Welcome everyone to our Investor Day here in Palm Beach. We are so grateful that you took time out of your busy calendars. We know it's a busy week for all of you, but hopefully we're going to have some things to say that will keep your attention and keep you excited. That was a video that you just watched, which was each year we bring our leadership team together, about 800, 900 people from across the country, and spend a couple of days and connect people to our vision and values and try to ignite the human spirit in the organization. That was our opening video, and we thought we'd share it with you today. We're going to take you through an agenda in a second here, but first I thought I'd introduce the team.
This is Team RH to my left. This is the key leaders of the organization. Some you know, some are more recent to the team, but I'd like to introduce Karen Boone, our Co-President, Chief Financial and Administrative Officer to my left. To her left, Eri Chaya, Co-President, Chief Creative and Merchandising Officer. DeMonty Price, Co-President, Chief Operating, Service, and Values Officer is the longest title in the company. You can see there from a values point of view, we're a company that's pretty steeped in our values, and DP, as we call him keeps us all in check and keeps us focused on the right things. David Stanchak who's our Chief Real Estate and Development Officer. Sandra Stangl. Sandra and I worked together a long time ago. I'm excited to be working with her again as she's joined us here as our President of New Business Development.
Brendan Sodikoff, who probably doesn't need an introduction. He's known for the best burger in America, the best steakhouse in America, the best donut in America. He's turning out to really be the best partner that we could have ever dreamed of as our President of RH Hospitality. We're going to take you through an agenda that looks like this. We're going to talk about our view of the retail industry and then put our strategy into that context and hopefully share with you why we believe it will be worth the ride. We're going to talk about our new model. We took the car off the racetracks there for a little while. When you become a public company, and we became a public company in 2012, I refer to it as you put yourself out on the racetrack.
It's got a quarterly cadence to that racetrack. Your perspective starts to shift when you're in a public market racetrack. Your view tends to come a little shorter and things tend to move pretty fast. We came out in 2012, and I think we were pretty good at that public company race for about three years. I think we made or beat every quarter in the first three years. Then, as many companies do, we blew a tire. When you blow a tire and you're on the public company racetracks, you have to make a decision in that moment. The decision is, do you take the car into the pits and you change the tires and come right back out into the race?
Do you see a blown tire, which can in that moment seem unfortunate, can you shift your perspective and maybe see a different opportunity and see an opportunity to come into the pits and build an entirely new vehicle? That is not an easy decision to make because you are in the pits for longer. Cars seem like they are lapping you. The fans seem very distressed and do not understand why you are keeping the car in the pits. You can become pretty unpopular very quickly in the public market for doing anything besides bringing a car right back out into the race.
We believed, and we saw a huge opportunity that we could reenter the race and even seem like we are farther behind, but see a view where we come back into the race with an entirely new vehicle that was so superior to the vehicle we entered the pits in and one that would catapult us forward and not only make up the laps that we lost, but really have a vehicle that we could ride for a long time that could put its way ahead. That is how we think about the last 18 months. We know, by the way, we are very fortunate to have some of our shareholders here that were with us in the pits because not a lot stay with you when you make the big decisions like this.
We have some that are in the room today that hung with us and we talked to and shared what our plan was. I think we are all going to benefit from that. Thank you for those of you that are here or those of you that are listening that could not make it. Let me share our view. I am going to start with this. P.T. Barnum said, "No one ever made a difference being like everyone else." Okay? P.T. Barnum, as you know, started the greatest show on Earth, right? Created something new and fabulous in the world that really got everybody's attention, brought people from far and wide to see a spectacular new show, a spectacular new experience. We believe retailers have spent the past 20 years becoming more rather than less like anyone else.
As we step back and we look at the last 20 to 25 years in retailing, we see more sameness, not less sameness. We think that sets up an incredible opportunity to stand out, and be unique. It is interesting today, if you read the headlines and, man, is it so different than 10 or 20 years ago when we did not have these devices. We used to sit around and we got our regional or national newspaper, and there was a couple of headlines you read a day. Today, I do not know how many headlines we consume just in a morning from publications far and wide all through the world. It seems that the headlines are just dominated with the age of Amazon and the death of the department stores, and actually linking those two. Our view is Amazon is falsely accused.
I think it's a convenient association. I think Amazon is falsely accused. The department stores, the fact is, they've been dying of old age and a lack of innovation for 25 years. You guys follow the industry. Let me put a question out to the group. Name a significant innovation at any department store in the last 20 years. A significant innovation. You can just think about the industry. 20 years. 20 years we've been going to department stores. Has anybody took a stab at significantly innovating the department store experience? I remember department stores when I was a young boy going with my mom, to what we called the Big E in San Francisco. It was The Emporium. It was a magical experience. You walked in, and under the rotunda was an elevated cafe.
About once a year, she saved up enough money to take us and have a bite to eat there. There was a carnival on the roof. There was a Ferris wheel that people came from far and wide. Going to see Santa at the Big E was incredible. Going shopping in a department store used to be a magical experience. I'm not trying to bash on department stores today. What I'm trying to do is put the industry in perspective from our view. Today, we would argue that you could probably take the names off the buildings, and in many cases, if you had to walk in and there wasn't a name, and you had to say, "Where did I just walk into?" you probably couldn't differentiate.
We believe this idea of Amazon being accused for the death of many businesses, many businesses have been dying for years. It's just convenient to blame Amazon. We kind of live by this quote of Charles Darwin, "It's not the strongest of the species that survives, nor the most intelligent. It is the one most adaptable to change." Robert F. Kennedy said this about change, and it's an important point. "Progress is a nice word, but change is its motivator. Change has its enemies." If you step back and you think about that, as we talk about change, that change and progress have to be linked. You can't have one without the other. It's interesting to talk about progress. For most people, it's difficult to talk about change. It's uncomfortable to talk about change.
A lot of times there's a perception that you're actually going to make progress without change. The degree of change usually is equal to the degree of progress. Little change, little progress. Big change, opportunity for big progress. Change has its enemies. Who are the enemies of change? It's usually us. All we have to do is look in the mirror. Why is that? We're creatures of habit. Humans are creatures of habit. If we had a webcam connected to our bedroom No, I'm not going there. If we took film for 30 days of our routine when we got up in the morning.
What side of the bed we got up from, how many steps we took to the restroom, what hand we picked up the toothbrush with, what hand we picked up the toothpaste with, what ritual we went through, what were our next several moves. If we laid that film of 30 days on top of each other, you probably could project it, and it might be a little blurry, but it would look the same because that's our DNA. That's our DNA. We also live in a world that is constantly evolving. The ability for us to not fall behind requires us to change, but that's uncomfortable.
One of the key things Cameron says to me after she has meetings with investors or analysts is, "Gary, they're asking me, they're saying How can you make me feel comfortable about what you're doing by pointing me to somebody who's already done it? Why would we be interested in doing something somebody's already done? Why would that be innovative? Why would that create big value? I understand where it comes from, because it comes from a need, right, of predictability. It comes from a comfort level that is hardwired into us as humans, right? If the public markets really want innovation, the public markets have to be comfortable with change, right? My sense is, in a lot of businesses, people are afraid to change because they're afraid of the next quarter. Right? Look, we understand we're in the public markets.
We understand we're a public company. We understand quarterly earnings are important. You should come to expect us to not make decisions for the short term. We're going to keep making decisions for the long term. Over the course of time, Warren Buffett likes to say, "Time favors the well-led and well-managed company." We believe, at RH, that's the important way to frame the perspective of change, especially in the public markets. The other thing we believe is there are those with taste and no scale, and those with scale and no taste. Right? Those with taste and no scale, and those with scale and no taste. We believe the idea of scaling taste is large and far-reaching.
If you want to kind of just check in on that, right, I'll give you a great way to just-- Where can you go and kind of get a quick read? Go to Zillow, go to Redfin, go to Trulia, go online and pick any neighborhood, any city, any neighborhood, and start with the houses and go most expensive, right, to least expensive. Start at the top. Start at the homes that are, wherever you're looking, $10 million, $20 million. If we're doing it in Palm Beach, it might be $120 million. Start from the top, okay, and start clicking down and say, "Who has really great taste?" Okay? Which of these homes have beautifully designed architecture, and how many have beautiful interior compositions that are really well designed?
I think if you take that simple test, you'd probably start to see what we see and start to understand the market the way we see it, because we see a huge market. We get the question all the time, "Wait a minute, you're playing up here at the high end of the market. Seems like it's a small market. Isn't that going to limit the opportunity?" That same question was asked to Apple about 15 years ago. The same question when Apple had 3% of the computer market, and they were making the most expensive computers in the market, but they were making the best computers in the market. Then Apple decided to, 10 years ago, introduce a phone. That seems like such a good idea today, doesn't it? Doesn't that seem like such a good idea today?
Doesn't it seem like so obvious that Apple should have entered the cell phone business? If we step back for a second and just think about the cell phone business, it was dominated, okay, by $49 to $69 phones. Okay? It was dominated by Motorola. It was dominated by Nokia. How many people here had a Motorola phone? How many people had a Nokia phone? Keep your hands up. If you had a Motorola, keep your hands up. If you have Nokias, keep your hands up. It's a pretty dominant number of hands, so if you can look back, keep your hands up for a second. How many people still have a Motorola phone? Keep your hands up. How many people still have a Nokia phone? Keep your hands up. Okay. When Steve Jobs, I think about what was that board meeting like, right?
Apple had 3% of the PC market, okay. Microsoft, I think, had 90% of the PC market. Jobs goes to his board and says, "Hey, we're going to get into the cell phone business. By the way, let me tell you how brilliant it's going to be. We're going to introduce the most expensive phone in the market. It's going to be $600." The market leaders have phones that are $49 to $69. How did that conversation go, do you think? I bet it was like, "Can you point me to somebody else who's really successful selling $600 phones? Can you tell me, Steve, why I should feel comfortable, okay, that a computer company that is 3% of the market, okay, that is struggling for its life, that's almost bankrupt, why should we get into the highly competitive cell phone market?
Won't we get killed?" What seems so obvious sometimes today, when you really look back at when the idea was formed, it doesn't always look great. Sometimes it can look like a baby, struggling, screaming Say the other things. It's not obvious that that baby is going to grow up to be somebody or something really important in this world. I don't think it would have been obvious to anybody that a computer company that had less than 3% of the market decided to get in the cell phone business when the dominant players basically had 98% of the hands went up in this room, and 10 years later, not a hand went up. 10 years later, not one hand, and the companies don't even exist. We come from that spirit. We try to see what others can't see.
We say in our company that we have to think until it hurts, until we can see what others can't see, so we can do what others can't do. It doesn't always look obvious, especially if you haven't been sitting with the people, thinking with them for that long. We think deeply about everything we do. We're not always right initially, and sometimes the ideas might come out looking like a baby that's crying and screaming, that needs their diapers changed, and it doesn't look really good. I bet modern looked that way to a lot of people. We launched RH Modern because that's what kind of blew that first tire. RH Modern, with a little care and a little concern, is going to turn out to be one of the most important things that this company's ever done, and it's not always obvious.
If someone asks us, "Can you show us someone else who's rolled out a modern concept at the high end?" There isn't anyone. This idea of taste and scaling taste and creating a market is how we think about the world. When Steve Jobs was asked, "What's the biggest difference between Microsoft and how do you know you're heading in the right direction?" He paused for a second in the film they found after his death called "Steve Jobs: The Lost Interview," and he looked up and he said this, "Ultimately, it comes down to taste. It comes down to exposing yourself to the best things that humans have done and incorporating those things into what you do." Looking at the best things humans have done, incorporating things into what you do, and trying to elevate humanity. We also believe this. We believe it's not about physical versus digital.
It's about physical with digital. It is about the seamless integration of a brand across all channels. I'm still dumbfounded when I read articles or reports on companies and the intense focus on what is the sales between retail or direct or web and retail. I still don't know why anybody cares. I really don't. I think there's some simplifying assumption that the web must make more money. We don't spend one second on that. Not one. Not one second. Have we ever talked about the mix of the business at strategy session, ever? Have we ever spent five seconds talking about where did the customer shop today? I really don't understand why people do. I think there's a ton of capital. We believe there's a ton of capital being wasted thinking about how to shift business from one channel to the other.
I don't know why that would make any more money. We'll talk more about that. Here's what else we believe. The web is the most democratic channel. It is the most democratic channel. Why? It is the most difficult to differentiate. Do you guys have your PCs or iPads or some device in front of you? If you pulled up Holly's Home Store, and by the way, that's a fictitious name. The lawyers made me use a fictitious name. I couldn't use somebody to compare to us, thought we might get sued. No. If you pulled up the Holly's Home Store, fictitious local retailer, Holly's Home Store here in Palm Beach, single store, 1,500-2,500 sq ft, has a website, and then you pulled up RH. Guess what? Our store looks the same size online. Right?
The smallest store in the world can look like the biggest store in the world online because their store is the same size, the screen's the same size. The only way that you know the difference between RH and Holly's Home Store is you have to click about 10,000 times, and then you have to keep clicking because their assortment is bigger than that. We believe the web is the most democratic channel. We also believe that the web is not the most profitable channel. I still don't know why anybody believes that. I really don't. I read all the reports, and we study this industry. We're obsessed about knowing whatever we can, finding any edge we can, and we study our own business.
I spent 14 years at Williams Sonoma playing the channel game that, quite frankly, was just moving cost or assets from one channel to another. We've debated how we think about it, but most retailers, and if you do the work, if you look at most retailers who have increased online sales, and it might be all, I'm saying most because there might be someone that I've missed, but most retailers who have increased online sales have decreased operating margins. I'd put up a big bet with anybody here. We go look at 100 retailers, and I don't think we'd be wrong. Why are people trying to shift sales online?
Why would a retailer take business from the highly profitable store, okay, and try to spend capital and spend expense to try to move sales to another channel and create a whole new cost structure, not really understand what the true metrics and how to make money there are. I got Amazon's become $140 billion, but it's not a lot of operating margin. Everybody's still trying to break down that model. It's like a $140 billion loss leader surrounded with other businesses. It's a marketplace model. It's not really like a retail store. Yet, man, there's a lot of time and shifts focused on trying to be like Amazon. We kind of sit there and go, "Why would we want to be like Amazon? We're doing something completely different.
Why would we want to shift sales to this other channel?" The only way the internet channel looks more profitable in a retail business if they're not allocating their costs correctly. Right? If they're actually thinking like, for some reason, that's incremental, and I should not take cost from all these other departments that created the product, created the brand, drove the business and so forth, and shifted it over here. We don't understand it, but I think it's going to probably, the dots will connect soon, and the simplifying assumption that online is more profitable than retail, I think the truth is going to come out very soon. The data tells us this, and the other question we put forth is name an online-only retail brand. Don't name Amazon because Amazon's this marketplace. It's not a retail store.
Name an online-only retail brand that has reached $1 billion profitably. That's a question, really, to the group.
Amazon.
No, not a marketplace, a retail brand. Those who've created a retail brand.
ASOS.
Who?
ASOS. A-S-O-S.
How big?
Not a brand.
Not a brand. Marketplace? Marketplace. No. Yeah. For instance, I love Warby Parker. I've got a lot of their glasses. They got a $1.2 billion market cap on $90, $80 million of sales several years ago. How many people have been waiting for them to come public? I love Warby, but I bet that they have to open a lot of retail stores to make the model work. Seriously, we're sitting here kind of like, somebody's got somebody, and then somebody's saying like, "No, well, no, they're not really a retail brand." If it was really more efficient, why wouldn't there be a whole bunch of people? Because the graveyard is getting filled up pretty fast. It's getting filled up pretty fast.
You name a lot of people that have already went into the graveyard that everybody thought were going to come out and have this new model. We believe the web is not the most profitable channel. We also believe this: the physical manifestation of a brand will prove to be more rather than less important, especially for brands not selling commodities. The web is an amazing distribution channel. Sometimes I give these talks, and people go, "Gary Friedman doesn't believe in the internet." Almost half our business comes online. It's not that I don't believe it. I believe that there's a lot of simplifying assumptions that are not true, and I think there's a lot of poorly allocated capital in our industry today. I think it's great for people like Amazon and other marketplaces because it's making everybody a lot easier to compete with.
We believe the most capital-efficient way to scale in a physical world is through a physical manifestation of a brand, and we believe that will prove true. We also believe that we live in a world of complexity and clutter, that we're bombarded with information and choices. We are bombarded every day with so much information. How many people just want to-- There might not be that many wants because it becomes like crack, right? You want like, "Oh, shoot, I didn't get any new texts. I don't have Instagram or" Snapchat, or all these things that my 15-year-old daughters have. Their minds must be so developed. I don't know how they keep track of everybody, but the information that's coming through. We're bombarded with information and choices. We live in a world of complexity and clutter, and we believe great brands can be a silver bullet. Okay?
Great brands can be a silver bullet. They can break through the chaos, simplifying our lives by delivering a predictable promise. By making it easy for us, not hard for us. We also believe that time is the ultimate luxury, that businesses or brands that don't deliver time value will become less valuable. Right? Businesses or brands that don't deliver time value will become less valuable. We also believe that brands with more control will become more valuable, that the biggest issue brands face today is the danger embedded in their distribution channels. Look at brands that are unwinding their business from distribution channels that have changed, and don't reflect the experience of that brand. We believe those with control from concept to customer will be rewarded over the long term. We believe in more control than less control as it relates to retail brands.
We think long term, the brands that have more control versus less control will be rewarded. We also believe this: it's not about marketing, it's about truth. It's not what we say, it's what we do that defines us. We don't have a marketing department in this company. No marketing department. We have a truth group. Why do we have a truth group? Because marketing is usually about putting lipstick on the pig. It's usually about trying to spin a story and make something look better than it really is, and that's not usually a good allocation of human or financial capital. We like to say, if our truth isn't relevant, we probably won't be. How do we become relevant? Our truth is really our work. Our truth is our product. Our truth is our Source Books. Our truth is our galleries.
Our truth is our online experience. Our truth is our service. Our truth is the experience that we create for the customers. That's our truth. That's what we think is the most important aspects of what the world would call marketing. We believe that if we want to be part of the conversation, we have to create the conversation. Right? Our product Source Books and galleries have led RH to become the most pinned, Instagrammed, and tweeted brand in our space. Guess what? We don't have a Pinterest site, and we don't market on Pinterest. We don't have an Instagram site, and we don't take pictures of ourselves and post them on our site. We don't tweet, even though it's the preferred communication platform for the President of the U.S. We don't tweet.
Yet somehow, we are the most pinned, most Instagrammed, and most tweeted brand in our space. Because the opportunity lies in the world talking about you versus you talking about yourself. The opportunity lies in doing great work, and there is a platform for people to talk about your brand. We don't have a Pinterest department in our company trying to figure out what to do on Pinterest every day. We don't have an Instagram department in our company trying to figure out what to post and what to do. We don't have our own blog. We don't have our own Facebook group. We did. I found out we did at one point, years ago. Then I said, "Seriously?
Let me see the Facebook page." I thought, "Oh my God." Seriously, we had a few people in our company that were trying to make up stuff every day and put something on Facebook, like someone was going to care. We don't have anybody in our company tweeting. I don't think so. I mean, they're probably tweeting, but as a social platform, fine. We don't have a Twitter department. I like Twitter. I think it's a great platform for people to communicate. We think the way to be a part of conversation is to create that conversation. You do it through your work. We also believe this: great brands don't chase customers chase great brands. Great brands don't chase customers chase great brands. Great brands are vision, not customer led. That doesn't mean we're not customer obsessed.
That doesn't mean we don't care deeply about our customers. We don't ask them what we should sell. We don't get their opinion on next season's color palette. We don't have focus groups. We've never had one. I just think that sounds so confusing. It's hard enough to have your own point of view in this world. Invite 100 people that you just gave a $50 gift certificate to, you're sitting on the other side of a one-way mirror, you have some stranger called a focus group facilitator asking random questions to people that don't have anything better to do with their time, show up for $50 with other random strangers and talk to a random stranger about a business that they don't even tell you why they're asking the question. It's not like, "Hey, we're doing a focus group for RH.
We'd like to know" No, they say, "Hypothetically, if there was a retail company that was going to do this, what would you think?" A bunch of random people that showed up for a $50 gift certificate. It makes no sense. Somehow, people allocate a lot of capital to it. Again, don't interpret that we don't care about customers. We're obsessed about our customers. We'll do anything we can to delight a customer. I just don't know how you get to a decision when you start inviting a whole bunch of people and say, "Hey, what should we sell? Let's bring in more. We have confusion with 500 people. Let's bring in 5,000. Maybe that'll make it more clear. Let's get more people. Let's get more customers to tell us what to buy next season." Something they've never seen.
I just can't see that that's how the iPod came along. I just really don't. I bet if you got 5 million people and said, "Hey, what would you like us to do, and how would you like us to deliver music to you? What do you think about a little white thing with a button in the middle that had 1,000 songs?" Why would anybody tell you what they wanted? That's what we get paid for. That's what we do. It's funny to me when businesses or brands kind of go off course, you read a lot about, wow, they hired a customer insight group. They hire 150 people. One of my former places I worked when I grew up, many years after I left, I would read they have a customer insight group, they have 150 people developing customer insights.
I had friends that were still merchants there, and I said, "Why did you buy that? Didn't you know that was going to be a massive markdown?" They said, "I didn't really want to buy it. I really wanted to buy this, and I wanted to bet on this, but we have this customer insight group, and they've got all this data that they come in, they say customers want this, not that. That's what I had to buy." Goofy. You ask yourselves, why is there not a lot of innovation? Wow, that just sounds like good things are going to happen when you have a bunch of strangers show up and opine on what you ought to do. The iPhone, Tesla, Instagram, or Disneyland did not come from a focus group. I'm sure of that. Henry Ford said this.
If I asked my customers what they wanted, they would have told me a faster horse." He believed that deeply. Let's talk about our strategy and how it kind of fits into our perspective of the industry. Our journey begins with a question, we like asking questions because it makes us think. Who is the home brand for the luxury customer? We asked ourselves that question, oh gosh, 10, 12 years ago, and it was real clarifying, because when we asked ourselves that question, nobody had an answer, and all of us worked in the home industry. When you can ask yourself a question like that and you can't get an answer, and you're experts in an industry, you're either way off course, or you just found a massive opportunity. A massive opportunity.
When we thought deeply about that question started to frame a very big opportunity for us, because we didn't believe there was one. What we've spent the past decade doing is creating the most comprehensive collection of luxury home furnishings presented in the most inspiring spaces in the world. This is a picture of RH Boston, The Gallery at the Historic Museum of Natural History. Why do we put the product in beautiful historic buildings? We say we're obsessed with great architecture, that we either find it and readapt it, or we build it. Why do we care about great architecture? Why do we care about great buildings? Because it renders the product more valuable. It renders the product more valuable. Yesterday, we had our partner day.
We had 150 of our vendors and designers and partners from all over the world here in the same room. One of them said, "Actually, I found a few products like RH at this home store, furniture store down the road. Quite frankly, if it wasn't me, you would have never seen it because they didn't put it in the same context." They didn't put it in the same context. I couldn't really see it, and the store was a mess, and it rendered the product less valuable. We obsess about things like this. We obsess about architecture. Why? Because that's where product lives. Right? If it lives in a more beautiful space, if it lives in a space that renders it more valuable, we believe it will connect with the customer, and they will pay more. Looking back, how did we get here?
We began as a retailer of nostalgic discovery items with a $20 million market cap. This was my first season. I arrived. This was the cover of the catalog. It says on there summer 2001. Right? 84-page catalog. It had an Aqua TROLL on the cover. Now you ask yourself, what's an Aqua TROLL? I thought it was Santa Claus. I did my first walk-through at one of our stores, and it was late April, and there was a yellow sofa on the floor and a pinewood coffee table, and I had the whole merchant team and the inventory team, and I was trying to learn about the business, and we're walking through every SKU and every product. Right?
Every margin, every turn, and then all of a sudden, we got to the middle of the store, and there was about 20 of these on a coffee table in front of a yellow couch. You got to understand, I just put $4.5 million of my own money into a business that everybody said wasn't going to make it, and it was going to go bankrupt, and it was the dumbest decision I could ever make. When I saw that table, I thought they were right. I thought there was 20 Santa Clauses on a coffee table in the middle of a gallery at the beginning of May. I thought, "Oh, my God, we haven't even taken our markdowns." "I already don't have much cash on the balance sheet." This is like, do I go back and talk to Howard about getting my job back?
Right? Seriously. I was like, I couldn't even get out, "Can someone tell me why we have a table full of Santa Clauses at the beginning of May?" They looked at me and said, "That's not Santa Claus." I thought, "I'm really dreaming. I'm not here. I'm not in the store. I'm dreaming. I'm home in bed. I'm dreaming." I said, "Excuse me, but listen. I know I'm half Jewish. I know I'm half Jewish, but I do know Santa Claus." Right?
They said, "No, no, it's an Aqua TROLL." I go, "What's that?" They said, "Well, his head pops up, and then he waters the lawn." I said, "Why is that relevant, and why is that on this coffee table?" They said, "Because it's funny." At that point, and this is a true story, I said, "From this point forward, funny is not a brand attribute." Okay? Funny is not a brand attribute.
We don't want to be the store that people wake up in the morning on the weekend and go, "Hey, honey, we're going to go shopping today." "Let's go to that really funny store called Restoration Hardware because you're going to find really random shit like a Santa Claus whose head pops up and he waters the lawn." This is how we started, and the reason why I start here, people go, "Oh, God." Some of you maybe have known me for years, knows, "I bet he's got the Aqua TROLL catalog." I show it to you. Why?
If we started here and we transformed to this, okay, a $2.5 billion. A company with a $20 million market cap on the edge of bankruptcy, with the cover of the catalog being an Aqua TROLL, okay, to a $2.5 billion luxury design platform with over 3,000 pages of our design and building some of the most inspiring spaces in the retail industry's ever seen. What the hell are we going to do when we do have capital, okay, and we don't have to obsess how to mark down the Aqua TROLLs that nobody wants? Right? How to get the customer to believe that they should buy higher-end furniture and home furnishings from us when we also sell Aqua TROLLs and Bite Me dog toys and fly swatters and Auto Bingo. When I got here, the number one unit SKU in the company was Auto Bingo.
Anybody play Auto Bingo? Yeah. Yeah. Does somebody that doesn't work for us? No, seriously, you know what Auto Bingo is? It's like a little card. It's about this big, and it's got little slide things, and it's for when. Many of you are not as old as me, but back when I was a little kid, you sat in the back of the car on a long drive, getting car sick while you were going, "Oh, there's a stop sign. I got B12." Right? You played bingo by seeing things while the car was moving, and in about 17 minutes, you're like, "Can you pull the car over? I'm sick." We came from that with no capital. That's where we came from, and we got to here. What are we going to do with the capabilities and the platform we have today?
What might we imagine if that's where we started, with no money, on the edge of bankruptcy? We had to raise money three times in the first year to keep the company out of bankruptcy. I tell people who don't know this, I actually got to sit with the accounts payable department every two weeks to have them review the checks that were going to be paid. The checks that were going to be paid that pay period, either to our people, our vendors, suppliers, the electric bill, and then show me how much cash we brought in. I made them add it up twice, and then I added it up on my calculator, because I had something that I still have today called an asset-based loan.
If somebody miscalculated and had a couple checks too much go out and didn't do the math right, the whole company was going to go bankrupt. That's how I had to spend my time at the beginning of this journey, for about three years. That's how close it was to the gallery that you're going to see across the street here being a 20-story office building, because that's what they were going to build. What might we do under the conditions we have today? The other thing that's important to know is furniture of this quality has never been made in these quantities. We are building the first luxury home furnishings railroad. That will be very hard to duplicate. We have a lot of scar tissue trying to figure out how to make furniture of this quality in quantities.
There was no manufacturing platform for furniture of this quality. There was no supply chain know-how. We've had to build this from scratch. We've also built a powerful product platform that attracts and amplifies the best design and manufacturing talent in the world. We had a light bulb go off. It was about eight, nine years ago. Light bulb went off when Apple created the App Store. They had the iPhone, they had the App Store, I had a friend that was actually working in technology, and he was going.
CES.
The CES conference in Las Vegas, where all the technology is marketed. Big conference. He said, "You've got to come. Come meet me. It's amazing. You're going to see where things are going." I wound up going, not that inspiring, really kind of confusing. The ugliest booths. Nobody had taste back then. It was really Steve Jobs that clearly an open field on taste and technology. I think back and I go, "There's no Apple product here." I'm like, "Where's Apple?" I spent the first couple hours walking around, I'm looking at all this ugly stuff, I'm listening to pitches on ideas, and I go, "Wait, where's the Apple booth?" They, "Oh, they're not here." "What? This is the biggest show in the world, and Apple's not here?" "No.
They have Macworld or something like that." I thought that was interesting to me. I was like, "Wait a minute. Apple's not here, they have Macworld, they have this really cool phone, they have this app platform, they have the iPod. They're changing the music industry, they're not here." We started to kind of nose around and look at why is Apple not there. Because they did Macworld. What happened with Apple, I think it's a big enabler, one of the reasons they're where they are today, is they built the best platform in the world, that platform attracts the best developers in the world. Over the last five, 10 years, how many people do you think were developing apps for Apple and not BlackBerry? Or for Apple and not Nokia?
Apple created the best platform, the best talent outside and inside developed for Apple. The light bulb went off for us, and we said, we had a design department. We probably had 40, 50 people in the design group. We thought we were kind of what we called kind of an inside-out company, a model I refer to as inside-out. You design everything inside, then you take it to the market to source it and send and present it. It hit me that Apple was an outside-in company in some ways. Even though they're an inside-out company for their platform, they have a lot of people developing apps all over the world. Apple has the best access to the best apps. The other thing that hit us was Apple created the iPod, and they have all the best music.
They had the best platform for music, so all the music was going to the best platform, yet they didn't write music and they didn't create music. We said, "Gosh, we've got this design department of about 50 people." Honestly, if we went to a design review and liked 5% of what that team designed over the course of the past six months, that would've been a great day. It would've been a great day. We designed probably 97% of the stuff we didn't even buy. We always feel like we need better people, we need better designers. The fact is, the best people are sometimes doing their own thing, and they don't live in Corte Madera, San Francisco. They might live in L.A. They might live in Amsterdam. They might live in Shanghai. They could live anywhere in the world.
We said, "Wait a minute. Maybe we're thinking about this wrong. Let's flip this upside down, and let's be an outside-in company. Let's put our focus on building the best platform, and let's try to attract the best designers, the best manufacturers, the best artisans in the world to develop products for our platform because we will render their work more valuable. We will give them more leverage." We began that journey, and we started it in 2009? Yeah, 2009. We just changed everything. You kind of needed to after 2008, right? 2008 and 2009, if you didn't change much, you probably wouldn't be here. That was a big epiphany for us. Today, we believe we're just at the tipping point.
There are people now that are coming to our platform that three years ago, four years ago, someone would've told us, "They will never design for you. They will never put their product on your platform." What's happened over the last four or five years here is we are building the most magnificent physical spaces for the best product in the world. Those designers, artisans, or manufacturers are saying, "Do I want my product over here mixed in, not well edited, not well presented in this crappy building that's not inspiring? Or do I want my goods presented on this platform?" We're just now, just because we've got enough of these big galleries out there that people are seeing it. There's a woman named Alison Berger. True story. Alison started blowing glass when she was 15. She's a professional glassblower. She's also an architect.
She worked for Frank Gehry. She also is a designer, and she's also an artist. If you met her and you talk to her, she is brilliant. She had been making some of the most spectacular lighting products I'd ever seen in my life. It was sold in a really exclusive kind of small showroom platform, I think. I don't want to say the name, but I think their total revenues are somewhere around $100 million, and they maybe have 12 showrooms in the world. Honestly, I would've never contacted Alison because I would've thought she'd maybe turn her nose up at us and thought, "Oh, no. I can't sell my $60,000 chandelier that's just so incredible at Restoration Hardware." I'm having breakfast with my girlfriend, Bella, in L.A. at Le Pain Quotidien. Yeah, Le Pain Quotidien.
We're sitting there, and this woman comes up, and I didn't quite notice, has a couple of dogs, and comes up and goes, "Gary." I'm like, "Gary, I've been thinking about you. I want to meet you. My name's Alison Berger." I'm like, "I know." I'm kind of in awe. She goes, "I think what you're doing, the gallery you built here in L.A., what you did with RH Modern here in L.A. is amazing, and I've been thinking about it. I think I could design incredible product for you." "You're right." I didn't know what to say. I was so excited. I'm texting the team, like, "You won't believe what just happened.
Alison Berger approached me at Le Pain Quotidien and said she's been thinking about us and wants to develop product for our platform." We were embarrassed to ask her because we thought she'd turn us down. We didn't think we were good enough. That was kind of a big moment for us. A big tipping point. Now more and more of the very best people are working for our platform. By the way, they're all different, and we try to enable them in all kinds of different ways, but they're also all the same. They care deeply about doing the best work in the world. Some have capabilities. Some have manufacturing capabilities, some have design capabilities, some have conceptual capabilities. First and foremost, we say we are curators, not designers. We're curators, not designers. We really don't really design anything. We curate.
We don't just curate product. We curate product, people, ideas, and inspiration. If we see a great product, the first thing we do is we ask, "Who did that?" We're more interested in who did it, because if you can find who did it. Who's the person that actually swept the details, obsessed over and over again, got the proportions right, got the dimensions right, got the finish right, got all those pieces right? Which means usually you're getting knocked down 10 times, and you have to get up 11 to get great work done in this world, because usually people want to take shortcuts. They all obsessed about great work, and they obsessed like we obsess about great work, but they're also so different. They all have different capabilities. What we try to do is we try to enable their capabilities.
Where they're strong, we amplify them, and when they're not, we try to support them. We think this platform that we're developing is unlike anything in the world. It's unlike anything I've ever been associated with. I think it's a massive advantage for RH and will be for years, and we're just at the tipping point. We also like to say this level of design was only available behind the Iron Curtain of the to-the-trade design centers. How many people have been to design centers? Lot of hands. How many people went there by themselves? Three. How'd you get in?
Walked in.
I mean, you walked in backwards, then they thought you were walking out? No, how did you get in?
I was in the business.
You're in the business, so they let you in. They probably thought you were a spy. Here's the interesting thing about the market that we're competing in. It's not only highly fragmented, but it has a lack of accessibility. My god. It's such a huge thing. We're competing with people that have a lack of accessibility. If you're not an interior designer, you don't have a resale license, you can't get in, right? Unless you're like Bud or Matt or Brian, and somehow you figured out how to work the system. There's a lack of accessibility, and then if you got in somehow, with an interior designer, someone with a resale license, or you snuck in like these three, there's a lack of transparency. Has anybody been to a design showroom and saw a price tag on anything? There's a secret code once you get in.
If you can get in, there's little stickers that have numbers and letters, right? Bud's laughing. He probably knows the system, see? He figured this stuff out. There's numbers and letters. You don't know the price. You don't even know what discount. You don't even know there's discounts. If you snuck in and you paid $15,000 for that dining table that they really sell, okay, to the trade at $8,000, you thought you felt really good because you got in and they actually sold you the table, and they weren't supposed to, until you found out that your friend, who's an interior designer, paid $8,000 for that table you just paid $15,000 for, right? There's this whole lack of transparency. There's a lack of scale. We love this market. If people go like, "Well, it's a small market." No, it's a huge market.
The number one phone in the world is the Apple phone. It's the most expensive phone in the world, not by a little, by a lot, because it's the best, and we believe people have a bias for quality. People will pay more for quality if they can, and people will stretch for quality. We're obsessed with quality, and we will always bet on quality versus price. Okay? We will never render anything less valuable to take a price down, right? To open up a market, because we think that is like opening up an infection, right? It's opening up a wound to a disease. Once you start going that way, good luck turning it around. We love this market. It's behind the Iron Curtain. It's highly fragmented. It has a lack of accessibility. It has a lack of transparency, and there's nobody that has scale.
We love this market. We see so much opportunity here. We've added the most prestigious bath and kitchen brand in the world to our platform, Waterworks. Some people have asked me, "Why? You sell some of this stuff." Waterworks has been doing it for 40 years. They're the best. They have the best product in the world, and we believe it positions us long-term. As we think about how we bring these brands together and how they'll amplify each other, it positions us as an authority in two of the most important rooms of the home, the bath and the kitchen, and long-term, you'll hear more about our vision for this business. We've also launched one of the most exciting new concepts in retail, RH Modern. We believe it's poised to become a billion-dollar-plus brand.
If you haven't been to L.A., this is the picture of our freestanding RH Modern gallery in Los Angeles. It's a great representation of the product. You'll see a representation in our new big design galleries. You'll see later today, you'll see RH Modern on its own floor. We're just getting started here. We start big. I got it. Most people start with an 80-page catalog. We started with a 545-page source book. Right? Make no mistake, we saw an opportunity, we didn't see anybody there, and we said, "We want to be first, and we want to be famous, okay, for the first fully integrated modern brand in the world." Right? That took all the categories and integrated them beautifully and created the first fully integrated modern lifestyle brand in the world.
That's why we moved so quickly, because we moved quickly, we had a couple of vendors, they blew a tire, they imploded, cost us $20 million. Got it. Okay, don't think for a second that RH Modern isn't one of the best things we've ever done. I'd go back and do this again. I'd take the ride as the biggest shareholder in the company from 105 to 25. Okay? Have the press make me feel like a fool, to do this again. This is going to prove to be a really big idea. Another important part of our strategy, becoming more and more important and something that we're going to obsess and become famous for here, is RH Interior Design. We are building an interior design business that moves the brand beyond creating and selling products, to conceptualizing and selling spaces. Right?
Beyond creating and selling products, to conceptualizing and selling spaces. Right? Did DP, did Kelly come?
Kelly's here, yeah.
Kelly's here. Kelly, where are you? Kelly's here. Okay, Kel, just stay there for a second. I'm going to tell the story. I only know some of the highlights. This just happened. Breaking news at RH. Last week, I said DP called Kelly. Their gallery had a $510,000 sale to a customer. Right? $510,000 sale to a customer. Maybe Kelly, if you can give the highlights. How long did it take, and what was the situation?
Yeah, sure. The client actually reached out to us on.
Just give Kelly a mic, yeah.
Thank you.
Kelly is our gallery leader of our Tampa gallery.
Yeah. The client actually reached out to us through RH Interior Design, through our website. It was a 9,000 sq ft home. They were interested in designing the entire home. It took an entire month from start to finish with my design team here. I have Nicole and Shelly, the gallery designers.
Oh, Nicole and Shelly. Everybody came. Hi, team.
Hey, Tim.
Stand up. Stand up. Here, come walk up here so everybody can see you. Don't have to bend their necks. Yeah, walk up here. Come here. Come to the stage. Here. Come up here. Come up here. People need to see you. How are you? Thanks for coming.
Thank you.
Hi. How are you?
Good.
How are you? Hi.
Hi.
Yeah. Go ahead, tell them about how this came together.
I'm actually going to divert to Nicole and Shelly, so they can share the story.
I'll follow in the back.
As Kelly said, the clients contacted the gallery after doing some research on the RH Interior Design website. We reached back out to them and set up to have their initial consultation in the gallery. That was approximately a week after we reached out to them via phone. They brought with them all of their samples for the home and really wanted us to be a part of making sure that they were on the right track for all of their hard finishes and all of their selections. The process went really smoothly. I think Gary's talked today about time value, and this is a perfect project and example of how we were able to deliver that to them through the design ethos and the design process that we have in place as a company.
I think that this is a client that was really special because they lived and breathed this design. They were very pleasantly surprised to find us and to utilize our service. They told us at the very end of the project that they have done this three times. They had always found somebody else, a competitor, had a whole presentation, and then walked away very disappointed and called the process painful. They were very thankful for the service that we provided, and they are very loyal to us now. They're extremely excited. I think that we all live and breathe our values, and we have a vision, and to be able to execute it is very exciting.
Thank you. A $510,000 order came together in 30 days. You guys went to the home, figured out the whole home, put together the order, worked with the client, and $510,000.
Growing.
Growing. Oh, still growing. Okay.
We have another 15.
You have another 15 coming. Okay. You might get the fourth home they do.
Yes.
Yes. They're actually closing on the property the end of this month.
Oh, they are? Okay.
They commented that they'd like us to be a part of the process sooner.
I really don't know much about this. It's not Okay. Kelly got on a call with DP, who said, "Hey," they had a $510,000 sale. I said, "Hey, get them on the phone." We were talking, Kelly said, "Well, we're presenting to you. You're coming to town." She goes, "What? I wasn't." I said, "Well, can you come to town?" I didn't know the whole team was coming. Thank you for coming.
Thanks for having us.
The real key is, I get asked every once in a while, "What do you think about Wayfair?" I don't really think Wayfair can pull this off. I don't think Wayfair can pull this off. I don't think they've got an integrated assortment. I don't think they've got a dramatic presentation. I don't think they have the design talent on their team. I don't think they have the passion. I don't think they have the connection with people that we can make. I just don't see that happening. When you think about this, we're just getting going on interior design. We're just warming up. We're making big steps. This is going to be a huge part of our business, and already it's 65% of our business in our retail galleries now. Interior design, where we have an intimate connection with the customer.
We're going in their home. When we go in their home, we see lots of opportunities to help them further. To help them inspire a whole new opportunity. The huge competitive advantage. I know other people have design services or this or that, but they don't have real interior designers. They don't have people that live and breathe it. I think they have part-time hobbyists or visual merchants that are being sent in a home to decorate. We're not decorators. We think about design. We have a really clear design ethos in our company. It's all about a reflect. Starts with a reflection of human design. It's about balance and symmetry, and order and proportions, and it's about the golden mean. You'll see it when we walk through our galleries, but there's no accidental things that we think about from design.
I tell you, when we go to this gallery across the street, and I'll take you through a tour and we'll talk about these things, but just study the way things are presented and the order things are presented. Because what that does, it gives us credibility. It gives us credibility to the consumer to come into this amazing space presented in an amazing way. It renders not only our product, it renders our people and our designers more valuable. All of this is a huge integrated play. It all works together. It's not really independent, and we're going to get better and better at this, and you'll see us making more investments to differentiate the brand and deliver thank you time value. Thank you, team. Yeah. Thank you. Okay, great. Let's see. I don't want to have a feedback mechanism. Someone take this.
Thank you. Thanks, Jack. We do some advertising. It is our truth. It comes from our truth group, not our marketing department, because we don't have one. This is some of the ads that you've probably been seeing in the key publications, in interior design magazines across the country. It says, just boldly on a spread, it says, "Imagine yourself here." You turn the page, and that's what you see. RH Interior Design, the infinite potential of a blank canvas, the home you hope to create. All you have to do is imagine. How to contact us and contact our design services. I don't know if they saw our gallery first or they saw this ad first. I think this is a really good campaign, and I think it gets across the idea, and it demonstrates our work.
How we can transform a home or a room, or an outdoor space. Okay. We made the brave move. It has the RH Members Program. Some of you still call it the gray card. It's not the gray card. What happened with the gray card? They thought it was a credit card. They thought we were like a department store trying to give them 15% off to take the credit card. There was mass confusion, and it wasn't good. Barry and Henry, you guys were right. They said that, I think, the first week. We renamed the gray card to the Members Program. We made the brave move from a promotional to a membership model that has enhanced our brand, streamlined our business, and dramatically improved the customer service, customer experience throughout the company. Huge.
As you know, the transformation of our real estate has the potential to double our retail sales in every market while lifting our direct revenues. Has anybody ever said that in the history of our industry? Has anybody said, "Hey, we have a new store concept that will double our retail sales in every market while lifting our direct business"? This is a really big idea. It is never been done. Why can we do that? People go like, "How do you build these big galleries and how does the productivity work? How does the model work?" There is a lot of pieces to the model. We will tell you some pieces of it. We do not want to expose all the confidential parts, but here is the headline. Less than 10% of our assortment is presented in our legacy galleries.
Before we take you through the magnificent experience that we have just built across the street, what is it about? Probably 40 yards away is our existing legacy gallery, and it is still open. We all get a chance because sometimes we do not even get the chance if the gallery is closed. I would really like you to have the opportunity to walk over and see this is who we are to the consumer today, walk 40, 50 yards, and then go, "This is who we are now." Ask yourself, who does that? When we are in a meeting in this company and we are trying to think really hard and see what others cannot see, you know when we know we are on the right track?
When somebody has an idea, everybody else in the room goes, "Well, who does that?" Usually the dots connect, the light bulbs go off, we go, "We do." Because the idea is that good. I think the idea, our real estate transformation, and these new design galleries are that good. It is that good of an idea. I think the numbers and the transformation that we are seeing today is just the beginning. We are planting a flag. We are claiming a market. It is not about just year one or two or three. It is about what is going to happen in the next 10 years, how this brand is going to be perceived. It works because we have spent over a decade merchandising our business beyond the four walls of the store.
We were trapped in these legacy real estate galleries that were built for Aqua TROLL and yellow sofas and pine tables and Bite Me dog toys. We were not limited by that real estate. We said we were going to merchandise the business beyond the four walls of the store. We were going to size the assortment to the potential of the market versus limiting it to the size of the store. We used the catalog and the web, we built the best assortment in our space in the world. The vast majority of our retail stores are still these little legacy galleries.
In our own hometown in San Francisco, Marin County, in the center right next to our headquarters, people go, "Oh, I've been to your flagship store." I go, "Oh, where?" They go, "In Corte Madera." That was store number five, I think, in RH. Store number six. The consumer doesn't even know in our hometown. They go, "Oh, I've been to your flagship store in San Francisco, the one in the Design District." It has 4,500 feet of selling. They think it's our flagship store. We are the best-kept secret in the world today from a brand point of view. We really are. The key here is to unlock the value of the assortment, we have to transform the real estate. It's a huge opportunity, and I think the numbers are going to be worth more than this long term.
I think it's like when Apple got into the phone business and they realized there was customer acceptance. Do you know that, I think it was just three or four years ago, they said the Apple phone won't work in China. It won't work in China. They won't pay for it. They can't afford it. It is the number one phone in China. Markets change when you do extraordinary work. The other thing we like to say is it's not about the internet. Only 12% of retail sales are done online. It is about the lack of imagination in retail. Most retail stores are archaic windowless boxes that lack any sense of humanity. There's no natural light or fresh air. Plants die in a department store. This has got nothing to do with Saks Fifth Avenue. Shit, I hope they don't sue us.
This is webcast, I've been showing this for a long time. It just happens to be a former Saks Fifth Avenue location that if the name wasn't there, could be mistakenly identified as a bomb shelter. It was torn down in Cherry Creek in Denver, Many of you were there when we opened it. We did an investor day a couple of years ago. We're building inspiring spaces that blur the lines between residential and retail that are more home than store. It's an important part of our strategy. It's more home than store. They're spaces that are flooded with natural light and fresh air, with garden courtyards and rooftop parks. Here's a picture of RH Seattle, the gallery in University Village. Here's RH Los Angeles, the gallery in Melrose Avenue. RH Austin, the gallery in The Domain.
RH Las Vegas, the gallery in Tivoli Village. RH Atlanta, the gallery in the Estate in Buckhead. RH Chicago, the gallery at The Three Arts Club. This was an important inflection point for us, We're going to spend a couple of minutes here. The next logical step for us in this journey was to further blur the lines between home and hospitality by seamlessly integrating a restaurant, a wine vault, and a coffee bar. We're not the first people to put a restaurant in a retail store. If you've seen recent attempts, they're really kind of bolt-ons. They're not seamlessly integrated. It doesn't really have anything to do with the experience. We think what we're doing here is revolutionary, and it's an experience that cannot be replicated online. It's one that activates all of the senses.
It activates all of the senses, and it drives significant consumer traffic. We're going to just play a little video for you.
[Presentation]
If you haven't been to RH Chicago, you really have to stop by. We've probably been there 20 times. There's so much to learn and so much we've obsessed about and learned about. We saw the impact of the integration of hospitality right away. We were really surprised by the numbers in Chicago. They were way ahead of anything we thought it could be. By the way, we're in the middle of a residential neighborhood. There's not a retailer for five blocks. Every weekend since opening weekend, we've had a line around the corner. I've never seen anything like it, even when it's snowing. This was a picture that was taken early on. I just got a video a few months back from John, our chef there, that took a time-lapse video showing all these people coming around the corner.
Name another retail store that has a line every weekend that wraps around the block to be able to get in, and there's no traffic. I remember the mistake I thought I made. David joined the company, and this was not an easy sell with the board. We wanted to open a retail store in the middle of a residential neighborhood, no one anywhere around, and we wanted to open our first restaurant in the middle of it, and so on and so forth. We garnered the board's support, but it was a big leap at the time. The economic model looked good. The financial risk wasn't as great, because we were kind of not paying for prime real estate. I remember, what was the date?
About two weeks before it opened or something, Dave and I are on the fourth floor, and they took the paper down from the windows, and I'm standing up there with him for about a half hour, and I'm looking down at a street that no one walked by, like for about 30 minutes. I go, "Dave, we've been here talking, and in the last 30 minutes, nobody's walked by.
I think I jumped the shark." I'm thinking to myself, "How did I even talk myself into thinking this was a good idea?" You ever have those moments when you have an idea, then you go do something, then it seems like a really good idea, then you're sitting there with yourself with that idea later, and it's kind of showtime, and you're thinking, like, "What the hell was I thinking?" I'm thinking, "This isn't going to work." I'm saying to Dave, "Dave, I might have really blown it here. This could be a disaster." Dave's new to the company.
He's probably thinking, "I just came to work for this guy who's having a mental breakdown on the eve of opening a really important store." Dave said, "No, listen, I know people in Chicago, Barry." Dave actually is an investor in a restaurant business and knows quite a lot about hospitality. He says, "Look, the neighborhood really is going to support this, the people in Chicago are going to support this. It's really extraordinary. No one's ever done anything like this." I'm still waiting. Finally, I saw someone walking by the street, and I go, "We got one. It's been 37 minutes, and someone just walked by." So, the fact that it came together and worked. That's all being an entrepreneur, right? Is when you have to fight that battle.
This has turned out that the lessons here, and what we've learned in coming back and iterating. What it led us to is, quickly I thought I was going to put a restaurant everywhere, by the way. Brendan flies out. Probably we're open about two months, and it was clear this was a huge hit. It was going to be a huge hit. I had the team rallied in every new store we'd already done, Atlanta, Melrose, this and that. Everyone we're going to do, I've got the team concepting where we can put a restaurant. I remember sitting with Brendan, and I'm thinking he's going to be really excited, and we go through that meeting.
I'm like, "So what do you think of this one, and this is what we do?" He goes, "No." He goes, "No." I'm like, "Oh, okay." I'm thinking, "Oh." I turn, we go to the next plan, he goes, "Yeah, no, I'd never put a restaurant there." I go, "Really?" I'm thinking, I thought this one was really smart and great. We go, "What about" We went through 20 plans, I didn't get one yes. Not one yes. We'd had a couple that got his vote of approval, and that is one you'll see here. This gallery was being built without a restaurant.
We were trying to figure out where we could put it here, and we said, "Well, we could put it on the roof." We said, "Well, we've never put one on a roof before. Will that work?" Well, we said, "We can figure out how to make it work," we delayed the store by a few months. We had to reinforce it with new steel. We had to be able to have the load to put a restaurant on a roof. You're going to go up to a restaurant later, and dine in a space that was supposed to be decomposed granite and have some hedges and outdoor furniture on it, now it's a magnificent restaurant. The other one we did was Toronto, at the last second.
Going forward now that I've learned a lot more about hospitality from Brendan, and really admire his discipline and deep thinking about those choices, right? At the time, financially, they would've been good for him. The initial deal we had together, he could've opened a bunch of restaurants, they might not have been that good for us, but they could've been pretty good for him. He is a really deep thinker about how a model will work and where it might work and where it won't work. The majority of our new galleries going forward will include hospitality, including the new galleries this year in Toronto and Palm Beach. We've been very thoughtful about where and how. This is a picture of RH Toronto that's just opened last month. It's the gallery in Yorkdale.
It's anchoring the new wing of the highest volume mall in Canada. This is the outside entrance, this is an actual photograph of the gallery. If you come in the inside, we did something really innovative. We had the developer, because they're building a new wing, put a 140-foot skylight across the front of our building. When you're looking at it from the mall and you're looking down the corridor of the mall that we anchor, it looks like we're sitting outside. The sunlight comes straight through, illuminating this courtyard restaurant. What's interesting here, this wasn't supposed to have a restaurant. This was a store that terraced back, like a couple of our galleries do and have had kind of balconies.
We said, "Well, what if we rip out the balcony above and we just create a walled-in courtyard with the sunlight coming through, we have olive trees, we create a restaurant across the front?" Again, not knowing if it was going to work or not. We just opened, this is what we know. In the first 25 days of operation of the restaurant, the volume is about 10% less than Chicago's first 25 days. Right? By the way, we're on a brand new wing of the mall. There's not a store for 100 yards on this new wing. There's us, they haven't filled it all in yet. We've anchored it, they're going to fill it all in. We were really worried.
By the way, the volume would be the same as Chicago's if we had gotten our license to sell wine out of our barista bar. You'll see we have a barista bar. A lot of times our restaurants have a wait time, and I think one of the magical things here is when you say, "Oh, would you like to get a cup of coffee? Would you like a glass of wine? Wander the gallery, and we'll text you when it's ready," and then they get to discover product. Dave, what's the latest greatest on the We think we're going to get it?
We think we'll be able to sell wine, and then this should be the same productivity as Chicago. We'll have more people wandering around with a glass of wine in the gallery, which usually puts them in a good mood. Every once in a while, you get one of those, somebody had one too many, and they get angry. Next coming up is RH West Palm, the gallery on Okeechobee, which is right across the street. Here you can see the dramatic courtyard, rooftop restaurant, wine vault, pantry, coffee bar. This is a little view of the restaurant. It was going to have palm trees until about eight days ago, when we came here, took a look at it, and we realized that the palm tree stocks were a lot wider as they all went up, and you blocked all the sight lines.
The best seats in the house in the corner, you couldn't see the fountain, which was not good. You're now going to see olive trees that just got imported in and installed a couple of nights ago. It's going to look a little different than this. Then you're going to see wine vaults that flank it on both sides, and you're going to see our pantry and barista bar, which we've now kept evolving the ideas. The ideas are going to get better and more relevant and more productive. This is the gallery in the historic Meatpacking District in New York. We love this location. It's quickly becoming one of the iconic corners in New York. It's anchored by the entrance to the High Line and the new Whitney Museum. It seamlessly integrates six floors of our multiple businesses and hospitality offering.
When you come in, we built this beautiful atrium that goes all the way up five floors to a beautiful rooftop restaurant and a skylight. I don't think that there is another retail experience like this in New York City that integrates the floors and the businesses so beautifully. We're very excited about it. As you come up, this is the rooftop restaurant. It will be in the middle of a park. We've got this beautiful sculpted kind of garden park that's being installed on the rooftop. We think it's going to be the modern-day Tavern on the Green. We think it's going to be a landmark in New York. It's going to be that beautiful. There you have it. Those of you that want to say, the shorts in the room is like, "They delayed New York. There they went, they misstepped, they screwed up.
They can't execute." Right? I said, "Guys, we have to have the picture here so they don't think that we screwed." New York we could open. This is the picture from last week when we were there. Yeah, yeah. Last week we were there. Dave took the picture, and he said, "Look at this. This is incredible." I go, "Hey, give me that picture because I got to prove to the world that we're not late opening the store." Those of you from New York know they're doing a whole infrastructure project. They're ripping up all the streets. They're putting in all new infrastructure, all new cabling. They're doing all new cobblestone streets. If you zoom in on that sign, "Sidewalk closed." Right? We didn't buy that sign and hang it up there. We didn't install this and stage this. We're pretty good stagers, okay?
This is why we can't open this fall. By the way, if it gets a little better, like late December, January, it's not supposed to be done now until the spring, which could mean the summer. You're dealing with the city of New York, right? You can't really hurry them up. It doesn't work that way. It's going to be spectacular when it's done. We don't want to try to force it either. You don't get a second chance to make a first impression in the most important city in the world. Okay? This is the most important city in the world. We extended our lease in our current gallery in Flatiron, costing us a few million dollars.
We should have called that out in the P&L, too in the release, because we're going to pay a little bit more rent for a while to keep it open. Unfortunately, we can't charge the city of New York the delayed fee on this rent. This will be a spectacular gallery when it's done. With only 15 galleries, we are in the early innings of our transformation. We believe we have the potential for $60-$70 in North America. We remain confident in our long-term goal of $4 billion-$5 billion in North American revenues, with industry-leading operating margins and return on invested capital. We believe long-term, we can grow the revenues of this company 8%-12% a year and grow our earnings by 15%-20% a year, and we believe we can do that for the next 10 years.
We think we've got really good line of sight with our retail strategy and the productivity with hospitality now being integrated in these galleries and the expected lift we're going to get from hospitality, and many new kind of product concepts and kind of new iterations of the RH brands that are in the pipeline that we're not going to talk about publicly. We also believe, and believe really strongly about this now, that the long-term opportunity for international expansion is, we believe, is huge and that RH has the potential to be a global brand. We are exploring locations to open our first gallery in London. We know the location we want. We looked at a lot of them. It's the only one we want. It's the one we've got to get. It'll be amazing and introduce the brand in London. Terrific. It's a few years away.
Take us a while just to get the real estate deal. We think the brand is highly accepted. We have customers today that are actually shopping in New York, shopping in Florida. We don't ship internationally today. They actually get their own container, and they're filling up containers and sending it over there. We're doing real money, millions of dollars internationally. We think that there's a huge opportunity to unlock this brand across the different oceans. When you step back and you consider, one, we are building a brand with no peer, two, we are creating a customer experience that cannot be replicated online, three, we have total control of our brand from concept to customer, total control, that you realize what we are building is very rare in today's retail landscape, and we would argue, will also prove to be very valuable.
With that, we're going to take a 20-minute break and come back, and we're going to talk about our new model, and we're going to open it up to Q&A. Karen Boone's going to take you through a few slides of our new financial model. It's 4:00 P.M., so why don't we come back? It's 3:54 P.M. Let's come back at 4:15 P.M., okay? Great. Thank you, everyone.
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Okay. One second here. Should have my ringer off. Okay, welcome back. To spend a little bit of time on our new model. This is how our model's evolving. We're doing a lot of things simultaneously to build a new operating platform. We're architecting an entirely new and fully integrated operating platform. There's a couple of big pieces to it. One is the new membership model, two is this new kind of operating model and operational model, and three is a new real estate model that we'll talk to you about today. Let me first start on the membership model. We'll give you a little bit more insight into this, but not too much, because it's still really important that this is a proprietary move. We took a big risk here. It is working. We don't want to give away the secrets.
Here's what you need to know. There was two objectives when we began this move to membership. One was to simplify and streamline our business. Okay. Simplify and streamline what is a chaotic industry and a chaotic business called retail. Develop a deeper connection with our customers. It's funny because I've got some of the team here, Sandy and Christie and Stuan are all here. They helped give me the courage when God, what was that date? We need the date. We were-
January.
January 4th. We did a walkthrough at our L.A. gallery, we went and we're doing a recap at a little cafe called Zinc, right. We're sitting around and we've been talking about this concept, we've been talking about it for a few years, of making this move from a promotional model to a membership model and the benefits. The team looked at me, I think Sandy kicked it off, and she says, "Gary, we have to do this. We have to do this." I said, "Look, no, we're going to do it." Then she goes, "No, no. No, we have to do this." The three of them are looking at me, and she goes, "Pinky swear." I swear to you guys, pinky swear. It's famous in our company now, the pinky swear.
I said, "Pinky swear." All the pinkies went in. I knew that was it. I would've lost all credibility as a leader if I would've broke that pinky swear. It's great having you guys here today. The pinky swear team that helped give me and the leadership team the courage to make this move, which I think is revolutionary. I think it's going to be looked back upon in the history of our company as one of the most important things we'd ever done. The objective, simplify and streamline our business and develop a deeper connection with our customers. Those were the two objectives. We believe that membership has eliminated the frantic buying patterns and associated returns, exchanges, and canceled orders that are a result of a chaotic promotional model. This is the actual graph of 2015 of our business before membership. Okay.
This is how it operated. Up, down, up, down, up, down, up, down, up, down. Okay. It creates massive chaos on an operating platform. It is really hard to run a business that is doing that and having these wild swings. This is our business after membership. Okay, this is 2017 and the trend going forward. Okay. The new membership model, what does it do? It dramatically simplifies sales forecasting and improves inventory accuracy. Try buying inventory to the blue line and try being right. Okay. It creates manufacturing efficiencies and lower costs. Imagine the impact on a supply chain.
Imagine the impact on the manufacturing base when you're always wrong with your inventory bets in this chaotic system, when you have all these different promotions and somebody decides to add another day, extend it by this, have a St. Patrick's Day sale with 17% off or all the crazy things you see in these emails. It's just total chaos. It moves everything around and makes the business hard to track. You spend an inordinate amount of your time as a leadership team of a retail company just trying to figure out your business week to week because it's so chaotic. It also improves execution and productivity throughout the supply chain and the gallery network. The DP will tell you and the teams will tell you, scheduling in our stores, in our galleries, how difficult it was.
All of a sudden you have an end of event on a weekend and all this business happens in one or two days. Then all of a sudden, no business happens. Very little business happens for the next two weeks. Then all of a sudden you have another big event. Hiring, training, allocating human capital correctly in a chaotic environment like that. Think about it from a home delivery point of view or distribution center point of view. All of a sudden, all these orders come in and now you've got to work double shifts and you're trying to process all these orders and hit the timelines. Then all of a sudden, not a lot of orders, and you don't have any work for anyone. 60% of your team is like, "I'm sorry, I have no hours for you this week." Right?
Oh, but please come back three weeks from now at the end of the next event." All through, it's massively chaos. I think those of you who have never really worked behind the scenes in a retail company, you look at something like our gallery or you look at retail, something like that looks amazing and so on and so forth. You go inside, if you were able to really, those of you who haven't, sit inside and work in a retail business that's got a promotional cadence. It is massive chaos. You'd never invest in a company if you really knew what it looked like behind the scenes. You'd think this is chaos. It was. Some of us thrive on the chaos, right? I don't know why, but we're okay with it, probably because we grew up with it.
Most of us didn't necessarily decide, I mean, I wasn't sitting there when I was 15 years old in high school saying, "Hey, I'm going to grow up and be a stock boy at The Gap, I'm going to work in retail my whole life and work my way all the way up." Some of us just find ourselves, we just got into this business and you get used to the chaos. Some of you think, "It's just always like this," right? We're humans. We're used to it. Simplifying, removing the chaos from a retail model, I think all of us here that we said and we had the pinky swear. Then we said, we had a leadership team meeting, we're all sitting in our leadership team room, sitting around the table. I go, "Do we have the courage to do this?
Do we have what it takes to do this? Because we are going to have to march through hell for this heavenly cause." We are going to get destroyed. Our stock will get temporarily destroyed. We're going to get destroyed in the press. People are going to think we're nuts. They're going to think we lost control of the company. We've got to be able to make sure we are aligned here because we've got thousands of people in this organization that we have to lead through this. Are we prepared to do the work? Are we prepared to lead this organization through this move?
I think we're going to look back and we are going to remember this move for the rest of his life because not only just these things about the simplification and the efficiencies, the cost savings, the reallocation of human capital time, the time we have. We did a time study. We were spending like 65% of our time trying to forecast and manage and figure out our business from week to week. Right? Now that 65% of the time is back, okay. We're getting to think deeply about opportunities. We're able to discuss things that we have never had time to get to. We're able to find opportunities that we would have never even noticed were there.
The reallocation of our time with the human capital in the company and the benefit we'll get off that reallocation of human capital, we think is going to pay off for decades. We're also developing this deeper connection with our customers. 65% of our retail business is driven by members who use RH Interior Design. Okay? We give free interior design services to members. 65% now of our retail business in our retail galleries is being done through RH Interior Design. We are getting into people's homes. We are developing connections and relationships like the one you just heard about. Okay. We currently have 380,000 members that drive 95% of our core RH business, right? In that, what's not included is outlet, contract, and Waterworks, right? Am I missing anything? Yeah. Everything else is included.
Our core business is being driven, 95% of our business is driven by our members. Our membership fee income is up 37% year to date. Our membership fee income is growing faster than our sales. Those of you who've been studying retail for years or been an analyst and looked at models like Costco or looked at the developing model over the years at Amazon and so on and so forth, knows that if you can crack the code on membership, there's actually accretion, right, to revenues and to profitability in a membership model. Not that our model's going to look like Costco's, right? Because Costco drives vast majority of their earnings through their membership, and it's a key part to Amazon.
If you can figure out how to thread this needle, it's actually a really good model financially, it will continue to kind of build over the next several years. Let me talk about our new operating model. Three key areas of focus here. Our distribution network redesign, our reverse logistics and outlet redesign, and our home delivery. Our distribution network redesign. 16 months ago, exactly 16 months ago, we peaked at 1.1 million furniture units across 4 furniture DCs, 2 furniture storage DCs that used to be DCs, right? 2 storage DCs that are 300,000 square feet, and the other one's 508,000 square feet. Technically, you could have said we kind of almost had 6 furniture DCs, but they were just storing goods for those DCs. We had 1,000 storage trailers out in the yards that we couldn't fit into the DCs. Okay.
Part of that was caused because we have a business in furniture and Bud knows this, he was in furniture for a long time. We've high ticket, high average ticket, right, low velocity. Right? High average ticket, low velocity. It's naturally slow turning, the nature of the business when you have high ticket, low velocity. There's another complication to it. It's a SKU-dependent business. What I mean by SKU dependency, if someone is buying the bed, first, by the way, they have to figure out what bed they want. They want it with the headboard or no, the tall headboard, the shorter headboard, they want the footboard, they want it in king, queen, Cal King, or queen. They want it in one of four finishes. Then of course, there's a SKU dependency. They're going to get the nightstand.
A very high percentage of the time they're getting the nightstand as part of the collection. Now, do you want the large nightstand or the medium nightstand? Do you want the one that's open drawer or closed? Do you want it in one of four or five finishes? Then of course, you might want that dresser, right? You got to have all these things and all this SKU dependency, and you've got to actually have it in the right DC at the right time. There's a lot of people who talk to you, the consultants will come talk to you about, "Oh, well, you've got this system that can pick from any DC and it really doesn't matter where the inventory is.
The inventory is always in the right DC." Yeah, let's run that cost model because that was sold to us, right, we built that system we started opening furniture DCs, all of a sudden we were spending What did we get to in DC transfers, Jeff, $9 million a year? Yeah. Yeah. $9 million a year in DC to DC transfers, meaning that that piece of that order is in the West Coast DC and I need it in the East Coast DC. Now I'm transferring that to the East Coast DC, but where's the reorder coming? The reorder's coming to the East Coast DC, and I just moved the inventory from the West Coast DC. Now this boat that's going through the canal and coming up the coast is going to the wrong DC. What happens?
Now it's in the wrong DC, I get an order from the West Coast DC, the system transfers it from the East Coast DC, where I just trucked it back to the West Coast DC, now I get an order over here and it's in the wrong DC again, right? That happens all the time in a system like that. Unless you're really disciplined and you're into the details and you really start understanding the cost, inventory can implode in a business. It could be working capital drain and it just creates so much cost. 16 months ago, we peaked at 1.1 furniture units across four furniture DCs, two furniture storage DCs, and we had 1,000 trailers in the yards that couldn't fit.
I'll tell you this, the furniture was not designed to sit in a storage trailer without air conditioning, okay, in 104-degree heat. Which amplifies like an oven inside a container to about 180 degrees. Ship cracks, finishes get destroyed, and bad things happen when goods are in furniture trailers. 16 months later, we are on track to end the year with 535,000 units of furniture. Okay? What do we have today? 580? 582 last week, I think. 582,000 units of furniture. With plans to close two furniture DCs by the end of the year, total of 1.75 million sq ft. We have eliminated storage trailers, and the two furniture storage DCs are almost empty. We'll be talking about plans for those soon. Our business is growing. Here's the funny thing. Currently, we don't have a head of supply chain.
We hired someone. I put them in a video. They didn't fit. They haven't been here in the last 10 months. This team, working together as a collaborative group, looking at the whole picture, said, "We're going to build a fully integrated operating platform. We're not going to build it in silos." We don't want to play Whac-A-Mole like most organizations do. This team thinks this is really important, and they do that, and that creates efficiency here, and it creates something wrong here, and then you go try to fix that, and you focused on that silo, and something goes wrong here. We've worked together and we're re-architecting all these processes, and we're thinking about it all the way through the organization. Right? What will it impact?
Somehow, this team, without an experienced head of supply chain at the top, I think has figured out revolutionary ways to run this business because we're not victims of history, and we're thinking deeply about it. 16 months later, we've completely changed the fundamental platform that we're going to run the biggest part of our business on. We also avoided the construction of a planned 1.5 million sq ft new furniture DC in Savannah that would have opened this year. Our five-year plan had a DC how often? Every 18 to 24 months. Every 18 to 24 months, we had a new 1.5 million sq ft DC coming. That's what the model had. Our plan now is to run the business with two coastal distribution centers. We expect and know in-stocks will improve and inventory turns will significantly increase.
You can just kind of do that math, right? You go back to here and you go, used to have 1.1 million furniture units, now you're going to have 535 and your sales went up. They didn't go down. Right? Expect in-stocks to improve and inventory turns to significantly increase. We have total projected annual expense savings of $15 million that we've called out separately. We have other savings that are woven through this in many areas. We have total projected inventory savings of approximately $400 million versus our previous long-term plan. If you looked at the long-term plan we had 16 months ago and said, "What does inventory look like over the next three to four years?" Now you look at where we are and where inventory is going to be, we're going to take $400 million of unproductive capital out of the system. Right?
That's one of the reasons why we reallocated that capital we were getting and knew we were going to get back into our undervalued stock. We thought that would be a great reallocation of capital for our shareholders. Let's talk about the reverse logistics and outlet business redesign. We are now liquidating 90% of our returns in-market, eliminating the need to transport product back to our distribution centers. How long are we into this now, guys? What, three, four months into this now? Huh? Yeah. About three, four months into this. We're moving very quickly. Let me give you a scenario. Let's say we had an order in Denver. We would have shipped that furniture from Patterson, that's just outside San Francisco, across the Rockies to Denver, right?
If there was a return, and it's got cross dock at our HDL provider who delivered it into the home. If there was a return, our HDL provider would pick up the goods in the home, bring it back to the HDL. We'd hold it in the HDL until they had enough for a full truck to go back to Patterson, which could have taken weeks or months. Okay? We'd put it on another truck and we'd ship it all the way back to Patterson. We'd receive it in Patterson. By the way, you don't even want to think about what happens to furniture once it gets out of a box. Okay? Once furniture comes out of a box, you better get it delivered without many touches because it never gets better. Okay?
Furniture never gets better when it's traveling through a supply chain once you take it out of a box. It's now moving out of a box back to an HDL. It's getting stacked up in an HDL. It's waiting for a truck. It's now getting touched again and put on another truck. It's shipped all the way back to Patterson, just out of San Francisco. We've got another team taking it off another truck, now we're taking it and we're sorting it. Now we're sorting to see what's first quality, what's second quality, and what's third quality, which is basically just written off. Second quality goes to the outlets. We had somewhere in between 10% and 20% that might have went back to first quality.
We would medic it, we would repackage it, 10%-20% of it, and it would go back into first quality. I guarantee you did not want to be the customer that placed the order and had that product that traveled that distance, that got touched that many times, that got medic'd, put back in a box, and got shipped again. We don't know the data on this, and we're changing the process very quickly. We just weren't measuring this. I got to believe that was marked first quality that got shipped back to Denver, or it got shipped somewhere else, to Seattle, that that probably came back, too. There was probably another move there. We had a whole team. We had medics. We were reconditioning it.
By the way, we were holding the inventory in the distribution center, waiting to deliver it to an outlet. The second quality stuff that didn't go into first quality, which the biggest part of it was that, it then got put away, and then it got touched again, and then it got loaded onto another truck, and then it traveled to an outlet, and it got touched again, unloaded, put in an outlet store. Not a pretty process. Not a pretty process, and nowhere near cost-effective. Made no sense. What are we doing now? Take the same scenario. Product's in Denver, gets picked up by the HDL, gets taken to an outlet directly in market. We now have 90% of the business, and we're moving quickly here. Just in a few months, we went from zero to 90.
A month ago, it was at 70, and we'll get it to 100 quickly. We're repositioning outlets, and we're realigning the system so the goods don't get touched. They'll be in better quality, and they'll go right to an outlet, and we'll sell them in higher margins because they didn't get screwed up along the way. We expect our tests and measurements here, said we expect will result in cost savings and margin enhancement of approximately $15 million-$20 million annually. From my point of view, that's a very conservative number. Let's talk about home delivery a little bit. Our evaluation of the home delivery network has led us to several conclusions. One. The current provider networks, the current third-party provider networks that we use are not designed to deliver a luxury customer experience. Most are low-cost commodity models.
When we started reviewing this, part of the team was deep set in the old culture. Nobody likes to be wrong. Nobody likes to be in a meeting and have the work you're doing be challenged and critiqued and all of a sudden it might get exposed to say, "Wow, this is really dumb." People generally try to defend history, and we know that, and we understand. It just happens. It's human nature. I remember one of the meetings, and we were in, there was this kind of defensive push because it just didn't make sense, like, wait a minute. We are paying a third-party provider to broker a delivery who's paying a third party, or you might call them a fourth party trucker, to then go deliver our furniture.
We've got 2 markups, then we're paying another third party to pay all those people. It's really convoluted, and you realize it's just the way it's been built in this country. Why? Because nobody's really built a furniture distribution network. Most furniture companies have been regional. They've worked them out regionally, and they've been family-run businesses and stuff, and they've been regional. Very few people have tried to scale this, it's been mostly scaled through third parties. I think a couple of people who have gone more nationally have done it and done a pretty good job, but nobody really at the high end. There's no standards at the high end of the business at the luxury level for the customer.
We're at this meeting, part of the team was saying, "Hey, some of these providers are fantastic," and this and that. I said, "Great. I'm sure they're really good people. I'm just not sure we're architected correctly." I said, "Tell me, take that one you're talking about right now. Who do they deliver for?" Team didn't exactly know. I said, "Somebody's got to know. Who else do they deliver for? It's not just us. Who else do they deliver for?" I said, "Pull up their website." We pulled up their website. Who do they deliver for? They delivered for Ashley Furniture. Okay. Really good company. Price points significantly lower than ours, customer expectations significantly lower than ours. They deliver-- Who else was on that list?
The Dump.
Yeah, The Dump. Anybody heard of The Dump? How many times have we sued The Dump for knocking our stuff?
Twice.
Twice. We've sued The Dump twice, right? Because all of a sudden, they have big flash things on their website or in their store signs that say, "The Restoration Hardware Maxwell Sofa, for half price." It's not the Maxwell Sofa. It's not the same leather. It's not anything. It's a rip-off, and they actually take our photos from our website, then they put them on their website, and they use them in their marketing, and they run ads. We've sued The Dump twice. If you saw The Dump, and it's not this meeting, this is true. I said, "Can we pull up" Anybody been to The Dump? Nobody in that meeting had been to The Dump. I said, "Pull up their website. Let's take a look at The Dump's website.
Let's pull up our website, and let's just do a little comparison." If you saw The Dump's website, you'd realize our product should not be delivered by people who are delivering product for The Dump. They're delivering for Dorothy's Furniture Store.
Jerome's.
Yeah. Just a whole bunch of random people that were in nowhere near the customer experience or quality level that we were at. Really, we have a lot of work to do here, and what was great, and by the way, the stuff I'm saying is public, and yesterday we had most of our home delivery providers and third-party leaders were all here. I said, "Look, we got to have an honest conversation here. Do you want to be in the quality business? I don't mind if you want to deliver for these people, but not with the same people, not the same warehouses, not the same trucks.
If you want to partner with us and you want to create a luxury experience and build a delivery network for our customer, let's have the conversation because, and by the way, let's have a conversation about cost because it's not right for me to say I'm going to pay the same as The Dump or Ashley, but I'm going to have expectations that are here." I said, "Let's talk about how much it costs. Let's talk about what's the service we want to have, and how do we architect it backwards?" Because I know returns are going to go down, customer satisfaction's going to go up, revenues are going to go up, margins are going to go up. Every metric will go up if we deliver better service.
By the way, we're going into homes with strangers who don't work for our company, who don't know our values, and that we don't have control over. We have tested now in the Bay Area market and insourced our own home delivery. We have, what, 10 trucks?
10 trucks.
I should have the pictures. Trucks, sexiest trucks you've ever seen. Yeah, seriously. Charcoal, metallic. Some of the supply chain team complained Eri's team took three months to approve the gray, right? Folklore now says it took two years to approve the color gray. It wasn't two years. It was two months, but we had to get the color gray. We're going to buy these trucks. We're going to make an investment. It's going to be our brand. What's the logo on the truck going to say? We have a beautiful RH logo on the truck, and it's got a graphic that's beautiful that's pasted on the side. It says, "There are pieces that furnish a home and those that define it." By the way, a good part of our furniture was being delivered by some guy that rented a Ryder truck that week and was delivering our furniture.
Hiring a partner, it's so far away, the odds of it being great are not high. The opportunity is way beyond high. It is huge. We believe it's going to be a huge unlock. Let me tell you what some of the early testing, here's the other thing, that our scale creates the opportunity to insource and/or build exclusive partnerships. We have the scale. Nobody has our scale at the high end today. Nobody. We're the only ones that can do this. Our current test in the Bay Area, while still early, indicates there's significant opportunity. Here's what the numbers look like. An independent survey sent to our customer serviced by our own insourced operation received a 93% satisfaction score versus our outsourced providers with a score of 62. That is a big gap. It is a huge gap.
We're just getting started, we're not that great. We're just figuring this thing out. Our insourced operation scored 100% when asked if you would request or recommend our delivery drivers or service versus our outsourced providers with a score of 77. A huge gap, a huge opportunity. You look at this and you say, even though we only got a 93 satisfaction score, something went wrong 7% of the time. Here's the good thing. These are our people. We hired them. We trained them. We're dressing them. They live and breathe our values. I'll tell you work in DP's operation, he's the Chief Values Officer of the company, you know the values. You have values meetings every morning in DP's organization. You have values calls every week in the organization.
My sense is, even though we screwed up 7% of the time, because our people cared and they reflected our values, the customer still would request or recommend them. That's a big deal when you screw up, because it means that you can save that business and you can save that customer. We believe this is a massive opportunity here. Let's talk about our new real estate model. By the way, in each of these areas, when we open up into Q&A, you'll have plenty of time to ask questions to the team. They're all here and they'll answer any of your questions. They decided it was more efficient to have me go through this presentation than having us get up and down. We practiced getting up and down and going back and forth, and it was kind of a little odd and inefficient.
Let's talk about the new real estate model because Dave is going to make a massive impact to the return on invested capital and the capital structure of the company with this new strategy he's putting in place. We're transitioning from a lease to a development model through a sale-leaseback structure that will reduce our capital requirements and increase ROIC. Let's give you some points here. One, we had two key learnings from our Chicago design gallery. We were successful in creating a standalone retail destination, very important point, and the addition of an integrated hospitality experience creates a more immersive customer experience that drives traffic. Dave has brought on Eastdil Secured. They are the premier real estate investment banking group, will identify capital partners and arrange sale-leaseback transactions for us. It is a whole new way of doing real estate.
Basically what it does is it cuts out the landlord and it takes a big chunk of the landlord's profit out and we're going to vertically integrate the real estate process. We believe the vast majority of new galleries will require little, if any, upfront capital from RH. Okay. Not this year yet, because the deal's in the pipeline. When, Dave, will we first start being affected?
In 2018. 2019 will be full.
2018, 2019, yeah. We have deals in 2018, development deals that are using our capital. Right. We'll get that capital out. We'll get our capital out, but there'll be a timing issue where we put our capital up to develop and then we get our capital out. Eastdil's creating a structure and a model where for a slightly higher cost on a cap rate on a building, maybe 20 or 30 basis points over a period that we can actually have the investment group fund the capital. Right? We think we can get to, in many cases, a zero capital model. We believe long term, the vast majority of the galleries will require little, if any, upfront capital from RH. You say, "Hey, Gary, why are you comfortable talking about this?
You're not comfortable about talking about some of the things in membership, some of the things here, there, and you're talking about this publicly and people learning." Our competitors can't do this. Right. You have to be able to sell on multiple floors. You have to be able to optimize a real estate pad. You have to be able to be a standalone location if you need to. Okay. The ability for us to take historic buildings and transform them, the ability for us to take a piece of property in the middle of Okeechobee that was going to be a 20-story office tower, right where the Our competitors can't do that. Right. They're mostly one-level retailers. Right. They don't know how to retail on multiple floors. They can't make the economic model work, and they don't have our volumes to make it work.
I could say other things they don't have, I'll be nice. The key benefits of a development model, opportunity to buy and develop unique retail locations, ability to structure sale-leaseback with significantly lower rents, the ability to eliminate percentage rent, okay, and expensive triple net charges and passthroughs, and the ability to minimize depreciation and amortization on our balance sheet. Right. All really good things. Let's talk about one that's in motion. This is one that Dave already had in motion that we're using some of our capital, but it will actually transition over at some point during the development stage and will become fully in the new model. This is a freestanding pad site at Southdale Mall. What's interesting about this, Southdale Mall is owned by Simon Property Group.
When Dave said, "I think I can get David Simon to sell me the best corner of Southdale Mall," the hard corner of where, Dave?
69th and France.
69th and France.
East side.
Sell me that property. Anybody knows David Simon? David Simon doesn't sell a lot of properties. He buys a lot of properties, if he's going to sell properties, you're probably not going to get a great deal. Okay? Dave knew David and has had a relationship with him a long time. Dave believed that we could render David's mall more valuable, and this would be more valuable to David Simon than having a Shake Shack or having a restaurant out of the corner or something else that they might be using this prime property for. This is what we're going to be building there. This is the location. Here you can see the streets that come around. Dave, which one is the one is?
The north-south is France and the east-west is 69th.
Is 69th. This is the hard corner. You can see the red is our development site right here. This is Southdale Shopping Center. We're filling it with a garden of browns. Imagine something like you're going to see across the street here. It'll help you see it once we do the tour. In the development and lease model comparison, we'll show a couple slides. In the development model, sale-leaseback, we'd invest $33 million to own the land and the gallery. We've already purchased the land for $2.5 million, Dave?
Yes.
Right. They're doing about, what, $500,000 of work on it?
Infrastructure work, yes.
Infrastructure work. Our pro forma says we're going to invest $33 million to own the land and develop the Gallery. It'll have a restaurant and all the amenities you're going to see across the street. We believe we will sell the property for $33 million and a leaseback property for $1.8 million annually, that would be a significantly lower rent structure and zero capital structure versus what our previous alternatives would have been. In a lease model, we would have no ownership of the land and Gallery. We'd invest $15 million of our capital in Gallery leasehold improvements. We would have somewhere around $1 million of depreciation a year, or maybe a little bit more in the early years because you have some time depreciation rules. Then we'd lease the property for about $1.8 million, plus have $400,000 of percentage rent in the model. Right?
It kind of looks like this if you look at the comparison. The RH development model has a net zero capital investment and no percentage rent, generating $25 million of incremental cash flow versus the lease model over a 15-year term. Okay? You see here sales in both models, $30 million. By the way, in this case, we are in the center right across the street in the Edina Mall, we had a deal that I did that was signed that I thought was a great deal that looked like the old model. Right? I thought I was really doing great, then this new guy joins the company who we all call the most interesting man in the world. He's really like the Dos Equis guy. He's the coolest guy in the company.
Structured the deal that made my deal look so bad, right, that we had to go figure out how to break up the deal across the way where we still have a store today. We were to break it up, and the deal comparisons looked about like this. Dave's deal was $25 million of cash and earnings better than my deal. Dave's deal is a net zero capital deal. My deal was $15 million of capital up front. It's not even the same world. It's not even the same model when you project this out long term and you think about what the capital structure of the company will look like using this new model. Oops. Anyway, in closing, before I open it up to the Q&A, I would say this. It's not about Amazon, with all due respect.
They are an amazing company and amazing what they do. It's not about big data, with all due respect. We love data. We love numbers here. We're obsessed about numbers. Right? Tana is our Chief Merchandising Officer, shaking her head saying, like, "Yeah, he really likes data." If you were in meetings with us, we really love data and love the numbers. What we believe it's about, what we believe the future of retail is about, is about imagination. Right? We think that's the secret weapon. Albert Einstein, who's said to be one of the smartest people who've ever lived in our planet with one of the highest IQs, said this: "Imagination is more important than knowledge." Right? We believe it's about imagining a new and revolutionary membership model.
It's about imagining a new and dramatically more efficient operating model, a new and significantly more creative real estate strategy, and a new and inspiring way to live. In these dismal days of brick-and-mortar retailing, where every week and every day you're seeing some article that's saying how many retail stores are closing and how they're shuttering, and they keep showing pictures of Sears, like, oh, that's new news. Like a Sears store that doesn't look very good, that looks empty, that's not doing any business, that looks like it's going to close, like let's just plop that on Yahoo News one more time. In these perceived dismal and dark days of brick-and-mortar retailing, it's about imagining a new and revolutionary retail experience. I ask you to imagine this with me for a minute.
Imagine a retail store where you valet your car in front of a 12-foot high wall of water inspired by the famous fountain in New York's Paley Park, where you admire a 70 by 100 foot installation by the world-renowned contemporary artist, Retna. Where you wander through 10,000 sq ft of tropical gardens featuring artistic compositions of outdoor furniture. Where you navigate three floors of interior installations and imagine the home of your dreams with an interior design professional. Where you savor your favorite coffee drink and a pastry from a barista bar. Where you enjoy a glass of rosé in a dramatic wine vault. Where you dine under heritage olive trees beneath a soaring glass atrium while listening to the sound of trickling fountains and taking in the sunset in a rooftop restaurant. Try to imagine that online.
Again, the point here, it's not that I don't like online. Okay? I just really believe that we're physical creatures, and we need inspiring physical experiences to really activate all of our senses to get the most and best and productive use of our time. We're about igniting the human spirit. We're about connecting with people in a unique way, and that's what we spend a lot of time imagining. It's no different than P.T. Barnum imagining the greatest show on Earth. Right? Truly understanding that you can never make a difference by being like everyone else. With that, I'd have you watch this clip.
Can I have your attention? You're all dismissed. Bankrupt? Better luck with your next job.
I am not a stranger to the dark.
This is not the life I promised you. Not even close.
Because we don't want your broken parts.
Girls, I think I've had an idea.
Look out, because here I come. I'm marching on to the beat I drum.
P.T. Barnum, at your service. I'm putting together a show.
I make no apologies.
I need a star. Every one of us is special, and nobody is like any one of us. That's the point of my show. Ready? Showtime.
Look out, because here I come. I'm marching on to the beat I drum. I'm not scared to be seen. I make no apologies. This is me. Oh, oh. Look out, because here I come. Oh, oh. Marching on. I'm not scared to be seen. I make no apologies. This is me. When the world is gonna cut you down. Send a flood, gonna drown them out. I'm gonna stand a little louder. Gonna raise my hands. Oh, oh.
No one ever made a difference by being like everyone else.
This is me.
I can't just run off and join the circus. Why not? You clearly have a flair for show business. For show business? Mm-hmm. I've never heard of it. Because I just invented it.
We were inspired watching that film clip. It reflects a lot about how we think. We believe we have to create something really special if we want people to come spend time with us and spend money with us. We believe that retail is missing that theater, is missing that show. Now let's get ready to tour the greatest store on Earth, RH West Palm, right after our Q&A session. Before that, I want to turn it over to Karen because there's a couple of looming big questions we've been hearing about, and we thought, let's just address those head on. Is that okay? Take it away.
Sure. Okay, we're going to do a Q&A with everyone, I have a few slides that we're going to cover that are going to address probably one or two of the biggest questions that people have had about us for some time. Our balance sheet, we'll spend some time on that. Then the bridge, we're calling it. The bridge to our 2018 operating margin. To start, I wanted to start by saying that I've been here five and a half years since I've joined RH. I've never been more confident in our business and in our balance sheet. We've had a lot of ups and downs. We've had a lot of changes.
I think, as Gary mentioned, the time that we have had as a leadership team to spend post-membership on the business and the kinds of things that we're uncovering really make our business model It's at a place where it hasn't been in the five years. Even though we had years of 25% growth, I think underneath, there was a lot of just mess and noise. I think we're really getting to a place where we're building long-term, sustainable growth that's going to be executed well up and down the P&L and through the supply chain, in the stores, in the call centers, everywhere. Just wanted to start with saying that. Our business outlook and strong cash flow are giving us tremendous flexibility in how we think about the converts, our debt balances, and our overall just general liquidity.
We started by putting a debt summary up here. A lot of you guys know this, but you can see that we right now have about $1.1 billion of debt outstanding. Very attractive low cost of capital of 1.35%. That's because of those converts, which are at 0%. We are going to spend a little bit of time just making sure that everyone understands the converts. That will go down to about $1 billion even by the end of the fiscal year with more free cash flow generation, and you can see the improvement in those debt ratios just since we had our peak in Q2 to Q4 at the end of this year. When we think about the options, what are the options that we have as it relates to the convert?
That's kind of the key question I get a lot of times and Cameron gets, and has been kind of something that's been on everyone's mind. Let's talk about the options. Cash is king, we'll start with cash, and that would be our preferred approach because it avoids dilution. What kind of options do we have? Well, we've kind of talked about what the cash flow we've had over the last year, but some of that was inventory-driven. Is that sustainable? We have now told you that we actually do expect inventory to be a source of cash next year. Clearly not to the same level and extent we had in 2017, but it is going to be another good guy for cash.
We've put up here nothing new that we haven't told you, that $240 million that was in our press release yesterday, and then some illustrative, don't hold me to these exactly, but this is directional for how we might think about the first half of 2019 and the second half of 2019, and then that first half into 2020. The converts come due in June of 2019 and June of 2020. Based on this, we have the ability to pay down with our cash that we're going to generate and our existing liquidity sources, our ABL and such, that we already have on the balance sheet and have availability on to pay down both of these converts. Now, these are at 0%, might we use that to pay down ABL, which is higher interest? Of course. This is one scenario.
What are the other options as it relates to the convert? Well, we as a leadership team, I would say, spend a lot of time thinking about financing, really talking to our banking partners, understanding the capital markets, when we could access the capital markets. I'd say that I'd put Eri next to any creative person in the country on knowing different debt sources and structures and converts, because we do spend a lot of time talking about it. We could go out right now, I don't know that we could get a 0%, but we could absolutely get a very, very low coupon convert that effectively would push out the other ones. We would take that cash, pay down the ABL, which is at that 3-ish% and other high-cost debt, we'd have a lot of options in the future.
Of course, we could go institutional term loan. That interest rate obviously is not as attractive. That's another option available to us. I guess the point I want to make is just that we're not concerned about these. We think that we could pay them off in cash, we could refinance, we could add other debt. We think that the strength of our business kind of improved credit ratings. Our stock is still volatile, which is a key condition for a convert. We have a lot of options with respect to this debt. I'm going to put this up here. Just kind of talk through what the converts are. We get a lot of people who misunderstand the shares and the dilution component. I'll just kind of talk through the June 2019 one just as an example.
We do plan to settle the converts in cash. I'm going to talk about what these are. The maturity, I'll just talk on the left-hand column. The $350 million June 2019 converts have a coupon of 0%. We are actually not paying any cash interest. There is interest, which I lovingly refer to as fake non-cash interest, that is imputed for GAAP purposes. It is on the balance sheet. That is basically giving a value to the conversion premium. People were willing to invest in our company and give us money at 0%, thinking and believing that our stock would be over that $116 price back when we issued it several years ago.
Just to be clear, that's not cash interest payments.
Right.
Right.
No cash.
Just be clear.
It is zero. It's zero money.
No cash interest payments.
We thank Barry Sternlicht all the time for really explaining this to us years and years ago.
Yeah. Thank you, Barry Sternlicht. He'll be at the party on Saturday night.
There's four scenarios at maturity. Next June of 2019, in a year and however many months that is from now. If the stock price is below 116, we will pay $350 million in cash. We have no choice if it's below that 116 conversion price. If it is at 116, we have the choice. It is at our option. We can either pay $350 million in cash or this 3 million shares. Those are the base shares underlying the convert. We can have 3 million of shares issued and have that dilution, or we can come out of pocket with $350 million in cash. The third scenario is at maturity, the stock is between $116 and this upper strike, which is 172.
That was the bond hedge that we bought at that time and paid cash for to push up the strike price and the point at which we would have no true dilution. Even though the bond holders, if the stock's at $150, the bond holders are happy. They bet right that they said, "We think the stock's going to be above $116. Pay us in shares for that." We will absolutely issue shares, and we have contracts with the bank who will deliver us similar amount of shares such that we'll have no dilution. That's the third scenario. We still have the choice for the 3 million, whether we pay it in cash or settle and give 3 million shares. The above 116 up to 172, we're basically covered. Over 172, we're on the hook for those shares.
There's an IR table on our website that shows the amount of basically dilution that you'd have from the different conversion prices. As an example, this specific convert at $200, I just wrote it down, it's 400,000 shares. You can go to the table on our IR site and understand what that dilution looks like for both the '19 notes and the '20 notes and see what the conversion dilution is at those respective prices. I just wanted to make sure that that's really clear. That's at maturity and what's really going to happen. What happens to EPS before then? No one's been asking us that question because the stock price hasn't been near the 116. If your intent is to settle in cash, you don't have dilution because you're never going to issue those shares.
Our intent at this time is to settle in cash. Once the stock goes above 116. Because we also have shares that we're going to deliver, we actually have contracts to deliver those shares. We won't have any actual dilution. We won't have any dilution on our EPS. For GAAP purposes, there is a small amount of dilution. The only time we're going to have dilution for these shares is over 172 in our EPS. I decided I'd address that because people are asking right now, "What happens in Q1 if your stock's at 120? Are you all of a sudden going to have 3 million shares coming into your dilutive EPS count?" The answer is no. Okay. I'll move on, and we'll take questions on this afterwards if anyone has them.
The other point I just wanted to address is built-to-suit leases, because a lot of people think built-to-suit leases are debt, and they are not debt. A lease is basically us saying, "Hey, landlord, we want to use your space. We'll pay you money." They take our money. Whether it's an operating lease or a capital lease or built-to-suit lease is really just about the specific terms. A built-to-suit lease is not an operating lease. It is not a capital lease, so it doesn't show up as debt. It's not even really a hybrid of the two. Many of our leases require built-to-suit accounting because we're taking on some of the construction risk. It's the main thing that usually trips it up. It's a required accounting treatment under GAAP. It's not like we have a choice.
It's not like we're out there trying to choose to do this. It's something that we have to do, and our auditors require that we do. It requires a gross up of the balance sheet for landlord assets. In the case of Simon or landlords, their land. The land might be worth $10 million. That's going on our balance sheet. It's going up in property equipment. It's going down in a built-to-suit liability. It has nothing to do with us. It's never going to turn into a payment. It's never going to turn into depreciation. It's never going to impact the P&L. It's never going to impact the cash flow, meaning cash will never come out of our pocket for that.
You'll see, and it's very easy because we just disclose it all over the place in the footnotes, that you see a gross up of amounts in property equipment, the built-to-suit asset, and the amount in the liability as its own line. It really has nothing to do. It's just a gross up of the balance sheet. There is a landscaping issue that happens where some of our rent is down in interest. We disclose that. If you wanted to take that and say, "Hey, their margins might be worse by 20 basis points when I'm looking at their peers," or whatever the number is these days, because you have some rent that's included down in interest. Absolutely fair.
We put that all over the 10Q and 10K, so you can actually see what that amount is and do that calculation in case you want to compare it to our peers. The last thing I'll leave you with is this is all going to go away. Lease accounting guidance is changing. It's been on the list of rules for the FASB and such for years and years, and it's happening in 2019. Once this happens, everyone's going to have new rules. Everything's going to look different. Everything will look the same. We think built-to-suit leases as we know them now will go away. My main point here is it is not debt. On the bridge. We provided a 2018 preliminary outlook yesterday. I'm not going to read all these because it was all in the press release.
You can see our revenue, our adjusted operating margins, our income, cash flow, CapEx. We've given that all for you now. The bridge to 2018 operating margin, we wanted to put up here and just show where it's coming from a margin versus SG&A perspective. It is about two-thirds, one-third gross margin versus SG&A. Where is that gross margin going to come from? Mostly product margin, and that is things like outlet. A lot of the savings that we've been talking about from the reverse logistics, that transportation and DC occupancy savings, that's in margin too. All of the labor savings from some of those initiatives are actually in SG&A. This is just a high level bridge of where we're going to get that. I'm going to spend just 2 minutes quickly talking about the third quarter.
This isn't intended to replace our third quarter conference call. We're going to have that. It's early for us in the close process, so I don't have all the details and data that I normally would. We want to just make sure we've called out a few items. Total revenue growth of 8%. We had a 6% comp. That 8% was negatively impacted by, we think it was about 1 point from the hurricanes, and we have market data, and we know which stores were closed, and we know which ones didn't have any sales during those periods. So that was about 1 point. Gross margin is going to be at the high end of our guidance range. It was 460 basis points better than last year, and this is all preliminary, technically, I should say. SG&A, we did have a beat.
It was driven by compensation, and a lot of that's because of some of these initiatives and having lower comp in the DCs and galleries and efficiencies in our model that we've been talking about. Interest, I did want to point out. We retired, as you guys all know, the $100 million of second lien debt. There is a debt extinguishment charge. It's like an extraordinary item under GAAP. That's its own line item on the P&L. That calculation was a little bit different than we thought. We did have a benefit of $0.05 versus our guidance, and I wanted to call that out because $0.05 of that is just an interest beat from it being in this debt extinguishment charge versus just in the interest line in our P&L. Taxes, we did have an effective rate of 32%.
That's very different than our typical 39% we might have. The thing that's driving that is there was a new accounting standard update related to stock comp and taxes. If you had stock-based compensation awards and an option was exercised and the employee got a greater benefit than you were expensing, that used to go to deferred taxes. It now hits your tax rate. Because our stock price has been doing well and employees have been exercising their options and they've been getting a lot of value, that's a great thing for us from a tax perspective. It's a true cash savings for us for tax, and we expect that to continue in Q4 and towards Q&A items.
I think these are the two big questions we've been hearing.
Yeah.
Do you want to stay up there for a little bit?
Yeah.
Let's take your questions and make sure we're just answering all the questions around these two big topics. Yeah. Go ahead, Brock. You want to start?
Yeah. Question.
Do you want to take the mic so we can hear the question? Yeah.
Oh, I'm sorry. There we go. Cool. Thanks, guys. I have a couple of questions. I actually have one in three parts. It's about how you sell stuff. The first point is how do you actually sell your product? I know that's a stupid question, but it's always been like you have a leather sale, you have a flooring sale, you have a lighting sale, you have this, that. A, how do you sell it? B, how do people buy it? Do they say, "Okay, I'm buying a new house. I have to furnish it. This month I'll buy a light. I'll buy a carpet next month, then I'll buy a leather couch that following month." I guess one is a cost thing and one is a revenue thing as far as how they could be optimized.
Lastly, at least I think based on my own experience, probably not the higher echelon of stuff I've bought, but I think you pay once. You buy a bedroom set, you pay X for shipping. If something's available over a three-week time period, I get it. If it's available six weeks later, a different part, I might get that too, and I might get another piece if it's 12 weeks later. It's a balancing act as to how many times you have to pay on your end in order to get my furniture over to me in a timeline that's acceptable. I don't know if that makes sense or if I have my facts right, but it seems like there you have a revenue opportunity, you have a cost opportunity, and you have a work capital opportunity. Would you address that?
I think I'll address just I don't know if you're asking about just revenue recognition, but a customer comes in and in the past, they might have waited to buy their lighting on the lighting sale, and they would've bought their couch on the upholstery sale or something. Now anymore, with membership, that's one of the things that has been a great benefit is they're coming in, most people are spending a lot of money when they're redoing their home or they're remodeling or they've moved. They're coming in and they want to buy a bunch of stuff. If you think about that order that we talked about, that was $500,000, that's a big order. It's their whole house.
Unless they said, "I want it all right now," and they searched for stuff that was in stock, I'm sure they had some special order business, meaning it was custom, and it's going to be made for them. We don't recognize revenue. We call it demand, written orders. That's kind of a common industry term. We'll have that whole $500,000, but if there's three chairs that were being custom made and it's going to take eight weeks to get them, there could be multiple. It kind of depends what the customer wants. They could stage them and all get them together, but the furniture's not all going to be ready at the same time. We will have multiple delivery charges if they want it as quickly as they can, and we won't record revenue until it hits the customer's home. I don't know if that-
Okay. Got it.
That might not be exact. I don't know if someone else wants to-
One last question. I don't want to put you on the spot. If you get it right from having your end delivery, your final
Talk into this mic. There you go. You're waving the mic.
I think I screwed it up.
There you go.
If it gets to where it has to be or where you want it all to be on the final mile, what kind of gross margin, this could be pie in the sky, it could be maybe what you think realistically it might be, but how much are we talking here? Is this 100 basis points? Is it 500 basis points?
Man.
We have more work to do to quantify that.
Okay.
It's going to be a meaningful number.
Yeah.
Yeah. It's going to be a meaningful number.
Okay. Fair enough.
We're just getting into it. We need to get a couple more test markets. We need to line things up. We need to track the data and really understand what the data tells us, where the opportunity is, and then we'll invest more aggressively around the biggest opportunities.
To Gary's point with once the furniture's out of the box, good things happen when there's lower returns and exchanges and all those things. Having a better customer experience, having lower returns and exchanges, all those things are just.
Yeah. It's going to be a big number. I don't want to go out there and try to quantify it.
Hi, guys. I see you guys put a slide up there that showed, I believe, a little over $700 million of free cash flow.
Yeah. We'll go back to that slide. Yeah.
Through 2020, first half of 2020.
Yep.
Obviously, as you guys said, you could use that to pay down debt, given that you could roll up the converts, given that you could refinance the debt at lower rates. What are some other things that you could potentially do with that cash or think about doing with that cash, as it represents a pretty significant amount of your market cap still?
Sure. I mean, at this point, I do think we want to make sure that the debt levels are in check. I do think we will be focused on paying down and having more general liquidity. That said, right now we have these deals on the real estate. If we could do more of those ourselves and capture more of the value, that's absolutely something we would do. There's a lot of places we can invest just in the business. I don't know if you're asking about acquisitions or buybacks or-
Yeah. Let me jump on in this. I think we said 2017 was about execution, architecture, and cash, right? We wanted to execute our new business model. We wanted to architect an entirely new operating platform. We wanted to drive cash flow by optimizing inventory, reducing inventory, and capital spending. I think we're at the very early stage. I think you're going to hear us say 2018 is about execution, architecture, and cash. We just made a significant bet for the size of our company. We created a capital stack that's probably one of the most favorable capital stacks. Private equity guys are sitting there going, "How did you guys figure this out?" We bought back $1 billion of our company at a net cost of debt of 1.3%. That's a huge bet. We don't take that lightly.
We have all our eyes focused on all the data, all the metrics. We are in first, from just a capital structure point of view, in risk elimination mode. Right? We believe we have a really good asymmetrical risk profile on this bet that I mean, look, where's the stock today? Where's the- Higher. Higher. Yeah. I mean- It's 105. Huh? It's 105. So it was. Okay, so 105. We bought $1 billion of our company at $49 a share. $49.66, what was the final price? $49.66. Okay, so we've already made $1 billion on this bet. We've already made over $1 billion on this bet in four months. We think the opportunity here is huge.
If we execute, we sure don't want to go backwards on this, we're not going to take our eye off the ball here until we're completely clear. Right? That doesn't mean that we're missing any other opportunities. Right? We don't need to take on any other risk. If somebody said, "Hey, are you going to go out and buy a business or buy a company today?" No. Right? 2017 is the year of execution, architecture, and cash. 2018 will be the year of execution, architecture, and cash. When we really understand our business model, our membership model, as we architect this new operating platform, we will really understand what we've got here. We have something that in the early stages of this transformation looks really good. Okay.
Step back for a second and ask yourself, if we gave you 9%-10% operating margins, do you think 10s are high? Would you give that number? Right. No, but no. Let's just be transparent here. I don't want to play games. No, seriously. Managing quarterly numbers and it's like, right, let's just be transparent. Right. The model looks really good, and we're in the early stages of architecting the model. I've never been so excited about the inner workings and the opportunity of a retail model in my career. Are we spending a lot of time on this model? Yes. How granular are we getting on the moving parts of this business? Every part. Every part. We are putting all the intellect, all the curiosity, all the discipline, all the imagination, all the creative horsepower in this company into building a model that nobody's ever seen.
I think we're going to extract more costs, we're going to have better execution, we're going to have just a leapfrog customer experience when we're done here. Everybody will talk about our model that we've architected, the operational model that we've architected with as much passion and respect as they talk about the galleries that we're building today or the products that we're building today. I think they'll also look back and say, "Boy, these people think deeply about capital." Like, "Wow, we thought they were crazy to buy $1 billion of our stock back based on the debt structure of the company." I think we're going to look pretty smart, but we're going to make sure we don't screw it up. Okay. I'm the biggest shareholder of the company. I have the most to gain, and I have the most to lose here.
This is like 97% of my net worth. This is not a casual investment. Right. We're thinking very deeply about this. We know every number. We review Oh, where's my bag? I took all the papers out. We have our weekly leadership review meeting. What are the headlines? The headlines never change. Execution and all the things that deal with execution. Okay. Architecture and all the pieces that deal with architecture and cash. Right. That's what we're focused on. If all of a sudden the cash gets better, I just don't see us doing anything. There's no upside right now creating risk in this company. There is so much upside focusing and executing. So much upside. If someone asks me today how am I thinking about the business right now, I would trade sales for profits right now.
I would trade a point or two of sales for a couple of points of operating margin if I see it because I can always go back and get those sales. If I don't get those operating margin points right now while we are deep into this, the guts of this business, if we don't architect this right now, if we lose focus and we look over here and we chase that bright, shiny object, we won't be able to go back and rebuild it because the engine will be going, and it is as hard when you take the car into the pit. You've got to do it now. We've got to make this as great as we can right now, and we've got to eliminate the debt risk in this company. Right.
We think we're at late stages of an economic cycle. We know there's a level of risk we're taking on because of the economic cycle. I don't know how to predict that, I think we're in a kind of a different economic age. We have more companies that are worth $500 billion in the world today than at any time in history. There's significantly more value created in the markets today than at any other time. We're in a new economic time. The 7-9 year move or 10-year move that says we're going to go down, in the economics, we're going to hit some kind of recession. I mean, at some point we will, but it might look different this time.
By the way, we believe based on our internal data and how we think about the business and our interpretation of the new tax bill, the Republican tax bill that's out there, we think that's really good for our business, and it's really good for our cash flow. Okay? That bill gets passed in some form, the current form. By the way, we were happy to hear Home Depot say they don't think there's a big economic hit if the tax deduction on mortgages go from $1 million to $500,000. Right? We believe that too. Our data's not as good as theirs. We're not as big of a company as they are. We're probably not as good at analyzing those things. We spend a lot of time on this stuff.
We spend a lot of time thinking about the capital markets, about the trends, about the economic environment. Our sense is that this new tax bill probably gives us another couple of year run. If that goes through, we're feeling pretty good. The cash flow model here will be better, right? If our tax rate falls by half or 30% or 40%, our cash flow is going to get better. We think that the investment that's going to be caused by the tax bill in the economy. Maybe it doesn't take the economy up, we're not anticipating up. We're anticipating kind of just keep on going, right? If it just kind of keeps on going, all these metrics will be some form of really good. We also know, new data might come in. New data comes in every hour, every day.
If it looks different, I mean, we know today we're pretty savvy capital market people, the reason we are is we experienced to go private, we experienced to go public. We've had very smart people like Barry Sternlicht on our board, who really educated us, that thought about capital markets. You don't learn this stuff growing up at The Gap, right? When you're a stock boy going through the ranks. We've learned a lot. I think we think very differently about the capital markets and how to finance the company. Some people say, "Why did you take on the 9.5% debt? Why'd you do the second lien term loan?" It's all math. Our business is math. It's imagination and it's math. Those are the two most important pieces of the business. We borrowed $100 million.
We structured a deal to take the loan out early at a cost of $7.5 million. We knew exactly what day we would start paying, was it $26,000 a day of incremental interest? Yeah. We knew exactly what day we were going to be paying $26,000 a day of incremental interest above $7.5 million, on that day, we took out the $100 million debt. You say, "Wait a minute. You spent $7.5 million for the debt." How many months did we have the debt, or days did we have the debt? Three and a half months. We paid seven and a half million dollars for three and a half months of $100 million. Let's do the math. Let's do the math of the same three months. We bought $100 million of our stock at an average of $49.
Stock's at $105 today. We made $115 million, right? Minus seven and a half. We netted $107 million. That seems like a good outcome. We understand that math. We also know today, if we wanted to do a convert tomorrow, we know factually we can do a convert tomorrow probably somewhere between 50 and 100 basis points. Right? Could we do a convert tomorrow for Let's just make up a number. I'm not saying we're going to do this, but I want you to know how we think. That it's important for you to know the DNA of this company and how we think. If we have today total debt $482 million. Where are we?
Yeah.
We have total debt of $482 million. If we did a convert tomorrow, what's our average interest on the $482 million? Was it three point something? 3.2%. If we did a $500 million convert tomorrow, took out $482 million of debt, we paid 50 basis points for that coupon, we're going to have a positive arbitrage of 270 basis points on $482 million of debt. You take the expected debt pay down of $482 million over a period of time, what would our debt pay down be? We'll get back to you with the exact number, but we'll know those numbers. We do this math. We know initially it looks like a $14 million arbitrage. Is that interesting? Sure, that's interesting. We think about doing that? Sure, we think about doing that. Why aren't you doing that?
We feel really good about our business trends. We think our stock's going to go higher. We think we can do another convert at a higher price. We know that we have to pay 50 to 100 basis points because the stock borrow is tight. It's optimal conditions to do a convert today. The stock borrow's tight because we have 47% of the stock outstanding short. We think as we continue to perform, we're going to run shorts out of the business. The stock borrow is going to loosen up, and we think we can do another zero convert.
Yes. One question over there.
Yeah.
Hi.
We can't see who's got the mic.
Yeah.
Oh, go ahead.
So just a-
Sorry
couple quick questions.
Oh, hi.
Hi. On the longer-term sales and operating or profit growth, can you sort of just give us a rank order of the biggest buckets? Obviously, supply chain, one of them on the margins, but how would that all fit together in terms of that 15% to 20% over time? The other thing is just on the membership growth. Any sense for what that's been on sort of a cash revenue basis, how that's been trending year-over-year as we've moved through 2017?
Yeah, I think on the margin, when you think about the long-term profit margin growth of the business, probably let us completely finalize our plans for next year and tighten everything up. We'll come out in the new year and provide, I think, greater degree of visibility into how we think the model is and where we think the model is going. It's very clear to us today it doesn't stop at 10.
I would just add that real estate continues to be a single giant value creation opportunity for us as we take these smaller legacy stores into what you're about to go see, as an example, across the street. The sales volume, especially with the new kind of deals that Dave's getting done. However we felt about real estate opportunity six months ago feels a lot better even today. That's another big one, obviously, beyond supply chain. Then membership-
Yeah. Sort of like cash revenue.
Yeah, the 37% is cash without the accounting. If you did it just on an accounting basis because of the deferral last year, you'd be like 200% growth. Just cash for cash, that is the 37% growth.
We have a question right here.
Hi, good evening, everyone. I want to take a step back, maybe a little bit bigger picture. You've been talking about the $4 billion-$5 billion in longer term revenues for a long time now. A lot of the things we talked about tonight, and things you just talked about recently, a leap frog customer experience, better execution, things like that. Then even more bigger, the membership model and the ateliers. How much of that was actually contemplated in the original guidance? Because it seems like, having a $510,000 sale under the old model would've been nearly impossible, with certain things going on sale at certain times, friends and family, certain times of year, maybe that person's not ready to buy then. Clearly, that's your guidance, and I understand that.
As we want to sit here and think about it ourselves, what was actually contemplated in that initial guidance that you gave now several years ago?
Getting to $4 billion-$5 billion?
Yes.
Yeah.
Even in respect to that, next year guidance $2.6 billion, only 15 galleries open now, $5 billion with 50 more galleries open.
Right. I mean, just the biggest value creators or the biggest buckets were the continued product expansion and the real estate transformation. Those two pieces, if we just did the math, we easily got to $4 billion-$5 billion. We do that same math today, we clear line of sight to $4 billion-$5 billion. The great thing about our model, and Carlos Alberini used to be the Co-CEO with me. Is Carlos here? Yeah, Carlos is going to be here for dinner.
Tonight.
Yeah, this is great. No, he's super psyched. I tried to get him here earlier. I would've had him on stage with us. Carlos had a really good way to frame this. He goes, "What's amazing about this is you have a test, we have a test in every market." In almost every one of these markets that we have an implied new gallery, we have a gallery. We have data that says when we go from this square footage to this square footage, when we go from this much outdoor presentation to this much outdoor presentation, when we go from this much bedroom to this much bedroom, here's what the lift will be. We've got that calculated out for every single market, and then we've got the few markets where we don't have a gallery calculated out.
I think we're going to be pretty accurate. That right there is the fundamental piece that gets you to $4 billion-$5 billion, and then you've got some other product category growths. There's ways that we can frame the business, as you've seen us do in the past, and we'll probably bring back Big Style, Small Spaces and Objects of Curiosity. Big Style, Small Spaces, we thought we could be more productive by moving it back into the core book. As we've done it, I think you don't see it as a customer and we're not optimizing people that have smaller homes or apartments and things like, "I love RH's style, but I sell this big furniture." Whether it's bringing back Big Style, Small Spaces, in its form as a source book.
What else are we big-
Possibly leather.
Yeah. RH Leather. We did a leather book. Objects of Curiosity, we just bought it wrong. We got over-inventoried, then we're like, "Oh, shit. It's going to take us too long." That was when we had all these promotions and 25% growth. Inventory accuracy on buying back then, really, really difficult with our goods. Yeah, it's really a different company today, and way more predictable and way more clear. We got off that crazy racetrack. We had comparable store sales of +25%, I think, for four straight years. I don't even know if anybody's ever done that in retail before. To do that, you're focused on it, right? We came out in the racetrack. We were a high-growth company. We kept growing. We did it really well. It's not sustainable. I'd never try to do that again.
If I had to play this movie again, I would've came out and grown the business at 12%-15%, and we would just have to have different. That's okay. We learned and we're a lot smarter now, right? Yeah, sure.
Question.
Yeah.
I've two questions, if you could. Can you go back to the line that you showed of the volatility historically of your sales, which was very lumpy, and you explained that elegantly in terms of sales on RH Leather, sales on this, sales on that, and that drove the business. I would've thought the line underneath wouldn't be as volatile, which I get, but it was almost flat.
Which I find hard to believe.
Furniture sales are still episodic, right? If it rains in N.Y., where I'm from, you're kind of not shopping on Saturday or Sunday. I would still think I would see some volatility, as evidenced even by the team before, who talked about the $500,000 sale. There still should be some volatility. It should be muted, how are you controlling that? Are you controlling the delivery times?
No.
If somebody orders, it just sound intuitive to me that it would flatline.
Well, it's not completely flat.
It still moves.
It still moves. Yeah. If we're doing roughly $40 million or $50 million a week, right? A $500,000 sale is going to move the business a little bit. Right? Point. It's not making the business go up 30%. Right? Our business is really consistent. We used to be a big furniture business in December. In the industry, it's the worst month for furniture. Everybody goes on vacation in December. We created an abnormal business in December and an abnormal smaller business in January by pull forward. Christmas takes a little bit of a dip because people aren't buying furniture, and then it comes right back in January. They're so small.
Is the foot traffic less volatile or it's because you're connecting
No, we're not.
I know. You're connecting with your customers and their loyalty, you're driving sales, however it may be, in a less volatile manner.
Yeah. No, we're not really a foot traffic business, right? We know because of the restaurants, we can get an incremental If we all step back and think about it, right? Go like, how often do you go to a furniture store? Not very often, right? Our business is really an event business. It's driven by people that buy new homes, that are remodeling a home, and that are redecorating a home, right? Then we get a layer of business that is people coming in, seeing a new chandelier, people getting a Source Book, seeing something, and we drive desire and drive need, and so on and so forth. They come into a gallery, they go into Chicago with a friend, and they have dinner, and they're sitting there, and they would've never gone to a furniture store.
Now they're in a furniture store, and they see this amazing bedroom, and they're like, "Honey, let's redo our bedroom." Right? Our business is not really a foot traffic business, and that's why we can pursue the real estate model we can. No one's walking by, just walking down the mall and like, "Oh, there's a couch. Let me buy a couch." It just doesn't happen, right? That's why we're re-architecting, in a lot of ways, business. It may not be intuitive because maybe you've never worked in the furniture industry, right? It's super intuitive. Jason Kemp. Where are you, Jason?
There.
Yeah. Jason Kemp was president of Bassett. It's kind of like that, isn't it? Unless you're doing crazy promotions.
Yeah.
There's no furniture business in December, really. In the last few weeks, it goes like that. We're all learning. Look, I used to sell jeans and T-shirts, right? Then I sold cookware, right? Then some really smart merchant at Pottery Barn while I was there, and Williams Sonoma was there, named Hilary Billings, said, "Let's put a sofa on the cover of the Pottery Barn catalog." When we set out Pottery Barn, it was like 60% of the business was tabletop, and then we had accessories. She put a white slip-covered sofa, shabby chic kind of thing, on the cover of Pottery Barn, and it was the best-selling item in the company.
Second question, if I can. On the delivery business, when do you think you'll do 100% delivery, and what do you think that will cost you? I know it's going to be materially better. I know it's going to result in better savings, less breakage and all that other stuff, you're basically taking what was historically a variable cost, right? Which was an outsourced cost and turning it into a fixed cost. I just want to understand what that fixed cost will be two to three years out from now, once you've fully brought that in-house.
One, I don't know if we will fully bring it in-house. I don't know what % might be partnerships. All I know is that we're going to create a luxury customer delivery experience. It may be a hybrid. Right now we're testing, okay? We're testing in-house in the Bay Area market. We'll be testing in another market soon. We just had all of our third-party providers here yesterday. We're setting our expectations. We're going to sit down and conceptualize and put strategies together to build a luxury customer experience. What % will be insourced versus outsourced, I don't know yet. We're just going to do what's smart for the business, right?
We're going to do what creates great customer experiences, which gets customers to buy more and be more loyal to the brand, we're going to do things that's ripe for the operating model of the business. We're not going to sit here today and say, "In 3 years we're going to be 100% insourced," and we don't know what the capital is, or it's going to cost, it's going to de-leverage the company 200 basis points. That would not be a really smart thing. We're just going to do smart things for the business. We think directionally, we're identifying today there's a huge opportunity. We know the metrics. When we don't execute a delivery well, there's massive cost. You have to send another truck, you have to pick up the goods, you've got to sell the goods then at a markdown.
You've got all kinds of costs when you don't stick furniture. Yeah, we'll let you know as we know more. Yeah.
Tim, we have a question right here. Thanks a lot. Two quick ones. The first relates to inventory. You're obviously pretty early on in your journey of changing the model around. Your turns are kind of 2.7, your prior peak is 2.6. Where do you think you can take inventory in the business if you think longer term about supply chain and what the opportunities are? Can you get above 3 times over time?
Yeah, it's a funny question because you guys look at inventory externally reported with occupancy and all that stuff, we don't really look at it that way. We'll get inventory against inventory turns, right? Just pure inventory turns. Yeah.
On the external basis.
Yeah
Based on what we know we're going to end this year and where we're heading next year, I would say yes, that's achievable.
Yeah. That's very achievable. On an existing inventory to an inventory basis, I showed you a slide that said we had 1.1 million units of furniture, and a slide that says we're going to end with 535,000 units of furniture.
Second.
You could probably do that math.
There you go. Second question. On the membership numbers, huge number that you shared with us. What are you seeing in terms of new member growth versus retention? As you're now a number of months cycling membership, what are you seeing in terms of people coming back? Are they coming back proactively? Are they kind of falling into it? To what degree does renewal, you find, relate to actually doing more business with you?
Yeah, we really like what's happening right now. We like the metrics as far as renewals. We like the metrics as far as new members. We are just learning where we can allocate more resources to make those metrics look better, right? We're learning. For instance, one of the biggest leakages of membership renewals, those people when they sign up they have a choice of saying, "Hey, renew me or don't renew me." We have a very high percentage that are on automatic renew. The biggest problem with automatic renew is you've got all this cybersecurity and credit card data breaches and so on and so forth. People are getting new credit card numbers at a higher rate than ever in history. I think it's got to be wreaking havoc on a lot of models like this.
It's interesting, I'm a member of the Soho House, the Soho House would charge my card for my $2,700 membership on my credit card. I just got a thing a few months ago that said that now to renew, I have to give them my checking account or my bank account number, and they're no longer taking credit cards. The dots connected for me as, bet this is because more members are falling out and then they're having to spend expense trying to find the members, trying to get people to sign back up, and so on and so forth.
We're just learning a lot about this stuff. The biggest leakage is that you go to hit the credit card on automatic renew. It doesn't work because they either lost their card or there's a credit card breach. We all get these things now that says, "Hey, was this a real bill?" Lots of opportunities like that for us. We think the numbers will get better based on what we know today. We like all the metrics. We really feel good about the membership model. Yeah.
We have a question over here.
Gary, thanks very much for the discussion of the capital structure. That was really helpful. I was wondering if you could dig into the 2018 bridge a little bit, help us understand your conviction in delivering particularly that exceptional margin expansion next year. What gives you that conviction? Help us see the vision.
Yeah. We feel tons of conviction about the numbers that we gave you, right? A big part of it is really clear. We know how much inventory we moved through outlets, through warehouse sales, as we tried to burn down inventory. We know what the margin's going to look like. So far our math is more right than wrong, right? In the last couple of quarters, we've been more right than wrong. The cost savings that we're going to get are real. We're closing two DCs, right? It's real money. We're not taking all the goods back all the way to the DCs. All the transportation costs are going to come out. We're not handling all the second-quality goods and handling it. How many touches have we eliminated? I think six touches, something like that. We're taking them straight to an outlet.
The goods in the outlet are going to be higher quality, they're going to be fresher goods, and we're going to have matching parts. We actually take sectionals, okay? We'd have a sectional sofa that got returned, and it would go all the way back to a D.C. A sectional is a bunch of SKUs. It's a right arm, it's a left arm, it's a middle section, it's a chaise piece, and you buy the pieces and you come together. The return on the sectional, you get a leather sectional return. It might've been a scratch in the leather, it might've been something. Perfectly good piece of product that people would pay real money for. Goes back to a D.C., gets checked back in as individual SKUs, and then was getting distributed out to the outlet stores as individual SKUs.
we'd have a right arm with nothing else, and we had a middle thing. The outlets were full of all these oddball SKUs. That's not going to happen anymore. Right? now it gets picked up as a sectional, it gets taken to the outlet as a sectional, and it doesn't go back to a D.C. and get held and checked in as individual SKUs. I have to use the men's room. I'm going to let you guys take the questions. One second. I'll be right back.
Yeah. I would add that we do have kind of known labor savings and known rent savings. We've been doing this transportation reverse thing since July, that's what's giving us some of the confidence with next year. Now, it's not going to be 100% of that $15 million-$20 million, because we're getting some of that this year.
Question on your far left.
How you doing? Thank you. I was wondering if you could talk about the $240 million free cash flow next year and just some of the building blocks to get to that. Obviously, you already pointed out inventory, but anything else you could add along those lines?
Yeah. The three biggest pieces are just that higher sales, higher earnings flow through, the inventory, and then we gave the new capital number. We've been running it, call it $130 million of capital, and to knock that down to that $65 million-$75 million range is pretty meaningful as well. Those are really the biggest three pieces.
Take a question up here.
Hi. I just have a couple questions on real estate. One, with the larger format stores, as they begin to mature, have you seen any significant difference in performance between the units? Is there-
No, other than what I would say, like Houston when there's a hurricane, when there's something going on with that market, but no. I think that when there's something geographical going on in the area, obviously that's impacting that entire market. Nothing that's saying, like, at the three-year mark it stagnates and something happens, no. We've had quite a few years now of some of these being in place. We feel really good that they will continue to comp positive and that even in the market, the online market around it is performing well also.
The second question I had, this with respect to Modern. You guys again highlighted it as a very potential powerful brand. As we think about the evolution of Modern, you have a store out in Southern California in L.A. Will there be other standalone Modern stores or it will be more incorporated within the larger format galleries? To what extent now, as you watch those sales, are they incremental or potentially cannibalizing sales of other products in your non-Modern type products?
Yeah, sure. First on the real estate, at this point, other than maybe, I don't know, never say never on like a Miami, I would say it's going to be a floor in the current galleries. That's our current thinking. One of the reasons we did it in L.A. is we already had the full-line design gallery, and it wasn't big enough to put Modern, and then we had a really advantaged real estate option with that Modern location. It was a perfect place to test. That market, especially because it does lend itself to Modern, you could probably replicate that in Miami and some of the other really urban areas.
For the most part, it'll be a floor, and the size of that floor and the size of the space dedicated to Modern will be really based on the market and what the architecture in that market is. Secondly, I'd say the reason why Gary's so positive and we feel so strongly about Modern is it has been much more incremental than even we had thought in the beginning. It's truly just if your house and your architecture is modern or not, it really does determine, and there's more and more modern architecture that's leading people to get that kind of furniture. I think we do believe that it's absolutely going to be a billion-dollar brand, and it's been highly incremental to our other sales that we've had in the past.
Our modern gallery in L.A. is about a half a mile from our full-line design gallery on Melrose. We're pleased with both results of both galleries.
Yeah. It was kind of telling when that opened, we thought, "Hey, we're going to see a dip on this other one." They both kind of rose with the tide. It was nice.
Another question right here.
Over here?
Yeah. Go ahead.
Thank you. Regarding the supply chain redesign, can you just expand on how much confidence you have in the ability of the brand to consistently delight its customer, maybe as we kind of think about what happened back in 2016? Given that you just had the vendor day, touch on how the relationship with your vendors has evolved to make sure the availability and timeline expectations will be met.
Sure. It's kind of two things. When we talk about supply chain redesign, we're really talking about delivery. The vendor piece, meaning where we get the furniture from and supply is kind of a totally separate issue. I'd say we're working even deeper and more collaboratively with our vendors than ever, we've talked about before the fact that the top 25 vendors are 80% of our volume. Especially those top guys, we're working with them all the time. Are they going to every once in a while slip up? Maybe. I think what happened with RH Modern will never happen again based on all the things that led up to that with the bigger Source Books and it was products that we didn't have the same kind of experience with the manufacturing processes. I'm not really concerned that that kind of a mishap will happen again.
Will there be things where we just don't know it's going to be a bestseller and it takes long and we have back orders? That's going to happen all the time. Then I think with the home delivery experience, it's people are delivering our furniture. I think right now we know that it's not where it needs to be. Will it ever be perfect? No. Can we make a lot of investments to train and hire better people and pay them better and have better SOPs and processes in place to make sure that they know what great looks like? Absolutely. I think we can go from here to here. Will we ever get to here? Who knows if it'll ever be perfect. There's always going to be someone who's not happy, I'm sure.
As a follow-up, Gary talked about the to the trade design centers, the opportunity for RH Interior to kind of disrupt that. Can you help us better understand talent acquisition within the company and the quality of the interior designers you're putting forth to drive disruption?
Yes, I'll probably turn that over to DP because.
Yeah
He's at the heart of that effort.
Absolutely. It's been a mission of ours to ensure that we attract the best talent that is out there. We don't have a model where we take a sales associate, put them through a two or three-week training program, and then call them an interior designer. They have to have domain expertise. That means they have to have background in interior design. They have to understand interior design. Many of them are interior designers in previous lives that have then come to work for us. We spend a lot of time vetting the talent and ensuring that we have the right talent before we make the decision to hire. As you can see from the designers that came up and had a conversation with you, they're not fresh-out-of-school designers. They're designers that understand design and have worked in design before. You're welcome.
Hi, I had a follow-up question on real estate. Does the new real estate model to the development deals change the way the number of stores you're opening a year? With hospitality, are you looking at where you place the stores in the markets in a different way? It seemed from the commentary that perhaps locations that you chose a couple of years ago, if they had hospitality, would've been different today.
Dave, you want to take the number of deals question?
Sure. I think we've said we're going to be at about three to five galleries per year, and we're highly confident in that, and that won't be a problem. The question was asked of me before, how does that change things? Quite frankly, Chicago has proved out that we are a traffic generator on our own. To go into a residential neighborhood like the Gold Coast and really be in our element with our customers and to be able to bring them there and keep them with us, it gives us tremendous flexibility. Before, our legacy stores are in malls, and you're kind of locked into the mall footprint. Today, the entire field is open to us, and we're able to get into great places like the Gold Coast.
The other nice thing about our model is we're a gallery model, so we don't have loading docks. We don't really have a situation where we have to bring trucks in and have a cash-and-carry business. It allows us to be really close to our customers in these really inspiring spaces.
A couple of questions on the outlets. How many are there now? How many will there be? You are doing them in-store, in-market clearance that says that you should have probably more outlets going forward.
Yeah. Right now, we have about 28 or 29. I will have to look up exactly. I would say we will have, I think, one more by the end of the fiscal year. By next year, we will open two or three more doors. You are absolutely right that they are not all perfectly situated for the reverse model to be shorter distance, lower transportation costs. Over time, we had opened several pop-ups. Those might reposition a little bit. Is the right number 35 or 40? We will kind of figure that out. It depends how close we can get them in between the home delivery centers to minimize reverse logistic costs.
Have you figured a size out that you want for those?
So far, the 15 to 20 size has been working well for us, but it depends on the size of the market. If it is a smaller market, it might be a smaller outlet.
Yeah. My sense, we're going to test a lot of things. We're going to test smaller outlet stores closer to our full-price stores. We want to take instead of the customer having to take, if you know the Bay Area, we have a highly productive store in Corte Madera near our corporate office. Closest outlet is Vacaville. It's a day trip for people to get up there and get back. Today, when we think about time value, you might have a really good customer that can afford to do their living room and their master bedroom, but they've got three more bedrooms in their house and they want a deal, they want to go look at your outlet. Now you're telling them, You have to take a day trip, drive to Vacaville, and you don't even know what's in the store.
You're not going to know when you're there. If it's not a good trip, you're going to drive all the way back. Our sense is, if I take that market, for example, it's probably better to have an outlet in San Rafael or in Novato, they're 15 minutes away, 20 minutes away, you're going to turn the inventory faster. They're going to look at it more times. You're not doing a big day trip. We think there's just a lot of opportunities there. We'll keep fiddling with this and evolving it as we go. We see a lot of opportunity in the outlet model in the reverse logistics business.
Just one question on the convertibles, Karen. If you're going to settle them in cash, isn't there a restrictive corridor of when you can settle them in cash? Isn't it like 90 days before the due date, or do you have an option as to when you can settle those in cash?
We can always settle them in cash.
You can declare them at any time?
We have to deliver shares if it's over I don't know. My banker friends are in the back. We have a resident.
They're on call.
Well, yeah, they're on call. Yeah. We have to wait until it gets closer to the maturity, so we can't settle a cap right now.
Right. I thought there was like a 90-day period, right.
There's a non-call provision. There's nothing that would force us to sell it in shares.
Okay.
The base, that is. Above that 116 in my example, we do have to deliver shares. Below, it's at our election.
Thank you. We have another question right here.
Hi. Just a couple quick questions I'm curious about. I assume with the hospitality that the galleries that have the restaurants, that they're ramping at a higher sales level because you have higher traffic. Maybe you can validate that for me. I'm not sure. I was wondering about your promotional strategy. How set is it in stone? You have your clearance. The members get a higher rate of discount on the clearance. There's some textile promotions that go on now and then. How is that evolving? Is that set in stone? Just lastly, Gary, you said something interesting about the New York store, that that construction could go on and on. I live in New York, I know what you mean, will that store open in the first quarter, or do you anticipate it will ramp at a-
Yes. First or early second quarter. I think based on what we know today of the street schedule and when it'll all be paved and when all the fences come down. Yeah.
The restaurant will open at the same time?
Yeah.
Okay. Should we think maybe because of that construction, that store won't ramp at the historical rate that a major flagship would?
If the district is still ripped up, we'll probably set lower expectations for it in the first few months. Yeah. For instance, we just opened in Toronto. We're at the end cap of a new wing of the mall. It's 100 yards before a store. They haven't filled it in yet, our plans are for that store to ramp slower, as Yeah. Our plans would just be logical based on a neighborhood, based on a development, based on construction, and so on and so forth, as that relates. Your question about the restaurants. We've only had one open for two years, and we just opened Toronto 30-something days ago. Yeah.
Four weeks ago.
Four weeks ago.
Three weeks.
West Palm's not open yet. We have a test of one, and we have a second test for 30 days, and we're still learning. We anticipate because the numbers were so good in Chicago, that they'll be I want to say the numbers, not just the numbers of the restaurants. I feel very confident at what we're going to put together from a food experience business. Under Brendan's leadership, I think we're at least in the first two so far, it looks really good. If you haven't had our food, I think you get to try some tonight, and I think you'll enjoy it. The thing that we still have to learn about is what's the translation and the incremental opportunity from the traffic that translates into higher revenue sales. We really look at this as an integrated model, not a standalone restaurant model. Right?
We built the model in Chicago to say, look, we know what the store would be doing just our 2X or two to five, 2.55 times X, whatever the first year is modeled at. We're pretty accurate at that. We added the restaurant, and it looked to have a significantly higher lift. Right? We need a few more under our belt to know what is the predictable lift. We're pretty conservative in our estimates and what we're estimating right now. I'd say, my sense would be there's more upside than downside as you think about how we think about the business going forward as you think about three, four, five, six, seven, eight restaurants coming online over the next 18 months.
The time check is 6:20. I don't know if we want to do one or two. We'll be obviously walking around within the gallery. I don't know how many more we want to take before we break for the tour.
Yeah. We take a couple more questions. Yeah. We can't see anything, guys. We're blocked.
We have a couple more hands up.
Yeah.
Okay. Let's do maybe two more.
Something I don't think you touched on here today was marketing and Source Books. I was hoping you could just talk about the evolution of the books, how that may change going forward, and what role we might see digital play in marketing in the years ahead.
Eri, you want to comment on any of that?
The evolution of the Source Books. We continue to always be really critical of our work and see what's working, what's not. Just to give you an example, the fall Source Book that recently got in home, we made considerable updates from last year's book. As Gary mentioned previously that last year we felt like we skewed the aesthetic and the style perhaps a little too contemporary. We also perhaps walked away from some of our key sellers and key franchise businesses. So just really looking at that, this year's book, we really leaned into those businesses, and we also brought back a more classic, updated look. So we're always looking to update and evolve the Source Book strategy.
Yeah. I think the other thing I'd add to that is what Eri brought up, and we talked about a little earlier, is you may see more specialty books come back out. You might see Big Style, Small Spaces reappear. You might or might not. We're working through those ideas. You might see Objects of Curiosity reappear. We test a lot of things all the time. We're constantly testing and measuring and monitoring. The good thing about the catalog Source Book model, it's a pretty low-risk test. It's a pretty low capital test. We can buy small amounts of inventory, put it in a single DC, mail books to select segments of our file and see our response rates. If they're doing well, we can grow them.
I think what had us back off on some of those things is we were doing it during the wild growth years, and we just couldn't buy the inventory accurately. So it just made the test have a higher risk profile.
Another question on your right side.
Two quick ones for Karen on SG&A. I think when I look at your SG&A over just the past two quarters, it's been up 12, 15 percentage-ish. On a per square foot basis, it's actually declined pretty meaningfully. Maybe just talk a bit on what's going on there. Secondly, now that you have Source put back in, I think in maybe one of the previous 10-Ks sort of disclosed there was a $30 million benefit on timing. How does your SG&A look moving forward now that Source is sort of up and running again?
Will you repeat the second question for them?
On Source, I think when that wasn't happening, there was a $30 million-ish benefit that you disclosed in your 10-K. I'm not sure if that's exactly what Source is, now that it's back in, does it change the run rate of the SG&A moving forward?
I think maybe you are referring to the timing of the Source Books?
Yep.
Okay. That's a great question because what our Source Book strategy is every year does have a meaningful impact on our SG&A. It impacts sales, of course, but last year when we didn't have a book in the spring, we had a lot of leverage. Our sales were impacted, but we had the lower SG&A because of those books, and then in the fall, they came in home later. This year when we had the book, we both had the modern book earlier in the spring, and then we had the books landing in the fall. There is some deleverage on the SG&A line in general this year versus last year. We're not yet speaking to specifics on SG&A for next year as it relates to the Source Books, just because the timing, number, depths of the mailing, et cetera, is not 100% known.
That is a lever and something that does impact SG&A. With respect to the last few quarters, some of the savings, I think people tend to say, "Oh, it's transportation, and it's occupancy related to some of these initiatives in the DCs," but there's a people element to all of those. We have had compensation savings in the DCs, just from everything that gets transported also gets handled, and then having some of the people costs come out of as we close these DCs, that's something that'll impact next year as well.
No more hands.
Okay. Let's go take a look at this, what we believe is the bridge.
It's raining a little bit.
The bridge started, yeah.
Do you want to still go to the previous agenda?
Yeah. Well, is it raining out there right now, Cam?
Is it still raining? There's a farmers market.
Oh, there is? Okay. Let's not go through the little galleries if there's a farmers market over there. We have umbrellas for everyone.
Yeah. They're right at the front.
Let's all meet in the main lobby. Let's go up to the main lobby. Let's get the umbrellas. Let's assess the rain, and then we'll kind of detail the plans from there.
All right.