Good afternoon. My name is Jennifer, I'll be your conference operator today. At this time, I would like to welcome everyone to the RH Third Quarter Fiscal 2015 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during that time, you may simply press star and the number 1 on your telephone keypad. If you would like to withdraw your question, press the pounds key. Thank you, I would like to turn the conference over to Cammeron McLaughlin.
Thank you. Good afternoon, everyone. Thank you for joining us for RH's third quarter fiscal 2015 Q&A conference call. Joining me today are Gary Friedman, Chairman and Chief Executive Officer, and Karen Boone, Chief Financial and Administrative Officer. Prior to this call, we posted a video presentation to our investor relations website, ir.rh.com, highlighting the company's continued evolution and recent performance. Before we start, I would like to remind you of our legal disclaimer that we will make certain statements today that are forward-looking within the meaning of the federal securities laws, including statements about the outlook for our business and other matters referenced in our press release and video presentation issued today. These forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially.
Please refer to our SEC filings as well as our press release issued today for a more detailed description of the risk factors that may affect our results. Please also note that these forward-looking statements reflect our opinions only as of the date of this call, 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'd like to turn it over to the operator to take our first question.
Our first question comes from the line of Peter Benedict with Robert W. Baird.
Oh, hey, guys. Thanks for the question. I guess my first question, just quickly, just looking at the fourth quarter. You've got the revenue guidance up, obviously, the earnings guidance was held. Just curious, what's affecting the flow through there relative to your previous expectations? That's my first question.
Yeah. This is Gary. Let me try to take that. I think that the way we think about the business is every quarter, especially Q4, always requires some level of recalibration versus our plan. That's because the environment is forever changing. The economic environment, the competitive environment, consumer trends, preferences, so many things. We believe our success is based on our ability to improvise, adapt, and win. Winning to us, if you stand back and as we've articulated, I think, in past conference calls and past quarters, is about two things. It's about gaining share and optimizing earnings. It's about two lines in the P&L, the top and bottom ones. As we've said, every other line is a lever and creates optionality and opportunities to win. When we have looked at recent data and said, "What's different?
What are we seeing and what are we learning and how are we improvising and how are we adapting, and how are we going to win?" There's a few things that are different, there's some new data that's affecting our thinking. Some of the things that are created inside the company that we have more control over, shorter term and longer term, some outside the company that we're evaluating and figuring out how to adapt our plans accordingly. There's a few things that are different from last year. I think Karen alluded to some in her script, in the video. One, I think we've mentioned that our circulated pages in the spring books are down year-over-year, pretty meaningfully so.
I don't think we've communicated this before, but if you just stack the spring books last year versus the spring books this year, you'll notice that the pages are significantly lower and the circulation was slightly lower this year. Our data indicated that we could significantly reduce our pages circulated without meaningfully impacting our top line. We had in the spring versus a year ago, 60% less circulated pages. That's a meaningful move. As we've watched it throughout the quarter, our sense is the new data would suggest that as the books from last year built, our ability to comp that build the way we thought, we were a little off in those projections.
We've got a bit of pressure that you saw at the end of Q3, and some projected pressure into Q4, depending on how the newness comes in with RH Modern and so on and so forth. That's the next point I'd make is the majority of our newness this year is tied to RH Modern and RH Teen versus a year ago. You've got significantly more newness building earlier in the year, a lot less circulated pages and less circulation in our attempt to optimize our model. We are always, as you guys know, testing and evolving our source book strategy and our marketing strategies here and trying to find the most optimal way to go to market with our business. We have a difference in the newness cadence year-over-year.
Our RH Modern book, I think we started the year telling you guys we're going to launch an RH Modern book that was going to be in about the 300-page range. I think we told you it was going to get to the 400 or 500-page range, and it ended up at 544 pages. Yeah, 540 pages. Because the book came together and many good ideas came together somewhat late, but we thought they were very important, we delayed the book a few weeks against our forecast internally. Because the book was significantly bigger, it took a couple of weeks to get through the printer and get through the mail system. We lost about a month, in general, from where we thought the books were going to be.
That was different and that affected our top-line trends, especially coming out of Q3 and early in Q4. There's a few, what I call macro regional factors that I think are important ones. I don't think you've ever heard us talk about the weather before, and I'm not going to talk about the weather. There's some meaningful things that I think everybody has to have on their radar today because they're the kind of things that could shift your business and change economic conditions, and you could place bets incorrectly if you're not careful. Here's the things that we're seeing and the data that has changed from half one to Q3, and we see the trends in Q4.
In the areas where the economy is more dependent on oil and natural resources, such as Texas, such as Canada, you can even throw in there Miami and parts of Florida because they're affected by South America. I don't know if we've communicated this before, but we ship a third of our business in Miami is shipped to South America. I'd say an even greater amount of our business in Miami, and in parts of Florida is influenced by South America because not all the product we sell to South America leaves the country. A lot of it is people buying homes in Miami and condos and so on and so forth, and we're furnishing those homes. When we look at the areas that are affected by oil, then also doubly so with Canada and South America, you're affected by exchange rates, right?
If you're looking at your spending power, if you're Canadian, if you're South American versus U.S. and exchange rates, you're meaningfully less wealthy. You're getting a lot less value for your dollar year-over-year. When you take just those three areas, when you take the Texas market, specifically Houston, which is being impacted the most. When you take the Miami market, and you take the Canadian market, which are all very important markets for us. In the first half of the year, they were pulling down total company sales a little under 2 points. Okay? At that point, we knew it was a drag, and it wasn't mean that those markets were 2 points lower. Those markets were meaningfully lower. They were pulling the whole company down, a little under 2 points. In Q3, that accelerated to 4 points. That's meaningful, right?
It's not just meaningful to us. I'd say it's meaningful anybody who's thinking about what the U.S. economy ought to look like and how we ought to think about it. It makes me think, hey, should we be calling Yellen in the department and saying, "Let us tell you what we're seeing." Those things from my point of view, and I don't mean to make anybody panic, but it's important how we look at those. These are important markets and markets that are connected to other markets. Miami's connected to New York, so on and so forth. A lot of the investment that's happening in Miami is connected to New York. We sit here and we say, "Wow, one was dragging down the company 2 points, now it's dragging down the company 4 points." What do you do about that, right? Do you just swallow?
Do you just say, "Just button down the hatches?" Do you say, how do you play the game differently? How do you win in changing conditions? You can either be a spectator and be on the sidelines and just report that that's happening, or you can decide to get in the game and be a participator and do something about it, right? We have a bias for action in this company. We're not good spectators, but we're really good participators. We think that's a dynamic that has to be watched and that's a dynamic that has to be reacted to, assessed and reacted to. We've changed our game plan because of some of those things.
The other thing that we've seen, I think we all today, the great thing about email is we all have access to customers, and we can promote much more flexibly and much more cheaply than ever before. The other thing is you can really see what your competitor's doing. You don't have to walk every mall to see what posters they put up in their windows or what they're doing, right? All the analysts on the call and investors on the call, I'm sure you all have some sort of tracking that says, what are people doing this year and what are people doing last year, and are promotions up year-over-year, and so on and so forth. Many of you guys all pointed out last week that RH ran a big promotion. Got it.
We weren't trying to be shy about that, by the way. One of the things that's happening is we track all of the competitors' promotions, and we know what everybody's doing, just like you do. We've noticed that there has been an uptick in competitive emails year-over-year. You have to look at the details to really get it sometimes, because if you're just counting emails, you're going to miss it. If you're just looking at the generalities in the emails, you're going to miss it. Many of the people in our industry today are sending multiple emails, and there's multiple messages, and there's multiple promotions being stacked on promotions. When we look at the data internally, it is the most promotional environment we've seen, meaningfully so.
It doesn't matter if you're looking at what By the way, there's new players that are bringing a whole new dynamic to the marketplace. I tell the team, "Look, I don't care who it is, whoever's selling goods in our case, that's coming in, whether it's an online player." You can't ignore someone like Wayfair today. They're doing big volume. They're not making money, but they have cash flow. The last thing you want to do is you want to let yourself get Amazoned by somebody. We're not going to allow that to happen. We're going to figure out how to play the game to win. If you look at the promotions from everybody, from Ethan Allen to Arhaus to Pottery Barn to West Elm, and you can say, "Who's the direct competitors?
Who's not?" At holiday time, if you've got stores in retail districts or retail malls, and there's thousands of people in those malls, and you're not doing something to maximize share, then you're a spectator. We've noticed a more aggressive promotional stance from all of the people I've mentioned. We've stood back and said the combination of all these factors I've articulated, whether it's we pulled back and circulated pages and so on and so forth. By the way, a lot of good things have happened here. I'd start with the headline. Operating margins in RH in the third quarter are up 180 basis points over last year. Find me another person or a sector that can say that. There's a lot of good news here.
If you want to know the details of how we're playing the game and how we're playing to win, there's a lot of moving parts. I'm just giving you some headlines. There's many other things. There's a thousand moving parts in a company like ours, and you're always looking at every piece of it and every line and every lever and every opportunity. When we step back and we take it all into context, and we say, "How do we want to play the game?" During Q4, when mall traffic is seasonally high and our home furnishing peers are aggressively promoting their business, we're making moves to optimize both our top and bottom lines and to take share. Period, right? To optimize earnings. Period, right?
How it landscapes. Karen kind of alluded to the landscape may be differently. Quite frankly, as the CEO of this company, I'm kind of indifferent how it landscapes. What I care about is what is the outcome and what's going to create the most value. Our belief is taking share, okay. Our competitors can't get it back. Taking share is important. There's a reason why Amazon launched Black Friday before everybody else in the world, right? There's a reason why we launched the promotion we did last weekend. It was to take share. There's consumers, there's shoppers, and we're going to try to take share. In the sense of that's the way I'd summarize it. It's kind of maybe a long piece. I felt like, look, we knew it was going to be the big question. The landscaping's different.
The numbers may not all add up if you look at it in a traditional way. I think this is not a traditional time. I think this is a very unique and different time. I think it's a time where you've got to pay attention to all the details, and you've got to worry about everything. These are the times when you don't, quite frankly, something changes in the economy, something changes in the competitive landscape, and you wind up on the short end of the results. We think our results are going to be the winning results in the industry. We think our results in Q3 were the winning results in the industry, and we think our results in Q4 will be the winning results in the industry.
Our next question comes from Jessica Mace with Nomura Securities.
Hi, good afternoon, everyone. Thanks for all the information, Gary. I guess to follow on some of the things you said about the environment, I was wondering if you could maybe give some specifics on what's giving you the confidence in Q4 to increase your revenue guidance range, even despite all the factors you named, like the oil and the later source books.
Sure
Some of those other things.
As of today, we are ahead of Q4. That's why.
All right, great. Just secondly, you gave some good information on the success of the RH Modern standalone store in L.A. I was wondering if there's anything you could share about maybe some other plans to roll out formats like that.
Yeah. I think as I said in my script, the level of innovation we've just unveiled in such a short period of time is really unparalleled in our industry if you think about the last three months, right? We've introduced two new businesses, one of which appears to be significantly incremental. With the first store, we've opened trending to do $25 million in its first year. By the way, that's the first time in my career That's never happened. I've never opened a new test store that was tracking to do $25 million in its first year. By the way, the customer doesn't know that much about Modern. This is just our initial assortment. This is just our first book that we ran. We are going to learn so much here. The assortment's going to get so much better.
The investments we'll make here and the knowledge we'll have here. To think that we're doing $25 million in our first freestanding standalone store in L.A., and by the way, the store that's three blocks away that we thought we'd have some cannibalization in is up more than double-digits. To me, it's phenomenal. When you look at the numbers inside of the stores where we've got a floor of Modern, and it's adding, at a minimum, incrementally in the new galleries, 40 points or more. Really terrific. Early, we're not in stock, the initial assortment. Vendors are ramping up. There's so much to learn here. It's so early, but really great news. Then we have four new distinctively different new stores that are intended to be tests and provide data to enable us to assess future opportunities and sharpen our strategic decisions.
So far, every one of them is performing beyond our expectations and gives us great confidence about the long-term strategy of this company. Which, if you just take the two big pieces I talked about in the video, the expansion of the brand, which is tied to Modern and Teen, and multiple other new things that we have in the works and in the pipeline for next year that we haven't announced yet, and following years. We are, I'd say from a long-term point of view, on track plus. You look now at the three new next generation design galleries, all slightly different, all intended to teach us something unique and different.
Whether it's how we perform as an anchor tenant in a major regional shopping center, how we could perform as a freestanding store, how we perform in a secondary market with slightly lower model and lower investment piece. What happens when we add hospitality to one of these big environments? On and on. Many new tests. First time we've integrated baby and child and Teen into the stores. First time we've integrated Modern into the stores. Yet to put Modern and Teen into Atlanta, now we feel we were already outperforming in Atlanta. You put Modern and Teen in Atlanta, the numbers look different. You look at what's happening with Chicago, you step back and say, "What's different about Chicago?" Well, it's our best performing gallery. I would tell you, highly debated real estate deal.
Probably the most debated real estate deal in the history of our company, and the history of our board of directors. People thought, like, "You're going into a residential neighborhood that's not a retail store for 5 blocks. Are you guys crazy?" We thought, like, "Look, there was an opportunity. It was a good economic deal. We could test to see if we could be a freestanding location, and if we could, we'd be more desirable. We'd have more optionality to places we could go. We'd also be more desirable and more valuable to developers." I think you have to ask yourself, what's different about Chicago? Why is it the best performing gallery? Well, there's 2 things. 1, the gallery's located in a residential neighborhood, not in a retail district or center. I don't think that's why it's the best performing gallery. Okay?
The 2nd thing that's really different, the gallery has our first foray into hospitality with the 3 Arts Cafe. Which happens to be just on its own a highly successful F&B operation. With an annual volume. Everybody said, "Don't tell anybody this," but it's tracking, and I'll tell you. With an annual volume tracking to do $5 million per year. There's not a name on the outside of the building. We didn't advertise the restaurant. The restaurant closes at 7:00 P.M. to 7:30 P.M. at night because we got a curfew agreement with the neighborhood. Everybody said, "You can never be successful. You don't really serve dinner." We're not serving hard alcohol. That was a big debate. Everybody says, "You can't have a restaurant without hard alcohol. It's a third of the business." Yet you saw the picture of the line outside.
With the line outside every weekend, just as a standalone. We've got a $5 million restaurant. I think that the questions to ask are these. Is the restaurant successful because it's in an inspiring store? Is the store successful because it has an inspiring restaurant that's driving more traffic? Is it both? We've created a unique and highly accretive experience where each amplifies the other, and you've got a whole new layer to this strategic view of what design gallery performance can look like long term. From my point of view, there's so many things that we're learning. We've got so many new tests. From a strategic view, it couldn't look any better today. From a tactical short-term view. Is every fourth quarter a war? Absolutely. In this business, can you not pay attention to all those little things?
You've got to be ready to fight the fights. You've got to be into the details. If you want to win in Q4, you've got to be highly engaged and you've got to be willing to improvise and to adapt. That's the whole thing in a nutshell. I'd say, look, we won in Q3, landscaped a little differently, earnings were a little better, top line's a little softer. I think you got a flavor for why the top line was softer and what we're doing about it in Q4. In Q4, top line might be a little higher, right? Flow-through might be a little different. The thing I'd focus on is 2016, right? I sit here and I look at the team and I say, "Guys, we launched Teen. We're really happy." Okay. We've launched Modern. I've never seen anything like it. Okay.
I've never seen anything come out of the gates like this, ever. Okay. Ever. Never opened a $25 million store in the first year in a trend. Then I look at the performance of these new galleries and the dynamic of hospitality, the dynamic of having Modern in these stores, Baby, Child, Teen, and think, like, do we add hospitality to other galleries? Is there another lift? I think strategically in 2016, you think about the 50-60 months against 20 months. You think about what we got in the pipeline and other things we haven't announced yet. I think we strategically today are the best positioned we've ever been at any point in time in our history.
Great. Thank you.
Your next question comes from Daniel Hofkin with William Blair & Company.
Good afternoon. Thanks for all the color so far. As it relates to the 3Q upside on earnings despite the revenues and then fourth quarter different flow through, is merchandise margin a key swing factor there because of what you're seeing in promotion or is there something else in terms of other expenses that are maybe the timing is shifting a little bit? That's my first question.
Yes. In Q3 on gross margins. This is Karen. Hi, Dan.
Hi.
Gross margin was right about where we thought it would be, overall on operating margins, we're really happy with the expansion. A lot of that was coming from the advertising leverage that Gary talked about. On the gross margin, there's a couple different moving pieces. We did talk about that we had these non-comp warehouse sales that are mixing in a little bit lower, but the improvement in our core margins was quite well. We're very happy that our core business is performing like we want it to. We did have higher shipping costs and deleverage from the new DC, but we continue to see leverage in the rest of our supply chain network and retail occupancy. When we head into Q4, as Gary mentioned, we are going to be playing the game a little bit differently.
We do expect to have some pressure on product margins with the promotional activity, but we still expect to see good leverage in retail occupancy and those things. We will have higher shipping costs. That's the overall, we think that negative gross margin of 50 basis points is going to accelerate and have further deterioration in Q4. Overall, still expect, obviously, you can see in our guidance, really good operating margin leverage in the fourth quarter and then to round out the year.
Can you quantify what you're thinking about in terms of the gross margin for the fourth quarter?
Yeah. We think it'll be about 100 basis points.
Okay.
In total for all those factors. The two biggest being a little bit increased promotional activity and higher shipping costs.
Okay. As it relates to, were there any executional, aside from clearly the bigger book and everything, was there anything that you felt like? It sounded like maybe you felt like in hindsight, you cut back too much on circulation, anything else that looking back, big obvious things that you would have wanted to do differently?
Yeah, I'd say we probably were too aggressive with circulated pages in reducing pages circulated in certain categories and certain areas, certain products. The good thing about that, we can increase pages circulated really easy. Right. I'd expect you see a reverse of a trend of that next year. We've got good data to tell us where to focus our efforts and how to think about circulated pages and circulation growth. We thought this year was a year where we had enough data to say, "Let's try to optimize this model a bit. Let's find out what's the operating margin look like?" We've been evolving here. We went from milling 10 books a year to two books a year, two books to one book, books that were 200 pages to books that were 300 pages.
It's like we've been innovating at such a pace that the ability to continue to take the data and continue to learn and continue to optimize, it's just in our nature. You'll see us continue to evolve and learn. I don't think you ever get it 100% right, by the way. Is this directionally right? Are we a company that's going to perform significantly better than anybody else in the industry this year-over-year? Do we have the highest earnings growth of any of our peers? We do. When we look at the top line, the bottom line, the operating margins, how we're going to perform this year, we feel very, very good about it. I think from quarter to quarter because we have so many tests, so many things that we're doing, yet we're very scientific about, by the way.
None of it is back of the envelope. We're in here debating and reviewing these things, and we have a lot of data that we're looking at. You're never going to be 100% right on any of these. The key is, are you strategically right on most of them or all of them? I'd say strategically right now, we're right on almost all of them. That's why I say I feel more confident than ever before.
Okay. Thank you. Best of luck.
Thanks, Dan.
Your next question comes from Budd Bugatch with Raymond James.
Good afternoon, Karen, Cammeron, and Gary. Thank you for taking my questions. This is Bobby filling in for Bud. Two quick questions for me. Karen, I was hoping for a little bit more color on the gross margin buckets for Q3. Can you help us parse out a little bit from how much was shipping, how much was from the DC, and maybe a little color on how much was from the outlet sales?
Yeah, I'll just give order of magnitude. The non-comp warehouse sales was the biggest drag. Higher shipping costs, and then the deleverage from the new DC. I'll give you order of magnitude, and then on the flip side, the improvement in the core product margins, excluding those outlet warehouse sales, was the bigger thing than even some of the leverage in the supply chain network for the existing DCs and in our retail occupancy. Part of that just being it's a lower quarter.
Okay, I appreciate that. That's helpful. You talked about at the Analyst Day, starting to flex your shipping payment, or you mentioned there was some room in there to help offset some of the shipping headwinds. Have you guys started to look at that or started to flex the cost yet?
For others that we do think there's a lot of, if you look at us competitively versus our peers, we are extremely competitive with the shipping we offer. We don't have a lot of surcharges or really many surcharges at all. Our shipping program is just highly competitive. We think over time, there's ways to optimize that. We don't have restocking fees like some of our peers do. I think we're the leader in that space as far as the bargain to the customer. Is there a way to get from that? Sure. With UPS, I think it's been widely known that they were increasing their parcel rates.
We were able to negotiate some great benefit in how that was going to impact us and delay some of the impact of that and have taken up our UPS rate table slightly on a couple of the bands.
Okay, thank you. Lastly for me, when we look at the fourth quarter, it's great to hear that it's ahead of plans today. When we think about the markets that you guys talked about, the Miami, the Houston markets that are facing the drag, what does your guidance imply for that drag in the fourth quarter? Does it stay the same as the third quarter at four percentage points, or do you expect it to deteriorate a little bit more?
It's about basically the same as it dragged in the third quarter.
We have a good read so far, how it's trending versus the third quarter, so far, four or five weeks in.
Thank you. That's very helpful and best of luck.
Thanks, Bobby.
Your next question comes from Brad Thomas with KeyBanc Capital Markets.
Yes, hi, good afternoon. Thanks for all the color already. My question was going to be around RH Modern. I was hoping you could give us an update on how maybe from a tactical standpoint, you'll start to get the product in more stores given how favorable the initial response is. Perhaps as we think out to 2016, maybe you give us a little bit more color on what kind of a lift it might be able to provide to the business.
Yeah, the first obvious one that Gary talked about on the video was that we do, or I can't remember when we talked about this, but we do absolutely plan to get it into Atlanta. That store is doing quite well, and it doesn't yet have RH Modern in RH Teen. There's a handful of additional legacy stores where we think there could be a vignette and some space in those. The bigger thing is the space that will be allocated in the new full-line design galleries as we roll those out in each and every market. There's space, as we've kind of long said, those galleries were being designed for what's on the come, not just the existing product offer. RH Modern has been part of that playbook, and it has a nice home in the design of all those future galleries.
Great.
We're not going to necessarily quantify the exact lift for 2016 just yet, but we do feel really good about based on the early reads, both in the markets where we have a real estate presence and the direct response that we're seeing. We think that's going to be even more meaningful as we get better in stock in Q4 and into 2016, where we think that's going to be a really nice driver for growth in the years to come.
That's great. Thanks, Karen. With respect to the galleries, it's really a diverse and different type of store you're opening in many of the cases here. I was wondering how much you're able to apply the learnings from 2015 here to something as soon as 2016. With all this that you're learning, how this makes you think about maybe the pace that the company grows at.
I think that's something that we learned, I don't know, I'd say two, three years ago, when we thought we were going to be opening 10, 15. At one point, we were out there saying we were going to open double-digit number of galleries each year, we quickly learned that there's so much to kind of learn as we test different pieces. Everything from how to structure the deals with percentage rent breakpoints to just other different factors within those deals on the lease side. The execution, we've just gotten better and better on how we merchandise the stores and have a plan going ahead, the kind of product offer and the space allocation. Even with this latest crop, as Gary mentioned, we have a smaller sort of mid-tier market.
We have a non sort of traditional retail mall location, we're anchoring a mall. I think every single time we do it, we're testing. Some things like the F&B experience, those kind of things we can apply pretty quickly, but that's sort of why we backed off from the 10 to 15 and started kind of going at a more measured pace because so that we can incorporate all those learnings. Thus far, there's even certain things we learned in Atlanta that could already be incorporated. There's things that we learned from Chicago that went into Tampa. Just as we learn, we kind of immediately apply it.
Great. Thank you very much.
Your next question comes from Oliver Chen with Cowen and Company.
Hi. Thank you. Karen, we had a question on the revenue growth and the comp versus total revenue spread. For fourth quarter, will it trend in terms of the low single-digit spread? And then as we think about the dimensions of that comp, is it going to be mostly conversion and traffic-led in terms of the comp on traffic versus ticket?
We don't guide comp, nor do we really disclose traffic and ticket. We always say that so far every single quarter that I've been here for the last three and a half years, we always generally see growth in traffic and ticket, which for us is average order value and number of orders. I will just say those trends are positive. We expect them to continue to be so. On the comp versus non-comp, or total revenue growth, I should say, versus comp, that three-point spread that we saw in Q3 was a little bit higher because we had the warehouse sales that I mentioned that we moved from Q4 to Q3. That dynamic both had an impact on our margins, but it also made at least about a point of that growth is probably attributed to that, and we won't have that recur in Q4.
That said, the performance of the new galleries continues to just be quite strong, and we're very happy with that. As more of the volume in those new stores ships in Q4, we expect what had been a really small delta between those, it'll stay in the two to three-point range. The thing I want to make sure continues to be clear is that just when some of those new stores start to have great performance in the non-comp bucket, things like Melrose getting into the comp bucket, Atlanta getting into the comp bucket, you're never going to have that many stores in the non-comp bucket in any given year at any given quarter.
Okay, thanks. That's really helpful. When we do monitor and we do think about how you're strategically executing on promotions and what's the best way to do this in a brand-appropriate manner? Is it within certain categories, or is it going to tend to be whole store in terms of how you would like that to evolve over time? Gary, in the video you mentioned home and hospitality. As the brand continues to evolve in terms of lifestyle, how does hospitality fit into the bigger picture, and what do you think about art and hotels and clothing in terms of how you're thinking about what RH means?
I think that take the hospitality part, we'll talk a little bit of the other question. I think when you think about building stores that are in the 50,000 to 60,000 square foot range and creating a destination, creating a sense of hospitality, it's no different than bringing somebody into your home, right? If somebody's going to visit your home, we've said we want to blur the lines between residential and retail and create spaces that are more home than store, if you will. If you're going to have somebody into your home, of course, you're going to offer them something to drink, possibly something to eat, and create a more engaging experience. To us, it's about how do you create destinations that people can be immersed in the lifestyle, can experience it, that want to sit with it longer, that maybe will discover ideas or products.
I think that that's what we're seeing today in Chicago. As I think about other things, the things that complement that, I think, are pretty intuitive. We've integrated contemporary art into our modern stores. If you think about things, people may be responding to the fact that WWD ran an article, and focused on apparel. That was, by the way, an interview we did in our modern gallery when we opened, and it was supposed to be about RH Modern, and somehow the writer decided to make it about apparel when she told us it wasn't going to be about that. I think everybody knows that we have a view that maybe long-term there could be an opportunity in that side of the business. It's nothing that's on the front burner. It's nothing that we're even remotely working on with any effort right now.
I wouldn't think about that. I think about how you think about hospitality, where when all of a sudden you take a store like Chicago and it's the least trafficked store, and all of a sudden it's the best performing store. I think there's something to learn there about hospitality inside a retail store and how it can be integrated and how it can drive traffic. At the trend we're on today, which is trending to about $5 million a year in the hospitality side in Chicago, we're feeding about 450 to 1,200 people a day. Much of that traffic is incremental, and we think that that is providing a real synergy to the experience in Chicago, and there's really something to learn there, which we think is possibly a big opportunity when we look at it.
Okay. On the promotions front.
Oliver, as far as the promotions and doing it in a brand-appropriate way, I think we try to always do it in a brand-appropriate way, whether it's our emails or our in-store marketing. You don't see a lot of things on the street. I think we try and keep the messaging clear. For us, we're very consistent with our promotional events that we run, and we don't often deviate from those. When we do, and even going a little bit deeper than we do, we see a great response. We have a lot of, I don't know, high-quality interior designers who work on projects for folks who have deep relationships with their customers and clientele. I do think we have a way to execute in a way that is brand appropriate.
I think you have to ask yourself what's brand appropriate in the world of promotions, right? We're in a promotional environment in the world. I think it's a permanent state of being. I think it doesn't matter where you are in the economic chain, people want value, and especially when you're buying high tickets. I think it's here to stay. I think everything that we do is brand appropriate. You don't walk by our stores and see big sale posters in the windows. You don't see big sale signs anywhere. You don't see a source book that's focused on price, right? You don't see ads that are focused on price. It's really focused on design, and we think about our business from a design, quality, and value point of view. You have to win on value, make no mistake.
You have to first win on design, and you have to win on quality, and then you have to win on value in that order, and you have to win on all three if you want to have a customer. There's constantly different perceptions of what that value equation is. We're going to always be evolving and always, again, playing to win. I wouldn't let one incremental promotion in the fourth quarter change the way people are going to feel about RH, right?
Yeah.
I think about it more, is RH's numbers.
Okay
At the end of the day better than the competition? Are they taking share, and are they growing earnings faster, and is this going to be a more valuable company? That's what I'd be focused on. We just beat our Q3 numbers that were on the street. We just guided up in Q4. We just told you we have exciting new businesses that we launched that are performing ahead of our expectations. The new galleries, which by the way, many people couldn't wrap their head around the new galleries we were going to open a year ago, are the most exciting things in retail today, I believe. They're all performing over our expectations. Those are the headlines.
Thank you. Really helpful. Happy holidays. Best regards.
Thank you.
Thanks, Oliver.
Your next question comes from Lorraine Hutchinson with Bank of America Merrill Lynch.
Thanks. Good afternoon. I just wanted to follow up on the out of stocks in Modern and ask when you thought you'd be back in stock, and if you think this will be a gating factor to the early success of Modern in the first half.
Yeah. Look, it's going to build as we go. We've got a lot of new product, some existing vendors, some new vendors. With anything new, there's going to be a ramp-up period. Some things are going to go right, some things are going to go wrong. We think the in-stocks are going to improve every week. We'll continue to ramp and continue to be in better and better stock. I'd say despite the fact that the in-stock position is not great today, the demand is outstanding. You can only anticipate it's going to get better as our vendors ramp and everybody starts to get some time under their belt here with this new business, and we continue to execute better. With any new business of this size and scope, you're going to have a ramp-up period. We're not making apparel here, right?
This is much more complicated than making furniture. Yeah.
Lorraine, just to clarify, it's not that we were in and then we were out. It's really just a build of getting some of those initial products.
Right.
It's every week, we get more of the initial runs of things.
Yeah.
We certainly want to be conservative with how we buy the inventory. Some of it, we started off with low buys, or a lot of it, we started off special orders, we could read and decide what to stock. That % of in-stocks will continue to improve gradually all through Q4 and then into the 2016 year.
Yeah. Look, the best sellers in a new business are always going to sell out, and you're going to always have to respond and catch up with those. We've got our share of those. I'd say it's kind of nothing that we don't have experience with, right? We've grown this business through the expansion of our brand. I think we've proven that we know how to do this. Look, the good news is supply chases demand. The most important thing in our industry is can you create demand? If you can create demand, you can get supply. The bigger issue is when you can't create demand.
Thank you.
Thanks, Lorraine.
Your next question is from Michael Lasser with UBS.
Good evening. Thanks a lot for taking my question. Gary, longer term, what gives you confidence that some of the exogenous factors that impacted the business in the third quarter and into the fourth quarter are not more longer lasting and not more just unique to this period? Does it put the longer-term margin outlook at risk if the company has to be more responsive to the promotional environment and some macro factors, even as it's launching a lot of new products?
I think that we've proven that we can navigate through those changing factors. I tried to put the factors into perspective with how we're playing the game. A lot of these factors have been there. Some look like they've gotten worse. Generally, I'd say you've got to look at it both ways, right? We're being affected by certain things now. Oil's at the lowest price in, I can't remember when oil has been at these prices. That's there. At some point, you anniversary these things, right? There's always pluses and minuses that you're navigating through in your business here. There's always certain markets that are going to over-perform, under-perform. There's certain things that are happening today that I think everybody's got to deal with.
I think, whether it's how we're dealing with it, how our competitors are dealing with these different factors. I think the key is, can you be honest? Do you see them? Are you creative enough, and can you think about how to navigate through whatever economic landscape in a way that you're going to take share and that you're going to win? I think if you go all the way back to 2008, when the economy blew up, and if you think about where we were then and where we are now, and how we performed in the worst economic downturn in history, I don't think we're facing anything like that. We outperformed everybody by a long shot. I think the key is this company positioned strategically to win?
Do we know how to win in the short term tactical moves that you have to make? Do we have a strategic framework here, that is going to continue to build distance between us and other people, that's going to continue to disrupt markets and take share? Look, I don't mean to make anybody too worried about this stuff, right? Sometimes maybe I tend to be overly transparent because, look, we've got shareholders and supporters on the phone, and I think it's important you know how we're playing the game. We can speak less about stuff and pretend like everything's just always great. I don't think that's the right way to build partnerships.
I think we tell you when things are working, we tell you when things are not working, we tell you when we make changes, we tell you when the changes are working, we tell you when the changes are not working. In aggregate, I'd stay focused on what is our performance, what is the outcome, what's the strategic framework of this business look like. As I'll tell you, what I said before, I've never felt more confident about where this company's positioned and what our outlook looks like than I am today.
My quick follow-up is, as you raised the guidance for the fourth quarter, was that all in response to what you saw from the promotion, from the increased promotion, or was it based on the performance of the new design galleries and the launch of Modern?
It's a combination of everything, right? You've got brand new business. Majority of the Modern books got in in mid-November. You've got that business ramping, you've got in stocks coming in. You've got stores that just had Modern. You've got, when did Boulevard open? These stores just got Modern, you've got that business ramping. You've got Teen ramping. You've got new galleries opening. Every week or two, we were opening some of these new stores. It's a combination of all those factors and all those trends and where we are quarter to date, that gives the data to say, how do we see the quarter based on how we're going to play the quarter.
Understood. Have a good holiday.
Okay. Have a great holiday. Thank you.
Your next question comes from Matthew Fassler with Goldman Sachs.
Thanks a lot. Good evening, congratulations on getting it all done. I know it's a very busy quarter for you. My first question, both my questions actually relate to Modern. Can you talk about the Modern customer, the customers actually buying and engaged in that brand, and what the overlap looks like between your legacy Restoration Hardware customers. Do you feel like you're engaging a new cohort here? Is this a loyal customer from the past who's coming back and shopping Modern? Anything you're learning about how this might be extending the customer base. I know it's early days-
Yeah
Presumably have some data.
Yeah. The early data would tell us that it's opening up an entirely new market. It's bringing in new customers, and it's accretive to our current core customers. Meaning that they're finding things in the assortment that they like, that they can integrate into our current assortment. I think we're seeing it hit on multiple levels, and that's why we're seeing the early response that we're seeing today.
That's great. If I could follow up. You gave some numbers, I believe, in the video about the lift that you're seeing in stores that are getting RH Modern. If you could talk about just what that cohort is right now and essentially what the RH Modern presence at retail looks like today. Obviously, you have Beverly Boulevard, you have the new galleries. Where else have you brought it in? When you put some of those numbers up there, what kind of store base did that refer to?
Yeah, Matt. The way to think about it is where we've opened new galleries, in Chicago, Denver, and Tampa. If you take those three. The way we think about the business, in each of those markets, we have a legacy store that was doing trailing 12-month volume of X. We've got an internal model that says, look the core business based on showing more of the core business, based on showing the categories by showing the outdoor business on the roof, so on and so forth. We have math that says that the number ought to go from X to Y, right?
Whether it's baby, child, RH Teen, so on and so forth. When you look at RH Modern, and you try to isolate the core business and where the core business should be performing to how our data has told us it will. You look at RH Modern and how incremental it is off that base legacy store. If you took the base legacy store in Tampa, Chicago, or Denver, RH Modern is adding 40 points or more of incremental volume on top of the base legacy store. Right?
Got it.
That's incremental to the lifts we would've expected in all the other business and categories, whether it's expansion of core, outdoor, baby, child, teen, et cetera.
Great. I appreciate the color. Thank you very much.
Your next question is from Oliver Wintermantel with Evercore ISI.
I just had a question, excuse me, on inventories. I know it's up because of all the newness. From a working capital perspective, when do you think we're going to see some relief on the inventory growth?
Yeah. We've kind of been talking about the cadence of inventory for the year, and really nothing's changed. We continue to expect to have year-over-year inventory growth ahead of sales growth in Q4, mostly because of the kind of cadence of newness last year with all the newness coming in the spring. We're seeding it, selling through it, and then a lot of our chunk of newness coming in the fall and just kind of not really a good compare year-over-year. We do expect to have higher inventory growth than sales growth. That delta right now that we have 10%-25%, that 15-point delta will certainly narrow by the time we get to the end of the year.
Got it. Thank you. I just want to go back quickly on the gross margin side. I think on the second quarter call, you said that a gross margin deterioration would be higher in the third quarter than the fourth quarter. Today you said that it's a little bit higher in the fourth quarter. Is it promotional, the big difference there, or what is driving the difference?
Yeah, that is the biggest difference.
Got it. Thank you very much.
Thanks.
We do have time for one final question. Our final question for today comes from Matt Nemer with Wells Fargo Securities.
Afternoon, everyone. I've got two. The first is: Given the success of Food and Beverage in Chicago, do you have time to integrate Hospitality into the 2016 vintage of stores? Would you potentially retrofit stores like Atlanta? Then secondly, Karen, how does the Austin store opening a little later than expected impact the fourth quarter guidance? Thanks.
Yes. As it relates to hospitality, we do, Matt. We're reviewing plans and opportunities right now, we also have opportunity to add hospitality to the existing galleries that we've already opened.
With respect to Austin, very similar to Atlanta last year, although Austin was scheduled to open in Q4, just like Atlanta last year. You see more impact demand more than it'll impact ships, because we would've had some volume in there, but it's not hugely significant. There's something there, but I think everything we see with the Modern ramp and the new stores and kind of early reads in the quarter to date, we feel good about the guidance, even with Atlanta pushing to 2016.
Great. Thanks so much.