Good afternoon. My name is Jennifer and I will be your conference operator today. At this time, I would like to welcome everyone to the RH Second Quarter Fiscal Year 2016 Q&A Conference Call. [Operator Instructions] Thank you. Ms. Cammeron McLaughlin, you may begin your conference.

Thank you. Good afternoon, everyone. Thank you for joining us for RH’s second quarter fiscal 2016 Q&A conference call. Joining me today are Gary Friedman, Chairman and Chief Executive Officer and Karen Boone, Co-President, Chief Financial and Administrative Officer. Prior to this call, we posted a video presentation to our Investor Relations website, ir.restorationhardware.com highlighting the company’s continued evolution and recent performance. Before we start, 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 the federal securities laws, including statements about the outlook for our business and other matters referenced in our press release and video presentation 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 release 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 may discuss non-GAAP financial measures which adjust 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. A live broadcast of this call is also available on the Investor Relations section of our website at ir.restorationhardware.com. With that, I will turn it over to the operator to take our first question.

[Operator Instructions] And our first question comes from Adam Sindler with Deutsche Bank.

Yes, good evening everyone. I hope everyone is doing well. I have a couple of questions here. I guess some of the more interesting news in the release was about the pull forward into the second quarter from the third quarter. Just wondering if you could let us know as you look to the third quarter if you think that’s going to be felt more in direct or in the retail business? And then sort of sticking with the top line when we are talking about Waterworks, good detail there, 4% to the quarter? Are the seasonality to that business similar to yours or are they different from yours? And then I am not sure you provided any guidance, but as you think about on an annual basis, what do you think Waterworks should contribute to your top line?

Sure. Hi, Adam. So, first on the – this is Karen, on the pull forward, substantially all of that beats that we had in Q2 was a pull forward from Q3 and that was higher sales, a higher percentage of our sales of that as we are coming from in-stock product versus stuff that was on backorder or special order. And then we did have just overall faster shipping than we expected on some of the backorder and special order product. So, a lot of that was in our outdoor business. Direct versus retail split, we don’t really look at it that way. It’s kind of both and we would expect it to have a similar...

More direct business, really.

So, in Q3, I wouldn’t expect that to have a meaningful impact on retail versus direct split. And then on Waterworks, they do have some seasonality. They don’t have a typical Q4 like a typical retailer because of the trade business and although the project base that happens in the spring. So, we only had 2 months of the quarter in Q2 and we will have a full third quarter. So for them, Q3 will be a little bit higher than their Q4, which is a little bit of a flip versus us. We haven’t disclosed the specific EPS impact that it contribute, but it wasn’t very meaningful in Q1. It was only about $0.01. And it will tick up once we have a full quarter in Q3 and Q4, but it’s not going to be a meaningful part of our earnings growth on the year.

Great. I just want to follow-up if I may the 90% in-stock on Modern is I think ahead of plan, but I know that at least previously you had talked about once things had sort of leveled out, you were potentially looking to expand your assortment in Modern. And I just wanted to confirm the fact that as we go through that process, when you do, that there potentially could be another pullback in in-stock levels. Is that something that we should consider?

Yes, one – this is Gary. We are not really ahead of our plan. We said we would be about 90% in-stock at this time and we are 90% in-stock. So, we are right about where we thought we would be with Modern. And as we continue to expand that assortment, I wouldn’t anticipate that we would have issues going forward. So yes, depending on customer reaction to new products or not, we may sell out of some faster than others. So, whenever you have product growth, you don’t exactly know how to forecast those new SKUs. So, you could affect in-stocks slightly. But now we have got a vast majority of the base of the product in-stock. The factories are performing well and the business is performing well. So, you don’t have anything like we had at the startup of the business launch, 544 page book.

Excellent. Thank you. Appreciate it.

Yes.

Your next question comes from Adrienne Yih with Wolfe Research.

Good afternoon. Gary, can you talk about the timing of the new product? When will it be at a level that you want it to be as we go into the third quarter and the fourth quarter and then how much newness? And then Karen, can you talk a little bit about the inventory? Sales inventory spread obviously improved a lot. What type of inventory, what was the aging of the product that you got out of stock on and when should we start to see that sort of more in line on parity basis? Thank you.

Maybe you can clarify for me a little bit on the question? There are a couple of questions around newness of new – timing of new products?

Yes, you talked about obviously shifting it with the marketing books, the spring book moving into the fall season. So, just wondering when you feel you will be in the full position the way that you want to be as we go into the fall holiday season?

Sure, sure. Okay. So, the books are now starting to get in home this week and they will be building through November as we rollout these books. And as far as they have couple of things, one, we have some new product hitting the stores that will rollout over that same cadence. And then our in-stock should build and we should by mid to late fourth quarter be fully in-stock.

Okay, thank you. And then on the inventory where we kind of came in, in Q2 at the end of Q2, right, where we thought we would. We started off the year with plus 30. In Q1, we said it would be very similar, it was a plus 27. So, we thought we would have that as far as making progress with our SKU rationalization and inventory optimization and that’s kind of exactly where we landed. By the end of the year, we do expect to have inventory growth right in line with that sales growth, which is really just a modest 1% to 3%. So, we do think that by year end we will have made progress. Some of that happens through lower receipts and then some of it just happens from making further progress in the inventory efforts we have been talking about. But we feel really good about the complexion of the inventory. We are not really worried about we don’t have a lot of high fashion, high – things that were going to go bad, if you will.

Okay. And then just a recent question on the Hanjin, do you have any inventory that might be susceptible to some of these delays?

We don’t actually contract directly with them. There are some of our carriers who might contract with them, so in through their alliance, but less than 2% of our goods are on their vessels. And we have already notified at all of those customers that have ordered the products that we expect to have very minimal, if any, impact to our business because of that bankruptcy.

Thank you very much and best of luck.

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

Thanks a lot and good afternoon and good evening. My first question relates to the buying cycle, you talked about the move to the membership program elongating or extending the bottom cycle – the buying cycle. How do you know or how do you think you know that this is actually a prolonging of the buying cycle? Have you seen the people come back and close transactions with longer lead times just in terms of differentiating what would be an extended cycle versus perhaps the customer not coming back at all?

Yes, Matt, it’s – so as you know, we have kind of one full quarter now that second quarter is our first full quarter in membership. And so we are continuing to track these trends and look at it, but it’s pretty clear to us looking at it today that the pressure to close your transaction is very different than what it was when we had end of events happening simultaneously by quarter – or excuse me by category whether it’s a lighting event or rug event, an upholstery event or friends and family event and so on and so forth. So, we are seeing fewer transactions at a higher average transaction, which is very good for the business. By the way, long-term, that should mean that we have fewer deliveries. We have more efficiency through the business in the supply chain, but we are still early on obviously to see if there is fall-off negative effects over the long run. The other thing that makes it a little unclear, as you are trying to evaluate all the moving parts right now is we are up against the book drop from last year and we have no book drop from last year, so a massive shift in customer contacts, circulated pages, newness from last year, so on and so forth. The real key is going to be looking at this in the fourth quarter and into the first quarter of next year, because then we will have comparable, slightly up total circulated pages year-on-year. And you will really see the performance of the business. And you will also see the performance of membership change, right. Like right now, the only marketing that we have had outside of the initial ads we did in The New York Times and a few…

That’s helpful. And then just a quick follow-up related to that, if you could talk about how your customer is receiving the member program, their understanding of it, perhaps the mix of member driven sales within the total business, any metrics or qualitative insight you want to give us as to how they are receiving the member effort?

Yes. Well, the – some of the early feedback was people were confused by the Grey Card. Originally, we called it the Grey Card with a major marketing effort. And we got feedback from customers and throughout our stores and in our care centers that some customers thought it was a credit card offer. So we repositioned that as RH members program as opposed to the RH Grey Card and tried to eliminate the confusion and we are making tweaks here and there. But the numbers and the sign-ups and the percent of the business we are doing all is tracking really within a few percent of where we thought it would be. So I am honestly surprised it’s accurate, we are. But it was all math, right. And one thing I would say and because I think people are somewhat confused, a lot of people think like we are eliminating promotions. Well, we are, but we really just created a consistent promotion, right. The membership was two. The gold membership was to eliminate the peaks and valleys in our business, which really create a havoc in the operational infrastructure. And the vendors trying to supply the goods with these peaks and valleys, ordering the goods correctly, it’s really chaotic running a business on what evolved to post 2008 and 2009, a very promotional retail environment. And yes, probably not as difficult if you are in the apparel business, right, but we are a really logistically difficult business like furniture. It’s very costly and it affects execution. So our goal was really to evolve the business to a more consistent model. And so really, we kind of went from an erratic peak and valley kind of promotional cadence to a consistent promotional cadence called membership, right. So there are a lot of people that brought up to me over time, well gosh, the last person the try this was JCPenney, decimated the business. And I said, well, we are not going off promotion. We are 25% off all the time. You give us $100, but you are getting a bigger promotion than a year ago. So – but the real key here is, is letting – the shift of the book drops is creating, I think the most un-clarity around our business, right. I mean, the books are the major marketing vehicle for our business. And shipping the books by six months changes a lot. So we have really got to let the books get in here at the end of Q3, into Q4, watch the business and the trends. Then we will have the second drop. We will have Modern hit in Q1. And we – when we look at how we think the business will sequentially build and the changes we articulated in the video and in the press release. We like the model we see in 2017 today.

Thank you so much.

Thanks, Matt.

Your next question comes from Steve Forbes with Guggenheim Securities.

Good evening.

So Gary, when you think about putting RH Modern in the Design Ateliers into legacy galleries, how do you take those efforts and put them into a smaller box size while maximizing the impact to consumer, is it something – I mean, do you add it if I take a very small handful of the bestsellers and created a smaller design space in the box and what should we expect as it relates to the pace of the rollout of these initiatives looking into the fall here?

Sure. Good question. Again, it’s kind of a – it’s basically a math equation, right. It’s taking a look at the best selling Modern items and collections, right. And we have got pretty good data. We have been doing this a long time that we can extrapolate. When we take something that is source book and web only and we put it into our retail stores, we communicated to you guys that we get a 50% to 100% lift on the item when we show it at retail. So we can extrapolate taking – now we have data. The first few stores that we put Modern into didn’t have the best of Modern. It just had our best guess at what we thought would sell with Modern. And in many cases because we ramped up in such a difficult way, it was really all we could get, right. So the first stores, honestly, I am surprised of the success we had with Modern. It didn’t even have the best of Modern with no data. Now we have got data on Modern. We know what the bestsellers are. We know what the best collections are. And we now – we just basically do our math that says, okay, we take this from – to a tri-channel and we are putting in retail. We know we’re getting these lifts. And then we basically just edit – we are changing about a third of the SKUs, right. So we are taking out the lowest performing SKUs that are – that have been in the retail stores for the last year and a half, the last 18 months, taking those out and replacing those with the best Modern SKUs. And our math says that we are going to get a positive arbitrage, right. And…

And then just as a quick follow-up, is there yet a plan to rollout Waterworks to the next generation galleries and potentially the legacy galleries themselves?

Not anything that we are ready to communicate. We have a lot of ideas here. Waterworks is a tremendous business. They are the best brand of their kind in their category. I don’t think anybody is close. And strategy number one here is to not screw it up. Sometimes, big businesses can kind of goof up really good smart businesses. And we are taking time to kind of spending time really discussing and debating our strategy, how do we evolve and marry the brands together in an appropriate way. We are going to, first and foremost, our efforts are to – is to really amplify and advocate for the Waterworks brand. I think they are a business that’s been undercapitalized for a long time running without capital. They have got tremendous product. I don’t think it’s exposed very well in the market. And so we are going to support them. I think we announced what San Francisco, one of their new flagship locations opening in San Francisco. If you are in L.A., go see their new flagship in LA or in Chicago. They have a tremendous strategy that kind of build their brand. And I think there will always be an independent nature of Waterworks, because it’s a very different business. It deals to the trade, to architects and contractors. We are much more of a retail-facing business. We think there is an opportunity long time – over the long-term to have much more exposure and visibility and transparency of that business directly to the consumer, but we want to be careful with it. We don’t want to infect the brand at all and have anybody think that we are lowering our quality or – we are – the only interest we have is to make that brand better. And then in an intelligent way, integrate these brands and allow us to access to their consumer, which is the highest demographic in the entire industry and to serve our consumer better. So, you are going to see this move like a clock, right? It’s going to move very slow. We are in no rush here. We feel very lucky that a brand of the caliber of Waterworks is now part of the RH family and platform.

Thank you, Gary.

Your next question comes from Peter Benedict with Robert W. Baird.

Hi, guys. I will just pivot over to maybe some more macro stuff I know it’s maybe hard to read just given all the things going on in the business, but any update on what’s going on in some of those markets you guys have spoken to in the past, Texas, Miami, the Canadian markets or any other regional commentary that you could share?

Yes, we have been tracking those and we did see some improvement to that negative 4 drag that we had talked about for the last few quarters went down to a negative 1. So, there is some improvement there. So, we are very, I would say cautiously optimistic about that kind of planning for something similar as we think about the back half. And we are anniversarying last year. We are coming up against anniversarying a tougher compare, so that’s good for our business in the back half.

That’s great. Was the improvement across all three or was any one more impactful than the other?

We haven’t given a lot of detail in – for each one specifically.

Yes, the way I think about it is last year that’s marketing, we articulated were a drag of 2 points in the first half and a drag of 4 points in the second half. So, we are up against the 2 point drag, right? So, you would expect it to moderate, because you are up against the drag. So, what that tells us is, so if you take last year’s 2 points and this year’s 1 point, you have got 3 points, which tells you its 1 point better, right? But the business didn’t really come back so to speak. It just didn’t get worse. Does that make sense?

Yes.

Maybe got 1 point better, so – but what we like about that is it’s not in a continued decline year-over-year. So, as we go into the second half, we are up against a 4 point drag to last year that could be neutralized year-over-year, then that provides lift, right.

Right. And then Karen, what’s the latest view on kind of free cash flows, again a lot of moving parts here, just your latest view on when you think that could evolve in the business? Thank you.

Yes, sure. So, we kind of stepped off that goal for 2016 on the last call just given where we took our guidance quite a bit lower. But we still feel very optimistic. It’s still very important goal for us. So, I am not committing to it for 2016, but feel very good about ‘17 and beyond, especially with some of the earnings things that we are going to cycle as we head into ‘17.

Okay, great. Thank you.

Your next question comes from Michael Lasser with UBS.

Good evening. Thanks a lot for taking my question. How should we think about the spread between brand growth and comp growth in 3Q? Is it going to be wider than the 1,000 basis points that you saw in 2Q?

Yes, so great question and this is one that we want to make sure we are getting some clarity and information on. We do expect that, that gap between brand comp and non-comp will continue to widen. We have a couple of things going on there. One, the Waterworks is not going to be part of comp. We are going to put that into the comp base when we anniversary the acquisition, so 1 year from Q2. So, that will have a full quarter in Q3 and Q4 as opposed to just part of the quarter in Q2. We also have additional new stores coming on plus we have – because we have a 14-month comp period for our new stores, some of the ones from last year won’t join into the comp. And so Q4 even if they are open in Q3, we have the new vintage that’s opening with the new stores this fall and the outlets that we are opening won’t be in the comp base either. So, we will see that widen even further.

And that will continue into the fourth quarter?

Yes.

And then a bigger picture question and it’s going to possibly be in a couple of parts, but Gary, you mentioned that Grey memberships are trending in line with your expectations. How should we think about overall customer acquisition to the brand? Presumably, you anticipated that you might miss out on some of the marginal customers that come in and buy on promotion and get into the brand. Are you missing out on those customers at the rate that you anticipated? And then with that, how is that going to trend into the holiday season? I guess maybe a separate question because you are going to have a more focused customer who tends to spend more. How do you think about that impacting the fourth quarter where you are competing for a broader pool of spending with giftable items?

Sure. So, the way to think about it is first and foremost, you have to get up against the books, right, apples-to-apples. So, the best time for us to answer the first part of that question is probably in the first quarter when we have had a chance to look at the new source books hit and how is the consumer reacting to the marketing of the membership and what does that look like. It’s the murkiest time to really look at it right now, right? But I would say even in the murky times, I feel on the more positive side than the more negative side. So, I think I feel very good today based on the fact that we are going through a murky couple of quarters where we don’t have a book. As it relates to customers entering the brand and specifically around holiday, I think we communicated that we are going to pull kind of stocking stuffers and the last of the legacy kind of leftover RH business off the floor. And we are installing these design ateliers. And we are really – it’s kind of the last little pieces of moving the business to a true design platform and not like a typical retail business. And so I don’t see us competing for that customer. We are not – might we lose someone buying a couple of towels for a holiday gift, yes. Might we lose some throw sales, we might. We are going to give away the stocking stuffer sales. We are not going to put all the Christmas lights up in the store. We don’t think that renders the brand more valuable, not the brand we are building today. So to build great brands, you have got to decide who you are and…

Gary if I can sneak one more in, how have you thought about your further push into the design services impacting your relationship with the trade, with interior designers and if you could frame how much of the business has been done through that constituency in the past, so we can get our own understanding of what the impact might be?

Yes. We are not going to release those numbers right, because that just creates a blueprint for our competitors, right. And so – but I will tell you that initially, some of the anecdotal feedback was when we went to the Grey Card and the membership program and we went with a full time kind of promotional positioning, right for buy into the membership and you get 25% off, that was – we got a certain level of feedback, anecdotal feedback from our teams and some of the trade designers they are working at – working with. The data and the performance of that group, right would indicate it’s not an issue. Now, I don’t know if that means over time, it becomes an issue. We were thinking do we need to provide more incentive for that group, do we need to provide another different level of service for that group. But I think our business is – the value equation of RH is very disruptive. The product assortment of RH is very disruptive. No one has our product assortment. No one has product this quality made in quantities. No one has our real estate positioning. No one has our source book circulation. No one has the traffic on the website that we have. And now no one is going to have the design services that we offer. And our design services are designed to also support interior designers and trade clients, right. So we act as a design office for them, right. They can come in with us and our interior designers work with their design assistants. And we manage their whole project and we manage all their orders. And so we are a huge value to that constituency, right, because they are generally entrepreneurs, small businesses. They have…

Cool. Thank you so much.

Your next question is from Oliver Wintermantel with Evercore ISI.

Hi, good evening. I had just two clarification questions. The first one is the shift of the book drop into the third and the fourth quarter. So, all else equal if the pages are and I think you mentioned that they are comparable should there be an additional SG&A pressure in the back half? And looking at your guidance for the third quarter and the full year, it looks like it might be roughly around 150 basis point SG&A de-leverage in this third quarter. But is that the right way to think about it? And if that is, could you maybe tell us how much of a help that was to SG&A in the first half?

Sure. So, it actually is not going to be a drag on SG&A. The biggest thing in Q3 that we are coming up against or I guess that we have that we didn’t have in Q2 and we will – won’t have in Q4, that’s unique to Q3 is some of the investments that we are making in our product in the floors. So, we have a big new floor set, the installation of the design ateliers, the cost of getting all that product, all the people involved in that effort, the new stores that are opening. So, three of the new store – three of the four new stores are going to be in Q3, so all those pre-opening costs. That’s the biggest drag on Q3. The advertising because last year we had the spring books and then we also had Modern, we will actually get some benefit in the second half from advertising.

Got it. Thank you. And then the other one was the guidance for the full year when you said the adjusted EPS $1.60 to $1.80, but then you have like these three items about customer accommodation, membership referral and then the inventory SKU rationalization, that gets you to the pro forma of $2.50 to $2.80. So – and then in – in the video, you mentioned that you cycle all the headwinds in 2017 and operating margin should be up and sales expanding. So, if I look at the consensus numbers of about $2.32 next year, so I just want to make sure that I understand where you based it off of that adjusted number or the pro forma numbers? Thank you.

Yes. So, we – we are really wanting to stay away from guiding 2017 at this part – at this point. What we were trying to do is just show that some of these costs that we have had this year, we don’t expect to be ongoing and continuing parts of our business. So, the cost related to the RH Modern and all the production issues that we had in the customer accommodations, the SKU rationalization and then this kind of one-time deferral, because once we anniversary the launch of the RH members program, we will be on a normal and more consistent as we collect the revenue. Even though it will be deferred, there will be revenue from prior periods getting recognized. So, we won’t have kind of the ramp up to where we will have all of the kind of more consistent cycle of booking that revenue. We were really just trying to say that hey, there is lot of kind of more one-time temporal things that aren’t going to repeat into next year. We are not necessarily trying to set guidance for 2017.

Okay, thanks very much.

Your next question comes from Matt McClintock with Barclays.

Hi, yes, good afternoon everyone. Gary, you just said that you are not trying to be Amazon, but you just brought over Alex from Amazon to help with the supply chain. Can you maybe walk us through some of his priorities, his initial priorities for the supply chain? It seems like there is lot of puts and takes going on in that area of the business? Thanks.

Yes, we think we have tremendous opportunity to match the customer experience that we deliver on the front end of our business to the customer experience we deliver on the back end of our business. And I think we have kind of taken leapfrog steps and moves on the front end. If you look at the difference between one of our old galleries and one of our new design galleries, it’s not even close, right. It’s not evolutionary, it’s revolutionary. And if you look at the quality of our people and how they have evolved in our galleries over the past several years, I think under DeMonty Price’s leadership, massive change. I mean, the design organization we have put in place, the leadership team that’s in place, I put our store teams, gallery teams up against anybody in retail, quality of the people, culture, passion, belief in our vision and in our strategy and our brand. I don’t think we have had the same evolution on the supply chain side of the business. And if you look at the disconnect that I talk about today is we, in many markets, we have an HDL whether that HDL is in-sourced or outsourced meaning that we have our people kind of running the home delivery kind of hub. We basically are shipping goods to home delivery hub. In some cases, we control that hub, in some cases, we don’t. But we are handing off the goods to delivery teams and truckers that are not our people and they are not our trucks. And it’s – you may get a truck that has Restoration Hardware logo on it, you may get a truck that has a Penske logo on it, you may get a Ryder truck or truck driving with Pottery Barn goods…

We are on 1,500.

Yes, so 1,500 resto associates accompanied deliveries last week of 5,000 deliveries. We have never done that before. Customers are sitting there just massively delighted and surprised. We are actually getting design jobs because we are going into customer’s homes. We are not making customers interface with strangers in delivery. These guys – they are interfacing with the quality of person that they would interface in their stores. And so you see us make transformational changes here. And I think that we are going to bring the level of execution and quality and service up to a level that’s in alignment of the brand that we built.

Thanks a lot for that.

Operator, do we have another question? Operator. Jennifer, are you there? Operator. Yes, we are getting close to the end of our call time. If anyone can hear us and I think we are going to wrap up the call now. And thank you guys for your time and we will talk to you next quarter.

Great. Thanks, everyone. Talk to you soon.