Thank you. Ms. Cammeron McLaughlin, you may begin your conference.
Thank you. Good afternoon, everyone. Thank you for joining us for RH's second quarter fiscal 2016 Q&A conference call. Joining me today are Gary Friedman, Chairman and Chief Executive Officer, and Karen Boone, Co-President, Chief Financial and Administrative Officer. Prior to this call, we posted a video presentation to our investor relations website, ir.restorationhardware.com, highlighting the company's continued evolution and recent performance. Before we start, I'd like to remind you of our legal disclaimer that we will make certain statements today that are forward-looking within the meaning of the Federal Securities Law, including statements about the outlook for our business and other matters referenced in our press release and video presentation issued today. These forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially.
Please refer to our SEC filings as well as our press release issued today for a more detailed description of the risk factors that may affect our results. Please also note that these forward-looking statements reflect our opinions only as of the date of this call, and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Also, during our call today, we may discuss non-GAAP financial measures, which adjust our GAAP results to eliminate the impact of certain items. You will find additional information regarding these non-GAAP financial measures and a reconciliation of these non-GAAP to GAAP measures in today's financial results press release. A live broadcast of this call is also available on the investor relations section of our website at ir.restorationhardware.com.
With that, I will turn it over to the operator to take our first question.
As a reminder, if you would like to ask a question, that is star and the number 1 on your telephone keypad. Our first question comes from Adam Sindler with Deutsche Bank.
Hi. Yes, good evening, everyone. Hope everyone is doing well. I have a couple of questions here. I guess, some of the more interesting news in the release was about the pull forward into the second quarter from the third quarter. Just wondering if you could let us know, as you look to the third quarter, if you think that's going to be felt more in direct or in the retail business. Sticking with the top line, when we're talking about Waterworks, good detail there, 4% for the quarter. Are there seasonalities to that business similar to yours? Are they different from yours? I'm not sure you provide any guidance, but as you think about on an annual basis, what do you think Waterworks should contribute to your top line?
Sure. Hi, Adam. First, this is Karen, on the pull forward, substantially all of that beat that we had in Q2 was a pull forward from Q3. That was higher sales, a higher percentage of our sales that as were coming from in-stock product versus stuff that was on backorder or special order. We did have just overall faster shipping than we expected on some of the backorder and special order product. A lot of that was in our outdoor business. Direct versus retail split, we don't really look at it that way. It's both, and we would expect it to have a similar-
direct business. Yeah, really.
In Q3, I wouldn't expect that to have a meaningful impact on retail versus direct split.
Okay.
On Waterworks, they do have some seasonality. They don't have a typical Q4, like a typical retailer because of the trade business and a lot of the project base that happens in the spring. We only had two months of the quarter in Q2, and we'll have a full third quarter. For them, Q3 will be a little bit higher than their Q4, which is a little bit of a flip versus us. We haven't disclosed the specific EPS impact that it contribute, but it wasn't very meaningful in Q1. It was only about $0.01. It'll tick up once we have a full quarter in Q3 and Q4, but it's not going to be a meaningful part of our earnings growth on the year.
Great. I just want to follow up, if I may. The 90% in-stock on RH Modern is, I think, ahead of plan. I know that at least previously, you had talked about once things had sort of leveled out, you were potentially looking to expand your assortment in RH Modern. I just wanted to confirm the fact that as we go through that process, when you do, that there potentially could be another pullback in in-stock levels. Is that something that we should consider?
Yeah. One, this is Gary. We're not really ahead of our plan. We said we'd be about 90% in stock at this time, and we are 90% in stock. We're right about where we thought we'd be with RH Modern. As we continue to expand that assortment, I wouldn't anticipate that we would have issues going forward. Depending on customer reaction to new products or not, we may sell out of some faster than others. Whenever you have product growth, you don't exactly know how to forecast those new SKUs, so you could affect in-stocks slightly. Now we've got a vast majority of the base of the product in stock. The factories are performing well, and the business is performing well. You don't have anything like we had at the startup of the business launching a 544-page book.
Excellent. Thank you. I appreciate it.
Yeah.
Your next question comes from Adrienne Yih with Wolfe Research.
Good afternoon. Gary, can you talk about the timing of the new product? When will it be at a level that you want it to be as we go into the third quarter and the fourth quarter, how much newness? Karen, can you talk a little bit about the inventory? The sales to inventory spread obviously improved a lot. What type of inventory, what was the aging of the product that you got out of stock on, and when should we start to see that sort of more in line on a parity basis? Thank you.
Maybe, can you clarify for me a little bit on the question? There are a couple of questions around newness of timing of new product.
Yeah. You talked about obviously shifting it with the marketing books, the spring book moving into the fall season.
Correct.
Just wondering when you feel you'll be in a full position the way that you want to be as we go into the fall holiday season.
Sure. Okay. The books are now starting to get in home this week, and they will be building through November as we roll out these books. One, we have some new product hitting the stores that will roll out over that same cadence, and then our in-stock should build, and we should, by mid to late fourth quarter, be fully in stock.
Okay, thank you.
Yeah.
On the inventory, we kind of came in at the end of Q2 right where we thought we would. We started off the year with a +30% in Q1, and we said it would be very similar. It was a +27%. We thought we would half that as far as making progress with our SKU rationalization and inventory optimization, and that's kind of exactly where we landed. By the end of the year, we do expect to have inventory growth right in line with that sales growth, which is really just a modest 1%-3%. We do think that by year-end, we'll have made progress. Some of that happens through lower receipts, and some of it just happens from making further progress in the inventory efforts we've been talking about. We feel really good about the complexion of the inventory.
We don't have a lot of high fashion, things that were going to go bad, if you will.
Okay. Just a recent question on the Hanjin. Do you have any inventory that might be susceptible to some of these delays?
We don't actually contract directly with them. There are some of our carriers who might contract with them, in through their alliance. Less than 2% of our goods are on their vessels, and we've already notified all of those customers. We've reordered the products, we expect to have very minimal, if any, impact to our business because of that bankruptcy.
Thank you very much, and best of luck.
Your next question comes from Matthew Fassler with Goldman Sachs.
Thanks a lot, and good afternoon. Good evening. My first question relates to the buying cycle. You talked about the move to the membership program elongating or extending the buying cycle. How do you know, or how do you think you know that this is actually a prolonging of the buying cycle? Have you seen the people come back and close transactions with longer lead times? Just in terms of differentiating what would be an extended cycle versus perhaps the customer not coming back at all.
Yeah, Matt. As you know, we have kind of one full quarter now. Second quarter is our first full quarter on membership. We're continuing to track these trends and look at it. It's pretty clear to us, looking at it today, that the pressure to close your transaction is very different than what it was when we had end-of-events happening simultaneously by category, whether it's a lighting event, a rug event, an upholstery event, or a friends and family event, and so on and so forth. We're seeing fewer transactions at a higher average transaction, which is very good for the business, by the way. Long term, that should mean that we have fewer deliveries. We have more efficiency through the business and the supply chain. We're still early on, obviously, to see if there's fall off negative effects over the long run.
The other thing that makes it a little unclear as you're trying to evaluate all the moving parts right now is we're up against the book drop from last year. We have no book drop from last year. You have a massive shift in customer contact, circulated pages, newness from last year, so on and so forth. The real key is going to be looking at this in the fourth quarter and into the first quarter of next year, because then we'll have comparable slightly up total circulated pages year-on-year. You'll really see the performance of the business, and you'll also see the performance of membership change, right? Right now, the only marketing that we've had outside of the initial ads we did in the New York Times and a few newspapers is really email marketing and our outdoor book, which has limited circulation.
The first real marketing of membership will be in the fall source books that are going out. You really need to kind of look at this over the next couple of quarters and see how the consumer's responding to the marketing of membership, to the fact that you've got more apples to apples marketing and circulated pages. Looking at it right now in the trough of the business with no books against the books last year. You can draw a wrong conclusion. We've said to ourselves we've really got to look at this thing through Q4 and Q1 to kind of really make sure we've got it in our sights.
I'd say today, though, just the early data and looking at the % of the business that we're doing on membership, looking at the average order of membership, looking at the buying cycles that we can see with the limited data we have, we like what we see today.
That's-
My sense is it's going to get better, not worse.
That's helpful. Then just a quick follow-up related to that. If you could talk about how your customer is receiving the member program, their understanding of it, perhaps the mix of member-driven sales within the total business. Any metrics or qualitative insight you want to give us as to how they're receiving the member effort?
Well, some of the early feedback was people were confused by the RH Grey Card. Originally, we called it the RH Grey Card, was this major marketing effort. We got feedback from customers and throughout our stores and at our care centers that some customers thought it was a credit card offer. We repositioned that as the RH Members Program, as opposed to the RH Grey Card, and tried to eliminate the confusion. We're making tweaks here and there. The numbers and the sign-ups and the percent of the business we're doing all is tracking really within a few % of where we thought it would be. I'm honestly surprised it's accurate, we are, but it was all math, right? One thing I would say, because I think people are somewhat confused. A lot of people think we're eliminating promotions.
Well, we are, we really just created a consistent promotion, right? The goal of membership was to eliminate the peaks and valleys in our business, which really create havoc in the operational infrastructure and the vendors trying to supply the goods with these peaks and valleys, ordering the goods correctly. It was really chaotic running a business on what evolved to post-2008 and 2009, a very promotional retail environment. Probably not as difficult if you're in the apparel business, right? When you're in a really logistically difficult business like furniture, it's very costly and it affects execution. Our goal was really to evolve the business to a more consistent model. Really we kind of went from a erratic peak and valley kind of promotional cadence to a consistent promotional cadence called membership, right?
A lot of people have brought up to me over time, "Well, gosh, the last person that tried this at JCPenney decimated the business." I said, "Well, we're not going off promotion. We're 25% off all the time. You give us $100, you're getting a bigger promotion than a year ago." The real key here is letting the shift of the book drops is creating, I think, the most unclarity around our business, right? The books are the major marketing vehicle for our business, shifting the books by six months changes a lot. We've really got to let the books get in here at the end of Q3 into Q4, watch the business and the trends. We'll have a second drop. We'll have Modern hit in Q1.
When we look at how we think the business will sequentially build and the changes we articulated in the video and in the press release, we like the model we see in 2017 today.
Thank you so much.
Yep.
Thanks, Matt.
Your next question comes from Steve Forbes with Guggenheim Securities.
Good evening. Gary, when you think about putting RH Modern and the Design Ateliers into the legacy galleries, how do you take those efforts and put them into a smaller box size while maximizing the impact to consumer? Do you edit it by taking a very small handful of the best sellers and create a smaller design space in the box? What should we expect as it relates to the pace of the rollout of these initiatives looking into the fall here?
Sure. Yeah, good question. It's basically a math equation, right? It's taking a look at the best-selling Modern items and collections, right? We've got pretty good data. We've been doing this a long time that we can extrapolate when we take something that is source book and web only, and we put it into our retail stores. We've communicated to you guys that we get a 50%-100% lift on the item when we show it at retail. We can extrapolate. Now we have data. The first few stores that we put Modern into didn't have the best of Modern. It just had our best guess at what we thought would sell with Modern, and in many cases, because we ramped up in such a difficult way, it was really all we could get, right?
The first stores, honestly, I'm surprised of the success we had with Modern. It didn't even have the best of Modern. We had no data. We've got data on Modern. We know what the best sellers are. We know what the best collections are. We just basically do our math that says, okay, we take this from to a tri-channel item, we're putting in retail. We know we're getting these lifts. Then we basically just edit. We're changing out about a third of the SKUs, right? We're taking out the lowest performing SKUs that have been in the retail stores for the last year and a half, the last 18 months, taking those out and replacing those with the best Modern SKUs. Our math says that we're going to get a positive arbitrage, right?
When you think about the Design Ateliers, our typical legacy store has kind of a great room in the middle, that great room has walls all the way around it. In the left and right-hand side, there's generally four small walls that would have generally a repetitive cabinet, right? We're very disciplined in how we present the goods. You have two of one cabinet, two of another cabinet. Those two cabinets come off the floor, and they're being replaced by Design Atelier cabinets, right in the center of the store. The other thing we do is we take out the cash wraps. Our business is almost no cash and carry anymore. That's why the earlier question which says, "How much was retail?
How much was direct?" When you think about the pull forward or things like that, we think of our whole business as direct. We have showrooms, we have source books, and we have a website. Those are places where customers interact, all our goods are kind of direct orders. Customer places an order, we ship it direct. We're taking out cash wraps, which are really not needed anymore in our business. None of our new galleries are built with cash wraps. All our business is really done through an iPad. We pick up a pad. We give up two cabinets, but we pick up a floor pad, and we give up two dining tables.
Net from a product and a productivity point of view, we really don't lose anything as far as product presentation, putting the Design Ateliers in, because we take the cash wrap out. We're replacing just some cabinets, which are not the highest performing SKUs, and we get another full pad of furniture where the cash wrap was, which is a living room pad, which is the most productive pad that we have in the business. The center of the store now communicates clearly that we're kind of a design business. I think more dominant than any other store of our kind. It's very dominant. You're going to see a very big change as far as the communication that we're in the design business. Remember, if you look at all the other retailers that have moved into design services.
Almost everybody has free design services today. It's really kind of commoditizing and I think kind of devaluing the service because the level of service you get is very different depending on who you're interacting with and why I made my comment in my prepared remarks in the video that you get a lot of people that are marketing design services, and they're sending a couple of salespeople into your home or a consultation with a salesperson or someone who might have minimal decorating experience. Where we've now been doing this for several years and never really marketed it besides one page in our source book. We haven't been sending emails about it. We haven't really marketed the program. We wanted to get really good at it. Now we've armed our people with tools and training. We have a specific design ethos in our company that everybody's trained on.
We now are installing Design Ateliers, and now we're going to really market this program. You're going to see it visually in our galleries in a very dominant way. We think that is another meaningful, positive move to the business. We're very excited about it. That's how it kind of plays out, the pieces come together.
Is there yet a plan to roll out Waterworks to the next generation galleries and potentially the legacy galleries themselves?
Not anything that we're ready to communicate. We have a lot of ideas here. Waterworks is a tremendous business. They're the best brand of their kind in their category. I don't think anybody's close. Strategy number 1 here is to not screw it up. Sometimes big businesses can kind of goof up really good smaller businesses. We're taking time to kind of spend time really discussing and debating our strategy. How do we evolve and marry the brands together in an appropriate way? First and foremost, our efforts are to really amplify and advocate for the Waterworks brand. I think they're a business that's been undercapitalized for a long time, running without capital. They've got tremendous product. I don't think it's exposed very well in the market.
We're going to support them in I think we announced San Francisco, one of their new flagship locations opening in San Francisco. If you're in L.A., go see their new flagship in L.A. or in Chicago. They have a tremendous strategy to build their brand. I think there'll always be an independent nature of Waterworks because it's a very different business. It deals to the trade, to architects and contractors. We're much more of a retail-facing business. We think there's an opportunity over the long term to have much more exposure and visibility and transparency of that business directly to the consumer. We want to be careful with it. We don't want to infect the brand at all and have anybody think that we're lowering our quality.
The only interest we have is to make that brand better, and then in an intelligent way integrate these brands and allow us to access to their consumer, which is probably the highest demographic in the entire industry, and to serve our consumer better. You're going to see this move like a clock. It's going to move very slow. We're in no rush here.
Thank you.
We feel very lucky that a brand of the caliber of Waterworks is now part of the RH family and platform.
Thank you, Gary.
Yeah.
Your next question comes from Peter Benedict with Robert W. Baird.
Hey, guys. I'll just pivot over to maybe some more macro stuff. I know it's maybe hard to read just given all the things going on in the business. Any update on what's going on in some of those markets you guys have spoken to in the past, Texas, Miami, the Canadian markets, or any other regional commentary that you could share?
We have been tracking those, we did see some improvement. That negative four drag that we had talked about for the last few quarters went down to a negative one. There was some improvement there. We're very, I'd say, cautiously optimistic about that. Kind of planning for something similar as we think about the back half. We're anniversarying last year. We're coming up against anniversarying a tougher compare, so that's good for our business in the back half.
That's great. Was the improvement across all three, or was any one more impactful than the other?
We haven't given a lot of details for each one specifically.
Yeah. The way I think about it is last year, as Mark said, we articulated, right, we're a drag of 2 points in the first half and a drag of 4 points in the second half. We're up against the 2-point drag, right? You would expect it to moderate because you're up against the drag. What that tells us is, if you take last year's 2 points and this year's 1 point, you've got 3 points, which tells you it's 1 point better, right? The business didn't really come back, so to speak. It just didn't get worse. Does that make sense?
Yeah.
Maybe got 1 point better. What we like about that is it's not in a continued decline year-over-year. As we go into the second half, where we're up against a 4-point drag to last year, that could be neutralized year-over-year, that provides lift, right?
Right. Karen, what the latest view on kind of free cash flows, and again, a lot of moving parts here, just your latest view on when you think that could evolve in the business. Thank you.
Yeah, sure. We kind of stepped off that goal for 2016 on the last call, just given where we took our guidance quite a bit lower. We still feel very optimistic. It's still a very important goal for us. I'm not committing to it for 2016, but feel very good about 2017 and beyond, especially with some of the earnings things that we're going to cycle as we head into 2017.
Okay, great. Thank you.
Your next question comes from Michael Lasser with UBS.
Good evening. Thanks a lot for taking my question. How should we think about the spread between brand growth and comp growth in 3Q? Is it going to be wider than the 1,000 basis points that you saw in Q2?
Yeah. Great question, and this is one that we want to make sure we're getting some clarity and information on. We do expect that that gap between brand comp and non-comp will continue to widen. We have a couple things going on there. One, the Waterworks is not going to be part of comp. We're going to put that into the comp base when we anniversary the acquisition, so one year from Q2. That will have a full quarter in Q3 and Q4 as opposed to just part of the quarter in Q2. We also have additional new stores coming on. Plus, because we have a 14-month comp period for our new stores, some of the ones from last year won't join into the comp until Q4, even if they're open in Q3.
We have the new vintage that's opening with the new stores this fall, the outlets that we're opening won't be in the comp base either. We will see that widen even further.
That'll continue into the fourth quarter?
Yes.
In a bigger picture question, and it's going to probably be in a couple parts, but Gary, you mentioned that Grey memberships are trending in line with your expectations. How should we think about overall customer acquisition to the brand? Presumably, you anticipated that you might miss out on some of the marginal customers that come in and buy on promotion and get into the brand. Are you missing out on those customers at the rate that you anticipated? Then with that, how's that going to trend into the holiday season? This may be a separate question, because you're going to have a more focused customer who tends to spend more. How do you think about that impacting the fourth quarter, where you are competing for a broader pool of spending with giftable items?
Sure. The way to think about it is, first and foremost, you have to get up against the books, right? Apples to apples. The best time for us to answer the first part of that question is probably in the first quarter when we've had a chance to look at the new source books hit and how's the consumer reacting to the marketing of the membership and what does that look like. It's the murkiest time to really look at it right now, right? I'd say, even in the murky times, I feel on the more positive side than the more negative side. I feel very good today based on the fact that we're going through a murky couple of quarters where we don't have a book.
As it relates to customers entering the brand, specifically around holiday, I think we communicated that we are going to pull kind of stocking stuffers and the last of the legacy kind of leftover RH business off the floor. We're installing these Design Ateliers. It's kind of the last little pieces of moving the business to a true design platform and not like a typical retail business. I don't see us competing for that customer. Might we lose someone buying a couple of towels for a holiday gift? Yeah. Might we lose some throw sales? We might. We're going to give away the stocking stuffer sales. We're not going to put all the Christmas lights up in the store. We don't think that renders the brand more valuable, not the brand we're building today.
To build great brands, you've got to decide who you are and who you're not, right? Brands are defined as much by what they don't sell as what they do sell. We're going to be very disciplined this year editing and eliminating the things that we believe render the brand less clear and less valuable. That's all in our forecast. We've talked about that. They're low-margin businesses, and they're not businesses we want to be in long term. We think we're replacing it with a real statement about design services and having in-store Design Ateliers. You don't have to get that many design customers to make up for a whole lot of little stocking stuffers or picture frames or other things. We'll let other people kind of battle out for that turf. That's not really the turf we want to dominate, right?
You can buy that stuff anywhere. It's hard to be really distinctive and unique. We're going to get really good at the few things we want to own and be great at. Hence the discussion around Waterworks, right? I mean, Waterworks is one of the best brands in the entire trade industry. It's really the only recognizable brand of its kind, right? When you go behind the iron curtain, that gets us into the serious bath business, the serious kitchen business, the surfaces business with tile and stone, wood floors, kitchen cabinets, so on and so forth. We're evolving away from a retail business. All our legacy stores that are sitting there in the mall where you're seduced into saying, "Gosh, I've got this real estate, and the malls have all these people for five, six weeks.
Shouldn't we sell stuff to the random people walking by?" Well, yeah. Maybe we had to do that to survive historically. That's not what we have to do anymore, and that's not our strategic direction. All those stores will close. It would look ridiculous. If you've seen our Chicago gallery or Melrose gallery or any gallery, to have stocking stuffers and tchotchkes and giftables and Christmas lights and stuff that you can buy at Target, for God's sake, mostly. It's hard to differentiate that stuff. That's not who we want to be. We're giving up some of that business. It's in our plan. No different than don't want to have the same kind of promotional cadence as everybody else. That's not what our business looks like.
If you go to the highest end of our business to the trade, that business is an interior design-facing business. Obviously, some consumers get into those showrooms with their interior designers, but that business is done on promotion. Designers get 25%-40% off the business. That's why we can't be like a luxury brand like Hermès that has no promotions, right? Because at the highest end of luxury apparel, there's no promotions. At the highest end of luxury furniture, it's 100% on promotion. We're now 100% on promotion. We're aligning ourselves with the highest end of the business. We've made it a membership model. We think that was the right way to thread this needle. No one's ever done this before. I appreciate all the concern and trepidations and skepticism. We have the same feeling, right?
We think that the decisions we're making this year for the business, while it's pressuring short-term earnings and results, if you never make these decisions, you never actualize the potential of a business or a brand. We're making some tough decisions that are painful in the short term. Again, our math and our bridges say we really like what the other side looks like right now. Unless there's some very bad assumption and calculation that we're going to mail all these new books and nothing happens, right? That's never happened in my 30 years in the industry. I think our data says that the outlook looks pretty good, despite the fact that we're going to give up some customers that are not as high a value, right?
Keith, if I could sneak one more in. How have you thought about your further push into design services impacting your relationship with the trade, with interior designers? If you could frame how much of the business has been done through that constituency in the past so we can get an understanding of what the impact might be.
Yeah. We're not going to release those numbers, right? That just creates a blueprint for our competitors, right? I'll tell you that initially, some of the anecdotal feedback was when we went to the RH Grey Card in the RH Members Program, and we went with a full-time kind of promotional positioning, right, for the buy-into-the-membership-and-you-get-25%-off, we got a certain level of feedback, anecdotal feedback from our teams, and some of the trade designers they were working with. The data and the performance of that group, right, would indicate it's not an issue. I don't know if that means over time it becomes an issue. We were thinking, do we need to provide more incentive for that group? Do we need to provide another different level of service for that group? I think our business is. The value equation of RH is very disruptive.
The product assortment of RH is very disruptive. No one has our product assortment. No one has product this quality made in quantities. No one has our real estate positioning. No one has our source book circulation. No one has the traffic on a website that we have. Now no one's going to have the design services that we offer. Our design services are designed to also support interior designers and trade clients, right? We act as a design office for them. They can come in with us, and our interior designers work as their design assistants, and we manage their whole project, and we manage all their orders. We're a huge value to that constituency. Because they're generally entrepreneurs, small businesses, they've got a lot of back-end support.
If they're placing orders from 12 different showrooms, and they've got to manage all those orders individually, and lead times, and issues, and late orders, and deliveries, and 12 different deliveries, and all the logistical costs, and then all the administrative costs and managing all the paperwork and following up all the orders, we do that all in a centralized place with an offer that nobody has. We're like taking a big swath of a design center and a lot of showrooms and putting them into one business in a cohesive, organized way with a service experience that doesn't exist at the high end of the industry. Again, we're not perfect today, by no means. We look at it like we're just now in the very early stages of who we're going to become.
That's why I refer to the point of moving beyond just creating and selling product to conceptualizing and selling spaces. Thinking about the business more as a design platform, more selling a whole room, a whole home. I think a lot of you saw the video that went out, of the house I did. I did that house to show what can RH do with a total home, top to bottom. I think you're going to continue to see our business evolve in a very dynamic way, and become more unique and more differentiated. We're not going to be a business that's going to be out there slugging it out with Amazon or anybody else that goes online that has just a mass market approach to a category. It's a very different business.
Cool. Thank you so much.
Yep.
Your next question is from Oliver Wintermantel with Evercore ISI.
Hi, good evening. I had just two clarification questions. The first one is the shift of the book drop into the third and the fourth quarter. All is equal if the pages are, and I think you mentioned that they're comparable, should there be an additional SG&A pressure in the back half? Looking at your guidance for the third quarter and the full year, it looks like it might be roughly around 150 basis point SG&A deleverage in this third quarter. Is that the right way to think about it? If that is, could you maybe tell us how much of a help that was to SG&A in the first half?
Sure. It actually is not going to be a drag on SG&A. The biggest thing in Q3 that we're coming up against or I guess that we have that we didn't have in Q2 and we won't have in Q4 that's unique to Q3 is some of the investments that we're making in our product and the floors. We have a big new floor set, the installation of the Design Ateliers, the cost of getting all that product, all the people involved in that effort, the new stores that are opening. Three of the four new stores are going to be in Q3, all those pre-opening costs. That's the biggest drag on Q3. The advertising, because last year we had the spring books and we also had Modern, we will actually get some benefit in the second half from advertising.
Got it. Thank you. The other one was the guidance for the full year when you said the adjusted EPS $160-$180, then you have these three items about customer accommodation, membership deferral, and the inventory SKU rationalization that gets you to a pro forma of $250-$280. In the video, you mentioned that you cycle all the headwinds in 2017 and operating margins should be up and sales expanding. If I look at the consensus numbers of about $232 next year, I just want to make sure that I understand where you base that off of that adjusted number or the pro forma numbers. Thank you.
Yeah. We're really wanting to stay away from guiding 2017 at this point. At this point, what we were trying to do is just show that some of these costs that we've had this year, we don't expect to be ongoing and continuing parts of our business. The costs related to the RH Modern, and all the production issues that we had and the customer accommodations, the SKU rationalization, and then this one-time deferral, because once we anniversary the launch of the RH Members Program, we'll be on a normal and more consistent as we collect the revenue, even though it will be deferred, there'll be revenue from prior periods getting recognized. We won't have the ramp up to where we will have all of the more consistent cycle booking that revenue.
We were really just trying to say that, Hey, there's a lot of more one-time temporal things that aren't going to repeat into next year. We're not necessarily trying to set guidance for 2017.
Okay. Thanks very much.
Your next question comes from Matt McClintock with Barclays.
Hi, yes. Good afternoon, everyone. Gary, you just said that you're not trying to be Amazon, but you just brought over Alex from Amazon to help with the supply chain. Can you maybe walk us through some of his initial priorities for the supply chain? Seems like there's a lot of puts and takes going on in that area of the business. Thanks.
Yeah, we think we have tremendous opportunity to match the customer experience that we deliver on the front end of our business to the customer experience we deliver on the back end of our business. I think we've taken leapfrog steps and moves on the front end. If you look at the difference between one of our old galleries and one of our new design galleries, it's not even close, right? It's not evolutionary, it's revolutionary. If you look at the quality of our people and how they've evolved in our galleries over the past several years, I think, under DeMonty Price's leadership, massive change. The design organization we've put in place, the leadership team that's in place, I'd put our store teams, gallery teams up against anybody in retail. Quality of people, culture, passion, belief in our vision and in our strategy and our brand.
I don't think we've had the same evolution on the supply chain side of the business. If you look at the disconnect that I talk about today is, in many markets we have an HDL, whether that HDL is insourced or outsourced, meaning that we have our people kind of running the home delivery hub. We basically are shipping goods to home delivery hub. In some cases, we control that hub, some cases we don't. We're handing off the goods to delivery teams and truckers that are not our people, and they're not our trucks. You may get a truck that has a Restoration Hardware logo on it. You may get a truck that has a Penske logo on it. You may get a Ryder truck or a truck maybe driving with Pottery Barn goods or other people's goods. They're not our people, quite frankly.
It doesn't mean that they all have to be our people. I think just because of the nature, I think of most supply chain cultures come at things from a low-cost point of view. I think we've got to look at our business from a high-touch, high-service point of view. We're going into people's homes. If it was okay to go into people's homes with people that had no connection to our culture. That were being contracted out daily, so there's no continuity at all. You would argue then, "Well, why shouldn't we do that in our galleries? Why shouldn't in Melrose Avenue or in Chicago or any of our galleries, why wouldn't we just put contract labor in there, too?
It would be cheaper." I'd argue that our results would be much lower, I believe that our customer satisfaction levels, our missed opportunities in building on sales, our return rates, our failed deliveries, our exchanges, our on and on and on. The back end of this business is so costly. I've always said for years, being in the furniture business, it's an ugly baby, but it's ours. You got to love it, and you got to care for it. It is a tough business. I think we've now elevated this brand. We've elevated the product. We have an average ticket that is significantly higher than our competitors. We should be getting massively more leverage, but we're not. We're not because we're not executing well. We have multiple failed deliveries. We have multiple return issues.
We have a strong view that if we invest and take the level of delivery to the level that matches the brand, that we're going to see these metrics get massively better, and we should get real leverage. Today, if you really looked at the supply chain cost and the architecture of it, I think it's architected for an old business. It's architected for the old Resto. It's architected for like a Pottery Barn-type business or a much lower-end business. Our galleries are different. Our people are different. Our design services are different. Our home delivery needs to be different, and it needs to be high quality and high touch. I think if you look at reviews on our company online, you talk to each other, you guys are customers. If I took what's the number 1 complaint about RH, it's that final mile.
It's that final delivery. It's we screwed up. It wasn't the same quality that you expected. I think it's the last piece of the puzzle to solve here. I'll tell you that DeMonty is just-- our Co-President and Chief Operating, Service and Values Officer is just setting a whole new level of standards for the organization. He's made multiple changes throughout the organization at many senior levels and bringing in a quality of leadership that we haven't had before. I just never felt more passionate and enthusiastic about what can happen operationally in this company. I could go on and on and on here. I won't. I tell you, I think it's the next one, two, and three years.
We were just talking last night with DP, which is what we call DeMonty, I think it's going to take him about three years to make it perfect. His standards are perfect, so he doesn't know anything but that. I will tell you, 6 to 12 months from now You're going to see massive change. For example, last week we had 3,000 home deliveries?
5,000.
5,000 home deliveries, excuse me. Yeah. How many did we have Resto employees on the trucks?
We are on 1,500.
Yeah. 1,500 Resto associates accompanied deliveries last week of 5,000 deliveries. We've never done that before. Customers are sitting there just massively delighted and surprised. We're actually getting design jobs because we're going into customers' homes. We're not making customers interface with strangers and delivery guys. They're interfacing with a quality person that they'd interface in their stores. You're going to see us make transformational changes here. I think that we're going to bring the level of execution and quality and service up to a level that's in alignment of the brand that we built.
Thanks a lot for that.
Yep.
Operator, do we have another question? Are you there, operator?
Your phone still on?
Jennifer, are you there? The operator? I guess we're getting close to the end of our call time anyway. If anyone can hear us now, I think we're going to wrap up the call now. Thank you guys for your time. We'll talk to you next quarter.
Great. Thank you, everyone. Talk to you soon.