Earnings Call: Q1 2015

Jun 11, 2014

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 Holding First Quarter 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. Thank you. I'd now like to turn the call over to Cameron McLaughlin of Investor Relations. Thank you. Good afternoon, everyone. Thank you for joining us for Restoration Hardware Holdings' Q1 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 Q1 performance and provide an update on the company's value driving strategies. Karen will conclude our prepared remarks with a discussion of our Q1 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 and 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, Cameron, 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. And I thought to myself, how could it be? We finished last year with comparable brand revenue growth, up 31%, marking our 4th consecutive year of comparable brand revenue growth in excess of 25%. In fact, we believe we are the 1st public retailer in modern history to accomplish such a feat. So I'm thinking to myself, how can we be so misunderstood? It reminded me of one of our Board members has said to me on several occasions. He said, if we go more than 6 weeks without thinking up, I feel like I'm 6 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 $1,600,000,000 startup. And 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 and 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, Sachs, Barney's, 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 have transformed our entire product platform. We have disintermediated the supply chain by eliminating the sale 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 and 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 $5,000,000 to $30,000,000 companies who are net who we now buy $50,000,000 to $120,000,000 of cost receipts from annually and represent 60% to 100% of their production. Over the years, we have invested both human and financial capital to enable these partners to scale their businesses and 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 square foot 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 cost. 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 and 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 2,001 to 1600 pages across 6 source books mailed in 2,003 and 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 important part of our multichannel 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. So for example, RH looks no bigger than HOLLY's home store on a home page and it would require a customer to click 10,000 times to understand the assortment size difference. So for now, the source book 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, but believe that we have proven that our methods and decisions have enhanced our 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 1 significantly larger store with a more dominant offer. We believe the new mailing in spring 2014 will again prove to be revolutionary transformative to our brand and business. Additionally, our online presence will go through equally transformative changes this year as we completely reconceptualize our website and greatly enhance our customer experience. 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 3 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 to 60000 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 enhanced 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 will be adding 2 additional floors to our top performing store in the company. Additionally, we will be opening our 1st next generation full line design gallery in Atlanta in October of this year. Atlanta will present more than 3 times the product assortment of our Houston full line design gallery and more than 7 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 $4,000,000,000 to $5,000,000,000 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 Denae 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 3rd 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 shelf stock facility last year, bringing the center to over 1,200,000 square feet. At the end of the Q1, we operated 6 facilities in the United States with nearly 5,000,000 total square feet to support our multi channel platform. Additionally, we now have in sourced furniture delivery hubs in our top 8 markets, which control more than 50% of our deliveries. This year, we will be launching our Final Mile system, which will greatly enhance 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 5 years as a private company under private equity ownership, if 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. So 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 1st public retailer in modern history to achieve mid-20s comparable brand revenue growth for 4 consecutive years. What's most important is who we are, how we think and what we believe in. That is why we achieved 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 Q1 performance and will then provide our outlook for the Q2 and upwardly revised expectations for the full fiscal year. We are extremely pleased with our financial results for the Q1 of 2014. During the Q1, we delivered net revenue growth of 22% on top of 38% last year and ahead of our original expectations. Total revenue increased to $366,300,000 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 2 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 Q1 is especially compelling given the fact that we have not had a source book in homes for nearly a year. The Q1 was positively impacted by our strategic inventory investment and continued benefits of our One Sourcebook strategy. By having better in stock positions and lower back orders, our conversion improved and we were able to ship and deliver products to our customers earlier. This resulted in additional net revenue growth in the quarter that was a pull forward from the 2nd quarter. Gross profit increased by 22 percent to $124,000,000 during the Q1. Gross margin increased 20 basis points to 34% from 33.8% last year. Our overall product margin decreased relative to last year, driven primarily by square footage growth and effective inventory management in our outlet channel. However, 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 Sprint stores 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 and A expenses increased 13% to $110,400,000 in the Q1 versus $97,300,000 in the prior year. As a percentage of net revenues, adjusted SG and 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 other corporate expenses. Our adjusted SG and A expenses excluding impact of a 9,200,000 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 $14,000,000 from $4,600,000 last year and adjusted operating margins expanded 2 40 basis points. Adjusted net income for the Q1 increased 217 percent to 7,200,000 dollars from $2,300,000 last year and adjusted diluted EPS increased 200 percent to $0.18 We had 40,800,000 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 Q1 increased by 32% to $483,500,000 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 Q1 with $149,000,000 in outstanding debt versus $114,000,000 last year and with $230,000,000 available on our credit facility. Our balance sheet also reflects the gross debt of approximately $46,000,000 of assets related to the accounting treatment of several of our full line design gallery leases as built 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 and L or cash flows and are not included in our CapEx. However, 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 $16,500,000 in the quarter and we continue to expect CapEx in the range of $15,000,000 to $125,000,000 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 $47,000,000 to $74,000,000 in the first quarter reflects the timing of several working capital items, including a $30,000,000 increase in our inventory balance since the Q4, dollars 23,000,000 related to the timing of income tax payments and a $20,000,000 change in prepaid expenses, which is primarily due to an increase in our capitalized catalog costs for the spring 2014 source books. Turning to our outlook. For the Q2, we expect net revenues to grow 16% to 19% to a range of $443,000,000 to 453 dollars We expect adjusted net income to increase 28% to 32% to a range of $25,400,000 to $26,200,000 translating into adjusted diluted EPS in the range of $0.62 to $0.64 based on 41,000,000 diluted shares outstanding. We're also raising our outlook for the full year. We are increasing our 2014 revenue growth target to a range of 20% to 22% from our prior expectation of 18% to 20%. This will result in net revenues in the range of $1,860,000,000 to $1,89,000,000 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 to our SpringSource 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 gross margin as our overall SG and A expenses are expected to deleverage due to investments we're making in new pages and expanded product assortment as well as the processing efforts with our spring 2014 mailing. We now expect adjusted net income to grow between 33% 37% to a range of $91,900,000 dollars to $94,300,000 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 to 2 point $3.0 which assumes 41,000,000 diluted shares outstanding. This compares to our previous expectations of adjusted diluted EPS in the range of $2.14 to $2.22 In closing, we're extremely pleased with our Q1 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. And with that, I would now like to open up the lines for any questions. Thank you. Your first question comes from the line of Daniel Hoskin from William Blair and Company. Your line is open. Good afternoon. Congratulations on a great quarter. Just a couple of questions. You talked about some, let's say, pull forward potentially from the Q2 due to higher end stocks and some of the inventory investment. Do you have any sense for how much that might have been? And 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. Yes. This is Karen. We think that it's hard to know exactly how much, but we did have expectations for how things would convert backwards and things. And we think that about 2 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. And if I were And we corrected our guidance for Q2. Okay. So that's right. That's essentially for the first half. It's kind of netted out. Yes. If I remember correctly in the Q1 of last year, you had a somewhat similar phenomenon. Am I correct about that? Yes. That is correct. Okay. And then 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 early or at the longest. Yes. This is Gary. I'll just let me take that from 2 Yes. This is Gary. I'll just let me take that from 2 perspectives. One, we like the response we're seeing in our business based on the book being in home. So to date, we are performing ahead of our expectations. So we like the build that we're seeing. There is obviously some social obviously some social media conversations regarding the size of the book and some environmental related comments. We kind of measure social media conversations measuring mentioning Restoration Hardware. And when we look at the numbers, there's a tiny fraction thus far. If you look at the conversations that are talking negatively about the it's less than 1 10th of a percent of the books mailed. So while we think there is 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. But so far from our point of view from a business perspective, the response has been very, very good. Great. And then I guess as far as inventory goes, can you discuss sort of going forward, should we expect inventories and investment in related to the investment in fulfillment and supply chain to continue to outstrip revenue growth for still a while going forward? So 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 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 kind of weighing the pros and cons of how much inventory we might want to continue to invest in. So 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 Niemeyer from Wells Fargo Securities. Your line is open. Thanks. Afternoon, everyone. So I just had a couple of follow-up questions on the spring source book as well. The first being, I think that the e mail 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. And then 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 this the books are still what do we get as of today? We're 40 45. 45 as of today, we're 45% in home versus I think 3 weeks of 100% in home last year. So we're not looking at an apples to apples build and you're at the very early stages of reading response. So 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. So the early reads with 45% of the books in home look to be better than our expectations. And 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. So we have better data around that. But nothing else that's really unusual. Our opt out is slightly higher than a year ago, but you'd expect that because the book is twice as big. Understood. And 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. And as we look at the Q2, you had 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 Q2 and even in the back half. So, agree it's a nice compare versus last year as we've now anniversaried all the strategic pricing from last year, but we also feel pretty good about what's happening with margins since we dropped the book. So I'd say Q2 food 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. And 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 preopening rents in the back half on the retail side. So there's little pieces moving back and forth in occupancy, but I think merchandise margin and shipping are going in the right direction. Great. Congrats and thanks so much. Thanks, Matt. Your next question comes from the line of Matthew Foster 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 sort of the newness in the book from a qualitative or even quantitative perspective if you can think about the turnover in product? And also given the number of books you have, I guess you have a lot of different context 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? Yes. Matt, we just got some very early data on I think on the new goods and 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 it 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. I mean, 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. So the hurdle rates for products to be profitable on our model are relatively low, which is kind of a new emerging model for us and gives us the opportunity to have a longer tail from a product perspective. Discontinued product. There's always going to be some discontinued discontinued product. There's always going to be some discontinued product, but we've got 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 kind of the return methodology as you think about where you're investing inventory. That's very helpful. And then 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 5 or 6 markets where you have those stores? Yes. That's continued. It's slightly different by market. Some are better than others, but they're all positive. And so we've seen on average nothing has changed across the aggregate portfolio. So the thesis and the early points we made about when we open a bigger store in the 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. Next question comes from the line of John Marin from Jefferies. Your line is open. Hi, guys. Thanks and congratulations. So that 18% comp was pretty stellar. I was just hoping maybe if you guys can talk a little bit more about what was driving that comp traffic ticket, furniture versus non furniture. And 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 size of the stores you want to go to market with and I will go from there. John, we don't really disclose traffic versus ticket and average order sizes and things. But I will just say that across the board, we were pretty pleased as you know with the direct and retail channel. And I think our comp just demonstrates that people really like our product and we do think we're taking market share. So 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 stapling out. It was growing really significant over the last 4 years and now it's not making any meaningful growth in that one specific category. So we're pretty happy with that because it does have positive impacts on the transportation side. So it's still growing but not to the same extent. Just a comment on the real estate update. I think we have great momentum buildings in the developer community. We have a lot of optionality. We just got back recently from the ICFC, the Retail Recon Conference in Las Vegas, which is the biggest retail real estate conference, I think, I believe in the world and every major developer there. And we the response to our new concepts, I believe is we're one of the most in demand concepts for developers today. And so 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. And in some cases, they're adding us on as an anchor and reconfiguring shopping center. In some cases, we're they're aggregating space for us. In some cases, where there's street developments, there's we can anchor a street or a neighborhood in a development area. So we're pretty flexible on our side, whether we go mall or non mall. And 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, I think there's quite a few people that were at the opening of our Greenwich store and got to see that got to be there for the opening event and opening party. And we're asking me, geez, this is amazing building, amazing store, this must be somebody made a comment to me, this must be costing you a lot more than your current existing store. And what's interesting there, there's another, what I 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. And we wind up with a space that has 3 times the exterior space, 4 times the selling space if you count the exterior space at basically the same rent as our 5,500 Square Foot Store in Greenwich Avenue. So 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 3 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 7 times the size in some of our next generation design galleries. We're seeing occupancy rates that are maybe 30% to 50% higher for 6 to 8 times the square footage, so 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. I mean, if you step back and say, when's the last time someone had a luxury semi big box kind of play, the last person I can think of that had a meaningful play like this was Nordstrom's and that was back in the 1980s 1990s. And so we are in many cases being seen as an anchor tenant in these deals or somewhat of an anchor tenant in So 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. So we're no longer in that situation and we've got a very different economic model because of that. Okay, great. And I was wondering if you guys would want to share or if you have shared the number of catalogs you sent out this spring? We don't see that. Okay. We believe that's just competitive information that we're not going to disclose. Got it. Okay. Thanks a lot. Thanks, John. Your next question comes from the line of Brad Thomas from KeyBanc Capital Markets. Your line is open. Thank you. And let me add my congratulations as well on a great quarter. Just a 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? And what's about the maximum that you 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 60000 square feet, we believe the right way to think about the real estate strategy is what the square footage growth that we're going to achieve each year. And I think as the last call, we've guided 30% to 40% square footage growth for 2015. And we're comfortable with that number. Okay, great. And then 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? Yes. There's really 2 things. Clearly if you have unique products, you've got more blind pricing and more pricing power in a marketplace. And 2, as our 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. So the first five, 6 years of building this was very, very difficult. And not that it's not still difficult, but when we had to conceptualize can people running a $5,000,000 business become a $50,000,000 supplier for us. The first going from $5,000,000 to $10,000,000 or $5,000,000 to $20,000,000 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. I mean, they're the only people that we found that could actually do it. But you had to partner with them, you had to invest in them in multiple different ways. Every one of our structures was different. Now, they're real businesses and it's a real platform that and a real partnership. Someone was asking me the other day, do you have contracts with all these people? And I said, no, we have relationships with all 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. And so one needs the other to really win. But there's obviously, as we work together and become more strategic and thoughtful in how we manage it, there's we expect to have more and more efficiencies, and whether it's buying power of raw materials, whether it's 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. And then the flip side of having very unique products in the marketplace and the pricing power you might get. And so 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 meaningful move in merchandise margins this year. And we probably have upside as we look forward. But every time you turn a corner, you see more opportunity. So we don't want to commit to too much, but we have good visibility this year. And 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, Keith. Your next question comes from the line of Peter Benedict from Robert W. Baird. Your line is open. Hi, guys. Thank you. Carrick, could you spend a minute maybe expand on some of the drivers of the SG and A deleverage in the second half? Kind of what in particular is driving that? Maybe I know you mentioned a couple of things, but maybe any more color. Sure. So we've talked about the first half was going to continue to benefit from the change in the source book strategy. But as we enter the second half, that's when we're going to anniversary those savings. But that's also where that significant step change we have in our business. We're going to add on top of that the anniversarying of that new investments that I mentioned before in the new pages and new assortments as well as the prospecting efforts for the 2014 mailing. So overall, we expect modest leverage in SG and A for this full year and most of our operating margin expansion is going to come from the improvements in gross margin. So look at 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. Yes. And let me just add to that. The way I think we to think about this is, we've basically doubled the page count, right? So 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. And so 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. So 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? And so 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? And so we've increased prospecting as we've had very good response rates and we want to continue to build our filings and build our direct business. And prospecting is an investment, right? So 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. So 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. So you're going to have initially that's going to take a while to have that payback. So those two things together in the second half, we position that we believe will have deleverage on advertising and anybody making a move like this would, right? But 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. And then 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? Yes. We don't disclose that kind of category information and purchase by category. But 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 for Q2 and into the back half. Yes. And I'd say generally it's by category, it's responding as we planned directionally. It's kind of 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? Yes. 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 is going to really have the biggest determination on that metric. I think I said on the last call, we've been as we designed the next generation design gallery and then 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 square feet to 100, I think we're down to 172. Yeah, 172 feet, right? And it used to be 110 feet deep and now it's 89. And so the size of the box got smaller without changing any density product density, right? I mean the first design was just the architect design is somewhat bigger and as we started merchandising it and planogramming it, we're able to make the box more efficient. Then you look at things like do you need all the ceiling heights to be 18 feet clear, do you need 18 feet clear on the 1st floor and the 2nd floor be 14 feet clear and 3rd floor be 14 foot clear? And how do you optimize all of that is dollars per square foot 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. So I'll tell you exactly what we told our Board a couple of weeks ago. We believe from our initial directionally our initial thoughts and our 5 year plan that we believe there's an opportunity to reduce the store costs by somewhere in the neighborhood of $1,000,000 to $3,000,000 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, etcetera. If you say, hey, you've got just do simple math, 50 stores and you save a $1,000,000 store, that's $50,000,000 in cash. If you save $3,000,000 a store, it's $150,000,000 in cash. If we get even smarter, you could say $4,000,000 of stores, that's $200,000,000 in cash, right? So 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, right? And so if you've got the stores operating at X dollars per square foot and they do 10% or 20% more than that, 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 to 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 capital for and that gets force rank down to the top 10 or 12 things. And they're all force rank based on two things. One is what is the financial value to the company? What is the strategic value of the company? And the capital allocation and both financial and human capital gets deployed based on what the returns are going to be both financially and strategically. So and that's how we decide to deploy capital. There's and it's funny because for a pretty big company we operate like a very little company. I mean 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 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 5 years under stewardship of private equity ownership that you develop really, really good capital discipline. And 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're 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 feed. But it's 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, 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. And we're very excited to talk to you next quarter. So we'll talk to you soon. Thank you. This concludes today's conference call. You may now disconnect.