Conference operator today. At this time, I would like to welcome everyone to the Restoration Hardware Holdings second quarter conference call. All lines have in place unmute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star followed by number one on your telephone keypad. To withdraw your question, please press the pound key. Thank you. I would now like to turn the call over to Ms. Allison Malkin, investor relations. You may begin your conference.
Thank you. Good afternoon, everyone. Thank you for joining us for Restoration Hardware Holdings second quarter fiscal 2013 financial results conference call. Joining me today are Gary Friedman, Chairman, Creator, Curator, and Co-Chief Executive Officer, Carlos Alberini, Co-Chief Executive Officer, and Karen Boone, Chief Financial Officer. Gary will begin with highlights of our second quarter performance. He and Carlos will then provide an update on the company's long-term strategic priorities. Karen will then conclude our prepared remarks with a discussion of our second quarter financial results and our outlook before opening up the call to questions.
Before I turn the call over to Gary, I would like to remind you of our standard legal disclaimer that we will make certain statements today that are forward-looking within the meaning of Federal Securities laws, including statements about the outlook for our business and other matters referenced in our financial results press release. 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 financial results press release for a more detailed description of the risk factors that may affect our results. Please also note that these forward-looking statements reflect our opinions only as of the date of this call. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events.
Also, during our call today, we 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 pages 11 and 12. A live broadcast of this call is available on the investor relations section of our website at ir.rh.com. With that, I will turn the call over to Gary.
Thank you, Karen. Good afternoon, everyone. We are pleased to report another quarter of record financial results. During the second quarter, we continued to take market share and deliver industry-leading performance, posting net revenue growth of 30%, marking our 14th consecutive quarter of double-digit increases. This is a reflection of our ability to innovate, curate, and integrate new products, businesses, and services, offering an unmatched customer experience. Our exclusive products, dominant assortments, and taste and style are resonating with consumers across all channels. Comp store sales increased 26% during the quarter on top of a 31% increase last year and 17% in the second quarter of 2011. This represents a 98% increase in comp store sales over the three-year period in the quarter, as we have dramatically improved our productivity per square foot.
Our direct business also continues to scale and accelerate, increasing 33% during the quarter, on top of 29% growth last year and 21% in the second quarter of 2011. During the quarter, we expanded our adjusted operating margin to nearly 9% from 7.5% last year and increased our adjusted net income by 62%, while at the same time continued to invest in our infrastructure and new businesses to support future growth. Adjusted earnings per share reached $0.49 for the quarter, up 48% over last year, and adjusted earnings per share for the first half of 2013 increased by 87% versus a year ago. As we enter the second half of the year, the demand for our collections remains strong.
Due to the strength of our business, the continued evolution of our Source Book model, and the enhanced ability to connect with our customers through digital and electronic media, we are moving to a once-a-year mailing of our Source Books. We believe this decision will result in a step change effect to our earnings and cash flow model, allowing us to reach double-digit operating margins and free cash flow positives significantly ahead of our prior expectations. We are eliminating the mailing of our Fall 2013 Source Books and plan to mail an annual edition each spring. Concurrently, we are increasing our earnings guidance for the remainder of 2013 to reflect our business trends and the associated cost savings. We do still plan to mail our holiday gift books in late October, and the Spring 2014 Source Books will mail the first quarter of next year.
We have proven our ability to test, scale, and roll out new categories and businesses such as Baby & Child, Small Spaces, and Outdoor. Over the years, we have developed these businesses methodically and achieved dominance in multiple categories in the marketplace. This has contributed to significant market share gains and top-line growth for our company. From our most recent introductions, RH Tableware and RH Objects of Curiosity, which launched this past spring and now have a retail presence in all of our galleries, to RH Rugs and RH Leather, both of which feature their own unique and innovative Source Books that will mail next spring, and RH Antiques & Artifacts and RH Kitchen, which are targeted to be introduced in 2014 and 2015, we have a robust product pipeline to support our long-term growth.
Later this fall, we will launch RH Contemporary Art with an innovative and immersive online experience featuring the works of over 50 international artists and an art journal with articles and features written by well-known art critics and authorities. We will also be opening our first freestanding art gallery in the Chelsea Arts District of New York City. This will be a five-floor, 20,000-square-foot exhibition space that will give our artwork a physical presence and our brand authority as a true curator of fine art. The worldwide recognition we've received from our first-ever art acquisition, the Rain Room, which was exhibited at the MoMA in New York City this summer, had the public queuing up for up to 10 hours to view this installation, earning RH Contemporary Art credibility at the highest levels of the art world.
We believe these efforts and associations also help render the RH brand more valuable and position us as a curator of taste and style. We're excited about the prospects for this new business and believe we have pent-up customer demand based on feedback from our interior designers and associates. As you know, all of the new businesses and categories we are pursuing are large, $20 billion-plus, highly fragmented markets where we have a customer base and multi-channel platform we can leverage. Over time, these can all be meaningful contributors to our growth. At our core, our defining strength is our taste in style and our ability to innovate and curate, which we believe can translate and be leveraged across many businesses and categories. We have long said we believe we can curate a world far beyond the four walls of the home.
Last month, we announced RH Atelier, a curated, artisan-crafted luxury apparel and accessories brand based in New York City that will be integrated into our next generation of design galleries. We are also exploring our foray into hospitality and are working on developing the first RH Guesthouse, a boutique hotel and private club, which will debut in New York City sometime in 2015 or 2016. Another example of how we are leveraging our core strength of innovation is how we think about connecting with our customers and creating awareness for our brand in this revolutionary new world of the internet and new media. Old methodologies of marketing and advertising are quickly becoming obsolete. We have been focusing on developing a new model based on advocacy versus advertising. It's about connecting with our customers on a deeper level based on our beliefs.
As opposed to telling customers what we are selling, it's about connecting with customers about why we're doing the things we do, which emanates from what we believe in and what we love. It's about truth versus marketing. Hence, we eliminated our marketing department and now have a truth group focused on doing things that reflect the values and virtues of our brand. We are shifting spending away from traditional advertising into new ways of building awareness and advocacy. One of the examples of this is the creation of RH Music, a new music platform for emerging artists from around the world. We are curating authentic artists that we love, giving them an opportunity to create music that they love. This will be instrumental in their own journey and that of the platform itself.
Much like the philosophy that our great country was built on, for the people by the people, RH Music will be built for the artists by the artists. We are hosting a private concert with three of our founding artists, Larkin Poe, swampadelic soul sisters from the hills of Georgia, The Brixtons, a Brooklyn pop duo, and British singer-songwriter Edie, this Thursday night at the Highline Ballroom in New York City. Our official launch concert is next week, September 20th, at the Greek Theatre in Berkeley, one of my favorite music venues in the world, where I saw Adele play two years ago. Tickets for this event are on sale at our RH Music website, rhmusic.com, online at Ticketmaster, and in our galleries throughout the San Francisco Bay Area. The concert will also be streamed live worldwide through our website at rh.com and rhmusic.com.
We believe the connection we can make with our customers through this form of advocacy versus traditional advertising will create greater awareness of those things we believe in and render our brand more authentic and valuable. We hope you can join us in person at one of our concerts to experience the taste and style we are curating and witness the energy and inspiration that is being brought to life by the RH brand. With that, let me now turn the call over to Carlos to provide you with an update on our next-generation design galleries and other long-term strategic priorities. Carlos?
Thank you, Gary, and good afternoon, everyone. Regarding our long-term opportunities, we remain focused on two key strategic priorities that we believe will create significant value in the future for our company. Our top priority remains the transformation of our current real estate platform into a portfolio of full-line design galleries. This represents the most significant opportunity for revenue and earnings growth as we unlock the true value of our dominant product assortment and new businesses. The other high priority for us is to continue to build a world-class infrastructure that will provide operating leverage and support our long-term growth. Let me first update you on our real estate transformation initiative. To date, we have opened five full-line design galleries in Los Angeles, Houston, Scottsdale, Boston, and Indianapolis.
We are extremely pleased with our results, as every one of these locations continue to outperform our expectations consistently, which provides further validation of our strategy. Our Los Angeles and Houston stores are in our comp base and comped in excess of 28% during the second quarter, outpacing the rest of the fleet. These two stores are highly productive, trending to deliver over $2,300 per selling square foot in 2013. Our Scottsdale full-line design gallery is expected to deliver annual sales per selling square foot of over $1,200 and also are ahead of expectations. Our most recent full-line design galleries in Boston and Indianapolis are expected to deliver nearly $1,000 in annual sales per selling square foot. In addition, all of these markets have experienced a lift in direct demand anywhere in the range of 30%-120% since opening.
Regarding future openings, we are on track to open a 25,000-square-foot full-line design gallery at the old historic post office in Greenwich, Connecticut, this will happen in early 2014. We also plan to open a new location in Los Angeles in an amazing corner on Melrose Avenue late in 2014. The new location will have 30,000 square feet, plus an outdoor courtyard and a rooftop park. In addition, we plan to expand our gallery in the Flatiron District in New York City, our strongest market and the top producer, and add approximately 17,000 square feet as we open two more floors in our existing building. This will also happen in 2014. We plan to open our next generation full-line design galleries in Atlanta and Chicago.
Atlanta will have 65,000 square feet and will open in late 2014. Chicago will have 55,000 square feet and will open in early 2015. These larger locations will accommodate the continued expansion of our core assortment, our Small Spaces collection, Baby & Child, as well as all the future new businesses that we are planning. Our negotiations for new locations are progressing very well. We are currently in discussions for over 30 locations, including several anchor tenant type leases. Have LOIs in place for multiple sites. We now see opportunities to be in well over 50 markets in the U.S. and Canada. The new anchor tenant deals we are being offered will provide opportunities for higher sales, increased earnings, lower capital investment, and higher ROIC than our initial target store economics.
We expect that our next generation full-line design gallery, with an average of 45,000 selling square feet, will generate total sales volume of nearly $30 million per location, which is 60% higher than our prior store economic targets. These stores are expected to generate 65% higher cash contribution dollars than our previous target store economics. With landlords contributing more capital to this project, our net capital investment is expected to be $200 per foot, down 20% from our prior targets. As a result, we now expect a payback period of 16-18 months versus our previous 20 months target. In addition, based on our experience to date, if we were to include the impact of the direct sales lift that we experience when our full-line design gallery is open in new markets, the payback period would accelerate further to about 12-14 months.
Our second strategic priority is to build a world-class infrastructure that will provide operating leverage and support our growth. During the second quarter, we opened our third furniture DC near Dallas, Texas. This building also houses a customer call center. This facility adds over 850,000 square feet of capacity to our network. During the period, we also completed the 420,000 square foot expansion of our Ohio shelf stock facility, bringing it to approximately 1.2 million square feet. We now operate six facilities in the U.S. with nearly five million total square feet to support our multi-channel go-to-market approach. During the quarter, we continued to make strides with our in-source furniture delivery initiative and remain on track to have hubs in seven of our top markets by the end of the year, which will represent nearly 50% of our furniture deliveries.
We have experienced significant benefits from our in-source activities to date. We believe our brand stands alone in the luxury home furnishings market. We will continue to expand our offer, disrupt the market, and take share. We are developing a real estate platform that will unlock the true value of our assortment, and we have built a fully integrated supply chain and infrastructure that is designed to support our growth and maximize profitability. We have an amazing team of highly passionate leaders, completely focused and committed to the continued execution of these strategic priorities. We strongly believe this will result in significant shareholder value creation and strong cash flow generation over time. With that, I would like to now turn it over to Karen to review our financial results and outlook. Karen?
Thanks, Carlos. Good afternoon, everyone. I will first review the second quarter performance and then spend a few minutes discussing our outlook for the rest of the year. We are very pleased with our financial performance during the second quarter. Total revenue for the quarter increased 30% to $382.1 million. Our comparable store sales increased 26% during the period, on top of 31% comp growth last year. We continue to post industry-leading top line and comp growth even while contracting our store base. We ended the quarter with 70 galleries open versus 73 last year. Our direct sales increased 33% to $177.8 million, on top of the 29% increase for the same period last year. Gross profit in the second quarter increased by 22% and reached $139.2 million. Gross margin decreased to 36.4% from 39% last year.
The biggest driver of this change relates to strategic pricing on new products, primarily related to new furniture introductions last fall. As discussed last quarter, we did shift the timing of one of our big spring promotions to coincide with the timing of the Spring Source Book in-home dates. Our spring savings event fell in Q2 this year versus Q1 last year. Our furniture sales and penetration also increased in the second quarter relative to both last year and the first quarter, which resulted in lower product and shipping margins during the period. Offsetting these trends, we leveraged our occupancy costs while continuing to invest in our DC infrastructure. Our total adjusted SG&A expenses increased 14% to $105 million in the second quarter versus $92.2 million in the prior year.
As a percentage of net revenues, adjusted SG&A expenses decreased by 400 basis points, driven by advertising savings and increased leverage of other G&A expenses. The lower advertising expense in the quarter was due to a decrease in the circulation of our Spring 2013 Source Books, as well as a shift in the timing of the book drop and in-home dates relative to last year. In addition, the net benefit of the change in our Source Book strategy on the second quarter was approximately $0.04 of adjusted diluted EPS. Regarding other G&A expenses, we also experienced significant leverage on our fixed payroll, professional fees, and other corporate expenses. As a reminder, our adjusted SG&A in the second quarter excludes variable and certain one-time non-cash stock-based compensation expenses, as well as legal and professional fees incurred in connection with our recent follow-on offerings.
Recurring stock-based compensation is included in both adjusted and GAAP net income and EPS. Adjusted net income for the second quarter increased 62% to $19.8 million, up from $12.2 million in the prior year. Adjusted net income is calculated based on a normalized 40% effective income tax rate. Adjusted diluted EPS increased 48% to $0.49 during the quarter, based on 40.7 million diluted shares outstanding. Turning to the balance sheet, inventory levels at the end of the second quarter were $406.6 million, up 48% from last year. We are very pleased with our vendors' ability to continue to meet our growing demand. We expect to end the year with inventory growth in line with our expected sales growth. Our capital expenditures were $20.9 million in the second quarter, and we continue to expect capital expenditures in the range of $95 million-$100 million for the full fiscal year.
As we've stated previously, we anticipate investing more than half of our 2013 capital expenditures on real estate, including the build-out of several full-line design galleries scheduled to open in 2014. This also includes our immediate plans to convert available backroom storage space into productive selling square footage in several locations. The remainder of our capital spend will fund supply chain and other infrastructure investments to support our growth. Turning to our outlook, let me start with our updated fiscal 2013 full-year guidance. We are raising our adjusted diluted EPS guidance to a range of $1.65-$1.70 from our previous guidance of $1.41-$1.47. This is based on adjusted net income in the range of $67.6 million-$69.5 million and 40.9 million diluted shares outstanding. We now expect revenue growth in the range of 31%-32% from our prior expectation of 23%-27%.
Our updated revenue outlook for the year represents growth in the range of 33%-35% on a 52-week comparable basis. In the third quarter, we expect to grow revenues between 35% and 39%, to $385 million-$395 million. Based on current trends to date, we expect our gross margins to be below last year's third quarter, but expect the decline to be significantly milder than what we experienced in the second quarter relative to the prior year. Our adjusted net income for the third quarter is expected to be in the range of $11.2 million-$12 million and assumes an adjusted normalized 40% tax rate. We are providing third quarter diluted adjusted EPS guidance in the range of $0.27-$0.29, which assumes 41.7 million diluted shares.
To give you additional context as far as landscape in the remainder of the year, we are also providing fourth quarter guidance today. For the fourth quarter, we expect to grow revenues between 23% and 26%, to $490 million-$500 million. Also, our fourth quarter fiscal 2012 had an additional week. Total revenue is expected to grow 31%-34% during the fourth quarter on a comparable basis. Gross margins in the fourth quarter are expected to be relatively in line with last year's Q4 margin performance. Our adjusted net income for the fourth quarter is expected to be in the range of $34.3 million-$35.5 million, with diluted adjusted EPS guidance in the range of $0.81-$0.84, which assumes 42.2 million diluted shares. As a reminder, last year's 53rd week contributed an additional $0.04 of adjusted diluted EPS to the fourth quarter of 2012.
In closing, we are extremely pleased with our second quarter performance. We delivered industry-leading revenue, comp, and earnings growth. Our business remains strong, and we are very optimistic about the remainder of the year. Our current trends and performance gives us further confidence in our ability to deliver on our recently revised long-term financial goals of revenue growth in the low 20s%, adjusted EBITDA growth in the high 20s%, and adjusted earnings growth in the mid to high 20s%. With that, I would now like to open up the line for any questions. Thank you.
At this time, I would like to remind everyone, in order to ask a question, simply press star followed by number one on your telephone keypad. Your first question comes from the line of Lorraine Hutchinson from Bank of America. Your line is open.
I just wanted to follow up on the elimination of the fall Source Book with a couple of questions. First, have you been able to test this and perhaps quantify any pressure that we might see on second half sales from eliminating the catalog?
Hi, Lorraine. This is Gary. Yes, we've been testing. We moved to the Source Book strategy in 2011, as you know, and we went from mailing 10 mailings per year to two mailings per year. We have tested the tails, actually customer segments and measuring the tails on books every drop since 2011. We've seen minimal sales erosion from not remailing a book to a customer. As we've mailed this now for going into the third year of testing these customer segments, we feel very confident that as we've migrated this assortment to a kind of furniture-based lighting and rug business, which are very much considered purchases and event-driven purchases, that the remailing of books gives us a very little impact.
Okay. Has the spring Source Book been completely expensed at this point, so you'll have no marketing costs in the back half from Source Books?
No, this is Karen. We mentioned that there was a $0.04 impact. That results from, we've revised our timing of the expected benefit of those books through the period that we'll mail the next book. In order to better match revenues with expenses, it would be a little strange to not have any advertising costs in the back half. A lot of those costs that were going to be in Q3 will be in Q3 and Q4, for example.
Okay. Is that what we should expect on a normalized basis for next year as well, that run rate?
Well, actually, in Q3 and Q4, and really this year, we won't really even, I guess, benefit from the full impact of the strategy and the step change that we've kind of mentioned. Because this year, we will incur certain one-time costs because we made the change and weren't planning to do it from the very beginning of this year. We'll have certain storage costs. We'd reserved certain printing time. There's certain one-time costs that we will incur in Q3 and Q4, but on an annualized basis, they'll be even more impactful, say, in 2014, once we have one Source Book for the full year.
Okay. Just one follow-up on gross margin. You talked about some strategic pricing and products. Can you give us a little bit more detail on if that's an ongoing strategy and how we should think about gross margins going forward?
Yes, Lorraine, this is Carlos Alberini. Hi. I think that we mentioned during the last call that we have followed with a strategic pricing, this started to happen towards the end of last year. We had anticipated that it would take us a couple of quarters to cycle through those pricing strategies. That is why, if you heard what Karen mentioned about guidance, we are expecting that our margins are recovering in the third quarter. We're still anticipating that we'll be marginally down from last year. In the fourth quarter, we expect those margins to be pretty much in line with last year's margins.
The biggest driver of the margin decline in both the first quarter and the second quarter were the product cost issues that are related to both that topic of strategic pricing shipping also impacted the margins because of the mix that we are experiencing with more furniture business. The great thing is that if you looked at the quarter-to-date performance and margins, we are seeing that it is marginally down. I'm talking about product margins. We're already seeing this, now we're talking about a month plus a couple of weeks of the quarter. It's very clear that the margins are recovering pretty strongly.
Great. Thank you.
Thank you.
Your next question comes from the line of Matthew Fassler from Goldman Sachs. Your line is open.
Thank you so much, and good afternoon, everybody.
Hi.
Good afternoon.
I'd like to follow up on Lorraine's question on the impact of the changing and mailing strategy. Karen, I know you've already said a lot, if I missed the answer to this question, I apologize. You quantified the impact of the change in the mailing strategy in the third quarter, I believe, at the second quarter, I'm sorry, at $0.04. Can you talk about how much you're kind of saving net-net for making this decision in the second half? I guess we need to look not only at the expenses that you are saving, but presumably that's offset by some gross profit that you might have captured from additional mailing. If you think about the aggregate impact of this decision on earnings for the second half of the year, would you say it's up, down, or neutral?
The first thing I would say is that the savings are implied in the revised guidance. You can see that we've not only But that also has a lot of other things. You'll see that we took revenue up for the year, but the flow through on that is much better because of this change in the advertising strategy. We're not providing specific guidance on the exact cost savings by quarter for Q3 and Q4. It's very easy to calculate what that was in Q2 because the fall books hadn't dropped yet. There's two things going on. There's the additional cost moving into those quarters from the spring books, but there's the elimination of a full production and mailing cycle with the fall book. Then the cost of some of the We're still mailing the holiday book and the RH Baby & Child holiday book.
There's still advertising costs. Again, it's going to take us probably this cycle to kind of read and see the full benefit. As Lorraine was kind of alluding to, understand the band impact and the sales impact. But we feel comfortable with the guidance we've set forth and those trends and our expectations for the cost savings and the sales impact are included therein.
Understood. A second financial question, if I could very briefly. To the extent that gross margin trends have improved meaningfully, is that a function of cycling some of the pricing actions that you talked about last fall, or are some of the mix and shipping dynamics that you're seeing today year-on-year different from what you had seen for the past several quarters?
Matt, it's primarily the first point, but also inclusive of the second point. Both are meaningful. One of the ways to think about this, as Carlos said, between Q1 and Q2, because there's shipping timing differences based on receipts and furniture shipments between quarter and quarter, the best way to look at the first half is to look at it in an aggregate sense, where gross margins are down about 180 basis points over the six-month period. The end of Q2, the end of the first half, cycles the strategic pricing impact. Because of that, it will also impact the mix. Right? We'll have two favorable benefits that start to happen in Q3 and will be even more meaningful in Q4.
We see minimal margin erosion in Q3 from last year, and minimal meaning under 100 basis points, and somewhere in the range of 50-100 basis points. Then we believe we can get to flat margin versus a year ago in Q4.
Got it. Then finally, you talked a lot this afternoon, Gary, about a number of additions to the lineup, if you will, and really taking the RH brand and taste level, if you will, and imprinting it in a number of new verticals, some of which are music and art and such, which are a little less tangible. Obviously, art, you talked about before music, I think is relatively new hospitality as well. If you could sort of talk about the commercialization or monetization of these over time, you're clearly expanding the brand to many different touch points and many different experiences for consumers. Clearly, there's a kind of commercial vision here, I'm sure. Can you talk about how you see that playing out and how you see them being unified over time?
Sure, Matt. Well, a lot of it comes down to that each one has a different role in the overall vision of how we connect with our customers. If you think about art, it's a very large and fragmented market. There's no real national presence. There's no one in the art business that has leverage. We believe our taste and style can be leveraged in that category. It does a couple of things. One, it's a big, meaningful business, $20 billion+ marketplace. We've got a customer base that we know for sure is putting a certain percentage of their budget towards art. There's more square footage on the walls of Americans' homes than there is on the floors of Americans' homes. We think it's a big business opportunity.
Being in contemporary art and fine art, we believe renders our brand more valuable and lifts the perception of the brand in the marketplace and gives us an opportunity to connect with customers, especially in the luxury market, in a different way. As you think about something like the Rain Room exhibition at the MoMA and what that's done for our brand and the perception of our brand, we think that's pretty impactful. We believe that's a lot more valuable than ads in magazines where you have deteriorating impact. Also, as we look at things and we see a dramatically different marketplace and power in the marketplace shifting to the consumer through the internet.
If you think about media 10 years ago, and you think about media today, and you think about the amount of blogs and the amount of power and what's happening through social media and other connections, and the ability for people to connect and really talk about what they believe in and the brands they believe in, we believe traditional advertising sources are becoming less and less relevant. As we look at trying to measure our returns in advertising investments, we believe there's different ways to connect with customers. There's different ways to bring awareness to the brand. As you know, we've had pretty significant events opening these new galleries in our major markets. When we open these new stores, we usually have a music event associated with the store. We have significant turnout.
We've got significant press through traditional press, but significant press through online blogs and social media. As you know, we're not necessarily proud of it, but we had a party in Boston that got shut down by the police and probably got more publicity than anything we've ever done. Not that we have a goal of having parties that get shut down. The power is in the hands of the consumer today. The ability for consumers to talk about brands that they believe in, the ability for brands to be authentic and do things they believe in, we believe connects with the customer in new and different ways. When you think about something like music, one, we believe there's an ability to create a music platform that's highly viable and commercial.
More importantly is to think about allocating advertising dollars in a way that connects with customers in a more intimate and a more authentic way. We believe our brand is governed by taste and style, our ability to curate and innovate, and the ability to curate music and musicians that we love, be advocates for those people, expose them to the world, brings awareness to our brand, and we think makes a meaningful connection to the customer. We think there's a long-term business strategy here, but initially, it's just a shift of advertising dollars.
Thank you.
Your next question comes from the line of Neely Tuminga from Piper Jaffray. Your line is open.
Great. Good afternoon. Gentlemen, could you help me understand a little bit more specifically what's going on with your customer file? I think, as we guide investors along the way on your story, there's always this big question about what the ramp is on customers and how big the herd is of going through the RH bottleneck as people really vest in themselves for your brand and your lifestyle and what you guys represent. Could you give us any sort of metrics around your new-to-file metrics or how early you think your existing customers are in their file in terms of how early they are in their spend in terms of their lifetime spend with you? Would you be willing to share any of those metrics or a conceptual mention?
Neely, we don't really disclose that data. If you think about the broader home market and what drives purchases, right? You really have an event buyer where buying is tied to the major events of purchasing a new home, remodeling a home or redecorating a home. That's on the customer's timeline, not necessarily our timeline. We believe the current trends in the industry, we've just lived through the worst recession that we've all seen. Through that, by the way, we've had average order growth, and we've had buyer file growth. Both those things happen at the same time, since it's a big movement towards your brand, big movement towards your product offer.
We expect as the housing market comes off its lows and as it has, that we'll see acceleration in the future. We're really well-positioned. We would expect both those metrics to increase over time. The biggest impact, though, is really, as Carlos mentioned, unlocking the value of the company by getting the new real estate into the market, right? By opening the new stores, we get the assortment into the marketplace. You have two phenomenons happening. You have dramatically higher sales in these new galleries with the customer experience and presentation we're putting in place. You get the echo effect of a much higher performance in the direct business in the market. We take market share massively within a marketplace when we open these new galleries. That's one of the key things to focus on.
The other point is the majority of our customer acquisition, new customer acquisition, happens in these galleries.
That's really helpful.
In all our galleries. Huh?
That's really helpful, Gary. Just one little follow-up to Matt's question about monetizing these new verticals that you're going into. Personally, I wish I could go to this concert at The Greek at this point. Looking at the lineup, it looks great. Just wondering, when will we maybe see the content kind of repurposed back onto the home page? Will we ever see that sort of gathering of all the different verticals into a single RH view from a digital perspective? Is that on the horizon?
Yeah, we're working on that. We're working on creating not just a website, but what we call the RH Portal, which will integrate all aspects of our brand. As you see, the innovative and immersive kind of digital experience we're doing with art, we think it's world-class, and it's going to revolutionize art purchasing online. Music and other things will also be integrated into this, and you'll have a more full and robust RH experience. As we think about all of these investments and all of these businesses, they all have very quick returns on investments. The one with the longest tick would be music, again, we're looking at initially as just a shift of advertising dollars.
When you think about, again, creating experience, getting customers to connect with the brand, if you think about the email that maybe most of you received, it's about RH Music and the event at The High Line, if you're on the East Coast or anybody on the West Coast where we just went into marketing the event at the Greek Theatre. Just the marketing of this event, just the awareness around, "Oh, my gosh, RH is having a concert at the Greek Theatre. They have these musicians. Oh, I can go to the website. I can click on the website and listen to some of the music." There'll be videos of the artists up on the website. The Greek Theatre is a 7,000-person venue, and we expect to sell it out. You can buy the tickets in our stores.
If you think about the excitement that our associates have inside our stores, telling the customers about our concert, and connecting with the customers about what's happening with our brand and what we're doing. It's just a different way of talking about the things you believe in and the things you love and connecting with people in a deeper, more meaningful way about many things, as opposed to traditional advertising of putting a print ad out there, that we believe doesn't create the echo effect of doing some of these other things.
Thank you so much. Last question from the second half.
Your next question comes from the line of Matt Nemer from Wells Fargo Securities. Your line is open.
Good afternoon, everyone. Just a couple of questions. First, on the comps, I'm wondering if you could provide a little context on just the change in the cadence of growth over the last few quarters. You did a 26, then a 41, back to a 26, all extremely impressive, but just a little color on what's driving the changes in trend.
Yeah, Matt, this is Karen. One of the things that we tried to articulate on the first quarter call is that our strong inventory position in Q1 did allow us to benefit from shipping some of that product earlier. As Gary mentioned, when you really look at the half, especially with the 53rd week and some of the timing of both the book and then the promotion falling in Q1 versus Q2 and such, it's really more meaningful to look at the half versus looking at Q1 and Q2. That's the number 1 thing I would say. Again, from a comp perspective, we truly are channel agnostic when it comes to so much of our product getting fulfilled through the distribution centers that for us, we love it when we have a strong comp, but we love it when we have strong direct growth as well.
if you look at it on the half, it's more balanced.
Matt, this is Carlos. I would like to add a couple of things to Karen's comments. If you look at what drove the comps, the levers that drove the comps during the second quarter, we have identified that the productivity of our interior design new team is significantly higher, that represents about a third of the comp increase that we saw, which of course drove significant value as a result of that because the expenses that we incurred to drive that type of growth drive a lot of productivity and therefore profitability. The other big thing is what we expect for third quarter. I'm sure that this didn't escape you, that we are guiding revenues growing in the 35%-39% year-over-year, that is a pretty significant revenue growth.
The same phenomenon that you saw in the first quarter that we are guiding you to look at it as a first half, is, in a way, happening in the third quarter again. Meaning that we're going to be shipping a lot of product in the third quarter that is going to drive a lot of that growth in revenues. I think the same comments that applied to the first half, you could say this is a business where revenues are driven by shipments, you cannot always anticipate exactly when that demand is going to be paired with the shipment of product.
Okay. That's helpful. Just a quick follow-up to that, which is the interior design team. When do we anniversary the changes? I mean, is that primarily something that's just happened recently?
Well, we started building that team about a year and a half ago, and we have said that by the end of the year, we expected to have interior design services across the chain. That is still our plan. The great thing about this is that this is not a one-time thing. What we are experiencing is that interior designers are cultivating significant relationships with the customer, and that is driving more volume as we continue to evolve in that relationship. It's not, okay, now I have a group that is producing pretty significant numbers, and then we are up against those numbers. It's more about how much more this group can develop as they interact with customers on an ongoing basis. They have enriched that relationship and also brought new ideas for customers to think about expanding their home furnishings with our lifestyle.
We think that this is going to continue to accelerate.
Okay, just lastly, given the change in the Source Book strategy, is there any need for a step function change in your investment on the digital side, whether it be a new platform or a lot of additional hires on the digital side of the business? Anything we should be aware of coming there?
Yeah. Actually, Gary just referred to our investments and for our Contemporary Art platform, and we have invested this year, and actually, we have also invested in our infrastructure for the entire web operation, and we will continue to do so. We believe strongly in having a worldwide infrastructure here, and that impacts every area of the operation. Of course, this is a big one. As you know, our direct business is a pretty significant part of our business, and we'll continue to support that to always be ahead.
Yeah, Matt, I would say, though, there is no planned step change in investment on the director web side. We don't foresee any shift of the spending per se based on the elimination of the Source Book to the digital side of the business. We believe this is really purely cost savings as we focus on finding what is the optimal model for this company and for this business. If anything, I'd say just as we went from 10 mailings a year to two mailings a year, and we saw significant savings and optimization of the model. By going from two mailings a year to one mailing a year, we're going to see another step change in optimization of the model. It's really learning here what is the right model and how to allocate our investments to drive the highest return on investment.
Okay, great. Thanks. Congrats.
Thank you.
Thank you.
Your next question comes from the line of John Merin from Jefferies. Your line is open.
Great. Thanks, guys. Congrats on a great quarter. Just for clarification, next year's opening in L.A., is that a new unit or a relocation?
Yeah, it is a new unit and a relocation of our Beverly Boulevard location today. As you know, at the time, this was a location that we opened. It was available, and we are very pleased that we took that because this lease is under market in a pretty significant way. We negotiated for this new location. It's going to be on Melrose Avenue. It's a fantastic corner, and also it will give us the opportunity to open a much larger house for our assortment. We're going to have over 30,000 sq ft plus a rooftop park, courtyard. It's just going to be phenomenal.
Yeah. It's a change from about 15,000 sq ft of interior selling space at our current location at Beverly Boulevard, and we'll be moving to 30,000 sq ft of interior space at our new location. It's a significant expansion of the assortment. Again, that first store on Beverly Boulevard was our very first one, and we're still kind of moving up and stepping up and trying to understand what is the right size.
Right.
For a large market.
The New York store that you said is expanding two floors. Was that to 17,000 or from 17,000?
No. We will add 17,000 square feet.
Oh, okay.
You may recall, if you were in our last call, we did mention that we were with plans to remodel and expand one of our locations. At the time, we didn't want to disclose the location. Now we are.
Okay, great. That's great. I was hoping we could focus a little bit on Indianapolis just for a moment. Last quarter, I think you said that sales in that market were up 2x. I think, Carlos, you mentioned something about 30%-120% in the new stores that you've opened, maybe Indianapolis, you could sort of place where Indianapolis is in that range now, and maybe add some color about anything that market or that store is teaching you about your entry with full-line design galleries in smaller markets.
Yeah. Actually, I have to say we are very impressed with the performance. It's interesting that you asked about that one. Indianapolis is up over 150% of life today, in terms of revenue and demand growth. We think that this is saying a lot about what those middle markets can offer in terms of opportunity for the brand. In addition to that, I mentioned that our direct business for all the five full-line design galleries were in a range of 30%-120%. Indianapolis happens to be the one that is over 120%. That's why, just thinking about the type of productivity that we can get in a market like this, when you think the type of real estate deal that we're accounting for a secondary market like that, you can imagine the type of returns and profitability that we can achieve.
We are very pleased with this. We have said that now we believe that the North American market offers an opportunity to open more than 50 full-line design galleries. We think that we could be well north of that number based on this type of experience.
Great. Thanks, guys.
Thank you.
Your next question comes from the line of Daniel Hofkin from William Blair & Company. Your line is open.
Good afternoon. Very nice quarter.
Thank you, Dan.
Thanks, Dan.
Just circling back on a couple topics as it relates to the change in the Source Book strategy. I know this was asked about in a previous question. As I recall, maybe in years past, there were times when changes in timing or number of mailings may have had a greater than expected impact on the business. It sounds like now you're able to sort of fine-tune that better. I guess, is that just a matter of sort of a more scientific approach to the house file, or what's driving that more targeted approach?
It's a very scientific approach to the mailing. When we moved from 10 mailings to 2, that was a very scientific approach, and a very lucrative approach in improving our return on investment from an advertising point of view. Just as we said earlier, we've been measuring this every quarter since 2011. We've held out customer segments that we haven't re-mailed in fall of 2011, spring of 2012, fall of 2012. Based on those tails or those customers and those customer segments that were not re-mailed a book, there's a minimal impact and doesn't warrant the cost of re-mailing the books. Again, you've got a very long buying cycle here. You've got an event buyer here. This is no longer a catalog business. You can't really compare us to Pottery Barn or Crate & Barrel or any of these other businesses anymore.
They've got a huge seasonal assortment. They've got a huge kind of accessories business and other businesses that are impulse businesses that rely on mall foot traffic, that rely on multiple catalog mailings. We don't have a business like that, nor should our model look like that. I think, the challenge that people have is with a lot of things we've done in the last four years, honestly, is trying to say, "Well, wait a minute, nobody else does that." From in 2008 when everybody went after value and lowered quality and took prices down, we went the other way and raised quality and took the prices up, nobody understood it.
From going to 10 mailings to 2 mailings, everybody's like, "Well, geez, that doesn't make sense." From going from small stores to big stores, the industry is saying, "Well, geez, that's not what everybody else is doing." What we're doing is trying to do what's right and what maximizes productivity, profitability, and return on invested capital in our business. We think this is a step change to the positive in the right direction, is going to move us much more quickly to double-digit operating margins and much more quickly to free cash flow positive.
Yeah, I think I would like to add. Really, a couple of years ago when we tested the Source Book strategy for the first time, at that point, we didn't know exactly what to expect. We had a very strong theory about the fact that our customer was becoming very much an event-driven customer, and therefore, we knew that and we believed that made a lot of sense. Today, I really see almost no risk in what we're doing because we have the proof. We have been seeing the behavior of this file now for over a year and a half, and it's very clear, especially because we have tested not mailing customers that had been part of the prior mailings, and we continue to see acceleration in their purchasing behavior.
We know that after seeing that for six months, we didn't re-mail a customer and that customer continues to interact with the brand. Now we're talking about, in some cases, over a year, and we continue to see that acceleration. We believe that in the numbers that we are providing today and the guidance that we are giving, there may be a nice size of conservatism because the one question mark here is what type of revenues if any, we are forfeiting. We have assumed a pretty conservative size of revenues based on our current trends.
We feel that we are navigating through pretty solid grounds here, and I think that we're going to be looking back and saying, "Wow, how is that we have been able to move this operating model in such a rapid pace and with the type of cost structure savings that we will experience.
Thanks. That's very helpful. I guess one maybe just brief follow-up on the gross margin and then on the guidance. In the second quarter versus how you expected things to play out, was any aspect of the promotional pricing incremental relative to what you expected going into the quarter? Then as it relates to the second half, I heard your answer earlier. Would it be fair for us to conclude that the stronger sales guidance and the profit flow-through just from that alone is a bigger factor than the Source Book strategy adjustment?
No. Actually, the expectations for margins when we were sitting here three months ago talking about the first quarter performance, we had pretty much the kind of expectations that became real about gross margins. We tried to give direction to you guys. Overall, this performance was ahead of our expectations based on some other levers, including a little bit of revenue growth over and above the guidance that we provided.
Okay. Yeah, no, that was just my question because it seemed like if there was, it seemed like it flowed through to some incremental top line.
Exactly.
As it relates to the second half.
Yeah. As it relates to the second half, we are providing the most accurate guidance that we can provide. Again, keep in mind that we're always going to be conservative. We are trying to help you look at how we see the landscaping taking place in the second half in both third and fourth quarters, and trying to be as transparent as we can. That's why we decided to provide fourth quarter guidance so you can see where every piece is going to fall or how we anticipate it's going to fall.
Okay. All right. Thank you very much. Best of luck.
Thanks, Dan.
Thanks, Dan.
Your next question comes from the line of Peter Benedict from Robert W. Baird. Your line is open.
Hey, guys. Thanks. Most of my question's been asked, but just I guess, Gary, you've talked about achieving the double-digit operating margins sooner than previously planned. Do you want to go further and say how long you think it's going to take you to get there?
not at this time. We're not disclosing that, but I think we've largely given you guys long-term guidance and goals about growth and where we thought we could be.
We would say that this change and this step change not only will move us to double-digit operating margins sooner, it gives us line of sight to higher long-term operating margins than we previously expected.
Okay, fair enough. Karen, just on D&A, can you help us with that? Your outlook has been growing about 2%-3% over the first half of the year. Does that start to step up materially in the back half? It's coming in a little light of where we've been modeling it, but just what can you tell us about the outlook for D&A? Thank you.
CapEx, if you saw our I'll just start with CapEx because that's what eventually drives it. The number one thing I'll point out, you'll see this when the Q comes out, is even though the year-to-date, six-month CapEx number is only about $30 million, there was $13 million or so of accrued capital expenditures. They've basically already been incurred, but they just hadn't been paid for yet. That number, we'll provide that disclosure in the 10-Q so you can see where we truly are for the half. We're not giving specific guidance for depreciation. The one thing I'd say is that capital that's being deployed, much of it is for full-line design galleries that aren't going to open until 2014. Where you might be off if we're coming below where you're thinking is because those assets haven't been placed into service yet.
With the D.C. opening in Dallas and the Ohio shelf-stock facility opening, those are both Q2 things, so those were placed into service in Q2. Then again, some of the retail stores, that's when the big dollars will be placed into service and that depreciation will kick in. Hopefully that gives you a little bit of color, but again, we're not giving specific guidance on depreciation.
Okay.
We only have time for one more question.
Your last question comes from the line of David Strasser from Janney Capital Markets. Your line is open.
Thank you very much. Appreciate it. One bigger, longer picture, longer-term question. You talked about some of the sales per square foot, the 2,300 from some of the newer galleries, 1,000 or so, give or take, around in Indianapolis, a smaller market, in Boston. When you look at your longer-term guidance, the numbers are well below that. I think you used 650 in sort of the most recent guidance that you put out. I'm just trying to get a sense, is that conservatism? Is there a reason? I know the galleries get bigger, but is there a reason that the numbers would come down that much as you look out over a multi-year basis?
Again, we'll try to always be conservative. Yes, $650 is more representative of the total volume that we have allocated to the larger box. Frankly, we don't have any experience yet. Yes, we believe based on the early results that we have achieved, that number may prove to be very conservative. We'll take one step at a time here. The great thing about this is that with $650, the model delivers amazing returns at a very fast payback. By the way, that payback is further enhanced with the impact of the direct business and the lift that we are seeing there. We will continue to monitor this, and if we see that there is an opportunity to take that number up, of course we will.
Just one follow-up on that. When you talked in the press release about, and I think on the call as well, about potentially 10 or more galleries coming if you go out two years. As you think about your infrastructure, how many do you think you can open from an infrastructure standpoint, putting aside sort of the timing around real estate and zoning and all of that type of stuff? What would you think-
Yeah
the infrastructure would have?
I think this question was asked during the last call, the way we look at this is if we start with, okay, how big is the opportunity and what is the right thing for the company to do, how fast do we want to move? Once we achieve that answer, then we build whatever we need to build to achieve those goals. Based on what we're seeing, everything that we can do to really move really fast here is the best thing for the company and the shareholders. We are mobilizing our team to build whatever capabilities we need to build, and we have made great progress on that to really be prepared to open those 10-plus locations a year starting in 2015.
Thank you very much.
Thank you.
There are no further questions at this time. I turn the call back over to Mr. Friedman.
Great. Thank you so much, everybody, for being on the call with us today. We look forward to talking with you next quarter. Thank you.