Elm Brands

Laura J. Alber - President

Analysts

Armando Lopez - Morgan Stanley Dean Witter

Rexford Henderson - Raymond James & Associates

Lauren Levitan - Cowen and Company

Matt Nemer - Thomas Weisel Partners

Jack Murphy - William Blair & Co.

Neely Tamminga - Piper Jaffray

Janet Kloppenberg - JJK Research

Christopher Horvers - Bear Stearns & Company

Laura Richardson - BB&T Capital Markets

Colin McGranahan - Sanford C. Bernstein

Presentation

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Williams-Sonoma Incorporated Second Quarter 2007 Earnings Call. At this time all participants are in a listen-only mode. We will conduct a question-and-answer session after the presentation. This conference is being recorded.

I would now like to turn the call over to Steve Nelson, Director of Investor Relations at Williams-Sonoma Incorporated, to discuss non-GAAP measures and forward-looking statements.

Stephen C. Nelson - Director of Investor Relations

Good morning. This morning's conference call should be considered in conjunction with the press release that we issued earlier today. I would first like to discuss the non-GAAP financial measures that are included in this morning's press release and today's conference call. In our press release, we announced operating results for the second quarter of 2007 that included and excluded $0.006 diluted earnings per share impact, the New Accounting Pronouncement FIN 48, FASB Interpretation Number 48, accounting for uncertainty in income taxes.

The earnings press release also contained comparisons that included and excluded a $0.05 per diluted share of net benefit from unusual business events in the second quarter of fiscal year 2006. In the Guidance section of the press release, we have included and excluded a projected $0.03 per diluted share impact of FIN 48 for fiscal year 2007, and a $0.007 per diluted share impact for the third quarter of 2007. We also compared our fiscal year 2007 guidance to our fiscal year 2006 operating results that included and excluded a $0.03 per diluted share net benefit from unusual business events.

For the remainder of today's call, we will be discussing our second quarter 2007 results, our quarterly and fiscal year 2007 guidance, and our fiscal year 2006 results excluding the impact of these items, and we will refer to these results as non-GAAP. These non-GAAP financial measures are provided to facilitate meaningful year-over-year comparisons. A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures, and an explanation of why these non-GAAP financial measures are useful, and how they are used by management, are discussed in Exhibit 1 of the press release.

I would now like to discuss our forward-looking statements. The forward-looking statements included in this mornings call, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements address the financial condition, results of operations, business initiatives, guidance, growth plans and prospects of the company in 2007 and beyond, and are subject to certain risks and uncertainties that could cause actual results to differ materially from such forward-looking statements. Please refer to the company's current press release and SEC filings, including reports on Forms 10-K, 10-Q and 8-K for more information on these risks and uncertainties. The company undertakes no obligation to update or revise any forward-looking statements to reflect events or circumstances that may arise after the date of this call.

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

W. Howard Lester - Chairman and Chief Executive Officer

Thank you Steve, and good morning and thank you for joining us. With me today is Laura Alber, our President; Pat Connolly, our Chief Marketing Officer; Sharon McCollam, our Chief Operating and Chief Financial Officer; and Dave DeMattei, our Group Vice President for the Williams-Sonoma, Williams-Sonoma Home and West Elm Brands.

I want to begin today with an overview of our second quarter 2000 [ph] business results and then a high-level outlook for the balance of the year. Sharon, Dave and Laura will then follow-up with the financial and brand detail... brand label details.

Although the economic environment in the home furnishing sector in the second quarter was one of the most difficult we have seen, we delivered year-over-year revenue growth of 4.1% and non-GAAP diluted earnings per share of a better than expected $0.24. This is $0.06 above the high end of our guidance. Also during the quarter, we repurchased 2.6 million shares of our common stock. We are very proud of these results and believe that they once again demonstrate our ability to manage our business during tough difficult economic times.

In our core brands, which include Williams-Sonoma Pottery Barn and Pottery Barn Kids, net revenues in the second quarter increased 1%. These results were in line with expectations, despite higher back orders at the end of the quarter. We were particularly pleased with the progress we made on our Pottery Barn initiatives during the quarter.

In our emerging brands which include West Elm, Williams-Sonoma Home and PBteen revenues increased to better than expected 39.4%, with strong growth across all brands and channels. Like the core brands, increased back orders in addition to higher customer service orders and transits, negatively impacted second quarter growth.

During the quarter, we continued to make strategic advancements in our supply chain infrastructure. From assistance perspective, we rolled out our new retail inventory management system to our West Elms and Williams-Sonoma Home brands. In the supply chain organization, we consolidated our returns processing operations into one dedicated location. This initiative is expected to result in the more rapid identification of return-related trends, in addition to lower operating cost. We also expanded our west coast distribution center, which facilitated the in-sourcing of our west coast furniture hub operations. As you might recall, this initiative on the east coast in 2006 allowed us to improve the furniture return rates in that hub by 30%, compared to the other hubs in the region.

As we look forward to the third quarter and the balance of the year, we are continuing to focus on the execution of two of our more strategic initiatives. Driving top line revenue growth across all our brands and optimizing our pre-tax operating margins, through operational advancements and cost-containment initiatives. Within these initiatives, our top priority continues to be the revitalization of the Pottery Barn brand. And we are pleased with our results to-date. Laura will provide you with the further update later in today's call.

Consistent with our strategic initiative to drive profitable top line revenue growth, we are investing in the growth opportunities that we believe will provide the greatest returns in both our core and emerging brands. In the retail channel, we are expecting to add 11 net-net new retail locations throughout the year, seven of which are in our emerging brands. We are also expanding the square footage of 20 of our existing stores and remodeling three additional stores in place.

In the direct-to-customer channel, we'll continue to leverage the rollout of our Pottery Barn Outdoor catalog into the third quarter, in addition to launching our new website in the Williams-Sonoma brand in the fourth quarter. We also expect to increase catalog paid circulations in both our core and emerging brands, as well as increase the marketing behind our fastest growing channel e-commerce.

To support all of these growth initiatives, we are continuing to invest in our supply chain infrastructure, including the expansion of our west coast distribution and furniture hub operations, the consolidation of our returns processing facility, and the integration of our recently acquired European sourcing company. We are also intensifying our sourcing and quality control operations in Asia and leveraging our in-sourced domestic furniture operations as part of our ongoing effort to reduce furniture returns, replacements and damages. Although these initiatives may result in short-term pressure on earnings, we believe the impact will be more than offset overtime by our continued ability to drive greater efficiencies in our supply chain operations and overhead cost structure.

Regarding the home furnishings environment for the third quarter and the balance of the year, we believe an ongoing cautious outlook is appropriate. Therefore we are reiterating our third and fourth quarter revenue and diluted EPS guidance. We are however, raising our full year non-GAAP diluted earnings per share guidance by $0.06 to the range of a $1.82 to $1.90, based on our better than expected earnings results in the second quarter.

Let me now turn the conference call over to Sharon and... to further discuss our second quarter results and provide additional details on our 2007 guidance.

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

Thank you Howard, and good morning. I would now like to first talk about our second quarter earnings results. As a reminder, financial comparisons maybe on a non-GAAP basis as described by Steve earlier in today's call. In the second quarter of 2007, non-GAAP diluted earnings per share decreased 4% to $0.24 versus $0.25 in the second quarter of 2006. Throughout the quarter, we remained intensely focused on our operational execution and our cost-containment initiatives, which allowed to us deliver diluted earnings per share. That was $0.06 above the high end of our guidance and $0.08 above the first call estimates.

The three key drivers of these better than expected results versus our guidance were as follows; first, we saw significantly better than expected results in the Williams-Sonoma and West Elm brands due to strong margins, solid cost discipline and continued productivity in the direct-to-customer channel. Second, we saw better than expected catalog productivity in selling gross margins in the Pottery Barn brands. Remember, last quarter, we reduced our operating margin expectations to reflect the risk of a more promotional environment. While we did see increased promotional activity, it did not reach the levels we anticipated.

And finally, we saw a better than expected productivity in our distribution and call centers, in addition to lower overhead costs due to the aggressive management of our variable and discretionary costs.

Net revenues in the second quarter of 2007 increased 4.1%, to approximately $859 million versus the second quarter of 2006. Excluding the negative impact of the shutdown of Hold Everything, net revenues increased 4.6%, including a 5.1% increase in the retail channel and a 4% increase in the direct-to-customer channel. Comparable store sales increased a better than expected 1.2% during the quarter. Retail leased square footage increased 4.1% including seven net new stores. Catalog circulation during the second quarter, excluding Hold Everything, increased 9.3% while paid circulation increased 9.5%. This compares to catalog circulation increases of 2.1% and a paid circulation increase of 7.6% in the second quarter of 2006.

Gross margin expressed as a percentage of net revenues in the second quarter, was 37.2%, a 100-basis point decrease on a non-GAAP basis from 38.2% in the second quarter of fiscal 2006. This decrease was primarily driven by increased markdowns and higher cost of merchandize sold in our Pottery Barn and Pottery Barn Kids brands, and increased occupancy costs. The increased occupancy costs as a percentage of net revenues was primarily driven by the retail rollout of the emerging brands. These costs were partially offset however by the elimination of all cost of goods sold associated with the Hold Everything brands.

SG&A expenses as a percentage of net revenues in the second quarter were 32.3%, a 40-basis point decrease on a non-GAAP basis from 32.7% in the second quarter of fiscal 2006. This 40-basis point decrease as a percentage of net revenues was primarily driven by reduced advertising expense, primarily in the Pottery Barn and Pottery Barn Teen brands, reductions in other general expenses, and the elimination of all SG&A expenses associated with the Hold Everything brands. These decreases were partially offset by increased cost associated with the growth of the emerging brand.

The effective income tax rate in the second quarter was 40.2% versus 38.4% in the second quarter of fiscal year 2006. This increase was primarily driven by the application of FIN 48 accounting for uncertainty in income taxes, which we implemented on January 29, 2007. The application of this accounting pronouncement resulted in an approximate 160-basis point increase in the effective income tax rate in the second quarter of fiscal year 2007.

I would now like to discuss significant year-over-year working capital balance sheet variances. All comparisons are versus quarter-end balances at the end of the second quarter of 2006, which are included in this morning's press release financial statements. Cash and cash equivalents at the end of the second quarter of 2007 were $58 million, after returning over $260 million to our shareholders, through share repurchases and dividends over the past 12 months. Our consolidated statements of cash growth are included in this morning's press release.

Merchandized inventories at the end of the second quarter of 2007 increased $86 million or 15.1% to $651 million on revenue growth of 4.1%. Of this increase, approximately 30% was driven by the emerging brands in line with sales growth, 20% in the Williams-Sonoma brand due to a year-over-year mix shift towards a higher-end assortment, and 50% in the Pottery Barn and Pottery Barn Kids brands driven by increased core inventory levels, as a result of slower sales growth.

Customer deposits at the end of the second quarter of 2007 increased $26 million to $201 million. This 14.8% increase was driven by a year-over-year increase in customer orders in transit at the end of the second quarter and an increase in unredeemed gift cards. Accounts payable at the end of the second quarter of 2007 was $206 million, up 9.1% from last year. This increase was primarily driven by the timing of payments in merchandising catalog payables at the end of the second quarter.

I would now like to briefly discuss our third quarter and fiscal year 2007 guidance. As a reminder, fiscal year 2007 is a 53-week year. The 53rd week is expected to add approximately 200 to 210 basis points of revenue growth, and 280 to 400 basis points of non-GAAP diluted earnings per share growth, to our fiscal year 2007 results. Conversely, we will see a negative impact of this in 2008. As we look forward to the third quarter and the balance of the year, recognizing that approximately 58% of our full year revenues and 80% of our full year earnings will be generated in that timeframe, we are remaining cautious in our outlook, based on the ongoing softness we have seen in the home-centered retail environment. That said, our guidance for the year has consistently reflected this outlook. Therefore, we are reiterating both our revenue and our diluted earnings per share guidance for the third and fourth quarters. We are however, increasing our full year diluted earnings per share guidance by $0.06, to $1.82 to $1.90 to reflect our better than expected results in the second quarter.

I will now turn the call over to Dave DeMattei to discuss the Williams-Sonoma, Williams-Sonoma Home and West Elm Brands.

David M. DeMattei - Group President, Williams-Sonoma, Williams-Sonoma Home and West Elm Brands

Thank you Sharon and good morning. I would like to begin this morning by discussing the performance of the Williams-Sonoma brand.

Despite a challenging retail environment, the Williams-Sonoma brand in the second quarter exceeded expectations on both the top and bottom lines across all channels. Net revenues increased 2.2% and the consumer response to our Father's Day and Outdoor themes were strong. We also saw an ongoing improvement in our merchandised margins. In the retail channel, we had a positive 1.1 comparable store sales increase and we continued to be pleased with performance of our re-merchandised small and mid-size stores.

In the direct-to-customer channel, we delivered the second... highest second quarter operating margin in our history, primarily driven by a strong consumer response to our seasonal merchandising strategies, continuing momentum in e-commerce, both in traffic and conversion and the ongoing success of our versioned catalogs. Higher response rates from paid search and electronic direct marketing also contributed to these year-over-year better than expected results. From a brand merchandising perspective, during the quarter, we continued to see strong growth in Cook's Tools, Electrics and Cookware as well as Outdoor merchandise.

As we look forward to the third and fourth quarters, we are doing so with a continued sense of caution, due to the overall softness in the macro-environment. We have however, made significant progress toward our 2007 initiatives and expect to continue to do so in the back half of the year. These initiatives include: leveraging our key vendor partnerships to introduce unique and exclusive products at a broad range of price points; launching the first phase of our website redesign, including expanded product information and How To [ph] videos; expanding our in-store marketing activities, including more interactive technique classes and an updated sales training program for all associates; and introducing new table-top and entertaining assortments to drive increased sales per square foot and an improved bridal experience.

We believe that all of these initiatives will enrich the shopping experience for our customers and advance the brands authority as the destination for high-quality cooking accessories, gift giving ideas and home entertaining essentials.

I would now like to update you on our progress in the Williams-Sonoma Home brand. As you recall, driving superior execution is our top priority and we continue to see ongoing improvements. During the second quarter, we continued to broaden our merchandise assortment, rationalize our catalog circulation strategy, leverage our e-commerce website and accelerate our year-over-year growth in both the retail and direct-to-customer channels. All of these initiatives resulted in a significant year-over-year improvements in the brand's overall performance.

In the retail channel, growth was driven primarily by incremental sales from new stores and an expanded retail merchandise assortment. Within the quarter, we successfully transitioned to a semiannual sales event strategy that allowed us to more effectively clear merchandise and better maintain our premium brand image on the sales floor. In the direct-to-customer channel, we continue to drive brand awareness through page search and build upon the momentum, driven by last year's catalog redesign and the e-commerce website launch in fall of 2006.

From a brand merchandising perspective, we continue to see positive consumer response to the furniture and decorative accessory categories. As we look forward to the back half of the year, we will open one additional store and focus on the following brand-building initiatives: Increasing brand exposure through leveraging the namesake Williams-Sonoma brand, expanding our merchandise assortment to drive greater sales productivity, including the introduction of the Chambers heritage wedding collection and enhancing the holiday gift-giving assortment, including a broader range of price points and an improved visual presentation. We believe all of these initiatives will drive increased sales and improved execution in the back half of the year.

I'll now provide you with an update on West Elm. We continue to be extremely pleased with the performance of the West Elm brand, which significantly exceeded top and bottom line expectations in the second quarter. In the retail channel, revenue growth was primarily driven by incremental sales from new stores and a significantly expanded retail assortment across all stores. In the direct-to-customer channel, year-over-year revenue growth was driven by higher conversion rates and increased catalog circulation. Traffic on our website increased over 15% and our initial test on shipping rate options resulted in an increase in consumer response. We will continue to test additional options in the back half of the year in an effort to drive increased average order size and higher conversion rates.

From a brand merchandizing perspective, we saw strong consumer response to our summer merchandise assortment. Furniture and selected textiles, including new product introductions continue to be key drivers of growth during the quarter. As we look forward to the third quarter and the balance of the year, we are encouraged by the increasing rate of improvement we have seen in the brands performance this year, and are optimistic about the initial consumer response to our fall merchandizing initiatives. We are also extremely encouraged by the overall performance of our stores, including the opening of our first flagship store in Washington DC earlier this month, which opened with record-level sales.

During the back half of the year, we will continue to focus on a number of brand-building initiatives, including launching the private label credit card in the retail channel in the third quarter, followed by the direct-to-customer channel later in the year rolling out a new marketing campaigns setting around people designing style and introducing new merchandise line extensions and expanded holiday gift-giving strategies.

In closing, we believe our unique design-driven merchandise offering is a significant competitive advantage for the West Elm brands. I would now like to turn the call over to Laura to discuss the Pottery Barn brands.

Laura J. Alber - President

Thank you Dave. Good morning. First, I would like to start with the Pottery Barn brand. Net revenue in the Pottery Barn brand increased 1% in the second quarter, continuing the reversal in trend from negative growth in the back half of positive... back-half of 2006 to positive growth in the first half of 2007. We are particularly pleased with the rebound in the retail channel, which delivered a better than expected comparable store sales increase of 1.8%. In the direct-to-customer channel, growth was negatively impacted by higher back orders and lower shipping revenue.

From a merchandising perspective, we saw strong growth in furniture and textiles. These increases however were offset by continued softness in decorative accessories and tabletops. From an operational perspective during the quarter, we continue to focus on the revitalization strategy for the brands. Our year-to-date results clearly demonstrate that we are working on the right initiatives and we believe the overall strategy represents a significant opportunity for the brand long term.

Our first initiative is to make our products more differentiated and relevant. Today, we have substantially reengineered our product development cycle, including shortening the design window, reducing our sample time and eliminating other risk [ph] administrative processes. All these changes will reduce our time to market, which will ultimately allow us to read seasonal market trends prior to placing next season's orders, in addition to offering our customers new ideas faster than ever before.

Our second initiative is to reintroduce value into the brand, from both a range of price points and the shipping perspective. Today, we have made significant progress on this initiative, including a full review of our product offerings and ongoing changes to our shipping charges. We are seeing positive consumer responses to both of these initiatives.

Our third initiative is to optimize sales productivity in our small and mid-size stores. We are in the process of reworking our first pilot store and will continue to monitor the results as ongoing changes are made.

Our fourth initiative is to refine our catalog circulation and customer contact strategies to drive increased sales and higher catalog productivity. Today, we have performed two tests on versioned catalogs, and the results were positive in both cases. Based on these results, we are expanding our test in the back half of the year and anticipate a further rollout in 2008.

Our final initiative is to address the opportunity we are seeing with brand extensions. To-date we have significantly increased the circulation of our Pottery Barn Outdoor catalog and expanded the assortments in our Pottery Barn Bed and Bath stores. Both of these initiatives have driven increased sales and are proving to be catalysts for new ideas for both the retail and direct-to-customer channels in the future.

As we look forward to the back half of the year, we are remaining cautious in our macro outlook. We are however encouraged by our first half of the year results, and our assortment strategies in the back half. Overall, the consumer response to our new merchandising strategies has been positive. We have a significant number of new product introductions planned for the third and fourth quarters that we are very excited about. While we recognize that our revitalization initiatives are going to take several quarters to fully implement and additional time to analyze, we are very confident in our execution and encouraged by our progress to-date in this difficult macro-environment.

I would now like to talk about Pottery Barn Kids. Although our results for the second quarter in Pottery Barn Kids were better than we expected, it was a difficult quarter. Ongoing macro pressure, challenging year-over-year comparisons and lower shipping revenues negatively impacted top line revenue growth in both channels. During the quarter, net revenues decreased 3.2% versus a 16.8% increase in the second quarter of 2006. In the retail channel, comparable store sales decreased 3.8% versus a record 8.1% increase in the second quarter of 2006.

In the direct-to-customer channel, growth was negatively impacted by higher backorders and lower shipping revenue. From a merchandising perspective, during the quarter, we saw positive growth in decorative accessories and apparels. All other categories were negative, particularly in furniture where we saw high backorders due to vendor quality issues. In the nursery category, these issues will result at the beginning of this quarter.

As we look forward to the balance of the year, we will continue to be cautious in our outlook, but are optimistic about the aspects of the business that we can control. We are excited about the merchandising strategies that we are rolling out in the back half of the year, including significantly expanded back-to-school, holiday including a substantial greater presence in Halloween and increased gift giving. In addition to these top line initiatives like Pottery Barn, we are going to test versioning of our catalog, beginning this quarter. We believe this initiative could drive increased sales in all channels and higher catalog productivity, in addition to enabling us to identify new customers for the brand. Despite the current challenges that we are working to overcome, we believe we are well positioned to successfully carryout our brand-building initiatives and to further established Pottery Barn Kids as the authority in children's homes furnishings.

I will now update you on Pottery Barn Teens. We are extremely pleased with the performance of the Pottery Barn Teens brand in the second quarter. Year-over-year net revenues increased 17.7% and we saw a positive consumer response to both our summer and fall merchandise assortments. From a merchandising perspective, growth was positive in all key categories with particular strength in furniture, textiles and decorative accessories. Increased newness and a relevant on-brand presentation drove these results and continued to attract new customers for the brand.

As we look forward to the third quarter and back half of the year, we are encouraged by the initial consumer response to our fall and back-to-school merchandise assortment. We also have set-up our new product offerings which are innovative and unique, and designed specifically the teen market.

I would now like to open the call for questions.

Question And Answer

Operator

Thank you. The question-and-answer session will be conducted electronically. [Operator Instructions]. And as a reminder callers are only allowed to ask one question today. Once again callers are only allowed to ask one question today. And we will take our first question from Armando Lopez with Morgan Stanley.

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

Good morning.

Armando Lopez - Morgan Stanley Dean Witter

I guess my question on Pottery Barn. If you could maybe talk a little bit about when you see the comp... the 1.8% positive comp like... do you think all of that or most of that is from execution or are you seeing some change in the underlying market? And then also if you could elaborate somewhat on the test store that you guys have been working on, and when you think... how that's proceeding relative to plan and what are you thinking about the rollout?

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

Thank you Armando. I am going to ask Laura to please talk about Pottery Barns.

Laura J. Alber - President

Hi Armando. So as I have been talking about all year, when we saw softness last summer in the Pottery Barn brands, we really put together a big focus strategy to improve our performance. And I went through those key initiatives in my prepared remarks. However... and really all of them contribute to the success that we are seeing in bringing that brand back to positive growth. And it's... I wouldn't say that it's one thing, it's many things done well, and we continue to see that we have lots of opportunity to continue to further those initiatives and adjust them as the market changes.

As far as the test store, we did re-merchandise one store and tried some new fixtures and that has been a very good process for all of us in looking at what the opportunities are. It's been... it's still really early in this initiative and we are looking to as many different stores of different sizes and also of different ages. And we did one store that had an all fixture pack and we are looking to do an additional store this quarter with a newer fixture pack, where we believe we can impact our key businesses that we believe have more growth potential than others, and we are going to do that this quarter rather than going to look at both sets of numbers combined and what kind of strategy for rollout into next year.

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

And Armando, it relates to your question about how we felt about the macro-environment I think in Howard's prepared remarks, he mentioned that the second quarter was probably one of the more difficult quarters that we have seen. And that we are continuing to be cautious. But there was no question that there was macro-pressure on all of our businesses during the second quarter.

Operator

And our next question comes from Rex Henderson with Raymond James and Associates.

Rexford Henderson - Raymond James & Associates

Good morning and thanks for taking my call.

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

Good morning Rex.

Rexford Henderson - Raymond James & Associates

Good morning. Congratulations on a pretty good quarter, surprisingly good.

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

Thank you.

Rexford Henderson - Raymond James & Associates

The questions I have, revolve around Pottery Barn again obviously, and seems to be the topic of the... de jure. And reconciling some of the information you gave us, you had good positive same-store sales in the stores. The catalog was apparently negative and yet, you said the catalog outperforms your expectations and that negative store seemed... catalog results seem to be from shipping fees. So I just kind of... I wondered if you could reconcile for me your feeling that the catalog was relatively good and yet it saved... revenue numbers were down.

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

I'm going to let Laura speak to the Pottery Barn DTC business. Laura?

Laura J. Alber - President

Yes, when we look at our catalog business, we're looking at both demand and net. And the demand was positive, but it was offset by higher backorders of the end of the quarter, and lower shipping revenues which is the strategy to bring back value into the brand and then also, of course there's always revenue recognition.

W. Howard Lester - Chairman and Chief Executive Officer

Laura, this is Howard. May I just add to that; let's not forget that last year the second quarter was quite a good quarter for us. And we didn't began to really recognize that we had economic issues, until the very tail end of the second quarter last year and entering the third quarter. So those occurred in the third and the fourth quarters, but this quarter was up against a very good quarter a year ago. So, I think the fact that we've been operating in a very difficult economic environment, as I have said this past quarter that we did improve in fact on last year's second quarter, is an accomplishment we are really quite proud of. So, let's not forget what we were up against last year.

Operator

And our next question comes from Lauren Levitan with Cowen and Company.

Lauren Levitan - Cowen and Company

Thank you. Good morning. Earlier in the year Sharon, you gave us a sense of the excess inventory from Pottery Barn and Pottery Barn Kids and how much you have been working that down. I am wondering if you could further update us on what that balance is, and your confidence level around where that would be, by the end of this fiscal year, recognizing that obviously that's something you will lead out slowly. And then related to that all, both Dave and Laura may comment on your early reads on fall, given I think most of the major brands... all of the major brands had dropped prior to when we really saw a lot of the concerns in the credit market. I am wondering if you could confirm that those reads flow through the time period that there has been a lot of concerns about the consumer. And if that consumer behavior is at all different from the conservative outlook that you have been modeling for your back half. Thanks very much.

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

Okay. Lauren just from the perspective of the guidance; I will just say, and then I am going to turn this over to Laura to speak to the drop that went in home, actually about a week or so ago. As it relates to the macro-environment, it was what I said in my prepared remarks, that our guidance has consistently reflected a cautious outlook, and we didn't revise our guidance. So clearly, our perspective going into the back half has not changed from where we were. We are seeing what we thought could possibly occur and that's where we are. And then Laura could you take her question regarding the Pottery Barn books and then I'll come back and take the inventory question.

Laura J. Alber - President

Sure. I think your question was, what happened... what has happened recently and I'll just say this Lauren; our business is volatile on a regular basis. And we are adjusting based on that and it's too early to really comment on what... we have some drops here, drop going home yesterday, we had a one going last week and it's really early in the life cycle to really comment on any... try to correlate the impact of the credit markets on the drops. But, what we are seeing is... all these trends that we are seeing are reflected in our guidance today.

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

And then Lauren, as it relates to the inventory; in my prepared remarks, I worked down the components of that $86 million year-over-year increase. And of that, if you did the math, you'd see that about half of that is in the Pottery Barn and Pottery Barn Kids brands. So we have made within... it's all been within our guidance. Here is our strategy. We are... it's core merchandise. We are staying in stock in the products. We believe that our in-stock positions right now are driving our business. So, we will continue to work through that and we are continuing to allow the Open-to-Buy on the new product introductions, so that we don't start the business for the back half. But we just reiterated our guidance for the back half of the year. So there has been no change in how we are expecting our inventory to flow throughout the balance of the year. And we are actually... if you noticed we were actually at the mid range of our guidance in Q2. We were at the 15% that was right in the middle of our range to 13% to 17%, and the reason for that was, we wanted the high end, because Pottery Barn was better than we expected.

Operator

And our next question will come from Matt Nemer with Thomas Weisel Partners.

Matt Nemer - Thomas Weisel Partners

Good morning everyone. My first question is, given your focus on in-stocks, can you comment and maybe quantify the impact of the increased orders in transit. And then secondly, can you provide any additional detail on inventory related to your exposure to Outdoor categories? Thanks so much.

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

Very good. Matt, we don't... we are not going to start quantifying adjustments on revenue recognition and those sorts of things. But what we did say for both the... in the core brands particularly, we did experience higher backorders. We've had very strong demand. I am going to let Laura speak to this because a lot of this is actually across all the Pottery Barn brands and then, the revenue recognition impact year-over-year was negative. We had more orders in transit at the end of the quarter. We have a lot of big drops that come at the end of the quarter, that sales come in and the goods don't get delivered. So second quarter is always a risk from the point of view based on when the books get in home. Laura, could you please speak to his question regarding the Pottery Barn backorders.

Laura J. Alber - President

Sure. As Howard mentioned in his comments, one of our key operational focus is improving our quality, and we have been working very hard to do that both in the first mile [ph] in the country of origin, where the goods leave and also here domestically. And as a result, we have actually put more quality processes in place overseas to have slower productions with some of our key vendors and we... it is causing us to have more backorders than we have had for a while here. And... but we believe strongly that it's going to pay off, because we need to ship our customers' first quality goods. That's more important than anything else right now.

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

And then Laura, could you speak to Outdoor, the performance of Outdoor.

Laura J. Alber - President

I think your question was, whether we have excess inventory related to Outdoor. And we took our... we are able to take our markdowns and they have been effective and I don't see it posing any additional risk to... there is really no risk in terms of the inventory related to Outdoor. It was a... we felt lot more sales come in later actually in the summer than we had anticipated and that really helped us.

Operator

Our next question comes from Jack Murphy with William Blair.

Jack Murphy - William Blair & Co.

Good morning. Another follow-up on gross margin. You talked that were pretty specific about why gross margin was down and a little bit about why it was better than guidance. But could you just brush out the margin a little bit in the second quarter as to how it was better than guidance. And I think you mentioned some of the brands were as better, but was there anything one large line item off in [ph] rather execution perspective. And then on a related question on the inventory; I think in the past couple of calls, you talked about the inventory levels in the industry. Any concerns there, as it relates to your outlook for the margin?

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

Jack I'll take those two questions. The first question... I'll answer the last one first. As it relates to the competitive environment, I don't believe that we could say that we have seen any significant change in that. But we believe that, based on the Q1 and Q2 results that our back half of the year guidance clearly reflects the margin expectations that we have in the buy environment we are operating in currently. So we are not concerned about that. As it related to why we did better on the margin in Q2 versus our guidance, we said that we saw very strong performance in the Williams-Sonoma brands. We saw... and it's a selling margin, also in West Elm we had a very good quarter in West Elm, the margins were better. We also saw better margins than we expected from a selling point of view. We're very specific about that in my prepared remarks; from a selling margin point of view in both Pottery Barn and the Pottery Barn brands overall. We actually had a higher selling margins, so that is the actual margins from the sales, not any other items that we've not line them. So those were the key drivers.

Operator

Our next question comes from Neely Tamminga with Piper Jaffray.

Neely Tamminga - Piper Jaffray

Hi, Neely Tamminga from Piper. I just want to ask and my congrats also. I think you had fantastic performance on margin and certainly expenses being held in control. So congrats on that. Hey, Sharon or Laura, could you guys talk a little bit about retail, the sales, just pattern in general. You mentioned, I think Dave also mention that, Father's Day was a very good holiday. Did you see a pick up at retail within the quarter, if you were to look at the sales pattern and then relatively for Laura on consumer; is there anything in the category performance at Pottery Barn whether it's bedding, lighting, home, office works etcetera. Is there anything within the category performance or the new initiatives that you guys have had out there with the smart technology, back-to-pre school, parties etcetera, that's giving you a sense of the consumer is just responding newness and that's a positive thing. It's not necessarily that you strapped for cash. Can you just a little bit more insight as to how you are looking at that?

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

Neely, I am going to take the question about the comps turn. Obviously, you know we don't release monthly comps, but I think it's fair to say that we did see a gradual improvement in retail performance throughout this quarter, as a total company. So that was how it played out from May through July. Laura could you speak to her question about merchandising.

Laura J. Alber - President

Sure. Without of course giving away too much competitive information, I really want to try to answer your questions, as well as I can. Clearly the customer is more careful with their purchases, they are looking for great value. They expect more from quality and where we have newness and relevant designs, we are seeing improved performance. And where we don't, we are seeing that we need to do better. And so, what that... as I said without going to what exactly is working, the new product innovation is really a key component of the better than expected results.

Operator

Our next question comes from Janet Kloppenburg with JJK Research.

Janet Kloppenberg - JJK Research

Good morning everyone and congratulations on the quarter. Just a couple of questions; Laura I heard you say that, the fall and back-to-school response, I think you said 14 was very good. If you said... if you gave an indication on the response for fall back at Pottery Barn. I missed that. So I would love you to give us that, if you'd reiterate what you did say about the first response to the fall assortments at Pottery Barn, I would appreciate that. And also for Sharon, with respect to the core merchandise at... inventory levels at PB and Kids being upward is. Should we expect that core investment to remain at this level for sometime, I guess until we anniversary it, at the end of the first quarter? Or what is the in outlook for the inventory levels in both of those businesses? Should we see it gradually come down? I did note that, you are looking for quarter's... the year-end inventory to be at 9% to 13% and I am wondering, if that is largely reflective of increased inventories in Pottery Barn and Pottery Barn Kids. Thanks very much.

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

Speaking to the inventory, Janet the year-end inventory increases. I would expect them to play out very similarly, to where we are at the end of Q2. A bigger piece of that increase will come in the Pottery Barn and Pottery Barn Kids brands, because we are going to continue to rationally level these inventories and make sure that we are feeding our business, as we do that. Laura, could you speak to the question regarding the back-to-school and fall strategies for Pottery Barn and Kids.

Laura J. Alber - President

Sure. Janet its hard to... it's very early to talk about the trends that we believe will carry through the whole fall season, it will be material. But what we do see, is strong response to new product offers and that's very encouraging for us. And we have some significant winners, which is great that we were chasing inventory on. So Teen has had the highest year-over-year growth increase all year and that was really the comment that I made, and that we continue to see that as we go into the back half as well.

Operator

Our next question comes from Chris Horvers with Bear Stearns.

Christopher Horvers - Bear Stearns & Company

Thank you and good morning. I am going to take a shot at the guidance question as well. As you think about the first quarter, you'd be by $0.02, should be $0.06 in the second quarter and Howard talked about it being a tough comparison. Sharon you talked about accelerating comps. Progress being made PB, West Elm doing fantastically. Help us think about the back half and why do we shouldn't say well, you are being very conservative, very conservative in your outlook and actually there's some sort of embedded upside going forward?

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

Chris, when we look at our guidance for the back half of the year and you look at the growth numbers that we delivered in Q1 and Q2, that's talking about the top line for the moment, you can see that on a two year growth rate if you take out the 53rd week, that we basically have consistent year-over-year growth rate on the top line, guided for both Q3 and Q4. It looks more aggressive because of the 53rd week, but when you do it on a 53 to 53, all of the sudden you are back in the 4.5% to 6% range on the guidance. So we still continue to see volatility. We have a perspective on the macro and that we do not think when you have got still almost 60% of your revenue to do in the back half, that isn't appropriate or that we have seen any trend that has been sustainable for a long enough period of time to say that those concerns are no longer there. So, from that point of view that is how we feel about our guidance.

Operator

We'll take a question from Laura Richardson with BB&T Capital Markets.

Laura Richardson - BB&T Capital Markets

Thanks. Actually I'd... following up on that guidance question, I'm looking at this from a little different perspective. And to me it looks like the Q3 guidance is very conservative, Q4 less so, even when you take out this extra week. So I was wondering if there were something that I should be aware of like new stores make more money, I mean margin-wise there are contributors in the fourth quarter where there might be drags in other quarters or results you are expecting from any of the new initiatives that will help the fourth quarter margins?

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

Laura, you are saying... you are not... okay you are not asking for additional perspective on the top line. You have now moved to the bottom line?

Laura Richardson - BB&T Capital Markets

Yes, exactly Sharon.

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

Okay. On the bottom line in Q4, you do have higher EPS growth.

Laura Richardson - BB&T Capital Markets

Right.

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

If you take out this 53rd week, which I quantified as 280 to 400 basis points of growth, which is basically if you do the math, $0.03 to $0.04 in the fourth quarter.

Laura Richardson - BB&T Capital Markets

Exactly.

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

And you have higher EPS growth; now remember what happened in the fourth quarter of last year. We had taken our revenues down from Q3 and Q4 by about a $150 million, to pay I expect to the catalogue circulation was out there. Obviously it came very quickly; we couldn't adjust it quickly this year from a SG&A point of view. We would expect to see substantially better leverage on the ad costs, we had to get through the holiday merchandise; we had deep markdowns. We also had significant pressure from the emerging brands. We have not had any questions on the call today about two of the brightest spots, that we have right now in the company which are the Williams-Sonoma... the Williams-Sonoma performance and the West Elm performance.

And then the improvement in the performance of the Williams-Sonoma Home brands. Those brands put extraordinary pressure, especially Williams-Sonoma Home in Q4 of last year. Remember we impaired two of those stores last year. So as a result of that, we had a big charge and that, of course is not going to recur in 2007. So as you look at it, I understand that it does look a little more aggressive, but I would tell you to please go back and take a look at the Q4 2006 explanations. And you will see that there are lot of things in there that were extraordinary to the macros falling apart so quickly that we couldn't respond to.

Operator

And we'll take a question from Colin McGranahan with Bernstein.

Colin McGranahan - Sanford C. Bernstein

Good morning. Just a very quick follow-up on the direct channel revenue. It sounds like the in-transit

impact is really a function of sourcing. But could you quantify just on the overall business, the impact of maybe the in transit and lower shipping revenues as you've changed that in backorder. How much of that... what percentage did that impact the DTC revenue growth in the quarter, just so we can put that in magnitude? And then was there any shift to... purposeful shift of trying to use the catalog to stimulate some retail traffic or was it really just the way that the business fell out in the quarter?

And then just secondly, expenses did obviously a pretty fantastic job. Controlling expenses in a choppy and volatile market and I know, in the call you mentioned some aggressive management of the DC and call centers. How much of that is being sort of structurally sustainable versus in this kind of environment you are really going to tighten the screws a bit?

And then finally, just a very strategic question maybe for Howard on the PB Kids apparel test stores; obviously, I know it's just two stores and it's a test. But according to your own 10-K, you think of yourselves especially retailer products for the Home, and I don't tend to think of children's apparel as a Home product. So what have you heard from customers that gives you the confidence that you can take the brand there?

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

Howard, why don't you address Colin's question about the apparels strategy and then I'll discuss the other details that he is asking about, when you are finished.

W. Howard Lester - Chairman and Chief Executive Officer

Well, with respect to the apparel, we just... a couple of years ago felt that it matched well with the assortment that we had in the Kids stores and would serve our customers well. It was a small mix that no one else was really doing the job and that we visualized, we wanted to do. And we thought, we would test it because we wanted to get more density into our Kids store and raise the productivity per selling foot in the stores. And we thought it represented an opportunity to do that and one that was not getting us really into the fashion apparel business in a way that we were uncomfortable. And so, that's why we tried and we have had good results with doing it in-store, and that's led us to pass these two stores. So, Laura do you want to add to that?

Laura J. Alber - President

Sure. I would love to. Our... you are right, our primary focus is to own the Home, but we have a very sizeable children's business now, and really lead the market in the children's business. It's clear from our customers that they see baby clothing as a key part of their registry, and as a great gift to give as well. And yes, the market is pretty a logical to toddler, and they do older children. But no one really focuses on the baby apparel. And with our personalization strengths and the way we merchandize our goods, we think it's a natural augment for our customer. And really that's the reason that we have built it in our stores, and the reason that we are going to test two small stores. And Sharon, do you want to answer the other question?

Sharon L. McCollam - Executive Vice President, Chief Operating Officer and Chief Financial Officer

Yes. Colin I am going to take the question. When you described our explanation about the SG&A variance, we have to be sure that we are talking about the correct comparison. When we talked about the call canters, the distribution center, etcetera, we were talking versus guidance in my prepared remarks. I believe that your question is from a year-over-year point of view. '06 to '07 we were favorable on SG&A by 40 basis points. That was driven by the reduced advertising expenses, which is basically on a rate basis ad cost leverage in the Pottery Barn and the Pottery Barn Teen brands. In Pottery Barn it was clearly... remember we dropped our fall catalog last year. This is what Howard was referring to, late in the quarter, we started to see our issues with advertising expense. We clearly had no time to adjust because that's when the macros began to significantly affect us.

So, as a result of that we are seeing ad cost leverage. In the PBteen brands, of course that performance leverages a lot of ad costs and we are very confident in the PBteen brand in the back half. Reductions and other general expenses we're very comfortable with. We've done them for the quarter-after-quarter. So we continue to see that happening. And then remember, the other big piece of it was the elimination of all of the expenses associated with Hold Everything. We actually shutdown Hold Everything in Q2 of last year. So, as a result those costs are gone.

So that's how we are thinking about that. As it relates to our direct-to-customer revenue growth, we are not going to be quantifying on an ongoing basis, backorders and revenue recognition in these things. I will say however that it does represent a couple of 100 basis points in that channel of growth, in any point in time when they shift. And it doesn't take a lot to do that. So it's every... and you think about the revenue in that channel of every $4 million is a 100 basis points. So, if we are calling it out, that's for sure that it's something that is important and obviously it adds a little conservatism to our guidance going into Q3 and Q4. Because if we can fill those backorders, of course that revenue will happen and we reiterated our guidance in the back half and didn't take it up.

Operator

Thank you. That is all the time we have for questions today. I will now turn the call over to Howard Lester for closing comments.

W. Howard Lester - Chairman and Chief Executive Officer

Well thank you everyone for joining us today for our second quarter earnings conference call. We appreciate your time and support, and we look forward to talking with you next quarter. Have a great day.

Operator

This does conclude today's teleconference. We thank you for your participation. Have an excellent day.

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