Good afternoon. My name is Jesse, and I'll be your conference operator today. At this time, I would like to welcome everyone to the RH second 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. If you'd like to ask a question, simply press star, then one on your telephone keypad. If you'd like to withdraw your question, press the pound key. Thank you. Cammeron McLaughlin , Investor Relations, you may begin your conference.
Thank you. Good afternoon, everyone. Thank you for joining us for RH's second 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 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.
As a reminder, in order to ask a question, please press star and 1 on your telephone keypad. Your first question comes from Steven Forbes with Guggenheim Securities. Your line is open.
Good afternoon. I wanted to start with the supply chain redesign. You mentioned four into three. Is Mira Loma the one you anticipate closing? Given the lease expiration, which I believe is 2020, what type of financial impact should we expect, if any, as you guys work through this whole process of optimizing the supply chain?
Sure. This is Karen. It is Mira Loma, which is Southern California, because the lease market down there is quite favorable, we actually don't expect to have a significant charge related to that. We're still going through the process. We've just notified all the employees, it's been a sensitive topic. We're treading lightly on that, but we are marketing the building. Again, because there's highly favorable rental market down there, we don't anticipate having a problem finding a sublessee to take over that with relatively small loss, if any.
Okay. Just as a follow-up regarding in-home delivery. Maybe, Gary, if you think about the long-term impacts, I try to digest them as well, could the optimization of the last mile potentially be net neutral or even net accretive to the business, the margin, the market share, given the potential benefits tied to lower returns, damages, plus the potential sales opportunity of getting the RH associate into the consumer's home. On that topic, maybe if you could just touch on where you are with any in-home delivery tests, if they're out there today, and how those tests have evolved, if you can comment on any of them.
Sure. I think we've been commenting for quite a while that we believe it's important for us to have more control than less control as it relates to the customer experience. The way we view it is the opportunity to be inside a customer's home, the opportunity to make a positive impression, not only in the delivery, but possibly in the after-sale market, is a huge opportunity. We believe that's just something we should have more control of than less control of. If you think about the home delivery industry and the architecture of third-party home delivery operations, they're really not architected for the luxury market. I think you've got to go back and say, no one's really scaled this business today. We're really the only ones at the luxury market with any kind of scale and actually any opportunity to even take this on.
Because of our scale today, we believe from a cost point of view, and you can't just look at it from one dimension, you have to really look at it holistically. What is the revenue benefit you're going to have from having a significantly better delivery experience and customer experience? What is the impact on, as we mentioned in the letter and you just mentioned now, on returns, exchanges, damages, so on and so forth? What is the cost to deliver it? Today, if you stand back, we really have two markups in the process. We have a third-party delivery company who's also hiring third-party truckers. You really have an opportunity to and everybody's making money. People are not losing money doing this for us. You really have two markups involved in the process.
When we stand back and think about it and start to model our scale against it, we like how all the metrics look. At the end of the day, we're testing it in one market. We're getting ready to go to two markets to test it. We're at the early innings of testing it, but we like what we see so far. Also, again, when you step back and we talk about it internally. A couple of years ago, we were having a big debate about this internally in the company and this debate, well, look at the cost of doing it externally. I said, "Well, look, you can always look at the cost of doing anything externally.
We could probably hire temps in our retail galleries, and we might be paying them less, too, but that doesn't mean it's the right thing to do for the business and the right thing to do for the customer experience." That's how we think about this. We're building a very special brand, a very special customer experience in our galleries and across all channels. We believe the in-home delivery experience is an opportunity to elevate the brand and continue to differentiate the brand long term.
Your next question comes from Brad Thomas with KeyBanc Capital Markets. Your line is open.
Yes, good afternoon. Wanted to follow up about the delivery network redesign. Gary, what's the right number of distribution centers for you to have longer term as you continue to grow this business? As we look at your inventory levels, about $600 million, with I believe most of that being in the DCs, how much do you think you could further reduce inventory by optimizing that delivery network?
Well, we think we're in the early stages of evaluating and redesigning and architecting the right supply chain for the business long term. From an inventory perspective, we believe that there's meaningfully more opportunity to turn the business faster, to have a much greater return on invested capital from an inventory perspective in the business. Exactly how that winds up and how many centers and how it's architected, we'll reveal that as we come to those conclusions. We're not done with the work. We're not done with optimizing the inventory. We think there's meaningfully more impact to make here in making this a much more efficient capital model.
Great. If I could ask a follow-up on the New York gallery, with the timing of that opening being a little bit up in the air, how should we think about that in terms of guidance and modeling the next couple of quarters? Thank you.
Yeah. Well, I think today, if anybody goes down to Meatpacking District would think it looks a bit like a war zone today. All the streets are being torn up. They're doing all the infrastructure work. They were supposed to be done in the spring. The spring was turned into the summer. The summer's now turned into the fall, now turns into the late fall. If you talk to people on the ground, they think it might be next spring. We're going to take it month by month. I'll be in New York tomorrow, be walking the site tomorrow, and we'll be evaluating it. When I was there two weeks ago, you couldn't cross the street. People don't have access to the sidewalks. As it relates to if it comes out of the model, I don't think it's going to be a significant impact.
We feel confident about our guidance. We'll update you as we know more.
Great. Thank you.
Your next question comes from Jeff Smoll with Citi. Your line is open.
Hi, Gary and Karen. Thank you for taking my questions. First of all, it looks as though you've run some limited time promotions over the last few months. Curious if that's simply part of your inventory initiatives or if you plan to be running that type of promotion with any regularity going forward.
Sure. Well, we've always said that there's regular kind of clearance activity that's going to happen in the business, right? Moving to membership doesn't mean that we're never going to discontinue product and refresh the inventory. There's always going to be a kind of a summer clearance sale, a winter clearance sale, and events to kind of clear through inventory. Just think about that as kind of status quo. That will always be part of the business.
I think we also mentioned in the past that as we evaluated membership, looking at the impact on kind of the higher ticket business or the lower ticket business, we clearly, on the lower ticket business, it took a bigger hit, and we began testing and now it's implemented kind of sales for things like our home furnishings business and so on and so forth, where the crossover point to buy a membership doesn't quite hit the price points, and we were losing part of the business there. We've reimplemented that part of the business, but that's a much smaller part of the business. We didn't want to lose it because it's an entry into the brand. Those are some of the adjustments, and I think we talked about that several quarters ago.
You do have a third layer of, yes, within kind of the regular sale cadence of the business, the seasonality of moving through seasons, moving through some of the product, that we are using that to move through the part of the business that's not going forward as we rationalize the offering.
That's very helpful. Thank you. As a follow-up, I was curious whether you can provide any color on the impact from Harvey in the Houston area and also whether there will be a potential delay to the upcoming Florida gallery from Hurricane Irma. Thank you.
Yeah. Well, like everyone in Houston, it was a pretty devastating event, and our hearts go out to all the victims of that significant storm. We were down, I think for six days in our business. We've opened. The business is slowly recovering. I think there's still a lot of chaos in the city and a lot of issues with transportation and a lot of people recovering from the event. We lost roughly a week of business in a pretty significant high volume store. That's factored into our guidance, and we expect the business to kind of rally back. As it relates to the Florida market, our teams are battening down the hatches. Everybody's prepared for the storm. We don't have any more information than anybody else does at this point to know the business impact in Florida.
Understood. Thank you again.
Your next question comes from Oliver Chen with Cowen and Company. Your line is open.
Hi. Thank you. We had a question related to just modeling the free cash flow profile for the back half. What will be kind of the biggest drivers we should focus on in terms of free cash flow for the back half? Gary, on the comments in the remarks, it looked like in the RH Interiors source book, you had swung a little too far towards the contemporary aesthetic. If you could elaborate on what happened there and some guardrails going forward, and just give us some more clarity about the opportunity. It's always a fine line as you're balancing innovation and newness and surprising and delighting versus core.
Sure. Well, I'll take that part, and Karen will address the cash flow part of the question. As happens inside organizations, you can overly tilt and shift one way or another as you focus on big opportunities. I think what happened here with the focus on building the RH Modern business, and the effort that took from the organization, I think it really skewed kind of our perspective and our eye a bit. Your eye can somewhat get tired of things that it shouldn't get tired of in our business. We always say we can't get bored of ourselves. We can't get bored of the things that really drive our business.
The fact is that, not only the internal shift with us, but I think also with all of the designers and artisans and manufacturers we work with globally, and who are really an external part of our product development platform. I think everybody started to develop product with a more modern point of view, a more contemporary point of view. It's what we were all working on. It's what we were all excited about. I think we just shifted the core book too far. I think as we take the interiors book, it's really important to evolve great brands slowly. Great brands usually don't swing around. They're like watching a clock. If you look away from it for a few hours, it moves, but you never really saw it move.
I think if you picked up the book we mailed last fall, and you paged through it and you compared it to previous books, it really shifted to contemporary, and it really took on a look too much akin to RH Modern in the first 60 to 80 pages. While we believe the world is moving in a more contemporary way, and that is an important trend, the core parts of the business and the franchise businesses can't be ignored, because that's what really drives that assortment. In evaluating it, looking back, we just think there's opportunities to kind of readjust, not swing all the way back. We want the interiors and the core part of the brand to continuously evolve and feel fresh, but it has to also look familiar.
We think we, in some cases, kind of jumped the rails and looked a little too contemporary. You see us move back to that. As it relates to the guardrails, all of us here that lead the business are the guardrails, right? We're constantly evaluating the data and evaluating the choices and the opportunities and trying to make the right bets and allocate the capital the right way towards the right inventory and hopefully get the right returns. You don't always get it right. The good news is it's a lot more right than wrong, right? The business is performing nicely. We like to say inside our business, we're kind of always unsatisfied, always on the move. You'll tend to see us always be a little critical of our own work.
As we look at it, we think we can do much better, and we think that we can quantify with the data missed opportunities and opportunity to expand parts of the business that we're famous for.
Oliver, on cash flow, the biggest two drivers in the back half, number one is certainly inventory. We'll continue to see that number come down by the end of the year. It's going to come down even more than we've already seen to date. The second is really just earnings. We have more earnings kind of power. Net income's bigger in Q3 and Q4 than it is in the first half. There's some other smaller working capital items that are contributing. The biggest two would be just earnings and inventory.
Okay. Gary, as we all get ready for holiday and retail has undergone this revolution and disruption, what are your thoughts for catalysts for you for holiday and how you can seek to optimize your store traffic? How did you feel about your assortment in terms of balancing price points? It sounded like there could be opportunity there. Just curious about traffic and holiday and thoughts on a year-over-year basis, what will be most different? Thank you.
Sure. Well, last year, we really pulled back, and we said, look, long term, we still carried some of the legacy RH with us over the years, and part of that was just out of the necessity as we are transitioning the business. We needed to hang on to certain things, and partly the holiday piece of the business was important. As we transition this business from a typical mall-based retail home furnishings business to really a luxury interior design platform, holiday, at least holiday the way it was previously characterized, doesn't really fit in the business, right? There's a new layer of holiday, a home decor layer of a holiday, an elegant gift-giving aspect of holiday that we're working on that you'll see us layer in.
I think last year, as we really pulled the plug and we pulled it out of the galleries, we took the hit. I'm kind of glad we did when we did. It's now beyond us, and it's over. As we evaluate what do we bring back in, how do we brighten up the mood of the business and the presentation during that time to maybe pull more people into the business, we're working on that, but it's a fine line, right? We're not a Christmas tchotchke business anymore. We're not the place you wake up and look for stocking stuffers, or you wake up and you look for this and that. We'll still have some of that in our holiday catalog, but it will continue to be a smaller part of the business as we go forward. It's just not what we're trying to be famous for.
Hence, nor does it line up with our long-term real estate strategy. If you look at the galleries we're building, where we're putting those galleries, for the most part, they're not in malls or they're not in the main traffic part of the mall. They might be a freestanding anchor kind of location, or if you looked at Chicago, we're in a residential neighborhood that really doesn't have any traffic, yet we have a gallery there that does over $50 million a year, right? There's really not a lot of gift giving in the store. That's not the long-term strategy. We kind of took the hit last year. We think there's opportunity to layer some back on. If you went by our galleries last year, I think I said it really hit me. I was down in L.A. and grabbing something to drink at Urth Caffé.
I look across the street at our gallery, and we didn't have one Christmas light. Nothing was twinkling, and I came back and said to the team, "Gosh, we look like the unhappy store." We don't want to be that, for sure. You'll see the galleries brighten up. You'll see a little bit more of a holiday Christmas spirit, and more focused on really a decor kind of business and a luxury gift-giving kind of layer throughout the gallery.
Sounds very good. Thanks for the details. Best regards.
Thanks, Oliver.
Your next question comes from Charles Grom with Gordon Haskett. Your line is open.
Thanks. Good afternoon. When we look at your implied gross margin improvement in the second half, up, I think it's 300 to 400 basis points, compare that to the front half of the year, which is up about 400 basis points on average, can you walk us through the step changes that you're going to see across the core merchandise margin improvement, the savings that you're expecting to get from the DC consolidation, and finally, the changes that you're going to do from the rerouting of the outlet products?
Sure. We probably won't break out a ton of detail on each of those pieces, but I will say that as we enter into the second half, we did go ahead and give a lot of detail in the back part of the press release that actually shows guidance for Q3 and Q4 margins. The delta, if you just look at what we're up or down versus LY throughout the year, it's a lot more about what we did last year in the second half than it is about this year. We're now in that 36 and a half to 37% gross margin range. The up roughly 400 basis points in the third quarter really has to do with last year. We had SKU rationalization. We had the floor sets. We were doing floor model sell-off to make room for all the design ateliers.
In the holiday period, we didn't have as many of those things. In both periods, membership was ramping, we weren't getting the benefit of that revenue, and in the second half, we are. You'll see that the change is more about last year than it is about this year. We're getting back to those 36%-37% that is more normal for us if you look back a couple of years before 2016.
Just to dovetail that, you're not assuming that you're going to get some of the $15 million-$20 million that you talked about from the outlet changes. Could that be upside?
No.
Is that more of a-
That's mostly in transportation. I was mostly just talking to it on the whole. There is some modest improvement. Obviously, it's still early stages, but we're already seeing transportation savings in the markets where we're not bringing that outlet merchandise all the way back to the DC. That's part of the reason why we're able to save and get out of a DC, is we're not taking up outlet space in the DCs. That reverse logistics decision has benefits all up and down the P&L, certainly in occupancy, which rolls up into gross margin, and shipping, transportation, which is up in gross margin. That's in there as well.
Okay, great. Just to follow up, that's helpful. Just on the membership rates, I'm just wondering if you guys would be willing to speak to the renewal rates that you're seeing and what the churn is on that and how that's trended. Thanks.
Really, because we're the only specialty retailer that's ever done this, outside of Amazon and Costco and a few others, we're the only ones that have made a move to membership that didn't start out with membership this way, and there's no benefit in us creating a roadmap for anybody else to follow. We're not going to say a lot about membership other than the fact that we made a very brave move. A lot of people thought it wasn't going to work. We're in a position to tell you today that it is working, and the renewal rates are positive. The membership growth is positive. Other than that, we don't need to give anybody else a roadmap to simplify their business and gain the benefits that we're going to gain over the next couple of years because of that.
Okay. Fair enough. Then my final question, just if you do achieve the $4 billion-$5 billion that you've outlined, and we look at your profitability today and compare that to where you were a few years ago, and it's probably not a good way to look at it, but when you look ahead, where do you think the profitability of this business could be, when you think of all the savings that you could do and the top line that you could generate?
Well, we've said we can have industry-leading operating margins. We think at one point we are characterizing mid-teens, and while that still looks achievable, what we don't know when we look long term is the industry going to change? Is there going to be other competitive pressures, or is it going to be more beneficial for us to be more sharply priced than go up and create a bigger market? How should we think about it? We're leaving some flexibility. I would say if nothing changed over the next 5-7 years, could this be a mid-teens operating margin business? Yes, it could. The model would say it could today. I think we don't want to get boxed into that. I think that, look, we're in a world that you have to remain flexible and fast, and you have to improvise, adapt, and overcome.
There's so many things changing. We just want to have a great model that allows us to win, and if it means winning at 15% operating margins, 12% operating margins, 11%, 10% operating margins, I don't know if that should really be the guidepost for us. I think that the guidepost should be how do we maximize the market share of this business and the overall profitability of this business, and have a viable brand that can win forever, for as long as we're guiding this business or beyond. We can all see today. I was talking to somebody the other day, and they said, "Oh my God, the death of the department stores, the [NCH], Amazon, the death of the department stores." Amazon's wrongly accused, right? The department stores have been dying forever.
It's been a slow death from a lack of innovation and from very rigid business models that couldn't adapt and innovate. We just believe today you've got to build a very flexible model, and you've got to be able to pivot the business and make the right kind of changes to win for the long term, not win for the short term.
Great. Thanks very much, and good luck.
Your next question comes from Brian Nagel with Oppenheimer. Your line is open.
Hi, good afternoon. Thanks for taking my questions. The first question, Karen and Gary, I have is just looking at the guidance that you've rolled on today, and thanks for all the detail there. It definitely is suggestive of a positive uptick or in trending the business. How should we think about it? What are the risks you're really managing against to achieve that guidance through the balance of 2017?
Well, I think we all have the risk of any kind of macro moves in the business. There's the aspect of what we don't know. We think we've got, as we've now cycled a year of membership, we understand what that looks like. We've made the adjustments that we needed to make with the model. We're architecting through some pretty big moves through the supply chain. I'd say as we get farther through this, we have more control rather than less control. We feel very confident about the guidance in Q3, Q4. As any company does, we have our internal list of opportunities and risks, and the opportunities far outweigh the risks when you look at our Q3, Q4 plan. There's a lot of uncertainty, I think, with just the political environment and all the noise around North Korea and those kind of things.
Could they affect the consumer if all of that heightens? Sure, it could. I think we're in a good position where we look at the back half and we say there's more upside to downside. We feel very confident in the numbers we put out there. We've got our arms around this model. We've now, as I said in the letter, we're past the most uncertain times of the transformation that we just led this company through. We're glad we did, and we are more right than wrong with our assumptions, and we really like the model that we see evolving. As we look into next year, we see more upside. We still are at the very early stage of this.
I was in a discussion with someone the other day that said, we were talking about the brand and the business, I said, "You really have to think about this company like a relatively new company." We're really seven years old, right? I got here in 2001, the company had a $20 million market cap, was about ready to go bankrupt. We had to raise money three times to keep the company out of bankruptcy. For the first five to seven years, we were just on the edge of bankruptcy trying to make it. We took the company from $300 million, losing $40 million a year, to $700 million, making $40 million a year. We're taking the company private, the economy collapsed in 2008, 2009, that set us back to a $500 million company losing money again, right?
We came out of that. Really in 2010 is when we made this significant pivot to the luxury end of the market, and really emerged as a kind of a new company, if you will. I look at this, I say we're really early stage. We're like a seven-year-old company, where the pieces are all coming together. It's becoming more clear where the big wins are, where the big opportunities are. We're 14 galleries into a 60-70 gallery transformation. We have so much more data. We're so much smarter now about what those galleries can be and will be. We're getting smarter and smarter from a direct business point of view and a web business point of view and a source book catalog point of view.
Now I think we're getting really smart from an operating platform and infrastructure point of view and a supply chain point of view. We're all getting very close to those parts of the business. There's not too many things that we're not aware of today, and aren't very close to today. That's one of the benefits of membership, right? Anybody who hasn't worked inside a retail business doesn't probably have the appreciation of the chaos you manage in a weekly, monthly promotional kind of business. When you've got different promotions, did you pull business forward? Did you push business out? How are you lapping? Then people are adding promotions. It's chaos. You can't really even see the big moves if you're playing that small game.
We made a very difficult decision a year and a half ago to create a new and different model, and I can tell you the benefit in this organization, the way we allocate our human capital, the opportunities we're able to see because we're not stuck inside the chaos and we can see outside of the trees that are right in front of us. We see some very big moves and very big opportunities, and we're close to parts of the business that we just weren't close to before. We're working in a highly collaborative way to architect a new kind of business model that's nothing like I've ever been involved in. We feel more confident than less confident about the numbers.
We feel like there's more upside in the third and fourth quarter, and we feel really good as we look into next year, what this model looks like.
That was very helpful. Maybe just a quick follow-up on that then. As we think about, again, reflecting upon what seems to be a nice stabilization and collection, higher in the business now, how should we think about the cadence of gallery openings into the next year or so, a couple of years? Also, what happens with the outlet business, especially now that it seems like you're through a lot of what has been the outsize clearance activity. How does that business evolve over time?
Well, we said that the outlook for the gallery openings would be 3 to 5 a year. We think that's the right number. As we've said before, we're in the development business now. We're really not in the kind of the mall leasing business where you're taking 50 feet of frontage and an already built box and you're fixturing a store and building a storefront, right? It's not what we do. We have to find pieces of property or existing historic buildings and go through entitlements and go through city councils and all these things that take longer.
I look back and I think how naive we were when we went public and we had our first couple of big gallery deals, and we said, "Oh, we can open 10 to 15 of these a year." I remember one of our biggest shareholders, who, by the way, stuck with us the whole way, and he said, "Really, Gary, do you think you can really manage opening 10 to 15 of these a year? What about, like, 4 to 5?" Because these seems like pretty, we just didn't know enough, right? We were overly enthusiastic, and the numbers were very seducing, and we thought we could go fast, and we were on that high growth train as a public company. I just think we're just so much smarter now. We have a lot more scar tissue, right?
Look, I'm one of the biggest shareholders of the company, and as I look at this, I don't want to play a short-term game. I don't want to race after fast growth just to know it's unsustainable. We want to build a company that has long-term, sustainable, durable growth. We want to build quality into the business. You find out when you're chasing growth, you can compromise on quality. I think at the end of the day today, we want to build a really high-quality business, a really high-quality brand. It takes the entire leadership team being into the details. These big galleries are big and complex. So look, if some years we open more than 5, we do. If some years we open less than 3, I hope we don't, but it could happen.
We think we can manage in a high-quality way the development of three to five of these big galleries. We also think we get smarter every time we do one, and then the next ones benefit from those learnings. We like the cadence and the path we're on. As far as the outlet business, what happens to it is as we move through these outside clearance initiatives. If you think about it, we've moved a lot of units at a very low margin. We've cleared through a lot of inventory. We have a bit more to get through in the third quarter, starts to normalize in the fourth quarter.
I think we are designing a self-liquidating kind of reverse logistics outlet organization that just, we will have the right number of outlets in the right places to kind of optimize the return process and the liquidation of inventory. Next year you might initially say, "Hey, are you going to have a big sales drag in the outlet business?" We don't think we'll have a big sales drag next year, only because we'll be selling a lot less units at a much higher margin. The sales will probably be somewhere in the same ballpark, but the financial performance will look a heck of a lot better because we're not liquidating so much of the second-quality inventory.
Thanks.
Thanks so much, Gary. Appreciate it.
Your next question comes from Matt McClintock with Barclays. Your line is open.
Hi. Yes. Good afternoon, and thanks for all the color today, Gary. Really appreciate it. I need to bring us back to the distribution centers going from five to three or five originally to three, just because I have two questions. It's largely because you seem to be going in the opposite direction of what the rest of the retail industry seems to be doing. The first question on it is this more a function about less growth, meaning going to three to five stores per year? Is it more of a function of SKU rationalization, or is it more of a function of underlying efficiencies in your supply chain? The second question is, I know you have another facility in California, but how does this impact delivery times or the potential for delivery times or the potential for out-of-stocks?
Just thinking back to last year, granted it was a little bit of a different situation there, but how those risks can have a meaningful impact on your business. Thank you very much, Gary.
Sure. Well, one, again, nobody's really selling the product we're selling, right? You have to be careful comparing what we're doing to what Amazon's doing or what other people are doing. We're kind of building an interior design platform. We're doing homes and projects, and yes, we still sell someone just a sofa or a chair or whatnot. The jobs, the average orders are growing. The kind of business we're running is very different. Designing the supply chain to support the business we're in is very important. We're really focused about on inventory optimization, return on capital, and the customer experience. You can get a sofa, to most markets in two to four days, right? I could argue you could run this company with one DC.
We don't think that's the right way to run it. You can get a product across the United States in three days, right? How should it be architected long term? We definitely think it's a multi-unit kind of structure that optimizes time to customer. The inventory duplication in four or five or We were on a path to go to eight DCs. The inventory duplication and the capital drag of that, and just the bloat on our balance sheet was going to make this company kind of impaired for a long time. We're designing a supply chain really for our business. Our business doesn't look like anybody else's business out there today. People ask us a lot, like, "Who's the competitor?" I believe we're building a brand with no peer.
You put somebody up against us today and say who's really offering the quality, the breadth of assortment, the integration of aesthetic, the kind of retail experiences we're building. There's not a real good peer. There's just different requirements for our business than there is other businesses. We're building a supply chain for our business to win in our business. It's going to look different, just like our galleries look different. When I took over this company, we had 106 galleries, and we were doing $350 million a year. Today, we have significantly less galleries doing $2.5 billion, right? It's a different company. More will be revealed as we go, but we think we're going to positively impact the customer experience. Look, the more DCs you have, the higher your in-stocks go, right? It's a lot easier to carry inventory in one DC.
You're always in stock. The goods are always in the right DC. When you have two, it's twice as hard. When you have three, it's three times as hard. When you have five, it's five times as hard. It's really that simple. People think it's not, but it is.
I think the point about the product being so much different than what everyone thinks of with Amazon, it's a big deal if your toothpaste or your book isn't there in two to three days. So much of the high-end furniture business is custom already. Even if it's not custom, people will wait an extra two to three, maybe four days to get it in market. That's just a tremendous savings for our occupancy cost and our working capital over time.
Yeah. We have over 70% of our upholstery business is special order.
Thank you very much for that color.
Yeah, yeah.
Sure.
Your next question comes from Michael Lasser with UBS. Your line is open.
Good evening. Thanks a lot for taking my question. If we assume kind of a modest rate of new store productivity or the contribution between the brand comp and your total sales growth For the third and fourth quarter, it looks like you're guiding maybe a mid-single digit brand comp on what are progressively easier comparisons. What would make the business slow down just from a brand comp perspective?
As we enter into the second half, you are right, we expect to know always maybe one or two of new store growth, which is non-comp. The delta between total sales and brand comp, that we don't expect that to be much big anymore now that we're kind of past the outsized outlet growth and Waterworks is in the comp base now going forward. You're right on where the guidance implies. Really, we're up against last year's kind of apples and apples. On last year, we were doing some SKU rat, we're coming up against that. Our guidance is our guidance. That's what it implies. I still think it's a pretty healthy top line and total growth.
Very healthy. Is there anything that would cause it to slow down in the back half? Like Gary mentioned that you're not going to bring back all the knick-knacks that you offered over the holidays, but maybe some of them, that should be a positive driver. Is there an offset to that?
Look, we're trying to be conservative, we feel confident about the guidance we put out there. If you look at the core business over the first couple quarters is roughly 9%. If you look at the guidance in the back half, you take the midpoint, it's not too far off that, we're just trying to be conservative as we think about our guidance.
Okay. My follow-up question is on the gross margin math . It does look like you're expecting anywhere between 2 to 400 basis points of gross margin expansion in the back half of the year. Your outlet margins, as you indicated in your release, are going to improve. It sounds like you're also getting some gross margin contribution from lower return rates, lower cancel rates. If we exclude those factors, are you seeing better selling margins, or because of the way the membership program works, coupled with some of the sale activity, the selling margins are a little bit lower still?
In the back half, about two-thirds of the gross margin improvement is products related, so merch margins. The rest is coming from transportation, the things that we've been talking about with our reverse logistics and such, and occupancy. The two-thirds that's kind of the product margin improvement is coming mostly from the core business.
Selling margin.
Self selling margin.
Yeah.
The outlet business will have a modest drag, but that was really a half one thing as we got that inventory down.
What's driving the big improvement in selling margins?
Just being up against everything that you saw. We've looked at and described ad nauseam, kind of last year what was happening in the business and we're anniversarying all that.
Okay, great. Thank you so much.
The next question comes from Cristina Fernández with Telsey Advisory Group. Your line is open.
Well, hi, good afternoon. I wanted to ask about the hospitality costs. You talked in the letter about having substantial costs over the next couple of years, should we think about this being more front-end loaded as you build the organization and lessening as we move into 2018 and 2019?
I think I'd take it just as we said it. Over the next couple of years, as we're building out the hospitality organization and we're building on a base of one, right? When you think about the pre-opening costs and the investments you have to make to build a national kind of restaurant hospitality platform, there's significant cost to get it up and get it going, it's all embedded in our guidance.
There's really two pieces, as Gary said. There's the organization, which is just building that team, and once that's in place, that team will kind of execute everything. It becomes if we have three as we do this year, but last year we didn't have any because Chicago was in 2015. We're going from having zero in 2016 openings to having pre-opening related to three. If we have three next year, obviously at least that piece of it isn't as big of a drag, it just depends on which ones and how many.
Yeah. It depends on if they fall into quarters. If we have a bunch of galleries falling in a quarter, that's going to be more of a drag because there's just a big pre-opening expense on a restaurant.
It's not unlike when we had the first big galleries and we had pre-opening rents and pre-opening cost of getting all the furniture there and everything set up. The first time we had it was kind of a big deal, but now we have that 3-5 every year, and it anniversaries itself, eventually it starts to lever and grow.
Yeah, it's much more people intensive business. If you just look at our Chicago gallery, I think we employ somewhere around 40-50 people in the home furnishings design part of the business, and we have over 100 associates running the restaurant, which is 10% of the business.
That's helpful. Then as a follow-up, any more thoughts into Waterworks and how you could integrate that into the RH core business going forward?
Yeah, we'll talk about that when we're ready to kind of reveal that plan and that strategy, look, we think it's the best bath and kitchen brand in the world. We are so proud to be associated with it, we think there's tremendous upside in that part of the business. It will, long term, I think we can amplify that business on our platform, it's just nothing but upside when we think about it long term.
Your next question comes from Curtis Nagle with Bank of America Merrill Lynch. Your line is open.
Great. Thanks very much for taking my question. Just quickly going back to the gross margin. As you've stated, you've seen some really nice benefits to returns, cancellations, exchanges from moving to the membership model. When did this inflect? Was this something you guys started to see in 2Q? Was it a little more recent in 1Q? Just kind of curious on the timing of that.
We really started to see it maybe halfway into the membership. It's hard to see trends, because when the cancels come in or returns come in or exchanges come in, you need to know what period they relate to, so it takes a while to make sure the data's clean. I will say that some of those items don't necessarily impact gross margin. Something like a cancel, it just impacts conversion, so whether or not a sale actually becomes a sale, but it has benefits downstream in things like the call centers from people calling and our people, everything. Some of it's what we call conversion, written orders or demand to sales, and then obviously transportation with things like returns and exchanges is significant. That does hit gross margin. It's kind of all over up and down the zone.
Yeah. Some of these things have a waterfall effect, right? Like returns and things, you really got to look at it at almost a rolling 12, maybe a 12-month kind of calendar, because it waterfalls down, right? A sale you make today doesn't necessarily return tomorrow. It might return two months, four months, six months down the road. You've got to really look at these things over time. I think what we said is, after we were kind of six months into it and two quarters into it, three quarters into it, we were saying that we like what we're seeing. We like what's happening underneath this and underneath the business. Clearly, there was an effect on the fact that we were giving a bigger discount, so we're taking a margin hit. We were taking $100 in membership, but we couldn't book that.
We were taking the hit on the gross margin line. We couldn't book the membership fees. We had to amortize those over 12 months. There was funny things in timing there, which we were trying to explain. We also made the decision to begin to re-architect our operating platform and rationalize our SKU count, which created kind of noise in the model, if you will. I think as we're now starting to cycle that, and we've cycled membership, and we've got now the kind of the waterfall and the trailing 12 months data and all these trends, now you can see the trends much more clearly. The noise is kind of going away from the business, and we've got enough data where you say, "Okay, that's real. That doesn't look like a three-month trend." We're very confident in how this is kind of revealing itself.
Now that the data's here, right, you can see a lot of things you couldn't see. There's many more opportunities that we're very excited about as we think about designing and architecting the operating platform for this new business model.
Got it. That's very helpful. Just a quick follow-up. Are you guys still expecting to pay down the $100 million second lien term loan by the end of this year?
Yeah, absolutely.
Yep.
Absolutely. Yeah.
Okay, great. Thanks very much for taking the questions.
Your next question comes from Budd Bugatch with Raymond James. Your line is open.
Good afternoon, and thank you for taking my questions. That was an interesting pronunciation. I guess, Gary, I do want to make sure I understand on the outlet situation. You have, I think, 28 outlets now. Some of them are short-term, and that number has moved around. Do we expect more outlets, less outlets, and just a kind of a profit-driven model for the outlets as well, or how do we think about that going forward? I do have one follow-up.
Sure. What we're trying to do is look at the outlets in an integrated fashion, right? It's really one business. It's the RH business and the outlet part of the business has really got to be thought about holistically, right? How do we optimize the overall profitability of the company and optimize return on invested inventory. We are at the early stages of architecting the right number of outlets in the model. Right now, I'd say that they're more supporting kind of the short-term moves we're making. Some of them are well-positioned for the long term. Jim Thompson, who runs our outlet and reverse logistics business, is working with his team, redesigning that network to really optimize the business. They're doing a great job. They've really done an excellent job in helping move through a tremendous amount of inventory in a short amount of time.
Really, long term, when you think about our business, we're going to have 60 to 70 kind of dominant galleries in major metropolitan areas that will drive a significant amount of business, as will the direct component of the business in that market. The idea is to really think more like a fully integrated market strategy where whether it's the gallery, the outlet, the home delivery network, how is it all integrated as a business model inside a market and optimize the profitability of that market. Clearly, it was not very efficient to just pick up Returns, take them all the way back to a distribution center, process them in a distribution center, hold them, and then pick them again and have more transportation to send them to an outlet in a market. We completely changed that model. The new model is significantly more effective.
We also believe it's going to be accretive to gross margin because we're going to eliminate about four or five touches of the product of moving it. Instead of taking a product from a gallery to an HDL, then an HDL to an outlet, and then process in an outlet and put it away, and then pick it again and take it to another outlet. You're going to eliminate multiple legs of transportation, multiple touches. Once you take something out of a box in our business, as you know, it tends to look worse the farther you move it, the more times you touch it. We're really designing a market strategy that can just optimize the overall business and try to liquidate product and market. We think it's going to be a significantly more accretive strategy and profitable strategy.
Okay. No, I understand all of that. My follow-up is kind of a detailed question. Karen, can you give us under the asset-based credit facility what the excess availability was at the end of the quarter?
I can look it up.
What?
It's lifted because of the amount of inventory coming down. It'll be in our 10-Q.
Yeah, I think it'll.
It'll be filed tomorrow.
Yeah, it'll be filed tomorrow. Yeah.
The availability of $600 million, you can't just take 600 times the amount outstanding because it is an asset-based calc. I don't have it.
Right
I don't have it at my fingertips, but it'll be in the Q tomorrow.
Yeah. The letters of credit outstanding, is that the same as it was at the end of the first quarter?
There's about 15 to 20 or so.
About the same. Okay. All right. Thank you very much.
Sure.
Our final question is from Adam Schindler with Deutsche Bank. Your line is open.
Yes. Good evening, everyone. Thanks for taking my question. Clearly, a very positive surprise on the free cash flow guidance for the year. As we move past 2017 and all the work you're doing at the outlets, how should we think about operating cash flow going forward and working capital specifically? Should we expect a tail from a lot of this optimization work that you're doing? Secondly, just to confirm, in the diluted share count that you report right now, what, if any, of the convertible stock is included in that?
Sure. I'll just do the share count really fast. We wouldn't include based on GAAP, and we wouldn't include it until the stock price was above, so you would issue those shares. There's 3 million shares underlying the 2019 and 2.5 under the 2020. To the extent the stock's over $116 or $118, you'd have 5.5 million shares come back into, to the extent those converted, come back into the share count at that time.
Okay. Thank you.
Yeah. That assumes that the company wouldn't pay the converts off.
Right.
We have the option to pay down the converts with cash.
Okay. Then on the free cash flow?
Yeah. You won't see certainly the same extent of cash flow this year, just if you look at how much inventory is coming down. That's something that won't be repeated. We won't take that same kind of significant step change next year, we still absolutely expect to be positive free cash flow and generate significant free cash in the future. We'll certainly give more guidance on that as it comes. Our profitability will rebound next year, that'll also be a nice driver next year, where we don't have things like margins getting hit so much with SKU rationalization and outlet. While we won't have as much inventory, we will have a lot more profitability.
Excellent. Thank you so much. I appreciate it.
Sure.
There are no further questions at this time. I'll turn the call back to Gary Friedman for closing remarks.
Great. Well, thank you everyone for your time, and we look forward to speaking with you next quarter.
This concludes today's conference call. You may now disconnect.