Welcome to the
Williams Sonoma, Inc. Third Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen only mode. We will conduct a question and answer session after the presentation. This call is being recorded.
I would now like to turn the conference over to Beth Patella Miller, Senior Vice President of Finance to discuss non GAAP financial measures and forward looking statements. Please go ahead.
Thank you, Ashley. Good afternoon. This call should be considered in conjunction with the press release that we issued earlier today. Our discussion today will relate to results and guidance based on certain non GAAP measures, including non GAAP SG and A, operating income, operating margin, effective tax rate and diluted EPS, which exclude certain items affecting comparability. A reconciliation of the non GAAP financial measures to the most directly comparable GAAP measures and our explanation of why the non GAAP financial measures may be useful are discussed in our press release.
$0.01 per diluted share, dollars 1,000,000 or $0.01 per diluted share and $6,000,000 or $0.04 per diluted share, respectively. These charges were recorded as SG and A expense within the unallocated segment. During the Q1 of fiscal 2017, we incurred tax expense of approximately $1,000,000 or $0.02 per diluted share associated with the adoption of new accounting rules related to stock based compensation. This call also contains forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which address the financial condition, results of operations, business initiatives, trends, guidance, growth plans and prospects of the company in 2017 and beyond and are subject to risks and uncertainties that could cause actual results to differ materially from such forward looking statements. Please refer to the company's current press release and SEC filings, including the most recent 10 ks for more information on these risks and uncertainties.
The company undertakes no obligation to update or revise any forward looking statements to reflect events or circumstances that may arise after the date of this call. I will now turn the conference call over to Laura Alberts, our President and Chief Executive Officer.
Thanks, Beth. Good afternoon, and thank you all for joining us. With me today is Julie Whelan, our Chief Financial Officer Felix Carballito, our Chief Marketing Officer and Samir Hassan, our SVP of Digital Technology. Our 3rd quarter results demonstrate the effectiveness of our strategic priorities to deliver value, quality and excellent customer service. During the quarter, strong execution against our product and digital initiatives drove new customer acquisition and top line expansion in the supply chain to position us to further differentiate our business and to deliver long term gains in market share and profitable growth.
Before I go on to discuss our performance this quarter, I want to take a moment to recognize the strength and compassion of our associates who came together to support each other and their communities in the face of several devastating natural disasters this quarter. From the hurricanes in Texas, Florida and Puerto Rico to the wildfires in California, our associates did a remarkable job providing assistance to those in need during this difficult time, often as they faced disruptions in their own lives. Unfortunately, these natural our financial results in detail, but I wanted to highlight that during the Q3, we drove net revenue growth of 4.3% and a combined revenue comp of 3.3%, which is inclusive of an estimated 50 basis point negative impact from the hurricane and is an improvement from last year. Also importantly, our demand during the quarter exceeded or was at least equal to net revenues across every one of our brands, most notably in Pottery Barn and Pottery Barn Team, which is a strong indication of the health of our business. Our strategic areas of focus on innovation and operational excellence are underpinned by our continued vision to create a high touch customer service platform that is transformational for the home furnishings industry.
For more than 60 years, we've been leaders in customer experience, which began in our first Williams Sonoma store with our founder, Chuck Williams, who served every customer with passion and care. And since then, his attention to the customer has become deeply embedded and a part of who we are today, a multi channel, multi brand retailer that continues to deliver superior customer service and high quality differentiated products. Our high touch customer service platform is comprised of several key components. We have a multichannel model with an experiential retail base that gives our customers the ability to touch and see our products together with the convenience of our established content rich e commerce presence. We have a multi brand portfolio that offers our customers proprietary, high quality merchandise, which addresses a range of demographics, lifestyles, aesthetics and customer life journeys.
We have a comprehensive database of approximately 60,000,000 households across our brands, which enables us to deliver personalized relevant messaging to our customers. We have a vertically integrated supply chain with direct sourcing and regionalized distribution centers to ensure that every piece of furniture is of the highest quality and delivered to our customers in a superior manner. We believe the combination of all these elements establishes a truly differentiated platform that is a core competitive advantage against mass retailers. And in this quarter, we continue to make progress in further enhancing and leveraging this platform to drive growth across our business. In digital advertising, we are committed to increasing our brand awareness and expanding our market reach.
In Q3, we launched our 1st sizable test of addressable TV with West Elm's House Proud TV commercial, which combines the targeting and measurability of our traditional direct marketing with the compelling storytelling strength of video. We followed this commercial with distribution across digital, print, social and targeted television. We also partnered with Facebook on their launch of collection ads, which brings to life our catalog on social media. Meanwhile, our content rich personalized e mail campaigns continue to drive improvements in customer engagement metrics and overall sales. As we have discussed before, our internally designed and developed e commerce platform gives us a distinct advantage to react quickly to changing customer behaviors and deliver impactful digital improvements with a fast time to market.
In the quarter, we continue to innovate by making improvements in our ability to deliver rich, engaging product storytelling to our customers. Our redesigned product page experience integrates this content in a way that allows us to better tell the story of our products and differentiate ourselves in the market. We'll be testing this new experience in Q4 and we'll be iteratively rolling it out through the quarter and next year. Digital leadership remains one of our most important priorities as we firmly believe technology enhances the customer experience. Therefore, it is with great excitement that we are announcing the acquisition of Outward Inc.
Together with the Outward team, we will drive further digital innovation to create highly engaging experiences that will revolutionize the industry. We believe the quality and scalability of Outward's 3 d models are unparalleled and that we'll be able to transform the way people shop for home furnishings across the industry and in our brands. We'll also drive efficiencies and cost savings in the way that we capture and create 3 d models and utilize them in a more extensive and seamless way across various digital channels. One such offers an intuitive user interface experience that is the only AR technology on the market that offers clear the room functionality using advanced techniques to dynamically clear the existing contents of your room. The Pottery Barn 3 d room view will also become a critical tool for our design crew, an exciting addition to our growing set of custom digital and retail services such as the West Elm Pinterest Style Finder tool, furniture hubs, which allows us to deliver furniture quickly and damage free.
The most important driver of our supply chain operations is customer service, and our initiatives there are targeted to significantly improve the delivery experience, which will set us even further ahead of the competition. Year to date, our supply chain efforts are yielding results. We continue to receive very high ratings from our customers on some of the most critical customer touch points. In Q3, we expanded the reach of our customer touch points. In Q3, we expanded the reach of our customer satisfaction surveys to include 3rd party delivery providers such that we're now able to obtain feedback for every piece of furniture delivered.
We also increased our points of interaction with the customer during the delivery process, including the implementation of a text message notification 30 minutes prior to delivery to enable better tracking on delivery day. Our customers are receiving their orders more quickly, while returns and replacements are declining. On our distribution centers, technology is further improving our order consolidation and decreasing the total number of packages per order. As we enter the holidays, we are well prepared with these process improvements and employee training in our DCs to further streamline and fast track order fulfillment for this peak season. Our vertically integrated supply chain, digital leadership and e commerce platform together are highly leverageable and create a unique platform that supports one of our key competitive advantages, our portfolio of well recognized branding.
By leveraging our shared household files, we are able to identify cross brand reference points to better service our customers across life stages, increasing relevance and loyalty. For example, when a customer registers at Pottery Barn Kids, they might purchase a West Elm Baby Glider. And if a customer looks for a coffee table on one of our brands' websites and doesn't purchase it, we can show them alternative coffee tables from other brands. Also, for a better cross brand shopping experience, we built a single sign on feature so that our customers can log into any of our brand websites with a single login and password. Our loyalty program, The Key, has been met with great success, growing nearly 20% a month since it launched 1 year ago.
We're attracting new customers and motivating keyholders to shop more often, spend more per transaction and purchase from more brands across the portfolio as they enjoy the benefits and rewards. We'll continue to expand upon the key program with improved technology and differentiated experiences and services that link our family of brands together. Additionally, our credit card programs attract many of our most valuable customers offering benefits and rewards, which provides our customers with personal assistance from design professionals to find products and services for a variety of needs and leverages our portfolio of strong brands in an integrated and meaningful way. We believe we are just beginning to unlock the possibilities of this portfolio by looking at the customer journey, not only within a brand, but across all of our brands. And we are excited that as a result of our strategies, we are seeing strong momentum in our performance to drive growth across the Pottery Barn brands.
Our net combined revenue comp was 0.1%. However, demand was much stronger at 2.3%. And furthermore, both our net and demand would have been higher if not for the hurricane. At Pottery Barn, we've been making progress on our goal to make the brand the most inspiring source of home furnishings in the world. The brand's 3rd quarter business performance continued its positive momentum, generating a 2.2% demand comp.
Demand in the quarter was driven by momentum in our American made upholstery collections, innovation in bedding and fall seasonal decor. We are making progress on our product strategies to increase brand relevance and acquire new customers. And as a result, we are seeing double digit growth in new customer accounts, which sets us up for future growth. We launched a broader assortment of opening price points and expanded our small space collection, adding depth, scale, color and customization to the product assortment. We also launched new differentiated aesthetics and saw a positive customer response to these collections.
We're driving growth in our decorating business with continued focus on easy decorating and seasonal ideas that convert new customers. Our multichannel model continues to be an advantage, and we are improving the shopping experience in store and online. In e commerce, we are focused on creating a best in class experience that is inspirational, engaging and friction free. We're adding content and inspiration to our website and in our marketing messages and our new tools such as our 3 d product visualization and the soon to be launched 3 Room View app are designed to make home furnishing shopping easier. Our investment in digital marketing programs is driving traffic and sales, and we are increasing the amount of personalized messaging to increase relevance.
And we are seeing favorable metrics with triggered e mails and personalized content and experts to help our customers with their personalized decorating and shopping needs. We're also enhancing the design of our stores through high impact store remodels in strategic locations. Our remodeled stores are driving accelerated comp growth, and we will continue to invest in future store remodels to further improve the in store experience and attract new customers. Our retail stores are a key competitive advantage for Pottery Barn brand. They are number 1 customer acquisition vehicle, driving traffic to our stores and online and remain a highly profitable part of our Pottery Barn business.
In our Pottery Barn children's home furnishings businesses, we are making progress, particularly in Pottery Barn Teen, which generated a net revenue comp of 3% against an exceptional demand comp of 9%. In Pottery Barn Kids, although we are not satisfied with the flat growth we saw, it was a substantial improvement over prior quarters. Our focus on baby has been a strategic initiative and was a key driver of this performance. Earlier this year, we launched a curated assortment of best in class baby gear, which has allowed us to gain further traction in sales, registry creations and new customer acquisition. Our furniture business remains strong, driven by our nursery and bedroom furniture.
We are consistently delivering on our promise to offer quality and value across all categories and are expanding our assortment of furnishings that are good for kids and good for the planet. Another highlight in Q3 for PB Kids was our seasonal business with strong performance in the back to school gear and Halloween categories. During the quarter, we also launched our holiday collection that is attracting a favorable response from our customers. Our new exclusive collection with Moniquelier and limited edition Peanuts and Thomas the Train licensed products are already in high demand. We are headed into the holiday season with an exciting offering of gifts with a focus on toys that inspire imaginative play for all ages, including a collection with Williams Sonoma Play Food and Le Creuset Play Kitchen Accessories.
We've also expanded personalization options across holiday keepsakes and gifts. In PBteen, growth was strong across all divisions of the brand during the quarter. With holiday assortment, which based on initial reads gives us confidence that we have produced a compelling collection for the holiday season. Our focus on collaborations, which we believe further differentiate the brand and attract new customers, continue to yield strong results as we expanded on our product offerings this quarter. We're particularly pleased with a fantastic response to our Harry Potter collection of exclusive home decor, which includes bedding, decorative accessories and gift staples.
Across the Pottery Barn brands, we believe we are well prepared for the holiday season with our ownership of key gifting categories and exciting collaborations. We are encouraged by the response so far to our holiday assortment and are confident that the strategies we have in place will result in further acceleration in revenue comp in Q4. The Williams Sonoma brand, as a premier multichannel retailer of high quality housewares, continues to extend its reach online in stores and is a vibrant active member of the community. Exclusivity and innovation are core pillars of our differentiated product strategy. This quarter, we further increased the number of exclusive innovative collaborations with our trusted vendor partners, including Stove, Profoni, Breville and Zwilling to offer our customers products only available at Williams Sonoma.
Our Williams Sonoma branded product line is a sizable growth opportunity and an important driver of new customer acquisitions. In Q3, we broadened this offering of professional quality affordable products in stemware, cook's tools and dinnerware. Community remains deeply ingrained in our history and culture. We are constantly exploring new ways to reach and interact with chefs and food communities across the country. For the 5th consecutive year, William Snow was a presenting sponsor for FEAST Portland, a premier food and wine festival hosted by Bon Appetit in Oregon, and William Snow also held its 7th annual fundraising campaign, raising a record $2,200,000 to benefit No Kid Hungry, an organization dedicated to ending childhood hunger in the United States.
Another key component of our growth strategy visibly was an array of colors, textures and patterns that allow customers to express their own individual style. Our Williamson Home business is growing double digits online and driving material traffic in dollars per square foot in our stores. We are growing brand awareness through substantially increased innovative marketing and the expansion of our retail presence. This quarter, we added 12 more locations for a total of 62 as well as our 2nd freestanding Williams Sonoma home store in the Chelsea neighborhood of New York City. We are focused on executing our growth initiatives to build this brand into a substantial business.
And as you know, the holiday season is the most exciting time of the year for Williams Sonoma. Our early reads on the holiday assortment in combination with all of the preparation we have done, including our launch of the buy online, pick up in store service, gives us confidence that we are well positioned for the peak season. West Elm, with its unique focus on the intersection of modern design, affordability and community, continues to resonate with and attract the broadest demographic of customers within our brand portfolio. The Q3 revenue comp of 11.5% was driven by the strength in our furniture business and a reacceleration of our decorative accessories and lighting categories. We believe we have the strategies, momentum and white space to double West Elm revenues and for it to potentially be our largest brand.
We continue to see growth opportunities not only across 3 key areas to drive growth. 1st, our emphasis on trend setting proprietary design gives us the edge in driving trends instead of following, and we continue to evolve our core collections to stay ahead of the competition that copies our styles. For example, we're seeing great response to our new modern collection and update of our mid century modern style with cleaner architectural lines, new textures, patterns and lighter color palettes. And our in house sourcing capabilities allows us to produce products that align with our industry leading focus on values based production. We've established ourselves as a leader with innovative programs and partnerships that customers are responding to, especially with our commitment to fair trade.
Our product partnerships also amplify this message. For example, in September, we launched our partnership with Lisa Sleep, whose social mission is complementary to West Elm's commitment to consciousness. The partnership allows customers to experience Lisa's American made mattresses in select West Elm locations and is attracting new customers to the brand. 2nd, we are accelerating innovation in our marketing, particularly in digital advertising. Campaigns such as House Proud, combined with an increased focus on content based marketing across all channels, play a material role in driving sales and customer loyalty.
We also continue to scale our new hospice model to drive superior customer service and loyalty across all of our channels. Our high touch service model centered around our design crew offering and installation services utilizes our physical presence to drive sales growth in both our retail and digital channels. In the Q3, we opened 5 new stores in Fort Worth Des Moines, Iowa Albany, New York Hoboken, New Jersey and Ardmore, Pennsylvania. These new stores are surpassing our high expectations, introducing new customers to the brand and driving growth in our e commerce business. Looking ahead, we are excited about our expanded decor and gifting assortment that we believe will drive new customer acquisition during the holiday season.
We are confident that the growth acceleration we have seen this year combined with our differentiated brand strategies will propel West Elm to become our next $2,000,000,000 brand. Now I'd like to discuss our newer brands, Rejuvenation, Mark and Graham and our international operations. Rejuvenation continues to perform well with another quarter of double digit comp growth driven by strong performance in our core lighting and hardware businesses as well as in our emerging categories of furniture, textiles and wall decor. Our category expansions combined with our increased presence online and in retail has continued to drive brand awareness and new customer acquisitions. Looking forward to Q4, we are focused on expanding our core programs and introducing gifting destinations on our website and in our stores and catalogs.
We are optimistic about the strong trends we see in Rejuvenation as we continue to broaden our product offerings and introduce revised aesthetics to drive incremental growth. We're excited about the long term prospect of Rejuvenation and its potential to become a significant multichannel lifestyle brand. Mark and Graham delivered another quarter of profitably launched lifestyle marketing campaign is driving growth in our core programs, and we continue to leverage the Williams Sonoma, Inc. Portfolio to extend the brand's reach and increase customer acquisition. Looking to the holiday season, we are focused on creating the best in class online gifting destination with an emphasis on digital marketing and our dynamic assortment of curated personalized gifts.
In our global business, our company owned operations in Australia and the United Kingdom continued to deliver double digit revenue growth in Q3. We also saw improved profitability in these two markets driven by the impressive growth in our e commerce business, up 44%, and our continued focus on operational improvements. To further enhance our global multichannel strategy, we recently launched directly operated e commerce operations in Canada to better serve our customers in that market. We continue to leverage the growth of our existing owned and franchised businesses by opening new stores, expanding through new channels and introducing our brands into new markets. In Q3, we executed several wholesale arrangements to introduce the William Snow brand to our U.
K. Customers with pop ups in both Fortnum and Mason and Harrods as well as the West Elm brand, the Ireland customer with a full scale shop in shop in Arnots in Dublin. We'll be also opening our 2nd West Elm store in the Kingston area of London later this year. During the quarter, our franchise partners continued their expansion as Alshaya opened 3 new stores in Bahrain, Liverpool opened 2 stores in Mexico and Hyundai LiveBar opened a new store in South Korea. We also expanded our brand presence in the Philippines with 2 shop in shops and Ruston department stores.
And as our global operations continue to grow, we are actively exploring opportunities for franchise expansion into new larger markets and to establish our e commerce presence around the world, both company owned and with our franchise partners. Overall, we are committed to driving top line growth and are making strategic investments to enhance our value proposition, deliver a superior customer experience and drive new customer acquisition. These investments are enabling us to enhance and more effectively leverage our high touch customer service platform and set a new industry standard. I will now pass the call over to Julie to discuss our financial results in more detail.
Thank you, Laura, and good afternoon, everyone. Our Q3 results reflect our ability to drive both top line and bottom line growth and to once again deliver on our financial commitments. On the top line, we are pleased to see another quarter of sequential revenue acceleration and a return to market share gains with our home furnishings businesses outperforming the industry during the Q3. Total revenues for the Q3 increased 4.3% to approximately $1,300,000,000 with comp brand revenue growth of 3.3%, which accelerated 50 basis points from the Q2 despite an unfavorable impact from the hurricanes of approximately $7,000,000 in lost sales or 60 basis points of growth. Our top line performance reflects strong growth in both our e commerce and retail channels.
In e commerce, revenue growth accelerated to 6.4% and increased 100 basis points year over year to a new historical high of 53.1 percent of total revenues, despite lost sales growth in the hurricanes of approximately 30 basis points. This growth was primarily driven by West Elm, Williams Sonoma, our newer businesses Rejuvenation and Mark and Graham and our company owned international operations, almost all of which had another quarter of double digit growth. In the retail channel, revenues grew 2.1% despite the lost sales from the hurricanes of approximately 90 basis points, including our in home design services and store remodels. We also saw top line improvements across all of our brands. West Elm continued its double digit revenue growth to 15.4% this quarter with revenue comps once again accelerating sequentially to 11.5% on top of 12% last year basis points from the hurricane.
Across the Pottery Barn brand, their combined comp accelerated both year over year and sequentially from the 2nd quarter. And while their net comp only accelerated 10 basis points, their demand comp accelerated to 2.3 and both reflect an approximately 50 basis point negative impact from the hurricanes. In Pottery Barn, we saw improved active, new and reactivated customer counts, which if you adjust for the impact of the hurricanes, helped to drive another quarter of positive revenue comp and a sequentially accelerated demand comp of 2.2. In our kids and teen brands, inclusive of the lost sales impact from the hurricanes, we saw a positive comp of 0.1% in Pottery Barn Kids, which was a significant improvement from last quarter's negative 3.9 percent. And in Pottery Barn Teen, we saw a positive net comp of 3% and a demand comp of 9%, both of which significantly accelerated in the Q2 year over year.
And in our newer businesses, Rejuvenation and Mark and Graham, as well as our company owned international businesses, we delivered another quarter of double digit growth. This broad based value is working. Moving down the income statement. Gross margin for the 3rd quarter was 35.9 percent versus 36.8 percent last year. Occupancy costs of $171,000,000 versus $168,000,000 last year leveraged 30 basis points during the Q3.
The 90 basis points of gross margin deleverage was primarily driven by lower selling margins. We made a strategic decision to provide more value to our customers. As such, we have been input by the accelerated growth we have seen this year across all of our brands. We also incurred higher year over year shipping costs. Ensuring a superior customer delivery experience is a key focus for us and these costs reflect our desire to ensure timely and damage free deliveries.
This combined with higher shipping rates and higher customer demand for furniture, which is more expensive to ship, were the primary drivers for the increased shipping costs. These increased costs, however, were partially offset by our supply chain fulfillment related benefits that we continue to see. SG and A for the 3rd quarter was 27.4 percent of revenue
and revenue from the prior year quarter. We expect the same store sales growth in the Q3 of the year and
expect the same store sales growth in the
Q3 of fiscal year 2019. Operating margin for the Q3 was 8.5% versus 8.9% last year. Our operating income of almost $111,000,000 reflecting the lost sales impact from the hurricanes was comparable to last year. And if you take into consideration the earnings impact of the lost sales from the hurricanes, our operating income growth was relatively in line with our sales growth. By segment, the operating margin in the e commerce channel was 20.7% versus 23.1 percent in 2016, reduced shipping fees as well as higher shipping costs to ensure a superior customer delivery experience.
We also incurred higher digital advertising costs to support our investment in new customer acquisition. The operating margin in the retail channel was 7% versus 7.9% in 2016, with customer experience in our stores and to support our new stores across the West Elm, Pottery Barn and Rejuvenation brands. The retail operating margin also reflects an approximately 20 basis point impact in lost sales from the hurricane. Corporate unallocated expenses as a percentage of net revenues were 5.8% in the 3rd quarter compared to 6.9% in 2016 due to lower employment expenses, the overall leverage of corporate expenses resulting from higher year over year revenue as well as lower technology infrastructure investments. The effective income tax rate in the 3rd quarter was 35.3% versus 36.6% last year.
The year over year tax rate improvement was primarily driven by the overall mix and level of earnings as well as the incremental benefits we continue to see from the improved profitability across our international operations, which are taxed at a lower rate. We are pleased that we have seen improved profitability across our international operations all year and that these profits have driven a corresponding reduction in our corporate tax rate. Our 3rd quarter diluted earnings per share grew to $0.84 which includes an estimated $0.02 negative impact associated with the lost sales from the hurricanes. On the balance sheet, we ended the quarter with a cash balance of $91,000,000 versus $75,000,000 last year, and we had $170,000,000 outstanding under our revolving credit facility at the end of the quarter. As a reminder, given the seasonality of our business, our cash levels reached their lowest point at this time of the year as we fund our business ahead of the holiday season.
During the Q3, we invested an additional $53,000,000 in our business, paid approximately $102,000,000 in dividends and bought back over $154,000,000 in our stock, leaving approximately $256,000,000 remaining under our current share repurchase authorization. Merchandise inventories at $1,177,000,000 increased 10.6% compared to last year. A large portion of this inventory growth, however, was associated with inventory that is in transit. Our inventory on hand and available for sale grew 6.7%. The biggest drivers of our inventory growth are our higher growth brands, particularly West Elm and Rejuvenation.
I would now like to discuss our Q4 fiscal year 2017 guidance. For the Q4 of 2017, we expect to grow net revenues to a range of $1,610,000,000
to $1,675,000,000
with comparable brand revenue growth now in the range of 2% to 6%. We expect our 4th quarter operating margin to be below last year, and we expect diluted earnings per share to be in the range of $1.49 to $1.64 This 4th quarter guidance will have us delivering at the high end of our ranges revenues and EPS growth of 6% despite investments in our business to drive future growth. For the full year, we are raising our revenue guidance. We now expect to grow revenues to a range of $5,225,000,000 to $5,290,100,000 with comp brand revenue growth in the range of 2% to 4%. We expect our operating margin to be 9% to drive top line growth through investments in customer service, value and new customer acquisition are working.
And we are focused on fulfilling our customers' needs during this holiday season by leveraging the power of our multi brand, multi channel model to offer high quality superior products with excellent customer service. Our guidance provides us with the flexibility to make the necessary strategic investments to enhance our value proposition and drive new customer acquisition and long term top line expansion. At the same time, we remain firmly committed to delivering sustainable earnings growth and maximizing returns for our shareholders. From a capital allocation perspective, we remain focused on a balanced capital allocation strategy. We plan to utilize our strong annual operating cash flow to 1st and foremost invest in the business in those areas that will fuel our growth and provide the highest returns.
We plan to utilize our excess cash flow to return capital to our shareholders' cash transaction through our existing cash balances and our current revolving credit facility. In an effort to further optimize our capital structure, we are also currently seeking term loan funding of approximately $300,000,000 in conjunction with the renewal and extension of our current revolver. This additional liquidity will allow us to reduce our seasonal reliance on our revolver and to provide additional financial flexibility. In summary, as we head into the Q4, we are confident that our strategic focus on digital leadership, product innovation, a high touch customer service experience and operational excellence together with our proven track record of strong financial discipline will allow us to continue the momentum we are seeing in our business and to deliver long term value for our shareholders. I would now like to wish you all happy holidays and I will now open up the call for questions.
Thank you.
We'll take our first question from Kate McShane with Citi. Please go ahead.
Hi. Thank you for taking my question. My first question is just with regards to gross margins. Julie, I know you walked through some of the puts and takes. But could you help us put into buckets how much is from shipping?
How much is more from expanding the opening price points? And how much was offset by the supply chain efficiency?
Yes. I'm not going to give you the exact amounts, but I think I can give it to you somewhat in order. If you look at it, the biggest driver of the gross margin decline is lower selling margins because obviously we had another fantastic quarter of occupancy leverage that further leveraged from the Q2. So if you back that out, the driver is the lower selling margins. The biggest driver is our investment in providing value to our customers through more competitive product pricing and through reduced shipping income.
And then as well as the higher shipping costs from higher shipping rates and a move to more furniture this quarter, which is more expensive to ship. So when you think about the supply chain benefit, there's another way you could do that answer. And you could say that the amount of investment that we're making in the product pricing, if you include the occupancy and the supply chain benefits, it completely offsets it. And the supply chain benefits are holding to about the same benefit we've seen all year long.
Okay, great. Thank you. And then an unrelated question, you had mentioned, I think, in your prepared comments about e commerce operations in Canada. Can you tell us a little bit more about that, what was there before and how does that change the overall global business?
Yes, sure. We've always had a very successful Canadian retail business and we put into place order free application to our website, but we didn't have a specific custom built Canadian website like we do in our other foreign countries that we're doing business in. And we realized that while we had a layer that allows customers to buy things, it wasn't as relevant as it could be. And also there's nuances with the pricing and matching different promotions that we wanted to get more cleared up and better control the inventory flow to the customers. So it's a better customer experience.
We appreciate all Borderfree does for us in getting us into other markets where we have less of an established business. But in Canada, we have such a sizable retail business, it was time to make sure that we had the same consistent online experience that we do in the United States.
Thank you.
We'll take our next question from Chris Horvers with JPMorgan.
Thanks. Good evening. Could you explain exactly what demand comp is? I think we're there's a bunch of investors that are confused as to what exactly that is. And then as it relates to the Q4, I know you're saying 9% to 9.2% for the year, but it seems like to get in your range, it's pretty tough.
Should we think about the gross margin sort of acting seasonally consistent as it does in prior years where gross margins up 150, 200 basis points sequentially after Q3?
Okay. So first, this is Julia. For your question regarding demand, demand is where the customer has ordered the goods and wants them and either we don't have themfrom a demand and net perspective, we weren't able to deliver them in time to be able to recognize them from a revenue recognition perspective. So it's the true health of the business because the customer wants the product. And so that's why we're calling it out.
And so it's just a fulfillment side of it that's making it not turn into net for example.
And let me give you one example. So in Pottery Barn, one of our many strategies is our international drop ship. And in international drop ship, it's capital light strategy and the product is not warehoused in our domestic warehouses. At the same time, the lead time is longer. So as we move more demand to some of those strategies, it doesn't fill in the quarter, if you will.
It doesn't
show up in the balance sheet.
No. We charge the customer if we have the good and we don't get it delivered, but we don't charge the customer if we don't have the good. So it depends on which is the reason.
Understood.
As far as the operating margin guidance, obviously, we have guided the operating margin directionally to be below last year. Yet the one thing I do want to call out is that this operating margin guidance will still have us maintaining an industry leading operating margin and operating income with strong operating cash flow. And at the end of the day, we are focused on serving our customer and accelerating our top line growth. We are focused on fulfilling our customers' needs during this holiday season, and our strategy is to drive top line growth through investments in customer service value and new customer acquisition are working. And so this guidance provides us with the necessary flexibility to make strategic investments to enhance our value proposition and to drive new customer acquisition, both of which has fueled top line expansion and will continue to do so.
So we have to continue to invest in those areas that are going to help us stay ahead of the competition and allow us to provide the best customer service to ensure long term sustainable profitable growth for our shareholders. And given our accelerating top line expansion all year, along with our return this quarter to outperforming the home front, we believe shorter term sales acceleration, but will also fuel long term top line performance for our shareholders. As a result, we are aggressively pursuing market share gains by making the necessary investments today, while still maintaining industry leading operating margins and operating income, and we believe this is in the best interest for our shareholders long term.
I think people are going to interpret that as being able to strike that balance. So is it aggressively pursuing share?
So I mean, obviously, right now, what our drive has been and as you've seen all year long is to go after the top line, it's working. And we've said all along, if we are investing in things that are working, we're going to continue to do that. On the flip side, we've got a lot of opportunities to offset the operating margin pressure. Whether it's continuous benefits we're seeing from the supply chain, there's a lot to go there as we've talked to you about before. We have opportunities to in source some of our advertising and technology costs, which will improve operating margin as we drive that top line.
It leverages all the fixed costs, which will improve operating margin, improve profitability in our international operations helps as well. And so there's a ton of things that we're also working against. We also lap in the Q4 the bigger investment for Pottery Barn on both the reduced ship in Q3 because we started it sort of mid quarter in Q3 and by the time the goods got delivered, etcetera, it was more of a Q4 play. So that's why we think there's sort of puts and takes on the op margin line.
Thank you.
And we'll take our next question from Michael Lasser with UBS.
Good evening. Thanks a lot for taking my question. So should we think about the difference between brand comp and reported comp along with the hurricane impact as sales you're going to get back in the 4th quarter as inventory is there and you don't face the same disruption that you did early in 3Q?
Well, the hurricane, obviously, we don't get back. That's just a function of quantifying the lost sales from the hurricane, but it speaks to the fact that it's not necessarily a downward trend in the customer demand if there's something that disrupted it. As far as, the demand versus net, yes. I mean, obviously, goods come in and then we can fill it or the goods weren't able to be delivered by the end of the quarter and that should come in. And obviously, that's a part of our guidance for the Q4.
And when you my second question is when you talk about investment in providing value through competitive product pricing, does that mean you're taking product prices down or you're just offering more friends and family sales more 20% off on certain items? How is it actually unfolding?
We're always seeking opportunities and making necessary investments to provide more value, whether it's in shipping or opening price points or even mix of categories. So for example, instead of having only expensive considered purchases like furniture businesses growing, making sure that we're offering customers those things that are easy to purchase and are great value every single day. At the same time, as it relates to promotions, we know customers are smart. They're looking for the best value, but they're not looking for it at the expense of quality. And we are consolidating and streamlining our promotions across our brands, and we do not intend to have incremental promotions.
Okay. And just a clarification, what do you expect you have an extra week this year, what do you expect the sales and earnings contribution?
We don't have an extra week this year, it's next year for us.
Next year, got it.
Yes.
Thank you very much.
Yes, thanks.
And we'll take our next question from Simeon Gutman with Morgan Stanley.
Thanks. Good afternoon. Julie and Laura, I have a question. It seems like this language around investing in price to create value, I just want to clarify that that does sound like a step change from the way that we were talking about it just last quarter. Can you talk about what prompted that change, if that is correct?
I guess that'll be my first question.
No change.
Okay. So this strategy was contemplated all year long?
Yes.
Okay. And then back to Chris
Just you may recall, when we laid out our Pottery Barn strategy and we've done all of our customer work, there were some key components to that strategy, including bringing the customer more inspiring decorating ideas, bringing back some of the decorating categories and building them, but also there was a clear request for more opening price points and better value, similar to the way the Pottery Barn brand was when we started it. And so while a lot of the high end product sells extremely well, we also don't want to walk the customer when they're furnishing their first apartment because we know that all customers are not modern and they want different aesthetics and Pottery Barn should be able to serve those customers like they always did. And by the way, that's the best entry to the brand.
Some of the language around it. But I guess as a follow-up to Chris' question about the trade off, if we look at the gross profit dollar growth, right, because the question is, do you have a full understanding of the elasticity here of how much value you put in versus how much sales you get back?
Yes. And real quick to go back to your other question on gross margin. I think as I was kind of framing up with Kate, at the end of the day, we were providing competitive product pricing for the customer and the reduced shipping. But I went out of my way to say that obviously the occupancy that is what brought it down. And so hopefully that helps you sort of square root the gross margin.
Obviously, we look at the dollars as well as gross profit. I'm happy you said that because I think that's important as well on the bottom line. And so we're obviously square rooting all that as to making that investment into the top line relative to the bottom.
Okay. Thanks, Julie.
And we'll take our next question from Brian Aqual with Oppenheimer. Please go ahead.
Hi, good evening. This is David Bellinger on for Brian. Hi.
Just a
couple of questions from us. It seems as though sales momentum at Pottery Barn was improving nicely over the past several quarters and then slowed here in Q3. Can you give us some more detail on the step back in trends and help us understand the key drivers there?
Yes. So as I said earlier, our demand comp was actually 2.2 and that also was affected unfortunately by the hurricane. So we continue to see improvement and the strategies that we're putting in place, particularly in DECAC, our furniture strategies in the small spaces are all working. And so the great news about that is that it's a strategy that builds upon itself into the future. And in particular for holiday, we are seeing a really nice start to the beginning of the season in Pottery
Barn. Okay. And then just switching gears on to the Outward acquisition and your comments on augmented reality and VR. Are we now seeing some type of shift in the home category more towards mobile that helped drive the timing of this deal? And can you provide us with any more color on how your mobile sales have progressed lately and how that stacks up against others in the space?
I'm going to actually let Sameer and Felix take that question.
Great. Thanks, David. I mean, this is the trend to mobile is one that we've been talking about for some time and that we've definitely seen in retail overall and in particular in the home space. And we're really excited about what the acquisition of outward means for our prospects across the entire digital experience, including mobile. Laura said it well before, 3 d imaging is going to significantly transform the way that people shop, especially in the home space and this is an area where we want to be a leader.
To talk a little bit about the partnership first and I'll address your question about mobile right after that. We've explored partnerships with a number of different companies in the 3 d space over the last few years and we believe outward is the best. At the heart of their platform is the encoding of a physical product in 3 d in a way that isn't purpose built for specific use case, but can be leveraged for any number of different use cases. And it's truly different than any other application of 3 d that we've seen. It's built for the long term.
It is in a space that's changing rapidly. We believe that this focus on future proofing will serve us well and the quality of their 3 d models is unparalleled. To talk about mobile specifically related to your question, like I said, we've been a partner of Outward for a few years now and we've already seen real ROI from their 3 d innovations. Augmented reality, which is a huge mobile play for us as well as 360 product spend on our websites including the mobile website. This is driving engagement on mobile, it's driving conversion on mobile and it's going to be a big part of both our mobile strategy going forward as well as our strategy with outward going forward in terms of developing new 3 d innovations that we're going to bring to the market.
And we're really excited about the prospects of what an even closer alignment with outward can mean for our prospects of improving our digital experience going forward.
I would say on an advertising front, we continue to shift funds from desktop to mobile and optimize to across device ROI across our brands. We're believers in the power of video across many of the mobile platforms. Laura mentioned our first test into programmatic TV, but we leverage that creative in many of our other videos that we create to advertise across many mobile centric platforms.
Thanks for all the color. Really appreciate it.
Thank you for the question.
And we have time for one last question from Chuck Rom with Gordon Haskett. Please go ahead.
Hey, thanks. Just on the Q4 guidance, not the B2C, and would you think that the total grosses are going to be down commensurate with what they were in the Q3? Is that how we should be thinking about it?
Yes. I mean, obviously, we don't guide the gross margin at this point and whatever pressure in that line has been assumed within the op margin guidance. But I think the way to think about it on the upside is that we are going to be lapping, as I said earlier, the Pottery Barn investment and reduced shipping income. And so that should help with the gross margin. We should see occupancy leverage.
And so and I think the shipping costs should not be as significant given the fact that there's less furniture sales that occur in the Q4 for the holiday season. And so you should have some of those benefits that flow through. Of course, we always have our supply chain benefits that are continuing to roll through, and we think there's still opportunity to grow those.
Okay. Okay, that's helpful. And then I guess when we take a step back and think about a little bit longer term here, your operating margins have obviously been on a little bit of a downward trend over the past few years. And just the backfill to Chris' question earlier, when you think about protecting market share and maintaining margins, do you think that's feasible over the next
several years? Yes, we do. And just remember, we are running our business for the long term. Customer satisfaction drives all of our decision making and the current environment has created a lot of disruption, which we believe provides opportunity for us to further drive growth. And so we're focused on making investments to better position our business for growth in the long run.
So just not to beat a dead horse, but those are digital advertising, global operations, making investments in technology such as the Outward acquisition and investing in our people who are, of course, the most important asset in driving our business forward. And as it relates to cost improvements, we also see tremendous opportunity in our supply chain efficiencies. Density in the supply chain drives costs down. Inventory optimization improved in stock and reduced overstocks drives costs down. And we are reducing our ad cost and media buying spend not by spending less, but by spending less on markup by taking more in house, so we can expand our reach more efficiently.
And last, we're building an engineering driven technology team that will allow us to more efficiently execute on digital initiatives by reducing the number of contractors. It is all of these opportunities that we believe will set us up and differentiate us from the competition and allow us to drive long term shareholder growth.
Okay. Thanks. And if I could just maybe sneak one more in here just to get a little bit verification here on the demand comp. Obviously, you guys have much better visibility than we do and that's sort of new terminology for some of us. Could you maybe help us think about how the comp trended throughout the quarter?
And then a lot of retailers that we cover have spoken about a nice pickup here in November. It sounds like that's the case for you guys. Just wondering if you wanted to help us out a little bit on that front?
Yes. I mean, typically, we don't give color on cadence, but I think it's pretty obvious clearly. Fortunately, October didn't have the hurricane impact. And so October was obviously probably a stronger month. And then November with no election distraction that we had last year should be a stronger month.
And we alluded to in the script that we've seen a strong start to the Q4. Hopefully, that gives you some sort of color.
That's great. Thank you.
And that concludes our question and answer session for today. I will now turn the conference back over to Ms. Alber for any additional or closing remarks.
Thank you all. I appreciate the questions and the engagement, and I want to wish you all a great Thanksgiving. And we look forward to talking to you next time.
Thank you. And that concludes our conference call for today. We thank you for your participation, and you may now disconnect.