Good day. My name is Skinner, I'll be your conference operator. At this time, I'd like to welcome everyone to RH third quarter fiscal 2017 Q&A conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, we will begin a question-and-answer session. If you would like to ask a question during this time, simply press star then the number 1 on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. I would now like to introduce Cammeron McLaughlin, RH Investor Relations.
Thank you. Good afternoon, everyone. Thank you for joining us for RH's third quarter fiscal 2017 Q&A conference call. Joining me today are Gary Friedman, Chairman and Chief Executive Officer, and Karen Boone, President, Chief Financial and Administrative Officer. 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 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. 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.rh.com. With that, I will turn it over to the operator to take our first question.
Our first question comes from Steven Forbes from Guggenheim Securities.
Good afternoon. Maybe I have to start with a high-level question, given the current outlook for corporate tax rates. Gary, if you can, maybe if you could just discuss your willingness or general thought process around the idea of investing margin into the business in a lower tax environment to drive share over the long term. Would you accelerate the rollout of home delivery or your hospitality initiatives? Are you really committed right to that kind of margin outlook that you provided at the Analyst Day, and would not proactively invest margin into the business in the environment that we may see?
Sure. Thanks. That's a good question. The way we think about the operating margin guidance for next year is that is inclusive of investing pretty aggressively into the continued enhancement and redesign of our supply chain, including home delivery. Would we consider investing faster, depending on the tax law? I think, depending on where it all lands and what gets passed, I think we'll evaluate it more specifically then. I think it'll obviously open up some optionality for us to consider things. As I think about next year and I think about the guidance that we've given, we're very committed to that guidance, and that guidance is inclusive of some pretty significant investments in continuing to redesign and enhance our supply chain, including home delivery.
As a quick follow-up here, can you just remind us how many next gens are in the plan for 2018? Maybe also a high-level question, as you think about the evolution of brand awareness, and how differentiated the RH brand is from the cohort here, are you guys starting to have discussions about a scenario where you can have even a larger footprint than that 60-70 store current goal. Maybe penetrate cities that may not necessarily house a legacy store today as brand awareness continues to evolve? Is it still too early as you think about that?
Sure. Let me take the first one. I concur with Karen.
Next year, we have three in the plan for sure, and then there's a smaller billboard gallery as well in the Napa Valley. Three of the larger and one smaller in Napa Valley.
Sure. As we think about the evolution of brand awareness and having a larger footprint than 60-70, as I think back on my career, whenever you're successful with a brand and a business, and you continue to improve it and evolve it, you generally, over time, see a bigger market than a smaller market. I think that's happened to us over the years at RH. I think it will continue to happen to us. I was in a conversation with one of our investors the other day, who was commenting on some friends of theirs that had been into our Palm Beach gallery and went there for, I think, lunch or dinner and then came out wanting to redo their bedroom and other parts of their home.
The comment was that these new retail experiences that were beginning to unveil in the marketplace, have the opportunity to create a real tipping point in the perception of RH as a brand. I think for those of you that were at our investor day in Palm Beach, and you had a chance to look at just 50 yards away from where we built the current new expression of our brand, was the legacy expression of our brand, hidden in the center, no real dominance, not a very impressive shopping experience. That the new physical expression of the brand is such a leapfrog. It's almost hard to believe that the company that runs the current legacy stores is the same company that's creating these dramatically different and enhanced shopping experiences.
I think we're going to find that tipping point and the people that maybe don't think about shopping RH today, and maybe don't perceive us yet as a luxury brand or don't quite perceive the breadth and depth of our assortment and the design services that we're investing into and the capabilities we have and the experience we can offer. I think when that really gets known, I think our market is going to get bigger, not smaller. There's going to be a meaningful tipping point as we really continue the positioning of the brand in these new next generation galleries.
If I look back at the history of my career, whether it was early days at the Gap or Williams-Sonoma, I remember when I first joined Williams-Sonoma, I think we had 48 Williams-Sonoma stores, and the discussion there was, "I think we can have 60 or 70." That was as big as anybody thought it could be. I think, what does Sonoma have today, 250 stores? I remember my first conversation with Chuck Williams and Howard Lester. The most we can have is 60 or 70. That just happens to be the exact number we're saying about RH. Now, do I think RH is going to have 250? I don't think so, not the size and scale that we're building.
Do I think that there's markets that are not on our target list today, that are not included in the 60 to 70, that as our brand becomes more successful and the brand awareness is higher and the understanding of the assortment and the services that we offer, of course, I think the market will get bigger than maybe what we see today. I think that's a natural evolution of a growing brand or business. I think if we were sitting here with Phil Knight at the same stage that we're at today and said, "How big could Nike be?" I don't think Phil or anybody on that team would have seen it. I know nobody saw it at the Gap. Nobody saw it at Williams-Sonoma or Pottery Barn.
If you asked me 10 years ago, what we were trying to do, we were trying to build a billion-dollar brand that could make 8% to 10% operating margins. Clearly, we've blown by that. I think that's just a natural evolutionary process that evolving and growing businesses go through. The market grows. You kind of create a market if you're really building the brand correctly.
Thank you.
Our next question comes from the line of Oliver Chen from Cowen.
Hi, thank you. We had a question regarding the merchandise margins. What was some of the main rationale for the strength? Over a longer time horizon, how do you see merchandise margins evolving? A second question, Gary, was about your thoughts on the evolution of breadth versus depth in your inventory planning and how you're thinking about the assortment and making sure that you're thinking about what's right for breadth versus depth, just to optimize ROIC in turns, and yet stay innovative and relevant to what customers want. Thanks.
Hey, Oliver, I'll take the first one. This is Karen, then we'll turn it to Gary. On the merchandise margins, the 460 that we were up for last year, we are still lapping some of the SKU rationalization and other items from 2016, I wouldn't necessarily take that plus 460 and carry it into future quarters or even next year. That 36.9, that 37% or so margin, you can see based on the guidance we've given for Q4, that we do feel quite comfortable with that. As we head into 2018, we've given you guys some indication of that 170-220 basis point improvement to there. We do feel very comfortable that we're getting back to those prior highs that we've had in that 37% range. Longer term, we see even further opportunity and upside beyond that.
Thank you.
Yeah, let me take the question about the evolution of the breadth and depth, the assortment and how do we balance the breadth versus the depth and what's best for innovation, I think was your question. I think about 2017 as kind of a reset year in many ways, right? We articulated that 2017 was the year of execution, architecture, and cash. That we were going to be focused on executing our new membership model, architecting a new operating platform, and optimizing cash flow by increasing revenues and earnings and decreasing inventory and capital spending, and that we were going to have no new businesses introduced outside of hospitality, introduced in 2017. Right? That's not a long-term view, I would say. Someone asked me the other day, "Gary, how do you think about 2018?" I said, "Look, 2018 to me looks a lot like 2017.
I think it continues to be the year of execution, architecture, and cash. I think we see a lot of opportunity in fine-tuning and executing our core business. We're in the early stages of architecting what I believe will be one of the most innovative and optimized operating platform in our space of retail. The focus on optimizing cash flow is important because of the current structure of our balance sheet, and the risk we took on in buying basically half the company back. 2018 will look a lot like 2017, but slightly different because we'll be farther down the path and our focus will now kind of shift back to our natural tendency of building growth. I think it is one of the core strengths of this business, or this team, and one of the things that we've demonstrated that we can do well.
As you think about the reset, it was important for us to reset the supply chain and redesign the supply chain because in its previous design, it was going to be a highly inefficient kind of capital usage, and we thought we could build a much more capital-light model and capital-efficient model by re-architecting the supply chain. We avoided building a 5th furniture DC in Savannah, Georgia. We stopped moving forward with that project. We've now re-architected the supply chain and are moving to a two DC network. Some people have asked, "Well, can you still grow the assortment with that two DC network?" We can. We've got a lot of room to grow on the new platform.
We're doing some things that are very innovative that, quite frankly, are new revolutionary ideas in how to think about DCs and inventory turns and just using the supply chain in a very new and innovative way that I don't want to talk too much about and give away too much to our competitors. You'll see, as we've got a whole assortment architecture that has many new business opportunities within RH that we're going to be focused on. Previously, we've also had other business opportunities outside of the core RH brand that we believe we can grow and be dominant in the home space. I think our tendency today is to kind of stay focused on the RH brand.
Hence, really the announcements around the Office of the President with Sandra, who initially joined us as President of New Business Development, I think has communicated to me that she's excited about what we're building here in RH and sees so much opportunity in RH. Her comment to me is like, "How can I help?" There's so much opportunity to grow this business, I think augmenting our merchandising and creative leadership and having both Eri Chaya and Sandra at the helm gives us just huge capability and great leverage in that area. I think you'll see us start to bring on new growth vehicles within the core RH business. There's multiple ways that we believe we can expand the assortment and open up the aperture of the brand and reach new customers and open up new markets.
You'll see us start to accelerate that in 2018, we'll be accelerating that on a new, significantly more efficient and optimized operating platform. We think it was really good for us to kind of take that breather for a year. As we get into 2018, you'll start to hear us talk about what's next and how we plan to continue to accelerate growth going forward.
Okay, Gary, just a final question. On the platform and thinking about the platform that you're building, what are your thoughts on the opportunities through the lens of customer engagement and what you want to accomplish there? Secondly, through the lens of M&A versus organic development, as you've done the successful Waterworks deal and how you think about the extendibility and the aperture and the capabilities in the brand.
I think today, Waterworks was a once-in-a-lifetime opportunity, right? Waterworks was by far the best brand in the bath and kitchen space, at the high end of the market, and in many ways helps render the RH brand more valuable through its positioning in the market and through its relationships with architects, interior designers, and their engagement in the building process of the home. To me, that was a very rare once-in-a-lifetime opportunity, we thought it was important to capitalize on it. Quite honestly, if you sat here with me 15 years ago and looked at the merchandising architecture and strategic architecture for the company, Waterworks was on there. I waited a long time for the opportunity to work with the talented team there. We're just really excited about the kind of opportunities that presents long-term.
That being said, today I would say our bias is for internal organic growth. We have, again, if you saw our merchandising architecture and the number of opportunities that are before us, they're almost kind of endless, right? It's like someone asked me, "When do you think you might buy another business or another brand?" Not that I want to ever close the door to optionality, and we treasure optionality, and we treasure trying to see all the possibilities so we can make the best choices. Someone asked me the other day, "When do you think you might buy another brand or do another thing?" I said, "Probably not in this lifetime." That if I look at the opportunities that we have in front of us, they're so meaningful and robust.
When you really start to think about RH internationally, we like to say we're building a brand with no peer in North America. I think that's amplified if you looked at it internationally. We just spent a lot of time in London and Europe studying the market and looking at opportunities, locations, and we look at the amount of business our customers ship over to those countries. We just think that there's a huge opportunity to brand. We have lots of people approaching us, knocking on our door about expanding the brand in the Middle East, expanding the brand in China, expanding the brand in South America, expanding the brand in Mexico. The thing, we've said no so many times. It's funny. If you say no enough, at some point, the deal looks so good, it looks tempting.
As we study other brands that have grown internationally, it almost seems that all the great ones tend to try to reacquire their brand over time and get control back. We're not in a big rush. We're just so focused on growing in a quality way and building quality into the brand in having more control than less control. We think control is an important word. Control of a brand is really important as we look out into the new and developing retail markets, where people with less control of their brand and their distribution network are going to get price competitiveness and actually brand erosion. It's hard enough to execute a brand when yourself. When you start giving it to somebody else, you got to be really careful about how much money they'll pay you to get control of your brand.
Well, hell, I've been here 16 years, man. I've been building this brand for 16 years. Most of this team, many of them been here with me more than 10. Yeah, of course, they'll pay a lot of money for this brand. It took 16 years to do it. Try doing it themselves. I don't think anybody's going to be able to copy us anytime soon. Just our general sense when we think about M&A versus organic development and growth is that I just think we're going to be doing this a long time internally, and I don't want to say never. If another Waterworks opportunity comes up, will we look at it? We look at everything.
Today, if I had to place a bet on what will RH look like in five years, it will look like an even more exciting and dominant brand in the luxury home furnishings marketplace and probably doesn't need to be augmented by outside M&A.
Thank you. Thanks, Gary. Thanks, Karen.
Our next question comes from Brendan Hopkins from William Blair.
Good afternoon. Just some of the longer-term guidance that you shared at the Analyst Day and kind of comparing that with your 2018 revenue growth outlook. You've just touched on some of it, I'd be curious, going from the eight to nine kind of comparable week growth next year to the eight to 12 longer term over, I think it was like a 10-year period on average. What would you say would be the main things? Would it be additional store growth domestically? Would it be international? Would it be brand or product extensions? What do you think are some of the biggest areas that would help you think about that little bit higher, longer-term range relative to 2018?
Sure. Well, it's the two things that have really been growing the business over the past several years, right? Our two key value-driving strategies are the continued expansion of our product offer, and the transformation of our real estate. Like I said, the brand architecture, the growth platform that we see today to continue to expand the RH brand through product and through services, we think it looks really robust and again, probably take us at least through the rest of my career, probably longer to do that. We see real growth coming from that part of the business. We see real growth, obviously, coming from the transformation of our real estate. On top of that, I think you think about what international could offer to the business.
David and I, and the team were over there in London, and we were looking at a gallery in London. It wasn't really about a gallery location in London. It was really about the launch of RH International. One gallery in London with our direct platform and capabilities, really reaches, for the most part, a lot of key wealth in Europe because everybody interacts with London. Whether business from Moscow, business from the Middle East, business from Paris and other parts of Europe, and London itself, which is a very robust retail environment. That becomes an important third leg. I think back to the point we talked about earlier is the brand awareness and the tipping point of the brand. I'm kind of amazed at the early numbers out of West Palm. I've always been a little nervous about that market.
If I look back when we were initially doing that deal, the legacy gallery was a modest, I'd say middle of the road gallery. The last several years, while we have been putting this transaction together, building the gallery, it's comped up nicely. You really look at it and say, "Okay, how big is Palm Beach? How far can we draw from? How do we think about our business here?" What's interesting about that one is just that the early response is so good and so strong. It's made us think about, again, the tipping point. When people see you differently and see the brand differently, and really see the brand for what it is, and the services that we offer today, particularly in interior design, and the ability to do someone's home. I know we talked at our investor day about, what was it?
A $500,000 or $600,000?
560, I think.
Yeah, 560 in Tampa that we had had, and our gallery leader and her team were there and discussed that. We just had another $500,000 interior design job close in Texas, in Willowbrook for a home in Williamsburg. We're just starting to see these bigger transactions, and I think people are just seeing us differently. How do you think about the value of brand awareness? How do you think about the value of that tipping point? Is that worth two, three, four points a year, as you really start to position this brand? We're just at the early stage of building these design galleries. Those are the pieces. It's really the continued expansion of our product offer, the transformation of our real estate, the increased brand awareness and growth of the brand.
We can always step on the advertising lever if we want, pull the advertising lever farther if we want. Right now we're holding back a little bit. We're testing a few things, but we're really trying to optimize the model. As we look forward, can we expand the circulation of our books? Can we invest more in print and digital advertising? Is there other ways to invest in driving brand awareness? We're early on there. International is, I think, going to be a real business. I think it's going to be much bigger than we ever thought.
Great. Gary, appreciate it. Best of luck.
Our next questioner comes from Matthew Fassler at Goldman Sachs.
Thanks so much. Appreciate the time tonight, as well as the time a few weeks back. Delivery. You spoke a lot about delivery at the analyst meeting in West Palm. Our sense is that delivery is misunderstood by many consumers as a commodity. I know that you're stepping up the execution of your delivery effort and insourcing more of that. I know you also have talked about not really believing in marketing per se. How can you integrate what you're willing to offer the consumer in terms of getting the product to them and that in-home interaction into the membership message in terms of their expectation of what they can get from their association with RH?
Yeah, I think, again, as we execute better, I think there's going to be tremendous word of mouth. We clearly will continue to talk about what we do and the work we do. Again, it's not that we don't believe in marketing. I say, "Look, we don't have a marketing department, we have a truth group," right? Because our brand is much more about our truth, and our truth is the products we create and bring to market, the way we present those products in the market, the galleries we create, the source books we create, the web experience we create, the service we deliver, the interior design offering and service that we're building. When you do great work, the world talks about it. We just have a bias to do great work.
We think it's more important to invest in our work than invest in talking about ourselves, right? Just think about it as you think about how we might go through capital allocation here, right? Somebody goes like, "I'd like $10 million more to put into digital marketing to run more ads or more this, or connect here." $10 million more for more print ads, or $10 million more for more catalogs. Look, the catalog is marketing, but it's really our work. We're putting our work out there. We don't spend money on social media talking about ourselves. Yet, as you read in the letter that Instagram, I think it's the day before yesterday, just came out with the most posted cafes and bakeries in the country, right? Our 3 Arts Club Cafe is the seventh most Instagrammed cafe in the country.
Like a cafe in the middle of a furniture store. Think about that. How many people wake up in the morning and go, "Let's go eat in the middle of a furniture store, and it's that inspiring that we're going to Instagram it." By the way, I don't know how many By the end of last year, we had 32 marriage proposals in the cafe at the 3 Arts Club Cafe in Chicago. 32 marriage proposals in the middle of a furniture store. You can't make that up, right? It's just our bias to kind of do great work. I think as we continue to do great work, we will put the work out there. We will talk about the work we do in a direct and humble way. We don't want to go try to chase a bunch of low-quality revenues, right?
Yep.
We want to build a high-quality business over time. It's going to continue to get out there. When we perfect home delivery, will we talk about it? Yes, we will. Of course, we will. Will you read about it on our website? Will it be in our source books? Will you hear about it from other people? Of course. No different than our galleries. We talk about the new galleries that we open. We have pretty interesting opening events when we open them. We celebrate our work. Our capital is more focused on doing great work.
Thank you. A very quick follow-up for Karen, if I could. I know that you're largely through the clearance activity and the merch margins coming up will show that. Can you talk about the role that the outlets played in the quarter from a revenue perspective, and how many of them are still standing?
Yep. We have 31 stores right now. I think we'll open one more by the end of the year. Outlet growth was actually, if you look at that 460 basis point up number, outlet was actually a drag within there because revenues were up about $5 million. That's about a point of revenue growth, and the margins were lower than they kind of have been in the past and could be. We do think that's another area where we'll have better margins in the future when we're not still working through some of the outlet inventory. As far as the number of stores long term, although at one point we were thinking we would open these temporary stores and close them down, because of some changes in the reverse logistics model, we're not going to be having outlet inventory sitting in the DCs any longer.
Our bias is to turn that more quickly. As we've been talking about, we're going straight from when it's a return and exchange and it gets dinged or whatever, it's going to go straight to the outlet. We need more boxes, more outlet doors to turn through that inventory. Some of those locations we won't keep. They were temporary, so we might close them down and then open ones up that are closer to our home delivery centers.
Thank you so much.
Sure.
Our next question comes from Michael Lasser from UBS.
Good evening. This is Atul Maheswari filling in for Michael Lasser. Thanks a lot for taking our question. My first question relates to your third quarter comp drivers. How much of it was really driven by Modern, and what really was the contribution due to your source book? Were there any other significant drivers?
Yeah, we don't actually give a lot of detail on the specifics within comp. We just give that 6% comp growth, outlet was a point which is non-comp. We don't parse out the details of the 6.
Okay. That's fair.
We continue to be very happy with Modern. We're still very happy with that business. Still think it's incremental. Still think it has a lot of runway to grow, it's doing great.
Okay, I have a follow-up question on your guidance for the fourth quarter. We've seen that holiday spending has been pretty volatile in the past few years. Could you provide a sense of how trends have been recently and whether you're tracking in line or above your expectations at this point in the quarter?
The question is.
Around holiday.
Yeah. Well, holiday is, over the last several years, we've de-emphasized our holiday assortment, right? As we've emphasized our positioning as a true interior design platform. The holiday assortment that was kind of the legacy assortment, whether it's stocking stuffers or gifts and knick-knacks, and even holiday decor, we believe it detracted from our ultimate goal to position the business as really the leading luxury interior design platform in the country. Holiday's been a smaller part of our business. We added a little bit more than last year, a layer of decor and some gifts. Quite frankly, we are always torn to go through that assortment because some of it's relevant and some of it just seems like it just doesn't fit anymore. We do have a lot of locations that are still in malls.
You still have holiday traffic that comes through the malls, you still have a customer that's there shopping for gifts. It fits a lot less in our freestanding, larger gallery locations. We're less impacted by the volatility in the holiday quarter than others. We're not a typical business like most retailers anymore. Our business is not as dependent on that fourth quarter, and you'll see that start to unfold next year as you start to see our operating performance and how it begins to smooth out. Not too unlike the graph that we showed you with our sales, pre-membership and post-membership. Our sales and earnings and our business will have some seasonal movement to it, we're not banking everything on Q4 like we have in the past in our new model. We feel confident about the numbers we put out there.
I think I've said in my note that we're running the business with a bias for profits versus revenues. We're not going to chase low-quality sales and low-quality revenues. We're going to try to optimize the business. We're focused on kind of maximizing gross margin dollar growth. If you think about our revenues, even this past quarter being up 8%, with merchandise margins being up several hundred basis points, the way we think about the business, and if you just directionally think about the math, one point of margin is really worth two points of sales when you think about margin dollars. When you think about our business being up 8% with several hundred basis points of merchandise margin growth, our gross margin dollar growth is significantly higher than that, right?
We're not going to let ourselves be victims of the lens that other people might be looking at our business or looking at our stock, and short-term momentum players who are in and out. We're sitting with a stock here with almost 50% of the active float short still. They're very high, in the high 40s. It changes week to week. We're positioning the company to win over the long term. That's how we think about the business. We're very comfortable with our guidance for Q4. We feel very comfortable with the guidance we put out there for 2018. Which by the way, 9%-10% operating margins would put us at the top of the heap if you look at the people who have had the historical high operating margins in our sector, right? Most of them, their operating margins are eroding.
We've set our company up for the long term, and you're going to see operating margins expanding over the next several years.
Okay, thank you.
Our next question comes from Geoff Small from Citi.
Hello, Gary and Karen. Thank you for taking my questions. I first want to circle back to your 9%-10% operating margin target for 2018, and specifically, I was wondering if you can provide some color on the internal, external variables that would allow you to achieve the high end of that range or conclude 2018 at the lower end.
Sure. In the guidance that we gave both gross margin and SG&A, that kind of assumes that both certainly if something negative happens with the economy, we'd be closer to the low end of the range or not really speaking to things that we can't control. We have not factored in, obviously, some of the benefits that could come from tax rate changes and such. Really, I think some of that depends on level of investment in things like home delivery and hospitality, timing of new stores, because when those new stores open, we get nice volume lift and occupancy savings versus our old model. I think we're focused on all the things we can control. If things go sideways that are out of our control, whether macro or otherwise, we'll certainly pivot and make changes as necessary.
Thank you. That's helpful. I was also curious what level of revenue your two distribution center model can support and, if and when you reach that level, are you planning to open up additional DCs or simply add square footage to your existing locations?
Yeah. That's really dependent on how we grow the business, right? One of the things that's a big positive to some of our recent growth and one of the biggest growing parts of our business is our special order business. Our special order business is a business we don't hold inventory, right? We really just cross off the inventory. As we continue to, again, build this as an interior design platform, as you think about interior designers using our platform, as you think about people wanting to have their homes reflect their own unique point of view and style, our sense is our special order business will continue to grow. We think that the supply chain that we've just built is just significantly more efficient for how to position and turn inventory and how we think about it.
We think we've got the ability to grow for several years on the existing platform. If we needed to expand it, most likely, we're just going to expand the platform itself and just add some square footage in a simple way. It's not anything that I see in any time in the future that we're going to have big, significant capital expenditures as it relates to the distribution center network. We'll be making investments in home delivery, obviously, as we go forward and we simplify that model and as we articulated, I think, in our Investor Day, the existing home delivery models that exist are really built for the middle market, and there's really no luxury home delivery networks built out there.
The people that play at that level control it themselves, and we think we will either take more control or we will partner with providers to build a whole new level of quality and service that's deserving of our brand from a home delivery point of view. We expect to invest in that part of the business, and that's built into our operating model for 2018 and beyond.
Thank you, Gary. Thank you, Karen. Best of luck in the fourth quarter.
Thank you.
Our next question comes from Peter Benedict from Baird.
Oh, hey, guys. Thanks for taking the question. Back on the fourth quarter, the CBR compare is really crater, the guide seems to imply something similar to what you probably did here in the third quarter. I appreciate the bias for profits over revenues. Just curious, is there anything, any discrete puts and takes that we need to be thinking about here in the fourth quarter that would prevent, I guess, an acceleration in CBRs as we think about the fourth quarter relative to the third quarter?
CBRs?
Brand comp.
Oh, okay.
The acronym was throwing him off.
Yeah. Didn't know what CDR was. Oh, CBR. Okay. Karen, anything we want to add to that?
Yeah. No, I guess one thing that I would just say is that the holiday business for us just isn't. You would think that it might accelerate if we had a big holiday business when you go from Q3 to Q4, but that's just not the case for us, as Gary mentioned. I can't think of any reason why it would accelerate. I think it's going to be similar, but I don't know that you would expect a big ramp up for any reason.
Okay, I guess shifting over to supply chain. If we fast-forward to next year, we're on this call, what are the main things you guys think you'll have achieved in terms of the supply chain re-engineering, the home delivery efforts? Obviously, you're going to have the two DCs, just trying to get some guideposts to how we should think about maybe the next 12 months and where we should be sitting a year from now. Thank you.
Sure. The biggest two things that we have achieved is just the plans and one is done and the other one's forthcoming is the closing of those two distribution centers. When you think about the occupancy savings and the fixed cost that's going to come out of the business from that, and frankly, there's still one other facility that we've kind of spoken about that probably could be another candidate to close down further in 2018. I do think we have a lot of progress that's been made just on the DC network footprint. Really what we've done with reverse logistics and the savings that have already come, and we're 90% through that, and frankly, that last 10% is just markets that there's just not really an outlet close enough extent, or it goes back to a DC because it's right there.
Not having all of those transportation and labor charges and touching the goods has been a huge achievement. Those are the big things that we've already done. What's on the come and that we keep talking about is just how we're going to think about home delivery and what that experience is going to be like. I think that's the biggest thing left.
Yeah. I'd say it's home delivery and phase 2 of the reverse logistics and outlet businesses. If we thought about our reverse logistics and outlet business and how it's architected today, our outlets are not necessarily architected or in all the right places to optimize that network. We think there's continued opportunity and savings as we architect the outlet footprint to align with the business and the returns and the most optimal way to turn the product at the highest possible margin and handle it the least amount of times. The home delivery architecture, the home delivery business, and design of that will, in some ways, emulate and look like the outlet architecture. We think there's just huge upsides there. I think the home delivery piece, how fast can we go? Where we'll be a year from now?
I think we'll know more after the first or second quarter of next year when we start to get the real data on the test market here in the Bay Area, and we start to get more clear in the learnings and the opportunity that we see and may tell us to go faster. It may tell us we need to learn more and test more. The early indications and the numbers we shared with you at the investor day, and just we gave you a few of the metrics that we're measuring, just indicate it's a huge opportunity. We're still pretty early on here. Even if you think about our D.C. network and you think about how to optimize the parts of the business, how do you really optimize a 2 D.C. network?
If you have goods, what percent of the goods are coming into the West Coast? What percent of the goods are coming to the East Coast? How are you moving those goods back and forth? How are you thinking about transportation and the design of transportation? Long term, do we have a bias to control more transportation, right? If we're going to control our own trucks on home delivery in some markets and partner with others, do we control our trucks or partner with others on key transportation lanes in our business and take more costs out of our business? We have a unique opportunity as you think about our supply chain versus others, right? Whether it's versus the former businesses I ran across the Bay, whether you think about us versus the Wayfair or just other regional players.
Our average ticket of our product is significantly higher than everybody's else, right? We can architect a supply chain, and we have the scale, right? If you think about the average ticket, you think about the average order, you think about the scale of our business exceeding $2 billion, going to $3 billion here soon. We just have opportunities that other people don't have because they're playing a different game, right? They have to play with a different cost model. If you're delivering an $800-$1,200 sofa, and you're talking about how much quality can you build into delivering that sofa, nothing compared to if you're selling a $4,000 sofa, right? If you just think about that math, right?
That's why we like our model, and that's why we believe with the market we're focused on and the scale we have, the math says you can do it entirely differently than almost everybody else that's out there, right? We like what we see going forward. We like what the math indicates the opportunities will look like. We like the ability that we have to invest into quality that other people are not going to be able to invest into quality. You just can't invest that much when you're selling an eight to $1,200 sofa.
That's helpful. Thank you, Gary. My last question is just on the cadence of your source book mailings next year and the circ plan. Are there any changes relative to this year that we should be aware of? That's my last question. Thank you.
Yeah. As you know, if you followed us for the last 8 or 10 years, we are constantly evolving our source book strategy because the market keeps changing, right? As more business shifts to direct, as more business shifts online, plus as we change the cadence or just the character of our business from a business that was a more typical retailer with a big holiday assortment that had a big peak in December. If you look at the furniture business and furniture companies, December is not a very big month at all. It's actually when everybody goes on vacation. January is a big month, right? The character of our business is changing and is different, and the real estate's different. The source books are going to continue to evolve.
We're going to continue to test things, whether it's the size of the source books, whether it's the bundling of the source books, whether it's breaking out parts of our business into their own source book, whether we have a lighting book, a rug book, a linens book, separate books to build category dominance, and other things like that. Even when we mail the books, those of you who followed us a long time, when we used to mail 10 to 12 books a year, almost monthly, we had the radical change that went to two books a year, and everybody thought we were crazy. We went from two books a year to one book a year. Do we go back to testing two books a year? If you think about our business just short term, right?
The nature of the furniture business being really a big business in January. Do we test some books, do we have plans to test books at different times of the year? Do we put some books out into the marketplace in January to see how that works as our business continues to change and evolve? Sure. We're just going to continue to test things all the time. Sometimes you're going to notice them, sometimes you're not. As we have key learnings that are worth sharing, we'll share those with you. If we shared every test and every change in this company, everybody would be further confused about what we're doing, right?
We're already so unconventional and defying conventional wisdom with almost all of our moves, whether it's big stores or still mailing source books when everybody's moving to digital and going up market, when people were going down market. You just think about most of the things we're doing are relatively unusual, and it's because we do test a lot of things. We're constantly curious and critical of our own work, and we're going to constantly test things. I guess I just told you, don't be surprised if you see some source books floating around in January, right?
Terrific. Thanks, Gary.
Yeah.
Our final question is from Janet Kloppenburg, JJK Research.
Hi, Gary. Hi, Karen.
Hi.
Hi. A lot of my questions have been answered, but let me just see if I can summarize, Gary. We don't know how the delivery upgrades will unfold next year. You'll be testing them, and you'll give us an idea maybe at the end of the year, the fiscal 2017 call or first quarter end. Is that how I should be thinking about the timing there?
Well, I think we'll be talking about it all next year. Just like we've been talking about the architecture and evolution in our supply chain redesign and the distribution center redesign and the reverse logistics redesign. I feel now our efforts are shifting to the home delivery part of the business and architecting that, and we'll be testing things and we'll be working through it. As we learn, we'll continue to improvise, adapt, and overcome, right?
Yeah, I was just wondering, how should we think about that high-quality delivery, that touchpoint with the customer. What impact should that have on operating margins? Have you contemplated in that 9%-10% outlook?
Yeah.
Should it be a bit of a pressure to operating margin because you're providing this higher-level service? How should we think about that?
We think long term, it'll be accretive to operating margins.
Okay.
We think we've got plenty contemplated in our plans as it relates to the investment in testing and architecture. We're going to learn as we go. Delighting our customers and having furniture stick, and reducing returns and exchanges, and also augmenting the selling experience. Think about it. We get to go in our customers' homes. They open the door and let us in.
Right.
That just seems like an enormous opportunity to me. Maybe we don't just send in the delivery team.
Okay.
Maybe we send in other people with them.
I get it.
Maybe we create a different experience. Maybe there's a selling opportunity in the home, right?
While we're reducing returns, reducing exchanges, reducing cancel rates, solving problems in the home. If there's an issue with a piece of furniture and the ability to adjust it or fix it. As opposed to now, if it's handled by a third party, a call goes into the customer service center. It just transfers. It almost goes into the black hole that gets dealt with over days and sometimes weeks as opposed to minutes. So we're just going to get a lot closer to the customer. We're going to architect the back end for the business we're running today. Architect home delivery for the business we're running today, not for the business we were running 15 years ago.
Okay. Gary, when you set out your revenue range for next year, I know you have a lot of ideas about new concepts or extensions of RH's concepts. I'm assuming that there'll be some new launches during the year, or is that a wait and see as well?
It's a wait and see. I think more likely than less likely. The team's all here shaking their head. If you had a little webcam in here, you'd see everybody shaking their head. Yeah, of course we are. We like to make sure we get things right. People say, "Well, when is that going to be ready?" Say, "When it's right.
Okay.
When it's right, we'll launch things. We've got a few concepts we've been working on for years.
Yeah, I know.
Because they're-
Well, it's exciting to think that one or two of them may emerge next year. Just lastly, Karen, I think you said right now you have three stores that you're thinking about opening for next year or maybe have deals in process or signed on. Are those structured as sale leasebacks or are those more of the traditional rent-structured deals?
No, those are the traditional rent-structured deals. Now we have opportunity to do sale leasebacks of ones that are in the pipeline, we've put up all the capital for those.
I mean, obviously the landlord put up some, we've put up capital. The ones that we talked about at Investor Day where it's kind of a developer-funded and we don't actually put the capital, the first one of those wouldn't be until at least 2000, probably 2019.
Okay. There would be an opportunity to transition these leases over time to that structure.
Well, the new deals are going to move more towards that structure.
I mean, one of those.
David, do you want to jump in?
We know there's an opportunity to do. We'll give you guys more details on those as we have them. At this point, the three that were opened, two of them we've been talking about for a while. Portland and Nashville are early in the year.
New York, obviously. Those three we've been talking about for some time, Portland, Nashville and New York. At this point, we don't have plans to do a sale leaseback on those. Of course, things could change. If we have an opportunity to monetize-
we will evaluate that opportunity.
Okay. Just lastly, Gary, your vision for hospitality within the new galleries. Will you strive to have some sort of hospitality venue in each of the new gallery openings, or how do you think about that and what's included in the operating margin guidance?
Yeah, I think there's going to be more than less. It's not going to necessarily be able to be everywhere. It in some ways might be determined on the volume opportunity we think we have in the market. The ones you just saw were actually kind of both last-minute bolt-ons, right? We were under construction in Toronto. We were under construction in Palm Beach. They did not have hospitality design. When we saw the success and the reaction to Chicago and we saw the lines around the block on the weekends and we saw the performance of the overall gallery. The impact that we believe hospitality was having on the traffic and then the incremental sales of the gallery. We quickly pivoted and said, "Where could we add hospitality to?" In Toronto, we took kind of the front loggia of the store.
The store terraces back on the mall-facing side and we built a courtyard cafe. We kind of figured out how to integrate it and how to do it. Then in Palm Beach, the only place we could do it is we said we put it on the roof. We delayed that opening for several months and had to beef up the steel to be able to put the structure on the roof to handle it. What's great about both of those, to tell you the truth, is we have the Chicago location, which has an interior courtyard cafe. We have the Toronto location that now has an exterior street front-facing courtyard open cafe under a skylight. We now have a rooftop cafe and F&B experience. We have a test of all three.
What's really exciting to us, it's almost kind of bewildering a little bit. Chicago benefited because we've got this great historic building. We've got this incredible central courtyard that we put a steel and glass structure over. We had this great passageway with vaulted ceilings. We created a wine vault and it was just a great neighborhood and we partnered. Brendan Sodikoff, who joined us as President of RH Hospitality, is a very well-known restaurateur in Chicago. We knew we would be benefited by that. We quite frankly didn't know exactly what to expect when we went into Toronto and how that would play out. When we went onto the roof in Palm Beach, would anybody come? Would anybody know there's a restaurant and wine vault and barista bar up there?
Quite frankly, if you look at the numbers, the numbers are really comparable to the initial weeks and months in Chicago which was a phenomenal success. Hats off and really bravo to the team that Brendan has built because he is obsessive-compulsive about quality and execution. He's one of the deepest thinkers I've met in the hospitality space. He doesn't really operate as a chef anymore, although he does the direction, obviously, for all the menus. As his team says, he's still a great chef but he's just such a great operator and team builder.
When I think about the fact that we just kind of opened 2 restaurants in a very short amount of time in 2 cities that nobody expected us to have a restaurant I don't know how well I don't think that many people knew Brendan in Toronto or Palm Beach as a restaurateur, yet we've got packed cafes and wine vaults and active barista bars. If you go to Yelp, and the team is holding their hands up to me, it's like 5 stars. If you go to Yelp, and you look at Palm Beach, it's all 5-star ratings. It's unbelievable. We're just really excited about this opportunity, and I think you'll see it. We're designing them into more than less. Portland, we did not have the space or capacity to get hospitality into Portland. In Nashville, it is the first built-from-the-ground-up version of Chicago.
We designed that to have the central courtyard restaurant, wine vaults, pantry. It has a lot of the characteristics of Chicago, flows like that. New York will be our second rooftop restaurant. We're building an amazing rooftop park. It's like a 12,000 sq ft rooftop park with this beautiful glass box in the middle of it, with a beautiful skylight on the roof. It's got views of Freedom Tower in downtown New York. I joke around with the team, I say it's going to be the modern-day Tavern on the Green. I really do believe it's going to be like this destination in New York because it's so wonderful. Where do you get to, in New York, eat in the middle of a beautiful park and have views of downtown?
By the way, the great thing about the Meatpacking District, you don't have a lot of high buildings. We have all this natural light that hits our building and hits our rooftop. We think that one's going to be spectacular.
It looks quite beautiful, I'm anxious to see it. Anyways, listen, happy holidays, best of luck for a great season.
Great. Happy holidays.
Thanks, Janet.
This does conclude our Q&A session for the day. I'd now like to turn the call over to Gary Friedman for closing remarks.
Great. Well, thank you everyone for your continued interest in our journey here. We're extremely excited about the outlook for our business and our future, and we could not be more proud and appreciative of really the passion and the persistence and the work and effort that our team of people and partners around the world put into kind of bringing our vision and our values to life each and every day, and as we continue our quest to be one of the most admired brands in the world. Thank you, and we look forward to talking to you after the holidays.
This does conclude today's call. You may now disconnect. Thank you very much for your participation.