Good afternoon. My name is Ben, and I will be your conference operator today. And at this time, I'd like to welcome everyone to the RH First Quarter Fiscal 2017 Q&A Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] I will now turn the call over to Cammeron McLaughlin. Ma'am you may begin.

Thank you. Good afternoon everyone, thank you for joining us for RH's first quarter fiscal 2017 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. Before we start, I'd 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 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'll 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.rh.com. With that, I'll turn it over to the operator to take our first question.

Your first question comes from Michael Lasser from UBS.

Good after. Actually thanks a lot for taking my question. So you talked about being encouraged on some of the renewal rate you're seeing with respect to the great membership program. Can you give us an explicit sense, quantitative sense of what the renewal rates are and what you're assuming within your guidance as you look forward over the course of the year about renewals and new sign ups?

Sure. So we're not giving that specific renewal rates. All we wanted to make sure we got across is that we did have a modest assumption for renewal rates and it is exceeding those expectations. So overall, we I guess are really happy with the program just from what it's done both on the operational side of the business and what it's done from a marketing perspective in elevating the brand. We also will benefit this year from higher recognition of the revenue, because we won't have as much deferral but we're not giving up on the limited data metric.

And then my follow up question is on the margin outlook for the second quarter impacted by the continued disposition and discounting of inventory. Philosophically how long is that going to last. And does it suggest something about customer that you could potentially tap into who would buy RH products but are price sensitive because it does seem like you're making some sales on these but it's not coming with much incremental profit.

Sure. So you're exactly right that Q2 is going to have a lower margin profile than what we had previously expected and kind of talked about. So that is the result of 2 things, we've spend a lot of time over the last few months and certainly over the last month or 2 on overall architects in the business but a big part of that has been that DC network design and we continue to believe and are even more positive in our kind of early thinking of that operating out of fewer facilities is the right thing for the business. So we do plan to accelerate even further some of the outlet inventory optimization and getting out some of that the second quality goods and this key rationalization effort that we began in earnest last year about this time will continue through the second quarter in into the third quarter whereas before we thought it would be done and we've added further skews to that kind of list of what we're going to get out of and also we're just optimizing inventory to put into fewer facilities. So that will have an impact on the margin profile. The outlet business isn't just mostly second quality goods. We don't have an intention to have that be a growth vehicle for the business. This is kind of means to the end in the short term.

Your next question comes from Steve Forbes from Guggenheim.

Maybe talk a little about the investments that you're making in hospitality. And where those investments are coming and how you think about ROI around those investments?

Sure. So the biggest investment is just around the team. So I think we've shown on videos and talked in the past about our fearless leader in the hospitality effort Brandon Tartikoff is the President of RH Hospitality he has now hired what I consider to be a world class team who is now getting ready to ramp that can be experienced in several of our new galleries this year and virtually most or it's not all of the gallery in the future will have F&D experience similar to what we have kind of dabbled with and kind of introduced into Chicago. So that's the biggest investment on the people front. Then when we open in each and then there's off course systems that go into operating at Yale right now we have a small effort in Chicago now we have to have systems in place to kind of scale that business. And then when we open the individual location they're kind of typical preopening type cost that we would have for a gallery we have those same ones where we have to hire the team in advance of the opening and have testing, the food testing the site et cetera.

Yes, I think. This is Gary. I think the way to think about the investment in hospitality which is a very, very different model than our core business is very people intensive business if you think about opening a restaurant which reportedly restaurants and cafes this year specifically in the second half of this year you've got all the startup cost happening and you don't have a full year of sales. So we believe the return on investment of these restaurants will be quite good because they don't have the inventory carrying costs of our core business they don't have the back-infrastructure of our core business. As Karen said, you have some light systems et cetera. But you have the people intensive focus of building and ramping the business. So we expect in the first 12 months of these businesses that they will be positive cash flow businesses.

All right. And then just, secondly on the reduced cadence of gallery opening. How does - obviously, now you've got to prioritize which ones you want to do, sooner rather than later. Does that change your thinking at all, I imagine it might to some degree. Which project you want to do tackle sooner and I would guess there the higher potential projects would come up more quickly real estate dependent.

I think you're correct there. We've got a list of priority stores ranked in volume, ranked in market opportunity, but because we are a development type business now we're not doing typical retail leases inside a shopping center where you can go to one or two shopping centers and take your pick of multiple locations. Each one of our deals is a unique development deal to do galleries of our size. So you can't always pick and choose when those developments are -- the opportunity is going to unveil itself. So while we've got a rank from top to bottom there's times where an opportunity comes up like when we're opening in Nashville it might not break at the top of the list but the opportunity to have a significant location in the best development in Nashville is there you've got to take that opportunity because it may not come up again.

Okay, thank you.

Your next question is from Matthew Fassler from Goldman Sachs.

Thanks a lot. Good afternoon. My first question relates to just trying to discern what's transpiring and the full price piece of the business and they have a lot of skew rationalization. How are you assessing what's transpiring with your core collections for example the new modern book, the outdoor book to the extent that you can look at the base business without some of the noise of obscure rat and the outlets and clearance activity et cetera. How are you accessing the health of that piece of the business versus your expectations and even versus last year?

Sure. Matt, Gary. We feel really good about the core business. If you think about the comparable number of 9 or the total growth of 11 without Waterworks through the accelerated outlet warehouse sales, I think that indicates that core business is strong. Your next question is probably how much of the 9 or that 11% is impacted by skew rationalization in the business. We think there's an incremental one to two points in that number.

You've gotten to my head. Thank you.

Yes.

You save me that question.

So think about the business, its somewhere between 7% to 8%; in the core business on the regular price part of the business.

Got it. And then the follow-up I will ask. It also relates to the hospitality and restaurant business following up again on John's question. How do we think about because now you're going to have a couple of restaurants. We know that Chicago's was kind of enormous volume wise. And I think you said that the ROI is favorable. How do we think about this impacting the geography of the P&L over time both from the restaurant piece of the business and then of itself. And then what happens to a gallery when you have a successful high volume restaurant tended to it.

Yes, Matt. For competitive reasons we just don't want to talk about that. You probably can see in the news we are in a litigation about proprietary formation regarding our hospitality business et cetera. Look we believe the model is really compelling. We're very excited about it, we're building an organization to pursue it and it will have different dynamics to it. As I said, it don't hold inventory. Inventory is pretty self-liquidating you don't need big backend infrastructure for the business it drives significant additional traffic to our galleries which we think creates incremental revenues. And more importantly, I think it creates an environment and an experience that is unlike anything in our industry. Yes, I think if you went to the Chicago gallery you spent several hours there and eat there for people who have been there, I think they are astonished at what a differentiated customer experience is created the way we've integrated it. I mean it's not just we've added a restaurant, other people have added restaurants right you we've had department store close to us that just remodeled in the mall I won't say the name. But they remodeled their whole store, they expanded it, they put in a brand new restaurant. You walk in the department store, you couldn't find the restaurant if your life depended on it. You walk to the store, you go up the escalator. It's not on the first floor. You get on the escalator second floor you can't find it. You walk through the children's department and then there's a little portal and you go into restaurant that has nothing to do with the brand or the retail experience of the store you are in. We're doing something I think that's entirely different. I don't think anybody has ever pursued a strategy like ours. An integrated at F&D experience into a retail store like ours. And I think we're advantaged from the sense that we're a home business, right and homes have kitchen. Homes have - you cook in your home, you serve people in your home, you have hospitality in your home. So we're taking the idea of home to another level and integrating it in a way that just, it kind of amplifies the entire experience.

Thank you so much.

Your next question comes from Brain Nagel from Oppenheimer.

Hi, good afternoon. So I think to a certain extent my question maybe a follow up to Tim. Just on the product that you are clearing. So question I have there and there -- pieces I try shove it together but where is this product coming from. Because if I go back to some of the initial commentary about clearing the product it seemed to me that there was a distinct amount of product that was designated for clearance. But now I would gather that amount is actually getting bigger. So is there more products now being cleared or are you doing it faster? And then the follow-on question I have is with his clearance now spreading over multiple quarters to what extent would this impact your ability to sell products full priced? Is the potential condition of the customer look for clearing activity within the branch? Thanks.

Sure. Let's work backwards on that one. Let's start with maybe Matt's question a few minutes ago, right. How do we think about the health of our full priced business and we feel very good about health of the full priced business. We do believe the business in our full priced stores is being augmented by a point or 2 because some additional skew rationalization efforts but majority of the impact is coming from our outlet business and warehouse sale. So we may expect that that division grow slower next year in the future and also has significantly better margins in the future. But where is product coming from I think I've articulated on several conference calls over the last year or maybe more that I had a belief that our supply chain network design was somewhat flawed in the fact that we had too many distribution points. And in a business like ours, where you've got a high ticket low velocity product that also has few dependency putting that product in multiple distribution points can ruin the inventory and can also put you in a position where you've got the inventory in the wrong place. And so as we're redesigning and re-architecting [Technical Difficulty] we believe that we should be operating the business out of fewer facilities. We think it is going to be a significant reduction of inventory in the company. I think we are going to have a meaningfully better working capital model in the future here, and we're going to operate the business on significantly less operating costs. So the closer we get to this and the deeper we get into what we believe is the right design for the operating platform it starts to unveil a clear path and we believe we should move more quickly to the end point rather than less quickly. So right now in some cases we're driving a faster sell down of the inventory to allow ourselves that more flexibility to architect the back end of the business more correctly more quickly. So you're seeing higher revenues at lower margins which is dragging down earnings, but it's also going to have a positive effect on cash flow and it's going to have a positive effect on getting to the optimal operating platform more quickly.

Got it. So Gary, is it fair to assume that the planning process of Q2 then should be the last quarter where we see this outside clearance activity or could it spread into the back half of this year as well?

Yes, I think -- if you think about what we've said in the press release given our focus on the architecture of the new operating platform actually cash flow we may as we're doing in the second quarter and fiscal year outlook accelerate the rationalization of our products operating we enable us more quickly. So we've made a decision, we're going a little wider in the skew rationalization effort and as we're seeing what the productivity of our collections look like with fewer skews with fewer finishes we're seeing that we can optimize the offer, we can reduce the offer somewhat more. And we are moving through those goods more quickly. So we're taking more aggressive markdowns and today as we look at the quarterly cadence, we believe it will still impact Q3 meaningfully and to a much lesser extent Q4. And we will be in a really good position in 2018 to re-architect the back end.

Thank you. Appreciate all the color.

Your next question comes from the line and Peter Benedict from Robert Baird.

Hi guys. Thanks. Gary, just following up on that last comment there. So re-architect is that going to start in 2018, just trying to understand what the endpoint looks like when you get the network redesign done. And just I guess a rough timing to when you think you'll get to that point?

We're architecting it now and running our numbers and models and trying to see where we believe the operable place is. But we still have a lot of data we're gathering and a lot of learning's that we're going through. So I'd say we will have the inventory mostly in the place we want it to be to be able to make the decisions by the end of this year regarding how many facilities we want to operate in 2018 and is there further simplicity in consolidation and optimization in 2019. So I'll just say that the moves we are making are going to meaningfully change the model of this business and make this a significantly more efficient model. So we're making the right long-term decisions to build what we believe will be the best model in our space.

Okay. That's helpful. And I apologize if you guys mentioned this already, but on the outlet sales. Can you give us a sense for the contribution that's implied in the second quarter, I think the 9% to 12% revenue plan for 2Q, what are outlet sales expected to contribute in that period?

About two points.

Two points. Okay, thanks Karen. And then the last question I just had was where do you expect inventory to settle in by the end of the year. It sounds like that's what you are really focused on this year. Any guideposts as to where we should expect that to settle? And when you talk to significant free cash flow this year you did $115 million, I think in the first quarter. Is that a number we should expect builds across the balance of the year and so it's significantly higher than that or how should we think about that?

Sure. So we're not guiding to a year-end inventory number, but I'll just say that we continue to make progress in getting rid of inventory and reducing inventory level. So it will go down from where it is now, as far as inventory levels. And then with respect to cash flow, we're not really guiding to that either. I would just say that we - our cash flow and our inventory is the biggest driver this year is the working capital benefit from inventory along with the reduced CapEx. So we expect to - we've made great progress we continue to make progress we're not -- this is not the only quarter that will have positive free cash flow but we're a little hesitant to give a specific target at this point.

Yes Peter, I would not take the $115 million and go times --.

Right.

Right. So it's not that simple.

Yes, understood. All right. Thanks guys.

Your next question is from Kelly Halsor from Buckingham Research

Hi, thanks for taking my question. I guess I just wanted to understand this where your guidance really changed here. So given you were very promotional last year where is the source of the -- down the net income coming from is that SG&A really are you bringing up that assumption as well and also are you assuming that any color around where we should expect growth margin to be whether up or down in and any cadence by quarter would be helpful. Thank you.

So the biggest change to the guidance from last quarter is around margins in the inventory as Gary noted in his quotes in the release. So basically our decision to move faster on the inventory acceleration of optimization is putting pressure on margins and earnings. But as he mentioned that that's where you're getting higher sales and we'll also have a good impact on cash flow. So that's the biggest change. Secondarily we did note that we moved out some of the store timing. So a couple of the stores shifted into 2018. So those are the two big changes from the last time we spoke. On margins, we do expect in Q2 to have some modest margin. It won't be as bad because we are anniversary some - last year. And then in the back half we'll be up against even more and we actually should see growth margins improve.

So just to clarify you're expecting gross margins to be down in the second quarter?

No, just modestly positive.

Modestly positive. Okay. Thank you very much.

You next question is from Oliver Chen from Cowen & Company.

Hi, we continue to see a lot of intensification of competition from both Amazon and Wayfair as well. What are your thoughts for how on the back-half will unfold and the customers will get the trip and how are you competitively positioned and if you could also give us an update on your thoughts about how you're feeling about optimized modern across the stand and what learning's you've had as you continue to make progress there? Thank you.

Yes. We don't really see any kind of meaningful threat from Wayfair or Amazon at this time. Those are very different businesses and presenting their goods in a completely different way and in many ways targeting the different customers. So I think I said that in my letter here if you step back and consider we're really building a brand here and creating a customer experience that cannot be replicated online and we've got total control of our content from concept to customer. I think those businesses are going to hurt people who don't control their content. They are going to hurt brands that are sold in multiple channels and where people are shopping price. So we've never felt better about our positioning from a competitive point of view.

Thank you and on the Modern side just curious about what kind of learning's you've had or you've made a different reactions in terms of what you've observed as it gets rolled out.

The second edition of RH Modern just mailed last month in May, I think it all got in home by week 3. So we're early in starting to read that but we expect that second mailing to be significantly more productive than the first mailing because the first mailing had no data. So we obviously had a lot of data and made a lot of changes and improvements and like we said in. In the letter is that we expect Modern to become a $1 billion plus brand. We think it is the only fully assorted, fully integrated Modern lifestyle brand in the market at this time. It's a level that market can reach.

Gary, it's the last thing on RH you've been really creative about building this as a lifestyle brand with a DNA that makes sense. What are your thoughts on the continuation of both vertical integration as you seek to optimize the quality experience at point of delivery and also along the axis of restoration hardware being a bigger brand across multiple kinds of experiences that that are more than just furniture.

Well, we believe I think I've said, I've been saying it for last year we believe we've a bias to take more control than less control of the consumer experience. So if that means moving from inside it yet arcs are physical store experience and moving into the delivery experience and the in home experience with our design services we think there's opportunity there, we think being closer to the customer's home is a big advantage. The ability to get into the customer's home is a big advantage. The ability to make sure delivery and installation is outstanding of an experience as the experience in our galleries if it is a huge opportunity and a point of differentiation. I think if you stand back and you think about our brand and business today, our goods are significantly differentiated and uniquely our print experience through our - the same, our website reflects the same and our galleries are significantly unique experiences and differentiated yet. Today I would say, we deliver furniture kind of like everybody else and we shouldn't. So you're going to see us make significant changes in investment to differentiate our brand at every customer touch point. Yes, I don't think we should, we should be just as different as every other touch point or we should be significantly better than anyone else that had everything single touch point. So that's how we think about it. And as you think about the business in other expressions of lifestyle I think we're aggressively investing in that with our hospitality experience integrating that into our retail experience with our galleries. So I think our retail experience is going to leap frog the entire industry and as it is today, I can't tell you how many people from all over the world are traveling to Chicago and seeing that gallery and taking pictures and trying to understand what we're doing there. I really think there's nothing like the customer experience we've created in Chicago and our ability to recreate that experience and that energy and that fully integrated customer experience is going to further differentiate our brand in a such a much more meaningful way then even that design galleries that we opened over the last three four years and these are going to be very hard to replicate. It's going to be very very hard for anybody to replicate it.

Thank you, Gary.

Your next question is from Brad Thomas from KeyBanc Capital Markets.

Yes. Thank you. Wanted to ask I guess a little about the second half and Karen any color you might be able to provide on how you're thinking about revenues and margin puts and takes in 3Q and 4Q as we refine our models?

Sure. So as we enter the back half, we will not have obviously the benefit of Waterworks we left that acquisition in the second quarter and then as outlet was growing last year the second half when we expanded that but -- with more stores we won't be growing as much of that six points that it contributed in Q1 will go down to two and then it will be even more modest in the back half. What is a very big difference for us this year is our source book strategy, so as you guys may recall, we did not have a Modern mailing in all 2016 so that Modern book just as Gary mentioned just got into homes recently and will benefit the second half will also have the interiors book hitting in the fall earlier than it did last year. So those are some things that will benefit the second half and then we have a 53rd week. So that's something that's going to contribute to the growth obviously in Q4. So that's on the top line perspective. Margins, I already gave a little bit of color will benefit in the second half based on what we're up against and as our key rationalization efforts and inventory positions will continue but they should moderate a little bit into the back half. We will have to deleverage in SG&A in Q2 and Q3 this with the source book strategy and we will have to deleverage in SG&A in Q2 and Q3 this with the source book strategy and then that will temper and then will have some incentive comps that we didn't have last year heading in Q3 and Q4. It will be that SG&A but…

Great. And if I can add a follow up on the share count, looks like you are guiding $34.5 million for Q2. Could you give us an update of where you ended the first quarter and then I think to get to your full year guidance that would assume that the share count increases in 3Q and 4Q is that right? And I guess more broadly how are you thinking about the current authorization there?

So the current share count that you see and how we are kind of playing it out through the year is simply just awaiting and it does assume some modest option exercises [ph] and new grants for new hires and such on the dilutive count. But obviously the increase is not related to issuance. We're not, we don't have any plans to disclose or kind of talk through our plans with respect to the share buyback; obviously we do have new fresh $700 million authorization, we finished the last $300 million but at this point we'll continue to evaluate that as an investment versus all the other investments we have on the table and do what we think is best for the return and for the shareholders.

Great, thank you.

Your final question comes from Matt [ph] from Barclays.

Hi, good afternoon everyone. Gary, I want to talk about high level promotions. You know, it's been over a year now that you took the path less travelled decided to do something different than the overall industry; and I'd like to get your thoughts on just high level, you know, how that's played out? If you knew today, what you knew or if you knew back then what you knew today? You know, how would you think about it -- would you think about it any differently? And just overall, where you think promotions for the overall industry are going? Thanks.

Yes, we're very pleased with the move we've made. We contemplated making this move for three years, we modeled it for three years. We probably wanted to make it several years before and we chickened out every time and -- so I'm very pleased we made the move. I think with any plan that we have or anybody has, you're going to be some degree wrong and the thing is we've -- you know, where we are off -- we've adjusted and made changes, I mean I think about -- we launched it and we called it the RH break heart [ph], right. And even people thought it was a credit card, instead it was a misinterpreted initially and we improvised and we changed it to the RH Members program. And there has been several little moves and adjustments we've made to the program but to the -- but with the main body to program we'd say, 70% to 80% of it is intact and it's correct and I think our ability to forecast the numbers and the percentage of customers that have adopted the program and the amount -- the percentage of your business that's been driven by the program is almost uncanny, look how accurate we've been there. So -- but you know, the model is based on a lot amount and people ask, 'gosh, why only $100, why wasn't it more or why wasn't it less?' There is a reason it was $100. When you go through the math and what we expected and the percent of our business we would drive to membership. And then our expectations what would happen to the lower ticket part of our business, particularly things like textiles and accessories; we probably underestimated the hit we took to sales there and we have -- we've adjusted there by adding a few promotions per year that deal with those categories because we were losing more than we thought so we've made some adjustments there but we really like this model, we think it's in a position that the company in a way where we just eliminate so much chaos, we're going to eliminate so much cost; we're going to be able to now architect our operating platform and our business model based on this and I think it will give us a long-term superior model. So we're very happy with it. I mean all the numbers that -- at least we're looking at today were good. I don't want to prematurely call it success yet but we're pretty close to there.

There are no further questions in the queue. I'll now turn the call back over to Gary Friedman.

Well, thank you everyone for joining us today. We appreciate your focus on our company and we look forward to talking to you next quarter. Thank you.

This concludes today's conference and we thank you for your participation. You may now disconnect.