Good afternoon. My name is Kyle and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Restoration Hardware Holdings First Quarter Financial Results conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you'd like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you'd like to withdraw your question, press the pound key. Thank you. I'd now like to turn the call over to Cammeron McLaughlin of Investor Relations.
Thank you. Good afternoon, everyone. Thank you for joining us for Restoration Hardware Holdings First Quarter Fiscal 2014 Financial Results conference call. Joining me today are Gary Friedman, Chairman and Chief Executive Officer, and Karen Boone, Chief Financial Officer. First, Gary will provide highlights of our first quarter performance and provide an update on the company's value-driving strategies. Karen will conclude our prepared remarks with a discussion of our first 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 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 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 on page 10. A live broadcast of this call is available on the investor relations section of our website at ir.restorationhardware.com. With that, I will now turn the call over to Gary.
Thank you, Cammeron, and good afternoon, everyone. One of our shareholders made a comment to me recently that I've been reflecting on leading up to this call. He said, "You might be the most misunderstood company on Wall Street." I thought to myself, "How could it be?" We finished last year with comparable brand revenue growth up 31%, marking our fourth consecutive year of comparable brand revenue growth in excess of 25%. In fact, we believe we are the first public retailer in modern history to accomplish such a feat. I'm thinking to myself, "How can we be so misunderstood?" It reminded me of what one of our board members has said to me on several occasions.
He said, "If we go more than six weeks without thinking up, I feel like I'm six months behind because of the pace of innovation at RH is so great." When I stop and consider those comments, it makes me think we should also apply the same innovative thinking that has produced industry-leading results to how we spend our time and communicate with our stakeholders. In that spirit, I'm going to spend my time differently today. As opposed to regurgitating our Q1 results, I thought I would use my time to frame for you not just what we've done, but rather who we've become, why we've been able to outperform our industry by such a significant amount year after year, and why you should expect us to continue doing so for many years to come.
When I stop and reflect, I'm reminded that we are still in the very early stages of a highly evolutionary brand and business. In many ways, we are like a $1.6 billion startup. While we are all accountable for the discrete quarterly and yearly time measures of being a public company, our efforts should really be focused on the transformational stages we are moving through that will define our business and, more importantly, redefine our industry. Real value has always been created by those who have the courage to lead rather than follow, who are interested in next practices versus best practices, and who are willing to destroy today's reality to create tomorrow's future. Let me start with a question that we believe frames our opportunity, then discuss the transformational stages we are moving through that will define our business and we believe redefine our industry.
First, the question: Who is the home brand for the luxury customer? The Neiman's, Saks, Barneys, Bergdorf customer. We believe we are. RH has built the most comprehensive curated collection of luxury home furnishings in the world under one brand. Additionally, we've transformed our entire product platform. We have disintermediated the supply chain by eliminating the wholesale markup and inefficiencies that exist in the highly fragmented luxury market, allowing us to offer unmatched value. As an example, and probably something not understood, is the fact that we have become one of the largest importers of luxury Italian bedding in the world, offering the exact quality of product produced in many of the same factories at half the price of the most well-known Italian bedding brands.
We are also the largest importer of Belgian linen and Thai silk. I believe have now become the largest importer of reproduction quality furniture, which has previously been limited to boutique factories and small quantities. A point we like to make is this: Furniture of this quality has never been made in these quantities before. In many ways, we have been building a new railroad. We've developed an exclusive network of artisan vendors who act as an extension of our product development and merchandising teams. These are some of the most unique and talented individuals in their respective industries. Many of these businesses were small, $5 million-$30 million companies who we now buy $50 million-$120 million of cost receipts from annually and represent 60%-100% of their production.
Over the years, we have invested both human and financial capital to enable these partners to scale their businesses. Now are enjoying the benefits of having an exclusive product platform that provides us with a unique and very hard-to-replicate competitive advantage. Another important differentiator is our RH Center of Innovation and Product Leadership, a 120,000 sq ft facility designed to enhance the product development and go-to-market process from product ideation to product presentation. Our investments into designing and building this facility have increased our capability and productivity in excess of 300%, while also significantly reducing our costs. I know of no other facility of its kind in the world and believe this also provides us with a unique competitive advantage. Some of you have been to the center and understand the capability it gives us. I would encourage those of you who haven't to do so.
We do request that visitors sign an NDA as the facility design, methodologies, and processes are all proprietary. We are also moving through a significant transformational stage in our direct business. We continue to be the pioneer in rethinking the traditional direct model. We've expanded from an 84-page catalog in 2001 to 1,600 pages across six Source Books mailed in 2003. Now to over 3,300 pages across 13 Source Books mailed once annually this year. No one has an offering that is remotely comparable, nor a presentation platform that is similar. Our Source Books are an important part of our multi-channel go-to-market strategy, as they represent the only current physical manifestation of our brand and cannot yet be replaced by the internet. What people overlook is the fact that the web is a very democratic platform.
The smallest retailer in the world can look as dominant as the largest retailer due to the fact that we are limited to the same-size storefront. For example, RH looks no bigger than Holley's Home Furnishings on a homepage, and it would require a customer to click 10,000 times to understand the assortment size difference. For now, the Source Books play a very important role in communicating the dominant and unique point of view of our brand. While not intuitive, based on the size of our once-per-year mailing, we have made several changes that are both good for our business and much better for the environment than our previous methodology and those employed by our competitors. We have moved from mailing our Source Book 10 times per year to once per year, reducing our pages circulated as a percentage of our sales by approximately 70%.
Additionally, we ship all of our Source Book titles bundled together versus separately, which is also more efficient and uses less energy. We use only Forest Certified paper, and we are the founding sponsor and only retailer of the Verso Forest Certification Grant, which provides funding to sustainably manage and harvest forests. We've also collaborated with UPS to ship UPS carbon neutral. UPS purchases certified carbon offsets on our behalf to support reforestation, landfill gas destruction, and wastewater treatment, which neutralizes the impact of our deliveries. I don't know of another catalog retailer of scale taking the steps we are to minimize our impact on the environment. We do realize that we are heading in the opposite direction than most in our industry, believe that we have proven that our methods and decisions have enhanced both our revenue and profitability and are based on new thinking and new math.
Our approach in the direct channel mirrors our real estate strategy, eliminating multiple smaller stores in a market with redundant assortments in favor of one significantly larger store with a more dominant offer. We believe the new mailing in Spring 2014 will again prove to be revolutionary and transformative to our brand and business. Our online presence will go through equally transformative changes this year as we completely reconceptualize our website and greatly enhance our customer experience. As you know, we are at the very beginning stages of what we believe will be one of the most significant retail store transformations in the history of our industry. The retail store is not dead. We believe it is anything but.
Over the past three years, we've continued to innovate, test, and prove that we can build a retail experience that defies conventional wisdom that everything is moving to the web and retail stores are a dying platform. We have proven just the opposite and continue to develop new, larger, and even more exciting concepts that will create an even more compelling and experiential environment for our customers. We also learned that we could partner with developers and create a win-win by moving from being a tenant who occupies high-cost interior mall or street space to adding value by positioning ourselves as a next-generation anchor tenant who can help transform a mall or a neighborhood. This results in unique and dominant locations that will range from 25,000-60,000 square feet with substantially improved economics and will enable us to unlock the value of our current and future product assortments.
We recently opened our newest full-line design gallery at the former historic post office in the heart of Greenwich, Connecticut, and the early reads have been outstanding. We remain on track to open our new, larger full-line design gallery on Melrose Avenue in Los Angeles later this year. Our new Melrose location will display 2.5 times the assortment of our current Beverly Boulevard location and greatly enhance our brand presence in this very important market. We will also be expanding our current Flatiron gallery in New York, scheduled to open Friday of next week. We'll be adding two additional floors to our top-performing store in the company. We will be opening our first next-generation Full Line Design Gallery in Atlanta in October of this year.
Atlanta will present more than three times the product assortment of our Houston full-line design gallery and more than seven times the assortment presented in our current Atlanta store. We believe this new format will generate revenues and earnings that will far surpass any of the previous design galleries we have opened and provide the proof of concept that supports our long-term growth objectives. After visiting the site recently, I believe that the Atlanta gallery will prove to be our most revolutionary innovation to date and will demonstrate the true power of the brand we have created. As mentioned, once our real estate transformation is complete in North America, we believe we will deliver $4 billion-$5 billion in annual revenues, achieve mid-teens operating margins, and generate significant free cash flow.
Let me shift your attention to what is probably the most underappreciated and misunderstood aspects of our transformation, our supply chain and systems platform. Under the leadership of Ken Day and his team, we are bringing the same spirit of innovation and disruptive thinking to our supply chain and systems platform. We believe we can significantly enhance the customer experience, reduce our costs, and build a platform that can support our long-term growth objectives. In 2013, we opened our third furniture distribution center near Dallas, Texas, adding over 850,000 square feet of capacity to our network. We also completed the 400,000 square foot addition to our Ohio shell stock facility last year, bringing the center to over 1.2 million square feet.
At the end of the first quarter, we operated six facilities in the United States with nearly 5 million total square feet to support our multi-channel platform. Additionally, we now have in-sourced furniture delivery hubs in our top eight markets, which control more than 50% of our deliveries. This year, we will be launching our Final Mile System, which will greatly enhance the customer experience and operational efficiencies of our furniture delivery platform. We will also be piloting our new fully integrated market strategy in Atlanta, coinciding with the opening of our new full-line design gallery. We believe there are significant opportunities to localize and integrate our stores, outlet operations, home delivery hub, and customer care operations in each high-volume market that will result in enhanced service and reduced costs.
Lastly, I would like to speak about our approach to managing and deploying capital and the financial stewardship of our company. One of the benefits of spending almost five years as a private company under private equity ownership is you learn the discipline of capital allocation that, quite frankly, is far superior than what one would learn in a retail career. Added to that, I believe we worked with some of the smartest and most innovative partners in private equity and have developed a mentality of investing that will benefit our shareholders in a greater manner versus others without our experience. In closing, when I reflect on the comment of one of our shareholders, it made me think about what is really important, and we believe it goes beyond what we have done, but rather who we have become.
We have become a team of people who don't know what can't be done. We've become a team of people who are defined by our values and beliefs, those things we would fight for and die for. While it is true that we have built one of the most compelling curated collections of home furnishings in the world, developed a proprietary platform of artisan partners that gives us a valuable competitive advantage, created an entirely new direct platform, and conceptualized a revolutionary new retail store concept, engineered a fully integrated multi-channel supply chain and systems infrastructure, and become the first public retailer in modern history to achieve mid-twenties comparable brand revenue growth for four consecutive years. What's most important is who we are, how we think, and what we believe in.
That is why we achieve these results and why we believe we will be able to continue innovating, leading our industry, and bringing our future dreams to life. Hopefully, we are a bit less misunderstood. Thank you for your support and interest in our journey. Let me turn the call over to Karen to review our financial highlights for the quarter.
Thanks, Gary, and good afternoon, everyone. I will first take you through our first quarter performance and will then provide our outlook for the second quarter and upwardly revised expectations for the full fiscal year. We are extremely pleased with our financial results for the first quarter of 2014. During the first quarter, we delivered net revenue growth of 22% on top of 38% last year and ahead of our original expectations. Total revenue increased to $366.3 million, driven by 24% growth in our direct channel and 19% growth in retail. Our comparable brand revenue growth, which includes our direct business, increased 18% on top of 39% growth last year. On a two-year basis, comparable brand revenue growth was 57%.
We continue to take market share as a result of our dominant assortments and superior position in home furnishings category. We believe our industry-leading growth in the first quarter is especially compelling given the fact that we have not had a Source Book in homes for nearly a year. The first quarter was positively impacted by our strategic inventory investments and continued benefits of our One Source Book strategy. By having better in-stock positions and lower backorders, our conversion improved, and we were able to ship and deliver product to our customers earlier. This resulted in additional net revenue growth in the quarter that was a pull-forward from the second quarter. Gross profit increased by 22% to $124 million during the first quarter. Gross margin increased 20 basis points to 34% from 33.8% last year.
Our overall product margins decreased relative to last year, driven primarily by square footage growth and effective inventory management in our outlet channel. Product margins in our core business were strong relative to last year and relative to our expectations. Our merchandise margins have expanded meaningfully with the drop of the Spring Source Book, and we believe this trend will continue through the balance of the year. During the quarter, we also benefited from improvements in our shipping costs and continued to leverage our retail occupancy costs. We experienced deleverage in our supply chain occupancy costs based on the investments we made in our DC network last summer. Our total adjusted SG&A expenses increased 13% to $110.4 million in the first quarter versus $97.3 million in the prior year. As a percentage of net revenues, adjusted SG&A expenses decreased by 220 basis points.
This decrease was driven by advertising savings resulting from the change in our Source Book strategy, as well as leverage on our other corporate expenses. Our adjusted SG&A expenses exclude the impact of a $9.2 million charge recorded in the quarter related to developments on a significant outstanding legal claim alleging that RH requested and recorded zip codes from customers paying with credit cards. Adjusted operating income increased by 204% to $14 million from $4.6 million last year, and adjusted operating margins expanded 240 basis points. Adjusted net income for the first quarter increased 217% to $7.2 million from $2.3 million last year, and adjusted diluted EPS increased 200% to $0.18. We had 40.8 million diluted shares outstanding and both adjusted net income and diluted EPS were calculated based on a normalized 40% effective tax rate.
Turning to the balance sheet, inventory levels at the end of the first quarter increased by 32% to $483.5 million. This increase reflects our ongoing initiative to improve our in-stock position and lower back orders and includes new products that will be introduced with our Spring 2014 Source Book and to meet the accelerated growth we expect in the second half. We ended the first quarter with $149 million in outstanding debt versus $114 million last year and with $230 million available on our credit facility. Our balance sheet also reflects the gross up of approximately $46 million of assets related to the accounting treatment of several of our full-line design gallery leases as build-to-suit leases. Under these arrangements, we are required to report 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 CapEx. Similar to a capital lease, under these arrangements, a portion of our rental payments will be classified as interest expense. Our total capital expenditures were $16.5 million in the quarter, and we continue to expect CapEx in the range of $15 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.
Our negative free cash flow of $47.74 million in the first quarter reflects the timing of several working capital items, including a $30 million increase in our inventory balance since the fourth quarter, $23 million related to the timing of income tax payments, and a $20 million change in prepaid expenses, which is primarily due to an increase in our capitalized catalog costs for the Spring 2014 Source Book. Turning to our outlook, for the second quarter, we expect net revenues to grow 16%-19% to a range of $443 million-$453 million. We expect adjusted net income to increase 28%-32% to a range of $25.4 million-$26.2 million, translating into adjusted diluted EPS in the range of $0.62-$0.64 based on 41 million diluted shares outstanding. We are also raising our outlook for the full year.
We are increasing our 2014 revenue growth target to a range of 20%-22% from our prior expectation of 18%-20%. This will result in net revenues in the range of $1.86 billion-$1.89 billion. 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 Spring Source Book and as we execute our real estate plan. During the second half, we expect our operating margin expansion to be primarily driven by improved growth margins as our overall SG&A expenses are expected to deleverage due to investments we are making in new pages and expanded product assortment, as well as the prospecting efforts with our Spring 2014 mailing.
We now expect adjusted net income to grow between 33% and 37% to a range of $91.9 million-$94.3 million in fiscal 2014, which assumes a full-year effective tax rate of 40%. We are providing full-year adjusted diluted EPS guidance in the range of $2.24-$2.30, which assumes 41 million diluted shares outstanding. This compares to our previous expectation of adjusted diluted EPS in the range of $2.14-$2.22. In closing, we are extremely pleased with our first quarter performance and are optimistic about our 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 target 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, I'd like to remind everyone, in order to ask a question, press star then the number one on your telephone keypad. We'll pause for a moment to compile a Q&A roster. Your first question comes from the line of Daniel Hofkin from William Blair & Company. Your line is open.
Good afternoon. Congratulations on a great quarter. Just a couple questions. You talked about some, let's say, pull forward potentially from the second quarter due to higher in-stocks and some of the inventory investment. Do you have any sense for how much that might have been? If you were to think about the sources of upside in the quarter, how much was that versus just underlying strength in the business? That would be my first question.
Yeah, this is Karen. We think that it's hard to know exactly how much, but we did have expectations for how things would convert and backwards and things, and we think that about two points of the growth in Q1 was product that would have shipped, and that revenue would have been recorded in Q2, and instead it was recorded in Q1. Okay. In our guidance for Q2
Okay. That's right. That's essentially for the first half, it's kind of netted out.
Matt.
If I remember correctly, in the first quarter of last year, you had a somewhat similar phenomenon. Am I correct about that?
That is correct.
Secondly, maybe you could just comment, obviously, a lot of publicity around the new Source Books. Just talk about the impressions that you're hearing from people, positive or questions that you're getting at this early stage. I know they've only been out for a few weeks at the earliest or at the longest.
Yeah. This is Gary. Let me take that from two perspectives. One, we like the response we're seeing in our business based on the book being in home. To date, we are performing ahead of our expectations. We like the build that we're seeing. There is obviously some social media conversations regarding the size of the book and some environmental-related comments. We measure social media conversations, mentioning Restoration Hardware, and when we look at the numbers, the tiny fraction thus far, if you look at the conversations that are talking negatively about the book, it's less than one-tenth of a % of the books mailed.
While we think there's going to be some people that unfortunately we mail a book to that we wish we didn't, who might have bought something in the past and for some reason didn't want to receive our books this time, we apologize for that. So far, from our point of view, from a business perspective, the response has been very good.
Great. I guess as far as inventory goes, can you discuss going forward, should we expect inventories and investment related to the investment in fulfillment and supply chain to continue to outstrip revenue growth for still a while going forward?
Very much like last year, in the first half, we do grow inventories in anticipation of the drop of the book, and then as the back half enters, we work through that inventory, and that inventory is really meant to meet that additional demand once we drop the book. By the end of the year, we would normally plan inventory to be roughly in line with sales, but some of the investments we're seeing have such a nice payoff with what they're meaning for transportation efficiencies and lower back orders and things that we're still weighing the pros and cons of how much inventory we might want to continue to invest in. Right now, I would say we'll end the year with sales growth roughly in line with inventory growth, but that's something that we're going to continue to monitor and evaluate.
Great. Best of luck.
Thank you.
Your next question comes from the line of Matt Nemer from Wells Fargo Securities. Your line is open.
Thanks. Afternoon, everyone. I just had a couple of follow-up questions on the Spring Source Book as well. The first being, I think that the email follow-up that you're doing is something that we really haven't seen in retail, and I think that's part of the fact that you know exactly when it's been delivered to a home. I'm wondering if that is having any impact on conversion. Secondly, I'm wondering if there's been any unusual opt-out activity versus what is typical when you mail the Source Books.
Sure. I'd say, Matt, the books are what are we as of today? We're 45.
Forty-five.
As of today, we're 45% in home versus, I think, three weeks of 100% in home last year. We're not looking at an apples to apples build, and you're at the very early stages of reading response. It's somewhat too early to get into the details. I think the way we planned our business and the way we planned our business to build and where it should be now, it's trending meaningfully higher. The early reads with 45% of the books in home look to be better than our expectations. The email notifications, that gives us obviously more visibility when the books have been received, have been delivered by UPS. We also understand what books might have been rejected and not wanted and so on and so forth. We have better data around that. Nothing else that's really unusual.
Our opt-out is slightly higher than a year ago, but you'd expect that because the Source Book is twice as big.
Understood. Then just a follow-up for Karen. You made a comment about the gross margin that you're seeing, the merch margin you're seeing with the new spring assortment. As we look at the second quarter, you have a very easy comparison. Can you provide a little context on how much of that we could recover in this current quarter?
We don't want to get too specific, but I would just say we do feel very confident about the merchandise margins heading into the second quarter and even in the back half. Agree it's a nice compare versus last year as we've now anniversaried all the strategic pricing from last year. We also feel pretty good about what's happening with margins since we dropped the Source Book. I'd say Q2, we feel good and some of the other components in gross margin are also moving in the right direction. We're seeing some benefits in shipping, then occupancy continues to kind of toggle back and forth between when we make investments in supply chain, for example, which will anniversary, but we'll have some pre-opening rent in the back half on the retail side.
There's little pieces moving back and forth in occupancy, but I think merchandise margin and shifting are going in the right direction.
Great. Congrats, and thanks so much.
Thanks, Matt.
Your next question comes from the line of Matthew Fassler from Goldman Sachs. Your line is open.
Thanks a lot. Good afternoon, and congratulations on a fantastic quarter. My first question is really for Gary and relates to talking about the newness in the book from a qualitative or even quantitative perspective, if you can think about the turnover in product. Also, given the number of books you have, I guess you have a lot of different contexts in which to frame the product. Can you talk about how that's influencing the way you merchandise it and what kind of response you've seen to that so far?
Matt, we've just got some very early data on, I think, on the new goods. We're very happy so far with the early response. As it relates to turnover in the product and elimination, we probably have a lower turnover or lower elimination rate than most people because we have what's developing what I call more of a long-tail business because of the multi-channel platform and the percentage of our business that really happens in a direct point of view. If you think about our stores, they're really showrooms for our product, and we've developed a direct model that's a very low-cost model. The hurdle rates for products to be profitable on our model are relatively low, which is a new emerging model for us and gives us the opportunity to have a longer tail from a product perspective and a broader assortment.
Most of the assortment newness is incremental and not replacing discontinued product. There's always going to be some discontinued product. We're pretty creative in density and how we merchandise and how we drive productivity as well as the mailing cycle has obviously changed the hurdle rates and the return methodology as you think about where you're investing inventory.
That's very helpful. Just a quick follow-up. If you think about the performance of the direct business in the markets where you've opened the newer and larger design galleries, I know that historically, those markets had great market growth on the direct side. If you could just give us an update as to what you're seeing in those five or six markets where you have those stores.
Yeah. That's continued. It's slightly different by market. Some are better than others. They're all positive. We've seen, on average, nothing has changed across the aggregate portfolio. The thesis and the early points we made about when we open a bigger store in a market, it drives greater brand awareness. More people participate with the brand, both in retail and direct, we believe will continue to be a viable part of our strategy.
That's great. Thank you so much, guys.
Your next question comes from the line of John Marrin from Jefferies. Your line is open.
Hi, guys. Thanks and congratulations. That 18% comp is pretty stellar. I was just hoping maybe if you guys can talk a little more about what was driving that comp traffic ticket, furniture versus non-furniture. Then Gary, I was hoping maybe you could update us on your hunt for real estate and what you're learning about availability and about the size of the stores you want to go to market with. I will go from there.
John, we don't really disclose traffic versus ticket and average order sizes and things, I will just say that across the board, we were pretty pleased with the direct and retail channel, I think our comp just demonstrates that people really like our product, and we do think we're taking market share. Again, we think it was pretty solid. Our furniture penetration did not grow as significantly as it has in the past. It seems to be stabilizing out. It was growing really significantly over the last four years, it's not making a meaningful growth in that one specific category. We're pretty happy with that because it does have positive impacts on the transportation side. It's still growing, but not to the same extent.
Just to comment on the real estate update. I think we have great momentum building in the developer community. We have a lot of optionality. We just got back recently from the ICSC, the RECon conference in Las Vegas, which is the biggest retail real estate conference, I believe, in the world, and every major developer there. The response to our new concepts, I believe we're one of the most in-demand concepts for developers today. We've got a lot of options. I think the developers are partnering with us, thinking in more creative ways than they have for probably other retailers. In some cases, they're adding us on as an anchor and reconfiguring a shopping center. In some cases, they're aggregating space for us. In some cases, where there's street developments, we can anchor a street or a neighborhood in a development area.
We're pretty flexible on our side, whether we go mall or non-mall. What's happening in the non-mall locations is because we can bring value to a neighborhood and you've got people who can aggregate space, we're able to do very good deals in that way, too. I think it's funny. There's quite a few people that were at the opening of our Greenwich store and got to be there for the opening event and opening party. And were asking me, "Geez, it's an amazing building, amazing store. Somebody made a comment to me, this must be costing you a lot more than your current existing store." What's interesting there's another what I'd call partnership win-win development play. We identified that building, it was coming up for sale. We found a REIT and someone to partner with to buy that building.
We pre-negotiated a lease arrangement in that building. So they knew what their rent stream was going to be, and they knew how much they could buy the building for. We wind up with a space that has three times the exterior space, four times the selling space, if you count the exterior space, at basically the same rent as our 5,500 sq ft store on Greenwich Avenue. When you think about it from a There's all kinds of good occupancy opportunities for us to create deals where we have significantly more space, significantly more dominant locations at significantly reduced occupancy per square foot.
In some cases, if you're doing a store that's three times the size, we might be able to hold occupancy in about the same rate where we're going to a store that might be seven times the size in some of our next-generation Design Galleries that we're seeing, occupancy rates that are maybe 30%-50% higher for 6 to 8 times the square footage. Significantly down per square foot. So we're very happy. We think this real estate model that we're developing is transformative and revolutionary in the industry. If you step back and say, when's the last time someone had a luxury, semi-big box, kind of play, kind of department store? The last person I can think of that had a meaningful play like this was Nordstrom, and that was back in the '80s and '90s.
We are, in many cases, being seen as an anchor tenant in these deals or somewhat of an anchor tenant in a neighborhood. We're very excited. We're very excited to get out of the auction space, the middle of the mall where they just auction the space off to the highest bidder. We're no longer in that situation, and we've got a very different economic model because of that.
Okay, great. I was wondering if you guys would want to share or have shared the number of catalogs you sent out this spring.
We don't do that.
Okay. All right.
We believe that is just competitive information that we're not going to disclose.
Got it. Okay. All right. Thanks a lot.
Thanks, John.
Your next question comes from the line of Bradley Thomas from KeyBanc Capital Markets. Your line is open.
Thank you, and let me add my congratulations as well on a great quarter. Just to follow up on that last question about the new full-line design galleries. I think you all alluded to 6 stores that you've signed already in negotiations for another 25. What do you think the number will shape up to be for 2015? What's about the maximum that you'd feel comfortable pursuing in 1 year?
I believe on the last call, we tried to transition everyone from thinking about unit growth to square footage growth, because that's really how we look at it. When you've got sizes ranging from 25,000 to 60,000 sq ft, we believe the right way to think about the real estate strategy is what's the square footage growth that we're going to achieve each year? I think the last call we've guided 30%-40% square footage growth for 2015, we're comfortable with that number.
Okay, great. Gary, just to follow up on some of your introductory comments. It seems that the company has a tremendous opportunity to source better than its competition and source even better in years down the road. What do you think the benefit to procurement costs could be as you continue to develop the infrastructure?
Yeah, there's really 2 things. Clearly, if you have unique products, you've got more blind pricing and more pricing power in a marketplace. 2, as we build this railroad, the railroad becomes more efficient, right? The more we invest and the greater the platform is, the more it can do for us and the more leverage we get. The first 5, 6 years of building this was very difficult. Not that it's not still difficult, but when we had to conceptualize, can people running a $5 million business become a $50 million supplier for us? The first going from 5 to 10 or 5 to 15 or 5 to 20 was shaky and difficult, right? Because you've got a vendor base that was undercapitalized, under-resourced, but had the talent, know-how, and desire to do it. They're the only people that we found that could actually do it.
You had to partner with them, you had to invest in them in multiple different ways. Every one of our structures was different. They're real businesses, and it's a real platform and a real partnership. Someone was asking me the other day, "Do you have contracts with all of these people?" I said, "No, we have relationships with all of these people." We are deeply connected both from a business point of view and from a values point of view, and it's every bit as much they feel this is their company and vice versa. We like to say we're shopkeepers without factories, and our partners are factories without stores. One needs the other to really win.
Obviously, as we work together and become more strategic and thoughtful in how we manage it, we expect to have more and more efficiencies, whether it's buying power of raw materials, whether it's leverage on their investments in occupancy, whether it's leverage in the amount we buy. Then the flip side of having very unique products in the marketplace and the pricing power you might get. One of the things you're going to see this year is a combination of pricing power and some of the efficiencies come through in our merchandise margins. We feel very confident that we're going to have a meaningful move in merchandise margins this year. We probably have upside as we look forward. Every time you turn a corner, you see more opportunities. We don't want to commit to too much, but we have good visibility this year.
The early response to the pricing structure that we have in place on both existing and new product would tell us we're going to have a very good year from a product margin perspective.
That's great. Thank you, [audio distortion]. Great work.
Your next question comes from the line of Peter Benedict from Robert W. Baird. Your line is open.
Hey, guys. Thank you. Karen, can you spend a minute, maybe expand on some of the drivers of the SG&A deleverage in the second half? What in particular is driving that? I know you mentioned a couple of things, maybe any more color.
Sure. We've talked about the first half was going to continue to benefit from the change in the Source Book strategy. As we enter the second half, that's when we're going to anniversary those savings. That's also where that significant step change we had in our business, we're going to add on top of that, the anniversarying of that, the new investments that I mentioned before in the new pages and new assortment, as well as the prospecting efforts for this 2014 mailing. Overall, we expect modest leverage in SG&A for this full year, and most of our operating margin expansion is going to come from the improvements in gross margin. In the first half, we had a lot of advertising leverage. In the second half, we're going to make those investments.
All in all, in the year, our advertising will be roughly flat as a percentage of sales.
Yeah. Let me just add to that. The way I think we think about this is, we've basically doubled the page count, right? On half the book, we're not yet optimized, right? It's new product. It's newly presented. We're going to learn a lot on all those new pages. We would project that those pages will be less optimal than the existing pages just because we've been able to go back and merchandise those and size those and look at density and all the things you do in a direct business to optimize them. Anytime there's significant growth in page count or assortment, you're never going to have complete optimization in productivity, nor will you in inventory investment, right?
That's why we think we've got to leave ourselves room from an inventory point of view because we're not going to be optimized with this kind of growth. The other piece here is prospecting, right? We've increased prospecting as we've had very good response rates, and we want to continue to build our file and build our direct business. Prospecting is an investment, right? You don't get paid at the same rate of return from a time point of view as you do on mailing to your house file. When you think about prospecting, you got to think about an 18-month tail, and in our case, in our business, a 24-month tail. You're going to have initially, that's going to take a while to have that payback.
Those two things together in the second half, we've positioned that we believe we'll have deleverage on advertising and anybody making a move like this would, right? We believe that as we follow up in the next year, there's opportunity to then optimize that page count. We'll start to optimize the prospecting and get probably leverage in the out years.
That's helpful. Thanks, Gary. Just circling back on the merch margin. Karen, you had mentioned that you've seen some improvement here with the new Source Book out there. I know it's early, but are there any categories in particular that are helping drive that? I know you have a lot of new stuff in there, but just curious what you're seeing from a category perspective.
Yeah. We don't disclose that kind of category information in regards to that category. Again, we're just pleased with what we're seeing so far with the drop and enough so to tell you guys we feel good about it for Q2 and into the back half.
Yeah, I'd say generally, by category, it's responding as we planned. Directionally, it's as expected.
Okay, great. Thanks, guys.
Thanks, Peter.
Your last question comes from the line of Lorraine Hutchinson from Bank of America. Your line is open.
Understanding that you're in investment mode right now as you transform the business, I was just wondering how you're thinking about return on capital and when we'll see ROIC and free cash flow really start to accelerate.
Yeah. I think the real question, right, is as we begin the rollout and significant capital deployment of the next-generation Full Line Design Galleries, the productivity of those galleries, how we wind up fine-tuning the investment into those galleries and what the productivity of those galleries and the effect in the direct business, when you put one of those new galleries in the market, it's going to really have the biggest determination on that metric. I think I said on the last call, we designed the next-generation design gallery. We've had time now to go back and design several of them and start to think about square footage and optimization, whether it's shrinking the storefront from 200 sq ft to 100. I think we're down to 172 ft.
Exactly.
Yeah, 172 ft. It used to be 110 ft deep, and now it's 89 ft. The size of the box got smaller without changing any product density. The first design was just the architects designed it somewhat bigger, and as we started merchandising it and planogramming it, we were able to make the box more efficient. Then you look at things like, do you need all the ceiling heights to be 18 ft clear? Do you need 18 ft clear on the first floor and can the second floor be 14 ft clear and third floor be 14 ft clear? How do you optimize All of that is $ per sq ft as far as how many walls you build, how high you build the walls, and what the cost is, and how many doors and windows, how you value engineer the doors and windows.
I'll tell you exactly what we told our board a couple of weeks ago. Directionally, our initial thoughts in our five-year plan, that we believe there's an opportunity to reduce the store costs by somewhere in the neighborhood of $1 million-$3 million per store on these next generation design galleries. We've got to build a few of them, but we've already got early numbers in on value engineering and ordering differently and sourcing differently and optimizing the size of the box, et cetera. If you say, hey, just do simple math, 50 stores, and you save a million bucks a store, that's $50 million in cash. If you save $3 million a store, it's $150 million in cash. If we get even smarter and we can save $4 million a store, that's $200 million in cash.
That significantly changes the cash flow of the business and when we'll get to free cash flow positive. The same thing happens on the performance of these stores. And so if you've got the stores operating at X dollars per square foot, and they do 10% or 20% more than that is going to change the return profile of these stores. And so we're going to learn a lot with Atlanta. And we are already value engineering the build-outs of the stores going forward. We're getting smarter all the time here. And then everything in our company beyond that goes through very rigorous capital review and return on capital investment review. We probably have 100 ideas here a year that people would like capital for, and that gets force ranked down to the top 10 or 12 things. And they're all force ranked based on two things.
One is, what is the financial value to the company, and what is the strategic value to the company? And the capital allocation, both financial and human capital, gets deployed based on what the returns are going to be, both financially and strategically. And that's how we decide to deploy capital. And it's funny because for a pretty big company, we operate like a very little company. I don't think anybody spends $100,000 here without coming and sitting in front of the executive committee and talking about where we're going to invest $100,000 into what and what we're going to get for it. So I think we're as disciplined as any kind of retail company out there. I think our five years under stewardship of private equity ownership, you develop really good capital discipline.
I think we've all learned a lot here, and we're so much smarter and grateful for that experience. I think about it, how it's changed myself and changed our team. We look at our investments just like probably an investor looks at their portfolio, right? And where do we think we have asymmetrical risk? Where do we think we have the most upside? How much do we want to invest here? How much we want to invest here? What are the low-level things that we're going to seed? But I think from any time in my point in time in history, and I've been in this business for over 30 years, I think we're as disciplined capital stewards as any retail company I've seen.
Thank you.
There are no further questions at this time. I'll turn the call back over to Mr. Friedman for closing remarks.
Great. Well, thank you everyone. We appreciate your support and interest in our company. We're very excited and proud of the results that we've achieved. I want to thank all of our team members and partners around the world and throughout our stores organization. We couldn't be more excited about what's happening in this company and with this brand. We're very excited to talk to you next quarter. We'll talk to you soon. Thank you.
This concludes today's conference call. You may now disconnect.