Earnings Call: Q2 2016

Sep 10, 2015

Thank you. Cameron McLaughlin, Investor Relations, you may begin your conference. Thank you. Good afternoon, everyone. Thank you for joining us for RH's Q2 fiscal 2015 Q and 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. Restorationhardware.com, highlighting the company's continued evolution and recent performance in addition to further details on the upcoming launch of both RH Modern and RH Teen. 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, 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 the call over to the operator to take our first question. Your first question comes from the line of Oliver Chen with Cowen and Company. Your line is open. Hi, congratulations on all the growth and the innovation. We had a question related to Karen, your comments were helpful on the Q4 and dimensionalizing the growth you'll see there. I mean, do you expect the outsized EPS growth to continue into the earlier quarters of next year as you have that the non comparable benefit from some of the new product lines? And also, we were also just curious on the FX front if the Chinese yuan is having any impact in terms of how you're sourcing? Yes. So on the first question, we do expect to continue to have benefits from these new businesses and new stores. We're not ready to commit to a specific level of EPS growth, but we're very excited about the businesses and the stores and do expect those to continue into and add to growth in both revenue and earnings in 2016. And with respect to the FX front and the devaluation of the yuan, we do have we expect to get some benefit. We're a little bit hesitant to commit to how much just because a lot of our vendors are a lot of the product cost that we have is raw materials and goods that aren't that are getting imported in. And so some of the savings is just on the labor. So we expect there will be some impact, but we're not going to commit to any specific levels just yet. Okay. And Gary, the RH Modern, congratulations, it looks really differentiated. What do you think we should think about for teen and modern as a percentage of sales over time? Or how should we think about how you view your market opportunity relative to your existing business? And I was also just curious. Thanks. Yes, sure. Well, I think there's a logical point of reference out there for teen. So you can draw conclusions based on that. And I'd say in modern, there's no logical point of reference, but it's a significantly bigger market than teen or baby and child. So if you stand back and think about the modern business and by the way, modern could also have an aspect of teen and baby and child in the future. So Modern is covering every aspect of the home except for those two rooms. So you've got living, dining, bedroom, bathroom, outdoor. You'll have accessories, textiles, window treatments, rugs, etcetera. So I think about it as an entirely new business. It's framed in a, we believe, a very new and differentiated aesthetic that we have not really offered today. So we believe it opens up a whole new market in many ways. As I mentioned, I think last quarter, we believe there's an opportunity to really create a new market because there's really no destination in store that is aggregated all the categories and presented them in an integrated fashion in the modern market today from our point of view. Thanks, Gary. And Gary, just a final question. What's your vision kind of for the customer relationship management part of the future of retail? As you guys invest in your supply chain systems and your shipping and your CRM component, I'm just curious about a broader question about how you see that evolving and how it may have the most impact on your business? Yes, we've got a pretty large and complex strategy. I don't say complex, but I think very logical strategy for how we think about the customer long term and have an integrated not only view of the customer, but a really much more intimate relationship with our customers going forward. We're working across all channels of it now and there's aspects of systems that go to that. There's aspects of the supply chain and delivery that go to that and things that we're doing on the supply chain and delivery side of the business. There's aspects of the service level in the stores and design services and so on and so forth. It's a very holistic strategy that we're pursuing on multiple fronts. And when we're ready, we'll lay that out in a meaningful way to you. I think if we told you everything we were working on right now, it might be like a mind dump, it might overwhelm you. But we're working on basically almost in every aspect of our business, I think in a very new and distinctive way. The innovation on the operational end of the business and on the service end of the business is every bit as meaningful as on the product end of the business and the category and new businesses side. But unless you wanted to watch an hour video, we're going to give it to you in pieces. Thank you for that and congrats on the most exciting stores and retail for sure. Thank you very much. Thanks. Your next question comes from the line of Matthew Fassler with Goldman Sachs. Your line is open. Thanks a lot and good afternoon to you. I want to start off just by getting an update on the performance of Atlanta as the obviously the first effort in the newest store format that you've got. Yes. Atlanta continues to exceed our original projections and expectations, Matt. So we're very excited about Atlanta. Atlanta will also Atlanta was built to receive both RH Modern and RH Teen. So we'll be receiving those new businesses. We're going to give those to Atlanta in probably the January, February period just because we've got we wanted to hold enough of the inventory to have into these 4 new next generation stores where we've got them somewhat merchandised differently, where we've got a full floor or modern 15000 square feet, 13000 to 15000 square feet depending on which of the stores you pick. And then also we have a freestanding modern store. So we're going to hold on Atlanta, but Atlanta is performing above our expectations and will continue to grow and be impacted in a positive way with the addition of RH Modern will have a full floor in Atlanta and RH Teen will have a half of a floor in Atlanta. So the store will continue to grow and ramp. And then we have many other new categories and businesses in the pipeline that will continue to feed these new next generation design galleries in the future. And Gary, it sounds like Chicago has some new features. On the video, you talked about some different things. Can you talk about the rationale, the economics, the operation and execution? Does this add to complexity? Do you outsource that complexity? And how unique is what you're thinking about Chicago, thinking for Chicago that is for that market? Yes. I'd first start with a view that we don't do anything unless we can do it as well or better than anybody in the world. So, I'd start there. I'd say, if you look at this company since we went public and take a look at anything we've done, whether it's new businesses, new categories, new stores, change the mailing cadence of our catalogs, take catalog page count to levels that no one's ever taken them to, open supply chain distribution, in sourcing. I think what people underestimate is how well this company executes. And I think what compared to other people in our sector, I know it looks like we're going so much faster and it's true and we are and we're doing so much more and it's true and we are, but we're a different organization, we have different people and we have different methodologies and processes. And I think that like I mean to focus on we're adding a restaurant and a wine bar in Chicago is so little compared to everything else that we're doing that is so important. I would just we're going to always do a lot of things, but a cafe and a wine bar in a store and creating a different kind of experience, it's like a little test. I wouldn't focus too much on it. We've got the best partner in Chicago, the best restaurant operator is our partner. But just think about it this way, Matt. We test and prove and scale new businesses here on a regular basis every season and every year since we've been a public company. We've hit our numbers every year and every quarter. We do what we tell you we're going to do. We're not perfect, but we're pretty good. But I wouldn't focus on a restaurant and wine bar in one store and get worried about complexity. It's inconsequential to the big strategic things we're doing. And then finally for Karen, are there any financial consequences associated with the launch of Keenan Modern in the Q3? You talked about the sales and the ramp and how that impacts Q3 versus Q4. Anything on the SG and A front to think about as we model out the cadence of expenses through the year? No. Just to give a little color more broadly, specifically with respect to teen and modern, no, what will have an impact, we do expect some modest deleverage in gross margins in the back half, but that's more a function of the new DC that's opening that I mentioned on the video. So we have that 1,500,000 square foot DC that will put some pressure on supply chain occupancy just until we anniversary that next year. And then shipping continues to shipping costs continue to be higher as we mix in more furniture and there's some higher parcel rates. So that will put some pressure on gross margins in the back half, only modest for the half. Q3 will be more pronounced than Q4, but we do expect to continue to have modest leverage in product margins and retail occupancy. So that's a little and then on the SG and A front, we expect to have great leverage in the back half. Got it. Thank you so much, guys. Your next question comes from the line of Brad Thomas with KeyBanc Capital Markets. Your line is open. Yeah. Hi, good afternoon. Wanted to follow-up on the real estate side of things and with Modern having its own standalone location here. I was wondering Gary and Karen, if you could give us an update on your thoughts on the potential for some of these concepts to have their own standalone location? Yes, I think that's a very good question. It's one that we are spending a lot of time here on. We're so early in modern. We as it developed and evolved during the last year as we really put our focus on it as an organization. And again, we work very differently than I think any retail company at least I've ever worked for. We work in a real project based approach. I think about it as more like a technology company when we have teams that all of a sudden come together and focus on big projects and bring them to life. And because we do it that way, these things tend to evolve and we see a lot more and we can move a lot faster. And as I could you can just tell you and I'll put this out here, so you can understand the perspective of how we work. When we introduced the idea for RH Modern in our long term plan to our Board probably 18 to 20 months ago, it was planned to be 120 page book. When we focus the organization on it and begin to work on it, then that's when you really start to learn and things start to come together. And we started seeing opportunities we couldn't until we focused on it, expanded. We thought it was going to be a 300 page book just a quarter ago. Now it's going to be close to a 500 page book. It will probably land somewhere between 4.80 and 500 pages. We're in final photography on it today. We just showed you, I think, it was about 40 spreads, I think, in the video. So you just saw less than 10% of the book. So you can just imagine, right, like you just saw less than 10% of the book. Most people launch books with like a 60 page catalog. And we're launching with 500 pages. So it's hard to kind of think about the model, but as it's come together, we started to believe the assortment could really deserve its own retail presence. And at first, we thought it was going to get a floor, a half floor of the new design galleries as it filled out. We thought it could take its own floor. We think now we think it's a bigger idea than we thought about 18 to 24 months ago. But I think that's what happens in other kinds of businesses, right? Like if you think about Apple, how big do they think the iPod was going to be? How big do they think the iPhone was going to be? When they launched the iPhone, the average phone was $49 and everybody had a Motorola Razr and they had a Nokia. And then that phone changed everything, right? And industry has changed. We think, not comparing RH Modern to the iPod or the iPhone, but I would say that comparatively, if you look at our industry and you look at modern, there is nothing like it. There is nothing like this concept anywhere in the world. We're the first ones to bring this comprehensive and complete of an assortment to a marketplace at one time. No one's ever launched a business with 500 pages. No one's ever launched a business like this, a specialty store concept like this with 18,000 feet in a freestanding location or 15,000 square foot stores. Now you say like, well, gosh, is that really risky? Well, I don't know, I'd look at everything else we've done, right? We've grown RH from a business that was a few $100,000,000 to a couple $1,000,000,000 by making big important strategic moves. We don't spend a lot of our time like a lot of other companies on little tiny incremental moves. We look at big strategic moves and things that will change the markets, change our company, and that's where we put our time, attention and effort. And we think this is big. I think this can be as I really think it'd be as big as RH is today and or bigger than we are today. I mean, there's no reason to believe that RH Modern can't be a multibillion dollar business in the U. S. And take your points of reference on anybody else doing anything, whether it's I don't know, look at West Elm or anything else, which is business I'm familiar with obviously, it doesn't have anywhere near the assortment we have today that we're launching with. And so I think this thing is going to be massively disruptive and create a new market. And you may see freestanding stores, you may see it integrated, but we're such at the early innings of this thing. But this is a big idea. We're not going to get it all right on the first swing, but we've got a lot in the pipeline. And this could be this book could go to 800 or 1000 pages within 12 months. And this is going to be a big deal from my point of view. I think it's the most important new business we've launched in the history of this company. So we have big plans for it. And we think as I said in the last call, there's so many converging trends that create an opportunity to create a market. And I think we've identified those trends. We've spent a lot of time on them. And the other thing is this business is a business we know, right? Here's another thing where you go, wow, RH Modern is like a brand new business. It is, but it isn't. It's every category that we're already in. It's every product line that we're already in. We know the percent of the business that should be living room, dining room, bedroom, bathroom. We know how sizes sell versus other sizes. We know how finishes sell versus other finishes. We know the lighting business. We know the window treatment business. We know the rug business. We know the bedroom and bathroom textiles business. So the great thing about this and why we can go so fast is we know this business. This is a parallel business with a different aesthetic that's going to be presented in a compelling way that I think is going to completely open up the aperture and the acceptance of the RH brand. So sorry, there's a little bit of a ramble, but I mean, this is a big deal. This is I think it's the most important and significant new home furnishings business to be launched in the last 15 or 20 years. That's very helpful. Thank you, Gary. And if I could ask just a financial housekeeping item. It looked like payables was a nice source of cash for you in the quarter. I know that's a goal for you this year to work with your vendors to try to terms. Any update on the progress in those discussions with your vendors? Yes. We're making progress. We have a ways to go, I'll say. But I'd say between the HSBC program, we're kind of opening up and offering to our vendors and then just some of the deposits that we used to have and making sure that as they grow, we get some improvement. We're making progress, but there's still ways to go. Great. Thank you so much. Thanks, Brad. Your next question comes from the line of Ram Rubinson with Wolfe Research. Your line is open. Hey, good afternoon. Great results. Thanks for taking the question. Hoping you can help on the shape of your customer and customer adoption. Specifically, where are, I don't know, your demographics in terms of awareness trial? What are you doing with prospecting? And I'm just curious how business is to new customers versus existing and whether those existing customers are pushing the edges of the assortment. I know those are a lot of things to think about, so I don't expect answers to all of them. But I'm just trying to get a sense as to whether or not your business and what the shape of the adoption curve, I guess, is looking like? Yes. Well, Aaron, this is Gary. And I'd say that we think about all those things and they're all good questions. They're not necessarily answers that we want to give out in a public way because it's educational to our competitors and others in how our business is responding and how we think about it. But again, I would just focus on our execution. I think we've been pretty good at introducing businesses, introducing categories, expanding categories, dimensionalizing businesses and reading and reacting to and responding to how those businesses develop and perform and how our customer reacts to what we merchandise. But so those are just ongoing things that we do and we're constantly learning, we're constantly improvising, adapting, improving as we go. So I don't know if there's anything specific you want to focus on those questions towards or Yes. That's right. You completely deflected it, which I understand that's smart of you. So maybe I may ask you another one altogether. The pace of innovation is huge. And of course, we all call for companies to innovate and then we get a little scared when they do innovate as rapidly as you do. Maybe just give us a sense internally of the guardrails of what it is that you guys say no to and what it is maybe that those things have in common so we get a sense that it's not like everything's getting green lighted? Yes. I'd say we'd say no to about 97% of the things we talk about. And it's also about So everything at this stage, I mean just to give you a quick perspective, we go through 2 significant strategic reviews in the company a year. And as we go through those things, we always have ideas that get surfaced, current things we're working on, new things we're working on, new things that come to the table. As dots connect, we see new opportunities and new businesses. And we go through a very rigorous strategic process here where every idea is dimensionalized and valued based on its financial value, its strategic value and its emotional value. And so the financial value to the company is sometimes the more obvious one. What is the revenue value? What is the earnings value? What is the cost reduction value? What is the efficiency value? When we think about the financial value to the company and then we go into we rank everything on strategic value. How does it position us in the market? What competitive how does it create competitive differentiation? And how does it position us long term to win? And so we go through many discussions around that. We try to value things strategically. And then we try to value things emotionally. And emotionally, as it relates to 2 constituencies. 1, our consumers, how does what we're doing, how will it connect with consumers, why will they care about it and will they connect to it emotionally. And 2, is our people, how will our people connect to this choice, this initiative, this strategy? Because to get great people and to get great people to do great work, they have to really care about what they do. We like to say inside maybe I shouldn't say this publicly, but now I guess I couldn't, okay. But they have to give a blank, right, about what we're doing and they have to feel connected and passionate to it. And so the emotional value is important internally and externally. Our people it has to connect to our people and it has to connect to our customers. And so we go through a process of taking whatever fifty or more ideas and we go through a rigorous process to value all of those and then we force rank those. And we say, if there was if we could only do one thing or die trying, what would we do, right? If we can only do one thing and by the way, as we value all those, there's also with the financial value of what's the financial capital and the human capital we have to invest into each one of those that helps us dimensionalize how we think about the complexity, the difficulty, the returns and so on and so forth. But then we try to see them clearly, right? And we debate we spent a lot of time debating them and getting clarity in the value. Once we had clarity on how we see the value of each of those choices and then we force rank them. If we do one thing or die trying, what would we do, we debate the hell out of that and then we pick 1 and we align on that as an organization, as a team and we figure out what are the human capital and financial capital we have to deploy against that, what's the return we're going to get against that and then we build the strategies, we take that and we translate it into a strategy and into the tactical moves to execute it. And then we go to the second thing, what's the second thing we do or di trying, what's the third thing we do or di trying. And then we try to understand what's the bandwidth of the organization. Do we have the resources? Do we have the capital? Do we need more capital? Do we need more resources? How do you create the risk profile? And we go through a whole risk assessment on each of these things and we look for initiatives and choices and projects and strategies where we have a great degree of asymmetrical risk to the upside. So it's probably not much different than how you guys how investors manage a portfolio, right. And except maybe there's not as much emotional connection to it. But we're leading thousands of people here. They have to really care about what they're doing to do great work. That's a great answer. Thank you. And I'm sure the emotions are on our side too, but it's great to hear your passion. Your next question comes from the line of Daniel Hofkin with William Blair. Your line is open. Good afternoon. Congrats on the fine results. Just maybe if I could ask for a little bit of color on the quarter, just big picture, not like little pluses and minuses, but if there were any kind of larger categories or let's say the friends and family event that you feel were call outs one direction or the other and the trend over the course of the quarter. Just interested also with Gary with your commentary on the video in mind, what you think might have contributed to the different growth rates between the channels? Not necessarily saying one is better than the other, but just what might have contributed to the difference? And then I have one follow-up question. Thanks, Frank. Where do we start at? Where do we start at? The key. Yes, nothing real surprising categorically how the business performed. I mean it ramped the way we thought it was going to ramp. I think I'd stand back and think about what's different this year versus last year and how we think about the business. The majority of our books were in home last year, late June and 100% by mid July, right? So there's really 2 3 key points to consider. 1, our books this year, spring books this year had 1300 less pages than last year, right? So if you just stand back and think about that, our spring books had 1300 less pages than last year. So we had to that's a pretty big move. We had to be very scientific about how our business was going to perform quarter to quarter, week to week, category by category, because that's a significant difference. The second point I'd say to think about as you think about the business and the big moving parts strategically. Beginning mid October, we will have 2 new businesses and 700 new pages versus 0 in the same period last year, right? So we just came up against a period where we had 1300 less pages. And our business over that period, right, is basically performed in the mid teens and then started we expect it to tail off in Q3 because really the books were 100% in home mid July, right? 70% in home late June, 100% in home mid July. So the shipping, the revenue recognition and the deliveries on those really ramped in Q3. So we come up against the build in Q3. And if you just look at our numbers from last year, our business tailed off last year in Q2 to 14% and then reaccelerated as we told you it would last year in Q3 and then accelerated to 22%, accelerated further in Q4 to 24%. And I think those are numbers that are pretty close to what we told you would happen. This year, it's a little different. The timing is different. The newness has got a different cadence to it. So here you're going to see us coming up just like in Q2. You're going to see the business tail a little comparatively because of the timing of the new businesses and the ramp of last year's book. So but the fact that I sit back and I go the fact that we could mail 1300 less pages and still have double digit growth is really meaningful to me. Because what we're doing here and it kind of goes back to some of Arum's questions and some of the questions that are earlier, we're always testing, right? We're always trying to fine tune our model. We're always trying to learn and our view was as we got into the productivity and the ability to kind of learn about fine tuning the advertising aspect of the business and the model. We thought, are we sitting on a business that maybe today, maybe today if we fine tune it actually has an 11% or 12% or 13% operating margin. If we just like on a run rate basis, if we pulled out and it's an interesting conversation because there's a lot of conversation around Amazon and Amazon now is starting to try to provide clarity and take investments out and future growth out. What's the core business operating on? If we really look at our core business and we kind of dial and right size the advertising if we really take a look at the investments we're making to lay the track for the supply chain, right, for the future growth, which we have to invest ahead of. If we really look at all the investments on the new businesses and we start to right size that, we acted like a private equity company, we said we're going to buy this company today. I think we're buying a company that probably has a 12.5% to 13% operating margin, but we're investing ahead of that. And so as we fine tune this thing, you're going to see us start to understand what's the underlying operating margin as we get smarter here, as we dig into this model and as we fine tune this model? And then what are the pieces as we grow? But if you just stand back and say, wow, they just reduced 1300 pages and they're still going to be in the double digits in Q3 when they're up against the book ramp last year, I think that's phenomenal. Then I sit there and I go, now we're going to add 700 pages, not a recontact, right? Like a lot of companies will mail a book again and it's a recontact and it's the same goods. We have 700 new pages of product hitting in late Q3, right? And that's up against 0 in the same period last year. So that's going to put the business in a position to now ramp. We're not going to get 0 for their 700 pages, right? It's all new content. So that's and we have lots of data that says what new content should how it should perform, what's the productivity per page by category, so on and so forth. And we think we're relatively conservative in how we're thinking about this. And then on top of that, we have 4 new next generation galleries opening in October November. We have a new freestanding modern store that's opening that's a pretty significant size story. In total, I think indoor and outdoor square footage about 18,000 square feet and 2 new baby and child freestanding stores opening. So when you think about whether it's categories, those are the big moving parts. The business is coming around against the ramp last year, 1300 less pages. Now you're going to have 700 pages against no pages last year. All those pages are incremental, right? And then you've got all this new real estate coming on board. And those are the important dots to connect as you think about the business. Yes. And then on the quarter specifically, the promo strategy was the same. Everything was pretty much as we expected it to be. On your question on retail versus direct, we've said many, many times that we're channel agnostic and don't necessarily care whether they order in the store, whether they order at home, especially agnostic and don't necessarily care whether they order in the store, whether they order at home, especially based on how our shipping model works. But I would point you to last year's retail growth was kind of an easier compare. Retail only grew 9% last year and direct was 19%. So there's always some of that going on. But we don't again, we couldn't be more channel agnostic as far as caring where the customer or where they choose to transact. I think the other thing that's affecting that could affect that a little, right, is we're making meaningful investments into design services and we will continue to be. You saw in the video, we're launching this fully integrated design atelier. We studied architect offices, interior design offices and basically we think we have a revolutionary new part of the store that we'll be launching that will really enhance the customer interface and how they design their home, whether they're doing it themselves, whether they're with their interior designer, whether they're with one of our interior designers or whether they're with an architect and an interior designer. But because of our investments in interior design, we're I think we're also bringing more customers into the store. We're creating more transactions in the store environment. And how do you project that? I'm not sure. I don't know. And honestly, quite frankly, I really don't care. I don't want to try to focus. I don't want to have a bunch of statisticians here trying to track where the transaction is happening and why because I just don't think there's a lot of value. I think we can watch those trends and we can react as cordially if it shifts one way or the other, we'll add more service and more support. But the adoption rate with cell phones and iPads and other things would tell you it should go one way, but we're really enhancing the store experience. We're making really important investments in design services and our ability to service the customer at the store level. We're building stores that no one's ever built before. Our business could shift the other way. At the end of the day, who cares? It's really our sales and earnings growing. As I said, Ken Denney says, well, the left hand side of it, the equal sign is important, okay, it's really the right hand side that counts. Fair enough. No, that makes sense. I guess, just kind of my other question as a corollary to all that as you think into next year and you guys already talked about the many more new store days next year with the additional galleries for the full year and then also all the new content. Just thinking about the year as a whole for next year without giving specific guidance, what are some of the other things that ought to be positive or negative relative to your longer term view? It sounds like potentially product cost could be favorable. Are there any other things we ought to be aware of at this point? I think the thing we worry about like everybody worries about is market instability. What happens with interest rates? What happens with the market? The high end of the food chain, you've got people heavily invested in the markets and if markets are unstable, I think that's something we all worry about. Not a lot we can do about it, just be prepared to deal with it. And what's going to be the effect of rising interest rates? Will it affect big ticket? We'll expect the home buying? We don't know. We've never I don't think the country has ever been in this long of a period of this low of interest rates. And so there's unknowns there and that's why quite frankly we position the company and tap the capital markets in opportunistic times and built our balance sheet to be able to execute our strategy in any kind of environment. Obviously, we'll if for some reason the economic environment changes and it dictates that we should change our strategy somewhat, we will. But at the higher big level, those are the things we think about. We can see correlations between our business and the market. And it's interesting as we all saw the market get beat up and then bounce back and go around, you can see our business week to week move a little bit. And how does that what does that mean long term. We think no matter what, we're going to continue to outperform, we're going to create new markets, we're going to take market share and we're going to do things better than our competitors, meaningfully better, not a little better, meaningfully better. So I think that's how we think about it. It's like at the end of the day, the markets will do what they do. The interest rates are going to move the numbers around the way they move the numbers around. But 3 years from now, 5 years from now, 10 years from now, there's going to be people that win big and we believe we're going to be one of those people. Of luck. Thanks. Thank you. Your next question comes from the line of Matt Niemeyer with Wells Fargo Securities. Your line is open. Afternoon. Thanks for taking my questions. First, directionally, I'm wondering if you can just give us a sense for how much the Q4 revenue growth guidance is driven by the new brands? And how would you assess the risk of getting that inventory delivered in Q4? I assume that it just based on when the stores open and when the brands launch that it's a bit back end weighted in that quarter. Thanks. Yes. Well, the risk would be baked into our forecast, right? So whatever guidance we just gave you, we looked at the opportunities, we looked at the risks, we tried to understand everything that can go right and everything can go wrong and put guidance out there that we believe that is the guidance we can hit. So I mean that's the way I think about it. Okay. And then just secondly, I'm wondering if there are any early signals from some of your books earlier this year that would show you that the more modern oriented product? I think there were some new product lines that launched with Outdoor that have more of a modern look to them are potentially a leading indicator for how that business, the new modern business will do. Yes, that's I think it's a very good question, Matt. As we articulated, we had both tested some modern that we there was product that we put in the outdoor book and in the indoor book that were originally developed and targeted for the RH Modern book and we thought that we had an opportunity to get some early reads and early customer response to that. And I'd say we're extremely happy with the early reads, extremely happy. And that's maybe why you saw this book go from 300 pages to 500 pages. Great. Makes sense. Congrats. Thank you. Your next question comes from the line of Peter Benedict with Robert Baird. Your line is open. Hey, guys. Thanks for taking the question. Just a couple. First, just a clarification. So the Modern and the Teen product as that flows in the back half of this year, from a product margin perspective, is that expected to be similar to the rest of the business? Or is it accretive dilutive? How do you think about that one? Yes. We'd expect it to be similar. We don't know exactly how it's going to sell yet. So but our the way we have the margins planned is implied in our guidance. Yes. Okay. Thank you. And then on the cadence of the 16 openings, any early view as to how you think those are going to start to come through? I mean, could we see more in the first half of this year? Obviously, it was all second half weighted. Any view of that? And then when we think about the square footage growth, I think this year around 16%, presumably next year will be higher, but how much higher? I guess any early thoughts on that. Thank you. Yes. We haven't guided that yet, but clearly it will be higher because you'll have more store months coming out of this year going into next year and then you'll have more stores in the following year. So we haven't guided square footage growth yet and I think we gave you directionally on that. I think we said 6 to 7 stores last time. So we're still looking at the same 6 to 7 stores. I would say those of you that are probably in New York probably read in the press or read online that there was unfortunately a tragic accident that happened at the location where a developer is developing a site for us. We haven't been involved in any of the construction yet, but there is an accident that I think the job in the meat packing store got shut down for 4 months. So that was originally a 16 planned opening. So could that slip into 17? It might. We don't know yet. We're trying to the developers trying to assess the new schedules of losing 4 months. But there was an unfortunate tragic accident and things like that can delay jobs like this. But it's nothing that's I'd say strategic whether the meat packing store in New York slips from 2016 into 2017, if it does, it does. We have a really good store in New York. It just means that we won't be able to accelerate the business maybe as much as we had thought in New York. But Yes, and we're at the weighted average worth in the mid teens this year square footage growth and that will accelerate next year. The exact amount kind of depends on the timing of those openings. They are mostly back half again. There's one that will likely be in Q2, but the rest of those will be in the back half again. Thanks, Karen. That's helpful. And just last question, just on the marketing spend this year. Obviously, a lot of innovation, the concepts coming, a lot of that was planned, but it sounds like even that this modern book was larger than maybe initially thought. I mean, do you think the marketing spend this year comes in similar to what you spent last year or those dollars grow a bit? Thank you. We will the dollars I won't give the dollars just yet because those are still moving, especially with some of the holiday books and things. But from a marketing spend and the leverage on the P and L, overall, we are expecting to have on the year 600 less pages because the spring books were so much lower, as Gary mentioned. So a big part of the SG and A leverage in the back half is advertising because we had so many fewer pages. Your next question comes from the line of Cristina Fernandez with Telsey Advisory Group. Your line is open. Hi, good afternoon. I wanted to ask about the source book for Irish Modern and Irish Teen. How widely are those going to be distributed relative to the spring source book as far as number of households and the penetration? Sure. I think about both of them. Teen, I'd think about more directionally will be circulated in the direction of the Fabian trial because you're mailing to a much smaller audience. So, you've got a smaller universe you're circulating to and we're going out there at a conservative kind of 1st male against that universe. So, I think we're probably in the 60% to 70% range and we're probably more in the 75% range against the home core book and interiors with modern. Thank you. And then another question as far as the inventory growth of 29%, how much of that is related to modern and teen versus the core inventory? And how are in stocks tracking on the core inventory versus last quarter? Okay. So on the core, it's doing great. I'd say we made some investments to make sure that our back orders were down. So it's doing fine. Modern and teen, a lot of that won't some of it's on the water, but it won't really show up until this quarter and into Q4. So we do expect because of the timing of some of those receipts, we do expect inventory, as I mentioned on the video, to outpace revenue growth just because we do need to make those investments Your next question comes from the line of Oliver Wintermantel with Evercore ISI. Your line is open. Thank you very much. Gary, what do you think will be the impact of the new concept on shopping frequency or average order value for your typical customer? Do you expect your typical customer to spend more frequently or comes more frequently spends more or do you try to attract new customers with these new concepts? I think it's going to be both. I think our current customer is going to buy more and we've proven that with the expansion of our assortment over the years And I think we will also attract new customers with this new aesthetic. So I think you'll see a combination of both happen. Okay, great. And then I had one for Karen. I think when I heard it right, you were guiding to free cash flow positive within the next 15 months. Can you maybe just give us the drivers? What do you expect is driving that from a working capital perspective or top line or bottom line growth? Thank you. Sure. On the free cash flow, what we mean by the 15 months just to be clear is either this year or at the end of 2016 for us it's kind of more meaningful to look at it on an annual basis. So we'll get if we don't get free cash flow positive this year, it will get really close. And if not, it will for sure happen in 2016. And it's really a combination. It's higher earnings. It's some of the real estate investment spend is getting behind us. We expect modest inventory improvements. I had mentioned before that we were trying to improve working capital through our vendor terms. So if there's no one thing that's contributing, it's a little bit of all those items. Okay, great. Thanks very much. Your next question comes from the line of David Schick with Stifel. Your line is open. Hi, thanks for taking my questions and congratulations on the quarter. You talked a little bit about marketing spend and the leverage opportunity in the back half. I guess my first question would be, Gary, as you think about the breadth as you're continuing to evolve the vision of all the brand is, what's the right level for marketing spend long term for the umbrella, if even that's the right way to think about it, restoration? And then just as a follow-up to the free cash flow question that was just asked, longer term, Gary, it was very helpful to hear your thoughts through operating margin. And I know Karen you just talked a little bit about it, but long term would free cash flow sort of move in that same function as Gary described or is there anything else at work over not 18 months but over 5 years? Thank you. The right level of marketing spend for RH Core. I think in each of these businesses we're learning all the time like how do you optimize it. At the same time the world is changing before us and how to reach the customer, right, whether it's through stores, whether it's through print, whether it's through digital, whether it's through social, There's so many ways to address marketing spend today. And I'd say that the hardest job in America today in any company is probably going to be the Chief Marketing Officer. It's probably why we don't have one. And so, at the most senior levels of the company, we are making those decisions and deploying those assets because I think it's very hard to figure this out right now. And I think there's a lot of money that's not being spent in a very intelligent way. So with the most senior levels of the company, we are paying attention to it and we are digging into it and we are trying to figure out how to optimize it. At the same time, how do you grab share? How do you grow the business and how do you invest into the future. And I think that this year, I'd say by next year we'll probably have we'll probably know the baseline on core RH, I would think. Like if we from an optimization kind of growth point of view, but we've got so many new businesses coming on. So whether it's modern, whether it's teen, whether it's new businesses that you'll hear about in the near future that will be coming online. And then the other thing that's unknown precisely yet is what is the impact on advertising spend once we roll out these new next generation galleries, right? Because they're going to be a massive billboard. And remember, it's probably true at all of our competitors, but at least in our business today, I think we're 67% to 70% of our new customers come through our stores. So if you just stand back and think about that metric for a minute, if that's happening where 80%, 90% legacy stores today, small mall based stores, What happens when you have these new next generation galleries? Does it go to 90%? Does it mean you can mail less catalogs? Does it mean you can advertise differently? There's just so many things yet to learn. But one of the things I know for sure is that when we open Denver, Chicago, so on and so forth, our business grows in these new galleries without mailing more books, right. So the square footage and the impact of the real estate grows the business. So that inherently leverages the advertising. Does it mean long term you can actually mail more books or does it mean maybe long term you should mail more books and you can even expand the market. There's just so much left to learn there. And there's so many things that are evolving and we're just very curious, very critical and very disciplined about how we allocate and how we place those bets. And that's why today the marketing spend of the company is really controlled at the highest level of the company because you're really in uncharted waters in today's world and environment and our company is in uncharted waters in our real estate transformation, the transformation of our direct business, the way we approach the market from a source book point of view. So a lot yet to learn, but all the indicators would say there's a lot of leverage and optimization to expect in the future because of happen with the real estate transformation and especially the things that we're learning this year. And then with respect to the long term outlook for free cash flow, there's nothing that would that's 3 years down the road or 4 years down the road that would make us think we're not going to continue to generate significant free cash flow once we hit that mark. I would say one thing that we expect to improve over time is inventory turns. As we have been growing by assortment and as we grow more by square footage, we do expect to optimize some of those inventory investments as we kind of learn from what we've introduced. Very helpful. Thank you. Your final question comes from the line of Janet Kloppenburg with JJK Research. Your line is open. Hi, everybody and congratulations on a great quarter. Gary, I wanted to get your thoughts on how you think about Ares Core. You have 2 new concepts coming on, 700 pages worth of new merchandise. And as you said, new concepts to be launched. How should we be thinking about RH Core and the level of newness that should flow into that segment of the business going forward? I'd love your thoughts there. And sure, I just yes, just one for Karen and then you guys can talk. It sounds like we should be looking for SG and A leverage to be more significant in the back half than the front half because of your indications on the margin line the gross margin line? If you could just help there. Thanks. Yes. Janet, really good question. So it's actually one of the things that we are talking about and debating internally. The core, even though the pages were less, we had better optimization and better density in the books. So we still had newness in the core business even with 1300 less pages. And so with one of the questions you can ask yourself is the long term today we believe modern is a new business and it's the right way to address it. Long term is it a new business, but it's really part of the bigger platform and just a bigger way to the core. One thing you don't know is how the consumer preferences will change over time, how trends change over time. If things move more modern, does modern get bigger? Does the traditional businesses slow down? How do you think about trends? If you think about all the trends in our business, whether it's traditional, whether it's industrial, whether it's modern, whether it's mid century. So honestly, I'm a little ambivalent about it. What we're focused on is how do we take these kind of we're pretty good at encapsulating an aesthetic and a point of view. And then communicating that and positioning that in a market in a very clear and compelling way. And as things change or shift, we should build a platform here that has the flexibility to maximize it and to move, right? Not have too much rigidity. So that's why we're early on here. When I sit about I sit there and go, do I like modern freestanding? Do I like modern in the bigger store? How do I think about it strategically? I like it freestanding in select places because I think what it does is it breaks through the market. So in LA, in Miami, in New York, right, like might you make a capital investment that creates a little bit of rigidity with the platform that amplifies a business like modern in some markets? In most markets, I think about modern and I think about core and I like them in the same box, because I can have core on one floor, modern on another floor, all these businesses and I've got a very flexible box and I can move and I can grow or shrink and position the business long term. I think the key is the breadth of the RH business. When you think of RH, how should you think about it? I think you ought to think about it as the quintessential taste and style leader for the home market at the high end, right? And that means modern, it means traditional updated traditional, it could mean many other things. A lot of people say, oh, you don't you guys don't have much color, right? You look on the blogs or talk to certain customers, like gosh, there's no color, they only have neutrals and grays and so on and so forth. There's a reason why we have that. It's the biggest part of the market, by the way, why we have the best growth in the industry. But there's a percentage of the market that is more color driven, right? Just like there's a percentage of the market that's more modern driven. And could you think about a business called RH Colors in the future? And could we encapsulate color into a book and into a catalog? And could we explode color in a way in the home market that is that no one's ever seen, right? And then you say, well, is that part of core? Or is that a new business? And how do you think about it? And so I think about the broader home business and how do we take as much share and own as big a piece of the luxury home market long term and how we encapsulate those businesses and what we call core, what we call new businesses, it may change over time, right? I think you just have to be flexible and not rigid and position yourself to kind of win and move and adapt and improvise. I don't know if that makes sense or not. Very insightful. Thank you. Yes. And then Janet on the back half, we do expect earnings and operating margins to accelerate and expand in the second half even more so than the first half. And that is driven by SG and A leverage being bigger in the second half than the first half. And will that And the biggest piece of that is advertising. Will that expand into next year because of the that expand into next year because of the ramp in store openings, Karen? That we really haven't nailed down the strategy for next year. So yes, we haven't we'll continue to learn as Gary mentioned and optimize the marketing plan. And as soon as we do, we'll have more to share on how that looks into 2016. Okay. Well, thanks a lot and congratulations. Thank you. Great. Thanks. We are now at the conclusion of today's call. I would like to turn the call over to Gary Friedman for closing remarks. Great. Well, thank you everyone for your interest in our company and I want to thank all of our team members across the country and all of our partners all around the world who support our efforts. We look forward to talking to you next quarter. Thank you so much.