Good afternoon. My name is Chanel, and I will be your conference operator today. At this time, I would like to welcome everyone to the Restoration Hardware second quarter fiscal 2014 financial results conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number 1 on your telephone keypad. If you would like to withdraw your question, press the pound key. I will now turn the conference over to Cammeron McLaughlin, investor relations.
Thank you. Good afternoon, everyone. Thank you for joining us for Restoration Hardware second quarter fiscal 2014 financial results conference call. Joining me today are Gary Friedman, Chairman and Chief Executive Officer, and Karen Boone, Chief Financial and Administrative Officer. First, Gary will provide highlights of our second quarter performance and provide an update on our value-driving strategies. Karen will conclude our prepared remarks with a discussion of our second quarter financial results and our outlook before opening up the call to questions. Before I turn the call over to Gary, I would like to remind you of our legal disclaimer that we will make certain statements today that are forward-looking within the meaning of the federal securities laws, including statements about the outlook for our business and other matters referenced in our press release issued today.
These forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please refer to our SEC filings as well as our press release issued today for a more detailed description of the risk factors that may affect our results. Please also note that these forward-looking statements reflect our opinions only as 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 will discuss a number of 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, as well as a reconciliation of adjusted P&L items for 2011 and 2012. A live broadcast of this call is available on the investor relations section of our website at ir.rh.com. With that, I will now turn the call over to Gary.
Thank you, Cammeron. Good afternoon, everyone. I'm going to use the time this afternoon to share my perspective on our recent performance, talk about the business environment we are operating in, try to frame the broader market where we compete, and how we believe the RH brand will continue to disrupt that market and gain significant share. First, let me speak to our current performance. We are in our fifth year of posting double-digit comparable brand revenue growth. For the past four years, our comparable brand revenues have grown in excess of 25% annually. During that time, we've continued to innovate and make significant changes to both our brand and business model, testing new concepts and methodologies, reading the results, and refining the execution. This year is no different. We are testing several new concepts and methodologies with the drop of our new 2014 source books.
The tests include the expansion of our product assortment, building depth and dominance in each business, the organization of our books by lifestyle and category, creating authority and top-of-mind awareness in every category we compete, and testing pricing elasticity to drive higher product margins. While still in the very early reading of the results, as our 2014 source books were in-home seven weeks later than last year and include over 3,300 pages versus last year's 1,600 pages, we are very pleased with the early trends and how the business continued to accelerate throughout the second quarter and into the second half. These trends give us the confidence to increase earnings guidance for the year. That guidance does imply revenue growth in excess of 20% for the second half, which would be our fifth straight year of 20% plus revenue growth, exponentially outpacing any other home furnishings retailer.
We are also refreshing our stores with new product later this year versus last year, as we wanted to first test and get reads on new collections to ensure a positive arbitrage when we implemented our new floor sets. Phase 1 of the new floor set was executed this week, and the entire reset will be complete by the first week of October. If you see one of our galleries, you'll notice the presentation of our Maxwell sofa in the new destroyed leather at the front of the galleries with a presentation of leather hides and chairs reinforcing our newly launched source book, RH Leather. The reaction to the new destroyed leather has been terrific, and we expect the new floor set to meaningfully accelerate our trends in this important product category.
We will also be rolling out new rug fixtures and placing our new rug assortment in all of our galleries during Q4 in support of our new source book, RH Rugs. As you know, we launched a nearly 300-page rug book with over 3,500 handcrafted styles by acclaimed rug designer Ben Soleimani that we believe will be highly disruptive in this fragmented market. We also expanded our assortments across furniture, lighting, textiles, small spaces, and baby and child, and now have the largest collection of curated home furnishings under one brand in the world. We are excited about our plans for the second half and expect to continue refining and improving our execution as the year progresses. Let me spend a couple of minutes addressing our view of the business environment we're competing in.
As of late, there have been multiple questions, comments, and discussions in the press and among the investment community about the continued caution of the customer, the increased promotional environment, and an apparent overall retail funk in the marketplace. I would like to share our view and how we think about our business on a yearly, quarterly, monthly, and weekly basis. Being in the retail business is like being at war. You need to have a solid strategy that is constantly evolving. You have to not only focus on your plan, but also address your plan and execution to the recent developments of the battlefield and the moves of your competitors. You have to be prepared for hand-to-hand combat monthly, weekly, and daily, as the environment is brutal and ever-changing.
What you can't do is let yourself become a victim of what is happening around you, whether it be the economy, the promotional environment, or the weather, because victims generally don't react quickly enough. Retail is tough. It is fast, quick, and ever-changing. It is not for the faint of heart. No matter what your plan or forecast is, it is some degree of wrong, and what matters is how quickly you improvise, adapt, and overcome. That is what I believe we are very good at. We are in a world that is speeding up every day. You're either striving to get better or allowing yourself to get worse. We like to say a retail mall is a graveyard for short-lived ideas. Most retail concepts don't live long enough to renew their lease. The ones that do create their own environment by quickly reacting to anything that comes their way.
You can count on us to be one of those retailers who will be around to renew their lease, good economy or bad, retail funk or not, and no matter what the weather is. I'm going to shift your attention to our marketplace, how we think about it, and why we are positioned to continue on our disruptive path. One of the questions I constantly get from investors is: who are your competitors? Is it Crate & Barrel, Ethan Allen, Room & Board, Pottery Barn? Sure, we compete with almost anyone who sells better furniture and home furnishings, but those are not who we define as our core competitors, and none compete in the market we are trying to disrupt. We believe we are competing in not only a marketplace that is highly fragmented but also lacks transparency.
It is a market that, for the most part, is not even visible to the consumer. In fact, a good portion of the market exists behind what we like to call the iron curtain, or commonly known as the to-the-trade design centers or districts, which are only accessible with an interior designer or with someone with a resale license. Even if you're able to get behind the iron curtain, there is another level of opaqueness, the pricings. An interior designer can purchase most items at a design showroom anywhere from 20% to 40% off. Therefore, you need to hire an interior designer to get the discount. Since the showroom never sells anything to anyone who is not a designer, there is no pricing integrity. Additionally, you generally pay the designer both a markup on the product and a design fee, so there really isn't a discount.
The fragmentation of the marketplace behind the iron curtain of design centers also creates a cost conundrum for the customer and a disruptive opportunity for RH. Not only does the customer have to schlep from showroom to showroom, as most are category versus lifestyle focused, which is time-consuming and lacks cohesiveness and integration, but you also have to track orders independently and pay separate delivery charges from multiple showrooms, which creates another opportunity for a brand like RH. In essence, what we are doing is integrating all the categories of a design district under one roof with a stylistic and aesthetic point of view and bringing it out from behind the iron curtain, opening it up to the public with transparency and pricing integrity.
We believe the transformative customer experience we are creating, combined with the leverage we get from our scale, creates an entirely new and disruptive model in this marketplace. That is why you should expect us to continue outperforming the market because in many ways, we are creating a new one. With that, I will turn the call over to Karen to review the details of our quarterly performance.
Thanks, Gary. Good afternoon, everyone. I will first take you through our second quarter performance, then provide an overview of our convertible debt offering and conclude with our outlook for the remainder of the year. We are very pleased with our financial results for the second quarter of 2014, delivering a record Q2 operating margin of 11.3% and earnings ahead of expectations. Total revenue in the second quarter increased 14% on top of 30% last year to $433.8 million. This was driven by 19% growth in our direct channel and 9% growth in retail. Our comparable brand revenue, which includes our direct business, increased 13% on top of 30% growth last year. On a two-year stacked basis, comparable brand revenue growth was 43%.
Although we had visibility to the mailing dates of our new 2014 source books, we did not change the timing and cadence of our promotional events and underestimated the impact that the later in-home dates would have on our planned promotional volume, namely our Fourth of July Friends and Family event. While the lower promotional volumes during the event had a positive impact on our gross margins, we believe this contributed to our lower Q2 revenue growth. We are very pleased with the trends throughout the quarter and into August. We continue to see a solid build from the source books and positive response to the newness introduced, giving us confidence in our outlook for the remainder of the year. Gross profit increased by 21% to $167.9 million during the second quarter. Gross margin increased 230 basis points to 38.7% from 36.4% last year.
Our merchandise margins benefited as we anniversaried the strategic pricing investments from last year, tested higher pricing on certain products with the drop of our 2014 source books, and as a result of the lower promotional volume during our July Friends and Family event. We also benefited from lower shipping costs and continued to leverage our retail occupancy costs during the quarter. Our total adjusted SG&A expenses increased 13% to $119 million in the second quarter versus $105 million in the prior year. Our adjusted SG&A expenses decreased by 10 basis points versus the prior year to 27.4% of net revenues. This was driven by advertising savings based on changes in our source book strategy and mailing cadence versus the prior year, offset by higher corporate occupancy and other costs.
Adjusted operating income increased by 43% to $48.9 million from $34.2 million last year, and adjusted operating margins expanded 240 basis points to a record 11.3% during the quarter. Adjusted net income for the second quarter increased 40% to $27.7 million from $19.8 million last year, and adjusted diluted EPS increased 37% to $0.67. We had nearly 41.3 million diluted shares outstanding, and both adjusted net income and adjusted diluted EPS were calculated based on a normalized 40% effective income tax rate and exclude non-cash interest related to our convertible debt offering. The pricing and execution of our $350 million 0% coupon convertible senior debt offering was a significant highlight of the quarter and the year. This transaction has allowed us to strengthen our balance sheet and positions us very well to execute our long-term growth strategy.
I have a few items to highlight regarding how this transaction impacts our financial statements. First, for GAAP purposes, we're required to calculate and record a debt discount equal to the fair value of the conversion option of the notes. The discount is then amortized as non-cash interest expense over the five-year term. This non-cash interest expense will be removed from our adjusted net income and adjusted diluted EPS calculations. Second, we purchased convertible bond hedges and sold warrants, which are intended to offset any actual dilution from the conversion of the notes and effectively increase the overall conversion rate from $116.09 a share to $171.98 a share. For GAAP reporting, the notes have a potential dilutive effect on GAAP EPS if the weighted average stock price is greater than the initial conversion price of $116.09 while the notes are outstanding.
Once converted or settled, there is anticipated to be no actual dilution until our stock price exceeds $171.98. Accordingly, we will exclude any such future dilution under GAAP purposes from our adjusted EPS calculation until the stock exceeds $171.98 a share. We have provided a table on our investor relations website that illustrates the potential diluted shares that would be included in our future diluted EPS calculation at various hypothetical average stock prices. Turning to the balance sheet, cash and cash equivalents increased to $181.5 million and reflect the remaining net proceeds of our convertible debt offering after paying down the outstanding balance on our revolving line of credit. Inventory levels at the end of the second quarter increased by 34.5% to $547 million versus the prior year.
This increase reflects our ongoing initiative to improve our in-stock position and lower backorders and includes inventory related to new product introductions from our 2014 source books and to meet the accelerated growth we anticipate in the second half. We continue to expect inventory growth to be roughly in line with our 2014 sales growth by the end of the fiscal year. Our balance sheet also reflects the gross-up of approximately $51 million of assets related to the accounting treatment of several of our leases as build-to-suit leases. As a reminder, under these arrangements, we're required to record an asset within property and equipment and a corresponding liability within other long-term obligations related to the landlord assets for these buildings. These assets do not impact our P&L or cash flows and are not included in our capital expenditures.
Similar to a capital lease, under these arrangements, a portion of our rental payments will be classified as interest expense. Our capital expenditures through the end of the second quarter were $38.8 million, and we continue to expect CapEx in the range of $115 million-$125 million for the full fiscal year as we execute our real estate transformation and build-out of our new full-line design galleries and make additional infrastructure investments to support our growth. Turning to our outlook. For the third quarter, we expect net revenues to grow 20%-23% to a range of $475 million-$485 million. We expect adjusted net income to increase 46%-54% to a range of $19 million-$20 million, translating into adjusted diluted EPS in the range of $0.46-$0.48 based on 41.5 million diluted shares outstanding.
With regards to the full year, we expect 2014 revenue of $1.85 billion-$1.87 billion, reflecting revenue growth of 19%-21% over last year. As we discussed with you previously, we expect that our revenue growth will accelerate in the second half of the fiscal year as we benefit from the product newness introduced with our 2014 source books and as we execute our real estate plan. We are raising our full-year 2014 earnings estimates and expect adjusted net income to grow between 37% and 40% to a range of $94.9 million-$96.7 million, which assumes a full-year effective tax rate of 40%. We're increasing our full-year adjusted diluted EPS guidance to a range of $2.29 to $2.33, which assumes 41.4 million diluted shares outstanding. This compares to our previous expectation of adjusted diluted EPS in the range of $2.24 to $2.30.
In closing, we are pleased with our second quarter performance and are optimistic about opportunities for the remainder of the year. We continue to take market share, execute against our value-driving strategies, and feel confident in our ability to deliver our long-term growth targets and maximize shareholder value. Our long-term financial goals remain as follows: Revenue growth in the low 20s and adjusted earnings growth in the mid to high 20s. With that, I would now like to open up the lines for any questions. Thank you.
At this time, as a reminder, if you would like to ask a question, press star, then the number one on your telephone keypad. Your first question is from the line of John Marrin with Jefferies. Please go ahead with your question.
Hi. Thanks, guys. Just the first question I have is around gross margin and a great performance this quarter. Just wondering if maybe you can help us understand the impact of the lower sales during the promotional event in July.
Sure. This is Karen. In Q2, we did, as we kind of described, test the higher pricing with the drop of our 2014 source books, and we're pleased with those pricing moves. We had actually planned for higher promotional volume during the July Friends and Family event, and that created lower revenues but at a higher margin. There was also a few other sort of good things happening within gross margin in the second quarter. Shipping was a nice driver to our margin expansion. With the inventory investments we've made and the move to one mailing a year, we had the lowest backorder rates that I've seen since I've joined the company, and we also continue to see benefits of insourcing our hubs. Several of those things were really benefiting Q2 as well, in addition to just higher merchandise margins.
You said on the last call that you were off to a good start on gross margin. Was there a good follow-through if you back out the event?
Yes.
I feel like there seems to be some upside in the model relative to guidance. Are you thinking gross margin up in Q3?
During the second half? Our guidance is our guidance. I'm not going to speak to upside. That's what we believe. I would say, while we continue to expect gross margin expansion, it's not going to be at the same extent that we had in the first half. It'll likely be in the 50 to 100 basis point range versus what we saw in the first half, and that's because of a couple things. One is shipping and transportation will just not be as efficient towards the beginning of a source book drop as it will in the end. In Q2, we're at the tail end of last year's drop. In Q3 and Q4, where the books had just gotten home towards the end of Q2, and we'll start with that demand and newness, we will have higher back orders.
Retail occupancy leverage will not be as big and as significant as we begin expensing some rent in the latter part of the year for several 2015 full-line design galleries. We're also opening our fourth furniture DC in Northern California in early 2015, and we'll have some additional occupancy investments in the fourth quarter related to that location. Those are a few things that are going to offset some of the positive merchandise margins that we're seeing and will continue to see in the back half.
Okay, got you. Great color. Thank you. Can you talk about Greenwich for a minute and how that store is performing here early on, and New York as well? Maybe help us sharpen the pencil around the timing on Atlanta and Los Angeles.
Sure. Greenwich and New York, we're very pleased with. Greenwich especially. I'd say New York we're very happy with, but it's not a full-line design gallery. We'll have a next generation full-line design gallery in that market eventually. We're very pleased with both those. The initial reads are very positive. I think the consumers responded very well, so we're very happy there. Melrose will open next month and Atlanta will be later in November. Both are tracking roughly with where we thought we'd be.
Okay. All right, great. Thank you.
Thanks, John.
Your next question is from Aram Rubinson with Wolfe Research. Please go ahead with your question.
Thank you very much for taking the call. Interested to know about the interplay between direct and retail. It seems as if direct kind of outpaced the growth of retail by more than it has been in recent quarters. Of course, the commentary around the drop times. Was just curious why that would have happened. Then also, can you give us a sense when you're opening these full-line galleries, what you're seeing in your direct business? You used to quantify what kind of direct increases you were seeing when you would open these stores. Are you still seeing that net add, or are we starting to see any cannibalization?
Hi, Aram. This is Gary. Let me try to take part of that, and I'll let Karen take part of that question. If you think about the expansion and the timing of this book versus a year ago, a couple things are impacting the business at the retail level. First, let me start by saying we're agnostic wherever the customer wants to place their transaction, and do believe long term, more and more consumers, as technology gets better and people become more comfortable with technology, we're seeing more people interacting in our stores and then going home and placing an order. We expect there to be some kind of a shift. Again, we're not really focused on that. A couple of things, if you think about it, would be logical.
One is this year, we held off on doing our floor set post the drop of the book so we could read the results on the new product and then make changes on our retail floors and ensure we're going to have a positive arbitrage on that floor set. As opposed to, in the past, we would change the floor set when we dropped the book, and there would be greater risk. Our stores perform at a really high level, and we thought it was more prudent to first test the new books, test all the new product, identify the best sellers and what the consumers responded to, and then make a floor set change. That's what we're doing now. What you've got is you've got the books getting all the demand of the newness, if you will, versus the customer seeing the new goods at retail.
I think that's probably affected the shift between the two. The other thing I'd say is we have continued to grow our assortment beyond the four walls of the store. We're getting to a level where as we continue to add new categories, expand categories in breadth and depth across our collection, until we transform our retail platform, the goods are just not going to see the light of day at retail. You're going to just accelerate demand just because of that. Where in the earlier days here, as we added newness, it was much easier to continue to add new products to the stores and make those changes. Now we're just at a level where until we transform the stores, I would expect direct to grow faster than retail.
Is it okay if I just follow up on one other thing? I appreciate the analogy of the war. How will you know when it's time to throttle back? What would you look at in terms of indicators to say, "Okay, hey, this is a battle worth fighting, but let's kind of slow down a little bit because we're seeing A, B, or C," and then appreciate that.
Throttle back. Maybe be a little bit more specific for me as far as the question? I'm not sure I'm reading it right.
Oh, sure. Yes. You're definitely charging forward and charging strongly. I was just curious if there would be signs that would tell you, "Hey, maybe we need to kind of slow down the pace of growth, slow down the pipeline of new stores." What signs would you see that would tell you it's time to kind of slow the growth down?
I don't know if we would see signs to say slow the growth down. I think what we're constantly doing is creating optionality in our business and testing to develop, conceptualizing and testing new ideas. Then what we do is we assess those ideas, then we move forward with the ones that work. I don't think there's an intention to throttle back. I think there is a methodology to read and refine and improvise, adapt, and overcome. We've got plenty ideas to grow the business. The key really comes down to the sequencing and the allocation of both human and financial capital, right? How do you choose wisely? How do you make the best decisions to invest both human capital and financial capital into that will yield the best return on those investments? We're constantly trying and testing things.
I think for the most part, our ideas are valid. How big is each idea is usually determined by how well we execute that idea, how big and compelling our vision is, and how well we translate that vision into a strategy and translate that strategy into initiatives that we can execute well. We're constantly moving and evaluating against that plan and prioritizing, reprioritizing, and sequencing and resequencing our investments. That's just what we do. We're not really doing any more than we've ever done. I think that as organizations learn and grow, great organizations usually can do more, not do less. We keep learning, we keep growing, we keep getting smarter. I think we keep investing wiser.
I think one of the things is obviously with the stock down a bit here in the early innings of the trading day or the after-hours day, is the perception that we missed the top line and the revenues, we got that. If you think about for one, I always say, whatever anybody's plans are, forecasts are, they're all some degree wrong. Clearly, ours were more of a degree wrong on the top line than we would've liked it to be. We had moving parts that were really, I think, hard to kind of capitalize. Whenever you don't have things that are comparable to a year ago, it's difficult to kind of forecast. We had a book that generally got in about seven weeks later. We have all kinds of new investments. We delayed a floor set. We had different promotional activity throughout the quarter.
As we assessed it, we clearly should have been smarter in how we built our plan for our big 4th of July Friends and Family event. Beyond that, there's a lot of little things that we're pulling the levers on, moving, improvising, adapting on that are no different than anything else. As I look back, I say, "Shit, I wish we would've done a better job forecasting that Friends and Family event without the books in." For the most part, it's kind of business as usual here, and we're executing against a plan that we're constantly reevaluating.
Well, thanks for that. Keep your eye on the big prize, not the little stuff. Thank you for that.
Yep. Absolutely.
If you want to follow up on the Greenwich question and the galleries, I would just say that Greenwich is no exception to what we've seen with the other five. In all cases, we've seen a direct lift, and even the ones that have been open for well over a year, we do see no cannibalization as far as taking sale away from the direct business. It very much works the other way. There's always a lift, and sometimes the growth in one channel outpaces the other. Again, as Gary said, we're truly agnostic, and it's really good for the market when we have those in the market. I haven't seen any cannibalization.
I'd make one other comment as people think about our pursuit of expanding our product categories and so on and so forth. They may not all appear to bear fruit today because today we don't have a retail platform for those product categories. If you think about when we transform the real estate portfolio of the company and create a new retail experience that will have seven to nine times more selling square footage, all of these product categories that we're working on now, all of these pieces that will be part of that larger puzzle will all get an exponential lift when we transform the real estate. While you might not perceive, like geez, it seems like you're doing all these things, you're not maybe getting the translation to growth may not seem as big.
Of course, it won't be, because so many of the things we're doing today will not see the retail floor, and that's where the majority of the business is done, not only in our business but across our business. If we didn't have our retail stores, our direct business would be significantly smaller today. Significantly smaller. When we transform the real estate, we will be unlocking the value of the current assortment and the assortments we're working on today and working on tomorrow. Right? Everything we're working on, the real value is going to come when we transform the real estate platform. I think that's when people will see exponential growth in this company.
Thank you very much.
Yep.
Your next question is from the line of Matthew Fassler with Goldman Sachs. Please go ahead with your question.
Thanks so much. Good afternoon. I've got two questions. The first relates to the merchandise and just if you could give us a little more color on the new categories. Presumably they're out there now, they're in the books and making their way into the stores. Where do you have the expectation that the top line should start to move based on some of these new releases?
I think in line with our guidance, Matt. When you think about our guidance of maybe 23%.
20%-23%
Right. I guess I'm thinking about not the numbers, but the categories themselves, sort of which areas give you the most excitement in terms of some of the new product lines.
Oh, gosh. I think clearly, we're really excited about leather and the moves we're making there. When you wake up in the morning and you say, "I need a leather sofa, I need a leather chair," or you're shopping for anything in leather, who's the top of mind place you go to? Most people, if they have an answer to that question, they might say, Jennifer Convertibles or something, or there are places that have a lot of leather. In our market, there's no top of mind retailer or experience that owns that category. We're going to own that category. We're very excited about it. I think if you walk into stores and I think we've got all but eight stores set. There's a couple that we have, and I don't know if New York is one of them. Matt's in New York.
We've got all but eight stores transformed yet because we have teams going into some of our bigger ones to do that set. I think when you see it, you're going to get it. If you've seen our Leather book, if you say to yourself, "Who else has a presentation like this in this category?" Nobody. If you stand back and you look at the rug business and you look at how fragmented the rug business is in the United States and think about how many little crappy rug stores you see on the street corners of the streets everywhere in every market across the United States. They all have going-out-of-business sale signs up that have been up for years that have never changed. It's a massively fragmented market. There's no scale. Nobody owns it. Nobody presents it well.
You've got a lot of players with a few little bit of rugs. That's a market. We're going to own that business, and we're building a platform to be able to do that. We have an assortment that is now leapfrogged anybody else in the industry. Really exciting about what's happening there. I think if you look at what we've done in the furniture business and you look at whether it's our upholstery book or our furniture book and what we've done with living room, bedroom, bathroom case goods, and what we've done with upholstery in sizes and finish and fabrics and choices, I think that we have incomparable assortments in those categories. When you say, a lot of people go like, "Wow, that's a big assortment." Think about how that simplifies things for the consumer.
When you're trying to do a house and if anybody on the call has furnished an entire house and been involved in that process, there are so many decisions to make. There are so many places to go. There is so much research to do. It takes a lot of time. It takes a lot of effort. The ability to simplify and consolidate and integrate under one roof, under one brand saves consumers tremendous amount of time and gives them tremendous amount of value because time is really the most important asset that all of us have. Any of us would choose to save time if we could, as well as save money where we have tremendous value creation. I'd say the other one is lighting.
Again, if you look at our lighting book and how it's presented and the assortment there and the dominance that we have in that category, again, the simplification of being able to shop at one place for your table lamps, floor lamps, ceiling lamps, wall sconces, indoor, outdoor lighting. I think, again, we've leapfrogged people in that category. There's multiple things like that that we're excited about. You'll continue to see us move and evolve this brand and dominate these categories and then integrate these categories under one roof and under one brand that we think will be transformative to the luxury marketplace.
That's super helpful, Gary. Thank you. Then a very quick follow-up for Karen. Given the third quarter guidance and the year, we can see what's implied for the fourth quarter. At the risk of having done my math too hastily right after the release, it looks like with the revenue numbers, the EPS numbers out there, you're guiding fourth quarter operating margin to roughly flat. If you could just remind us what would happen last year. I know the expense number last year was pretty low, and you have the burden of the catalog cost this year in Q4. Is there anything else in the business that would lead you to believe that the operating margin won't lever on the kind of revenue growth that we should see in Q4?
You're generally in the right ballpark with Q4. I would say there's two things. One is the investments that I mentioned on the supply chain where we won't have the same shipping and transportation benefit, and then we'll have some deleverage in supply chain occupancy, and then retail occupancy just won't be as big because we're going to start paying your expensing rent for some of the 15 locations. Those are some of the investments that aren't around now or in Q3 that come along in Q4. Coupled with that is the advertising deleverage that we talked about with the significant page count expansion, and we're on a one-year versus one-year, that will deleverage SG&A in Q3 and Q4.
It's just with some of the other investments going on in Q4, including the Atlanta opening that used to be in Q3 and is now in Q4, those are some of the things that are dragging on Q4 operating margin versus the rest of the year.
I'd say too, in Atlanta, because it's the first next-generation full-line design gallery in the company, we're focused on executing that really well. We have some extra investments from manpower and execution and focus. We're also looking to build that out to be our first fully integrated market across both the retail front and the back-end supply chain call center and outlet. We're making bigger investments into that store as a market that is incremental versus opening other stores. Because it's the first and the biggest one, we plan some important grand opening events around it.
Thank you so much.
Thanks, Matt.
Your next question is from Matt Nemer with Wells Fargo. Please go ahead with your question.
Thanks so much. Afternoon. I'm curious how important the floor set is to getting people to pull the trigger. Do you think that not having that ready, you've got folks that are sort of on the sidelines thinking about a big order, and your store associates are saying, "We're going to have a new floor set next week or the week after." Could that be a factor?
Probably. I would think that we know as far as the newness ramp, not having the newness on the floor until later curtails some of those potentially next best sellers, if you will. We already saw as we kind of unleashed the new destroyed leather Maxwell sofa on the floor that in the first couple of days, it exploded. The good thing is, because we've taken the time to test and read, we know the best sellers now, right, from a direct point of view, which are always the best sellers also in the retail and vice versa. Now putting those in the store and allowing the customer to interact with them, I think you're right on, Matt. It clearly takes away the hesitancy from the consumer and allows them to really try it, test it, interact with it.
I think there was a recent study on it. I can't remember what consulting firm put it out there that now has done studies that said, well over 70% of online purchases are driven by a retail interaction, right? An interaction in a retail store. They're talking about how important that stores are and will be the foundation of retailing in the future, no matter what happens online. Clearly, when the customer can interact and have an experience with the product in the store, it helps not only store sales, it helps online sales. That's why we've seen in all the markets we've opened a new, bigger gallery where we have more product on the floor. Not only do we get a retail lift, we get a direct lift.
Okay, that's helpful. Secondly, I'm wondering if there are any learnings from the source book strategy this year that sort of inform how you're thinking about next year. I realize it's still a ways away, but should we expect a similar strategy, or I assume there will be some changes? Anything that you can discuss?
Yeah, I think you're correct to assume there's going to be changes. We're early in assessing everything, but as we continue to expand the assortment in the business and as new ideas roll into it, we're questioning how much bigger the book can be, how much bigger the drop can be. I think one of the things as I look at it and assess it and get feedback and all of this kind of consumer touch points that we interact with, that while the book being this big is a positive that there's nothing like it, and it breaks through and it's dominant and so on and so forth, there's also a bit of an intimidation factor. Forget about the customers that didn't want it.
We know about that, and we're going to try to not mail it to people that aren't interested in the book because that isn't helpful for anybody. Even for the consumers that are interested in our brand, when you get the big book like that, you wonder how many people are going. Listen, I run the company, and my big set of books came, and I was telling the team last night, I said, "Look, it's sitting on my counter in my kitchen, and I haven't even sat down and went through all the books yet," because it's a lot. You have to have a committed time that you're going to go through it. We're assessing, is that good or bad? Should it be broken down into two or three ways? How many pages do we have to give each category?
Can we identify that? Is there ad cost opportunity? Again, it's like anything we do, we test it, we read it, we refine it, and we do it better and smarter next time. I think all in all, I think we're very comfortable and confident about our second half guidance. We've guided the business in the 20% plus range in the second half of the year. If you think about that, I think that last year we ended the year, I think it was we're 30 last year, 30, 32. This is our fifth year. If we're up 20% for the year, this will be our fifth straight year, right? You say to yourself, Did the source book work? I'd say yeah. If that happened, I'd say, yeah, that's really good.
Not a lot of people put up these kind of compounded numbers year after year. Now, might the number be in the 20s and not in the 30s? Yeah. We're up against bigger and bigger compounded growth. Again, I think the ability for us to continue to grow our business without significantly growing our square footage or even on a smaller Over that five-year period, our store count went from, I think, 100 and something to 70-something stores. We reduced our store count by 30% or almost a third, and we grew our business significantly. The key now becomes reversing that and unleashing this assortment in the retail marketplace with physical stores. That's the explosive part, because everything we've worked on, every product we have, if you put it into the retail environment, it will lift by 50%-150%.
If you think about that, you take the middle of that's a pretty big exponential growth if you're going to grow your average square footage in these new markets by six to eight or nine times. Right?
Sounds good. Thanks so much.
Thanks, Matt.
Your next question is from the line of Lorraine Hutchinson with Bank of America Merrill Lynch. Please go ahead with your question.
Thank you. Good afternoon. I know there are a lot of timing shifts with the book, but if you aligned the timing versus the drops last year, how have the results been?
You can't align the timing with the drops last year because it's different promotional cadence year-over-year.
Okay.
The promotional events are different, right? You can't compare the Friends and Family 4th of July event to the spring something event. You just can't line it up, unfortunately. It's different times of year-
Okay
by seven weeks.
Waiting to test the product before you updated the floor sets, are you generally happy with that decision at this point?
Oh, yeah. I think that Look, we have an average store volume that's in the $10 million range, right? I think we have the highest square footage of anybody at least in our class of retailer by multiples. The risk of negative arbitrage by not being prudent and just swapping out goods on the floor without testing them, I think we operate at a level where the risk becomes too big. Listen, there's risks to take and there's risks not to take. There's places where you say, "Hey, the asymmetrical risk here to the upside looks really good. Take that risk." When you do $10 million a store, the asymmetrical risk starts to look like it points to the downside if you don't have any data. We thought it was prudent to drop the books, read the data, and then execute the floor set.
Great. Thank you.
Your next question is from Peter Benedict with Robert Baird. Please go ahead with your question.
Hi. Hey, guys. A couple quick ones. First, just I'm curious how the furniture versus non-furniture mix looked in the second quarter. A lot of non-furniture new product in these source books. Did the non-furniture products start to gain a little share back, or is that something maybe for the second half?
Yeah. We're still early to look at that. Again, we're happy with the early reads but I don't know if that's necessarily something that we're.
Yeah, Peter, it's pretty similar. It was 57% in Q2. It was 57% in Q1. It was 58% last Q2, it's hovering around the same amount. We're very happy with all the categories. I don't know that there's one that's-
Yeah. The big thing that you'd look at as non-furniture is the rug expansion, right? That would be really the biggest investment we made, and we're really happy with how that's growing and tracking. We don't particularly spend a lot of time talking about the furniture, non-furniture mix. That's not how we grow the business.
Yep.
We grow the business at the category level and focus at the category level.
Sure. No, totally understand. Okay. Then just Karen , we noticed stock-based compensation jumped pretty heavily in the second quarter. Just didn't know if that's a new run rate for you guys or if there was anything one time in that number.
No, that is probably a good number. As you know, when we went public, there was a lot of the old private equity plans in place and a lot of that vested. As we've granted for new hires and just our focal grants, that is probably more like a run rate. You can see that on the cash flow statement when you back out the one-time charges last year that has increased and that was one of the items that was offsetting some of the leverage in SG&A.
All right. Perfect. Last question, new product for next year. Kitchen color, is that still expected for spring 2015?
That is expected for next year. Everything else is confidential at this point.
Got you. Okay. Thank you very much.
Okay.
Thanks, Peter.
Your next question is from Brad Thomas with KeyBanc Capital Markets. Please go ahead with your question.
Yes, thanks. Good afternoon. Just one more follow-up here on the sales. I was hoping you could talk a little bit more explicitly about how the last month and a half have gone and how Labor Day was, just in light of the timing shift on the source book and the Friends and Family promotion.
Yeah. Our guidance reflects the latest trends. As we said, both towards the end of Q2 and into Q3, we did see an acceleration, which is reflected in that increase. If you look at the 20%-23% guidance, that's obviously quite an increase over the 14% we posted in Q2.
Perfect. I just thought I'd ask it explicitly again.
Yeah.
Just on the real estate front, nice to see eight stores that you all have signed and more that you're in negotiations with. I was hoping you could just give us a little bit more color on how those negotiations have been going and the level of landlord contribution that you're getting and what the implied rent might be on some of these new stores, given that there's more and more proof of concept that you all have of these full line design galleries.
We're probably not going to share specifics by store, but I'd say we're very pleased with the landlord contributions. There's certain instances where now that we completed the $350 million offering and have some of our capital, we are making the decision to really look at the economics on each deal and say, if we're going to be paying higher for the landlord capital, we're going to toggle that and make sure we're making the right long term decision based on the returns of the business, thinking about whether we use our capital or their capital. Each deal looks a little different. I'd say we're still happy with the 30%-40% square footage growth for next year. Probably, we'll start firming that up as far as which deals and timing, because some of those eight deals are 2016.
As soon as we land the plane on the 2015 plan, we'll give you guys more color on the timing and sequence of those locations.
Second quarter. If you were to sort of isolate that out, can you just sort of confirm that you would've been, let's say, comfortably within your revenue guidance ex the sort of later book timing and maybe the decision not to reset the floor, which actually sounds like probably the strategic good idea, but maybe had a bit of an initial sales impact?
Yeah, I think if you look at where we are running today and where we are guiding, yeah, we would've been fine. For example, just to give some color. When we came up against the book drop from last year and had no book, our run rates dropped to zero. Then they started to build. We had a plan that the run rates would drop and then build by week as books started to get in chunk by chunk, throughout the quarter. Early on, against our internal numbers, we were comfortably ahead of that build. Again, starting all the way down around zero. We were comfortably building until we got to the Friends and Family event in July. It's a huge event for our company.
Because we didn't have all the books in home by the time of the event, and the books had been all in home for over a month before that event last year, we believe that we didn't get the lift that we thought during that event. Then, post that event, we're happy and we're back on track with how the business is building and where the run rates are. We have data inside the company that says, "Hey, this is how many weeks it takes for new products to mature, to build to their new run rates. This is what happens when we're in stock and newness versus not in stock and newness. When we get in stock and all this newness, this is how it'll perform." We've got a lot of data around that. This was a big move.
3,300 pages against 1,600 pages, mailing it later, putting it through the system. Our printer had to build three new machines just to put these books together that they called monster mailers that only service our company. They're the biggest printers in the world at R.R. Donnelley. We put the books through UPS to ensure better delivery. The books were bigger. They were going to take longer. They were delivered, I think, this year over 10 weeks.
10 weeks.
Last year, over five weeks. There's just a lot of changes, a lot of moving parts. Getting that all right within that, look, I wish we could've been better, but again, I look at our numbers compared to everybody else in the industry, and I'm pretty happy.
Okay.
I look at our acceleration of our numbers versus everybody else in the industry, and we feel really good.
Fair enough. Yeah.
Yeah. We're not going to get it all right all the time, especially when there's
Oh, sure.
that move around.
Yeah, when you've got that much change going on, there's more potential-
Yeah
I guess, room for error in both directions. It sounds like from a merchandising standpoint during that event, there's nothing that you've identified that you feel like, okay, maybe that category we didn't resonate as well. You really feel like it's confined to the just not having the books in place ahead of it?
Yeah, no, I'd say across the board we are either overperforming or underperforming by category. There's not one category that's exactly on when you have that much newness. It's the aggregate of it all, we feel very good about. We're constantly reading and refining and dialing in our execution everywhere. Dialing in our inventories and our in-stocks and because with newness, you never buy 100% right. Right? It either is selling better than you expected or less than you expected. In my entire 32-year career here in doing this, I've never seen anybody buy anything exactly right and forecast anything exactly right. Never.
Sure.
What you've got is you've got all these new products, thousands of new products, and they're all some degree wrong, over, underperforming. What you're hoping for in aggregate, that you're directionally right. In aggregate, we're directionally right, but because of the timing and because of those changes, we missed the top line. In retrospect, do I wish we were more conservative in forecasting the top line? Yes. Did we have better margin results because of selling less things on promotion and other things working in our favor because we had better in-stocks on things because of lower sales and less deliveries per order, which all helped the bottom line? Yes. Am I happy that we beat the street estimates by $0.03 a share even though we missed the top line? Yes.
I've had a lot of investors ask me throughout the course of the last year, "What do you feel best about and what do you feel less certain about?" I've always said, I've been very transparent and honest. I said, "Listen, we're growing the company at a very fast rate. We're compounding year over year over year over year significant increases. We have a lot of new products, and those products are going to be in the retail stores just yet." The top line is going to be less predictable at times. I feel really good about the operational execution of the company. I feel really good about how the team's executing and operating. From an expense and operational point of view, I think we're executing really well.
I said, "I feel very confident we're going to make the earnings numbers." The top line could be a little bumpy here and there because we've got a lot of things changing, that's what I've said to a lot of people who've asked me that question. That's what I say to the management team here. I said, "Look, don't feel so bad. We still have the best numbers in retail. We beat our earnings estimate and we have the best growth, the best outlook, and the best long-term strategy of anybody. Keep your eye focused on the big prize. Let's keep learning. Let's keep adjusting and adapting and refining and get smarter every day." That's the key to winning long term.
That's very helpful. Just two quick follow-ups. One on, I think, Brad's question just now about besides occupancy or let's say capital investment and how you're kind of splitting that between you guys and the landlord, are there any other aspects of kind of the new full-line design gallery that you feel like are in some cases evolving relative to what you were thinking a year or so ago when you kind of, I think you put out some initial thoughts about what the economics might look like on average?
Yeah. It's interesting. When we put out the initial economics, they were based on the view of the assortment that would be in that store at that time. Over time, as we continue to evolve and innovate and have new ideas and build out an even better assortment and platform, you would expect that we'll do better. Are we ready to raise the guidance on those kind of things? No. Do we have a lot of new ideas that will be part of that retail assortment and that retail experience that we didn't have a year ago? Yes. Are we ready to quantify those and raise that number? Not yet. We want to continue to test and get more data. I would say as I pull back and I look at it, hover up at a higher level, I'd say there's more upside than downside.
Okay, great. Then finally, thinking about supply chain, you guys have done a lot to kind of improve your own in-stocks and take more ownership kind of once the product, let's say, hits the U.S. shores. How are you feeling about the, let's say, scaling up with some of your key design and vendor partners? Obviously, that's a key focus for you. How are you feeling like that's progressing?
Yeah. I think every step up in our business requires a step up at the vendor level, right? Because I'd like to say that products of this quality have never been made in these quantities before. In many cases, we're building a new railroad. That requires not only us to step up, build new infrastructure on both the front end and the back end of the business, both from a human point of view, organizational point of view, and from a systems and physical facilities point of view. That requires the same thing from our vendor base, right? They keep executing, but every step up, there's always going to be some issues. That's why we have teams here that we deploy internally and to kind of help scale that.
I would say it's hard to do, but by doing it, we can create a long-term competitive advantage. It's not easy. It's not always predictable. We're going to have issues here and there. Some deliveries will be on time, some will be late. I think for the most part, what we've proven is that supply chases demand. If you create demand, people will figure out how to supply that demand, and that's what our vendor base has done, and we think they keep getting better and smarter, just as we do. Their operational capabilities and executional capabilities continue to grow. All of them are highly motivated to kind of build this new platform with us.
Great. That's very helpful. Best of luck in the second half.
Great. Thank you.
Thanks, Dan.
Your final question today is from Jessica Mace with Nomura Securities. Please go ahead with your question.
Hi, good afternoon, and thank you for taking the question. My question is a follow-up on the comments you made on the promotional environment and how important it is to be proactive and react quickly. I was wondering if, looking forward, you could just talk about your philosophy on how you balance the need to be competitive and protect your margins.
Sure. We generally operate from point of view of trying to be less promotional than more promotional unless it's strategic. Last year, we commented that we put in strategic pricing to take more market share. We thought that there was leverage in our operating model that would throw off more profitability, gain share, and try to weaken the competition. We executed against that plan. Our current view is that we don't believe we need to be more promotional than a year ago. We are testing pricing elasticity. We think we've got opportunities to raise merchandising margins, as well as get some leverage in other parts of the gross margin throughout the company that Karen referred to. We're always refining the model. You're always reading and reacting. I'd say that's our general view today.
Throughout this last quarter, our promotional activity was basically flat to a year ago, for the most part. As the books are scaling up, we feel pretty good. Look, if there's a need to get more promotional, if there's a need to pull that lever, you always like it when your merchandise margins are up and not flat or down. Our merchandise margins are up versus a year ago. That gives us flexibility and gives us the ability to play offense if we need to, or react if we need to. I like how we're positioned right now.
Makes sense. Thanks again.
Thank you everyone for your questions. I will now turn the call over to Mr. Friedman for closing remarks.
Great. Thank you, everyone. We enjoyed the conversation and appreciate your interest and look forward to talking to you next quarter. Have a great day.
Thank you everyone for joining today's conference call. You may now disconnect.