Cammeron McLaughlin - IR Gary Friedman - Chairman and Chief Executive Officer Karen Boone - Chief Financial Officer.

Matt Nemer - Wells Fargo Security Jessica Mace - Nomura Securities Matthew Fassler - Goldman Sachs Peter Benedict - Robert W. Baird Oliver Chen - Cowen and Company Brian McGough - Hedgeye Daniel Hofkin - William Blair & Company Cody Ross - Wolfe Research Lorraine Hutchinson - Bank of America Merrill Lynch Cristina Fernandez - Telsey Advisory Group.

Good afternoon. I'd like to welcome everyone to the RH Fourth Quarter and Fiscal 2014 Q&A Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question-and-answer session. [Operator Instructions] Thank you.

Cammeron McLaughlin, Investor Relations, you may now begin your conference..

Hi. Good afternoon, everyone. Thank you for joining us for RH's fourth quarter and fiscal 2014 Q&A conference call. Joining me today are Gary Friedman, Chairman and Chief Executive Officer, and Karen Boone, Chief Financial and Administrative Officer.

Prior to this call we posted a video presentation to our Investor Relations website, ir.restorationhardware.com highlighting the company's continued evolution and recent performance.

Before we start, I would like to remind you of our legal disclaimer that we will make certain statements today that are forward-looking within the meaning of the federal securities laws, including statements about the outlook for our business and other matters referenced in our press release and video presentation issued today.

These forward-looking statements involve a number of risks and uncertainties that could cause actual result to differ materially. Please refer to our SEC filings, as well as our press release issued today for a more detailed description of the risk factors that may affect our results.

Please also note that these forward-looking statements reflect our opinion only as of the date of this call and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events.

Also during our call today we may discuss non-GAAP financial measures which adjust our GAAP results to eliminate the impact of certain items. You will find additional information regarding these non-GAAP financial measures and a reconciliation of the non-GAAP to GAAP measures in today's financial results press release.

A live broadcast of this call is also available on the Investor Relations section of our website at ir.restorationhardware.com. With that, I will turn it over to the operator to take our first question..

[Operator Instructions] And your first question comes from the line of Adam Sindler with Deutsche Bank. Your line is open..

Yes. Good afternoon, everyone. Thanks for taking our questions. I guess obviously sort of the base question here is the revenue slowdown that we're looking at for 2015. If you maybe help us understand what is driving this. It does seem to imply a pretty significant slowdown in the brand comps as well.

And obviously given that you're saying 2015 is a bridge year, but then sort of as you think about this longer term, getting back to 20% next year.

But if we take, and this is we guess a two parts, sort of near term help us understand? But then longer term if we could help understand sort of the maybe disparity, if you will, between longer term guidance of $4 billion to $5 billion once the network is fully built out versus the 20% CAGR because you'll have 20%-ish, even below that CAGR, would get you to the $4 billion in change in just several years from where you ended 2014?.

Which question do you want me to start with?.

If you could just start with the near term, please, would be great..

Sure..

Thank you..

Well, let me talk about this. The way we think about our 2015 revenues and why they should accelerate in 2016 is twofold. One, all of the new real estate opened in the back half of this year. So while 2015 will only receive a partial benefit from those new galleries, 2016 will have a much greater benefit as they roll into the next year.

And then two, our development accelerates, our store development pipeline accelerates in 2016 with current plans to open 7 new next-generation galleries in the following year. So really 2016 gets the benefit from the new stores.

And if you think about the stores that opened this year that roll into 2015, we really only had one of these big stores, Atlanta, that opened this year, right, that rolls into 2016 – rolls into 2015. So that's why we see this as a bridge year.

I think that additionally, as we kind of mentioned in the press release and video presentation, we have two new yet to be disclosed businesses opening in the second half of this year. We believe those businesses will ramp throughout 2016 as we add a second and more informed mailing of each of those sourcebooks. So you've got two factors, really.

You've got the later openings this year, and then you've got those 4 stores really rolling into 2016. You've got the 2 businesses that we will be disclosing in the next quarter or two, and those will ramp in the back half of this year, and then be fully realized in 2016..

Okay. That makes sense. And then just on the longer term, if you could help us think about the guidance of sort of a longer term CAGR of 20% versus the $4 billion to $5 billion in sales once the network is fully built out.

Appreciating that you're ramping openings in 2016, should we expect acceleration from that even? Given that you did mention 9 signs for 2016 and 25 identified or in advanced negotiations? Or is there sort of a number where you'd like to cap yourself, just so you can make sure you can execute properly on all these because they're not cookie-cutter?.

Yes, they're – right now, our plan is for 2016 to have 7 of the next-generation design galleries. As we look into 2017, could that ramp? I mean, it could. I think, though, what I'm hearing as you ask me the question is you're kind of modeling this out.

You're kind of saying hey, if you grow at 20% a year, you're going to hit this $4 billion to $5 billion. I….

Exactly..

The way to think about the $4 billion to $5 billion in the real estate is that is just one of our initiatives, right? So the real estate transformation is one of our initiatives that tied together with our expanded product offer, right, gets us to $4 billion to $5 billion once we have transformed the real estate in North America.

Beyond that, there is strategies here to continue to drive the product offer in multiple new ways that we have not disclosed. And there is an international expansion plan for the business. So you really – it's not just looking at the real estate move as the only move, right.

So we believe that we can continue to grow the business in the 20% plus range for the foreseeable future based on the strategies that we have and the initiatives that we have in our pipeline. But you have to kind of look at the real estate as just one of the things we're doing..

Got it. That was very helpful. Thank you so much..

Yes..

And your next question comes from the line of Matt Nemer from Wells Fargo Security. Your line is now open..

Afternoon, everyone. Thanks so much. Two questions. First on Atlanta, can you provide any additional color on the early performance relative to that 12 to 18 month payback forecast? And you mentioned that it's the direct lift is one of the stronger lifts among your new format stores, and I'm curious what factors might be driving that.

And then secondly, in terms of the new concepts, do you have any more detail on the timing of RH Kitchen and the other concepts, and whether or not they're included in your revenue guidance or would that be upside to your revenue guidance? Thanks..

Yes. Let me try to take those. Karen, you can add some color if I miss anything here.

But as we've said, we're very pleased with the early reads from Atlanta and we expect the sales in Atlanta to further accelerate as we introduce the new businesses we plan to launch in the second half of this year, and then additional new businesses that we have planned for 2016.

So one of the things, when you step back and you think about these new stores that we're building, we've built them for the future pipeline that we have in progress, right. So we didn't build them for today, we built them for tomorrow.

So Atlanta is the first store to include all of our current businesses, RH Interiors, Small Spaces, Baby & Child and Outdoor. Additionally, there will be two new businesses introduced in the second half of this year, both core to RH. So both will be within the home realm of the business that relate to the RH business.

We think both open up entirely new markets and are significantly incremental to what we're doing today. So they're categories that we don't serve today. And those categories will be launched in a catalog, and they will be then inclusive in these next-generation design galleries, right.

So Atlanta will benefit and continue to ramp in the second half of this year. And then will continue to ramp further into 2016 as it benefits from those new businesses for the full year and it benefits from new businesses that will be added in 2016. We have announced Kitchen. We have not announced the date that we're launching Kitchen.

Kitchen is not one of the two businesses that we will be launching this year. So I can end that speculation, because we've already gotten e-mails from people that said, is one of the two businesses Kitchen. And so we probably should have made that more clear. So kitchen is not.

Kitchen has taken us a little bit more time, as we are approaching the Kitchen business in a fundamentally different way than anybody has in specialty retailing. So – and we're very excited about it. We just have to do more work to be able to execute Kitchen at the level we expect to.

But the two new businesses that we are launching, I think I mentioned on the last call, one of them I believe represents our finest work ever, and might represent one of the biggest market potentials that we've addressed with a new category, a new business. So – and the second one I think is also significantly incremental.

But one I think is a game changer. We're not ready to talk about it yet, because we want to talk about it when we can show it to you fully visualized, and you will hear more about it on our next call. So as you think about Atlanta, we're very pleased where Atlanta is tracking based on the categories and the businesses it has in it today.

We have expectations that it will further accelerate in the second half as it gets two new businesses, right, which the square footage is designed to take. And it will continue to accelerate into 2016 when we introduce at least one more business, and that could be Kitchen..

And I would just add all of the metrics internally are on track. The direct list you mentioned, why is that happening? I think it's just if anyone has been there or seen it, it's just we've often said that these stores serve as somewhat of a billboard.

And so I think the impression that you get even just driving by that thing is versus being kind of hidden in the mall in 7,000 square feet, the advertising, sort of the marketing that we get from the brand just from having that store physical presence is no surprise. It's driving the direct lift.

But at the same time we're very pleased that it's been as strong as it has been. And with respect to all those payback metrics, just as a reminder none of the direct lift is factored into those. That's kind of gravy because if it's not in that four wall contribution..

Greenwich, New York, I mean, Greenwich, then we had an expansion of New York, we opened Melrose and we opened Atlanta. They're all very different. And I think it's important to note as you think about the business and the indications or reads you should take from each of them. Greenwich was really a full line, a basic full line design gallery.

So Greenwich was more like a Houston or our initial LA or our Scottsdale store. So it was about the same square footage expansion as those and it only has the core RH business and it then has an expansion of the RH Outdoor business. The New York expansion, and by the way, we're very happy with Greenwich. Exceeding our plans, very excited there.

The New York expansion is the one store we've been disappointed with. And let me tell you why we believe that has not played out to our expectations. It is the only store that did not relocate to a new location. So what we did in New York is we added two floors above an existing floor and half. We closed the basement and we then went up two floors.

So we expanded our square footage and we had an expanded assortment of our Interiors business and we put some Outdoor on the top floor in New York. That store has not gotten the lift we expected. So we're disappointed with that.

What's the lesson there? The lesson is, it's the only one that did not go into a new location and does not have – there is no physical change from the exterior of the store.

So we believe that just expanding a store in its space without changing the facade or changing the presence of the store is a key lesson for us, that the customers don't know enough has changed, right. You can't see it from the outside. Melrose on the other hand is in and of itself is another kind of store change.

So Melrose replaced one of our first, what we called full line design galleries, right. So we opened in LA in an ex-William Sonoma Home location that was a temporary location for us. We had signed the Melrose location. We knew it was going to take several years to develop and build.

And we didn't want to wait in LA to have an expanded assortment of our business in the market. So we picked up the Williams Sonoma Home location when Williams Sonoma closed those stores. We were able to build that out, remodel it, put it in a courtyard and present our brand. We were very happy with the lift. We've learned a lot.

But we already had a store in development. So Melrose represents just a better version and bigger version of full line design gallery. It's not a next-generation design gallery. It does not have Baby and Child. It does not have Small Spaces. So it's just a bigger version of a full line design gallery. And we're very pleased with the results in Melrose.

Atlanta as I said, is the first full design gallery. So that's the only one that represents the new model, and we're very pleased with the early results in Atlanta. And we're very excited to continue to feed that footprint with the businesses that we've developed in the pipeline that are designed for all these larger stores..

Thanks so much for all of the color, and good luck this year..

Yes..

And your next question comes from the line of Jessica Mace with Nomura Securities. Your line is now open..

Hi. Good afternoon..

Hi, Jessica..

Hi..

My first question, if you could just clarify on this bridge year for 2015.

Is it fair to say that the dynamic is fully related to the timing of opening stores and or could you tell us if there's any change in what you expect in your comparable sales growth?.

Well from our internal plans it has everything to do with the later development of the real estate and the real estate coming on later. And so I mean, just to be clear, we don't expect this company to continue to comp at 25% forever. And that's never been an expectation.

So we – the real estate is essential to continue to have the 20% range revenue growth..

Understood.

And then if you could provide any further color on the performance of the gross margin expansion and the SG&A performance in the fourth quarter? And maybe just some of the timing for the significant benefits you expect to see in 2015?.

Sure. So for Q4 our gross margin was actually right in line with what we had kind of been talking about for the whole last half of the year. We had talked about the half having 50 to 100 basis points expansion. Our actual was 90 basis points gross margin expansion in Q4. That was 30 basis points, which was right where we had talked about.

And then SG&A was also kind of similar. We had said we expected modest deleverage, and the biggest drivers within SG&A, we were flat in Q4. We had some deleverage of advertising, as we've been talking about with the expanded page count.

And that basically offset some of the great leverage we had all across the rest of the P&L with a lot of our fixed G&A costs. So that's kind of the story and the color on Q4. With respect to 2015, just in general that operating margin expansion that we're talking about, we expect the majority of that to come from SG&A leverage this year.

The biggest driver being advertising leverage, which Gary mentioned some of the optimization we're going to be having with our sourcebooks this coming year, but we do expect to have some modest gross margin expansion in 2015 as well..

Great. Thanks very much..

Okay. Thank you..

Your next question comes from the line of Matthew Fassler with Goldman Sachs. Your line is now open..

Thanks a lot, and good afternoon. The question I would ask just relate the direction of operating margin to your store opening trajectory. So your incremental margins are likely to increase nicely in 2015 as revenue growth slows a bit to your plan and the operating margin expansion stays somewhat similar.

If any of that reflective of less new footage? And I guess the other question related to this, as you look at 2016 is there any reason why incremental margins would change at all from where they are going to be this year? In other words, should you be able to get good operating margin expansion a year out, even as the rate of average footage growth accelerates?.

Yes, we would expect the operating margin to continue to expand..

Yes, and one of the big drivers there, Matt, is related to the real estate transformation. The occupancy leverage that we're getting with these new deals is really significant. So we have this legacy portfolio that's highly productive and leveraging.

And as these new stores come on, those are such superior economic deals than we've seen that that occupancy leverage is going to continue..

Yes. And then – let me just build on that. I think if you study the slide that Karen puts up that shows the path to the 15% to 16% operating margins to get to the mid teens, there's really a couple key things and a way to simplify it.

If you take the real estate transformation and you say, take any market and say, we are going to meaningfully increase the sales in that market. And in that market we also expect to have occupancy leverage, not only in that market, right, but we'll have occupancy leverage across the greater company because we're increasing sales.

The other thing that happens is when you have a significant increase in sales, we're not planning to increase advertising in that market to drive those sales, right. So those sales happen as a result of the real estate transformation. So advertising leverages significantly in each of those markets, right.

And so you've got two big levers, and then you've got the other levers of those incremental sales across the entire infrastructure of the company. Again, what's very different here than I think many other businesses that are growing, is we've spent years and years and years building this assortment.

Remember, in the typical market less than 10% of our assortment is displayed at retail. So we've built the assortment. We have more things coming, right, but we've built the vast majority of the assortment.

And now by opening these new stores we will get the sales and the leverage because it's not like we're building the assortment as we're trying to drive the sales. We've already built the assortments. So we just have to unlock those assortments into the marketplace.

We will – by transforming the real estate that will meaningfully lift the sales in every market, that will drive down occupancy, that will drive down advertising cost and it will drive down overall SG&A across the company and across the board..

Great. Thank you so much for that. Appreciate it..

Yes..

Thanks, Matt..

Your next question comes from the line of Peter Benedict with Robert W. Baird. Your line is now open..

Hey, guys. Question just on the operating margin. Thanks for the color on the year and how you're seeing gross margin and SG&A. But if you think about the first quarter kind of implying flattish, maybe up a little bit. And I understand that the revenue is a little lighter there.

But as you go across the balance of the year, you're obviously guiding to a lot more operating margin expansion. I mean, the revenue growth rates implied over the following three quarters aren't materially higher than what you've got in the first quarter.

So I'm just curious, other than just sales leverage, are there any other puts and takes, Karen, we should be thinking about in terms of what's maybe pressuring the early part of the year that may fall off for the back half?.

Yes, sure. So Q1, if you just think about what Q4 looked like, just roll that forward to Q1 because we expect the same thing. We expect the modest gross margin expansion but the ad costs. Our books mailing once a year have pretty much a one-year cycle.

So when we double the page counts and we have a deleverage in ad cost in Q2, Q3, and Q4 it's just going to continues into Q1 until we lap that and have the benefits of some of the optimization we're having with our next year in 2015, the coming books. When those optimization efforts hit in Q2, that's when you'll start seeing the ad cost leverage.

So in Q1 you still have a little bit of the deleverage that we saw throughout the year. Now that really helped in another year with very little square footage growth drive a lot of our sales and the great things that happened in our business.

But in Q1 you're not going to see the same level of operating margin expansion as we will in Q2, Q3 and Q4 in 2015..

Okay, that's perfect. And then just thanks very much for that. And just as we're thinking about 2016, and Gary you said maybe seven of the new design galleries coming online.

Do you think any of those come early in the year? Do you think the timing would be more spread, as best you can tell at this point or should we be thinking back half of the year for the 2016 openings as well?.

Yes, I would say it's still going to be weighted back half, but we may get a couple of them open in the first half. But because they're all big development deals, they're just really hard to gauge.

We actually just until several weeks ago thought we had eight, and then one of our major landlords had an issue with moving a critical tenant that they needed to move and the store gets pushed by six months into the following year. So I wish these could be simpler and more predictable, but they're not.

And many ways they're probably the most complex development deals that I think anybody has been involved in retail because, even different than a department store where you're just looking for a pad. They've got pads for department stores and you've got a simple build.

These are – they have to make the room for us or find the room for us, or we have to find a building that works. So we're confident in getting them all done. But as we're doing them, I think we're learning and we're learning about the complexities.

And while it's rolling out a little slower than we might have originally anticipated, I think the benefits from that, I think we're smarter, we're making -- we're learning lessons, we're making a lot of good changes and continuing to tweak these and make them more productive. And I think we'll still be able to hit our long term targets here.

I think in this one year and this bridge year, we would have hoped this year would have been more like seven or eight stores and it wound up being four..

Understood. Thanks for the color..

Yes..

Your next question comes from the line of Oliver Chen from Cowen and Company. Your line is now open..

Hi. Congrats on a solid finish to a great year. We had a question related to the inventory needs over the next year. How should we think about the magnitude of cash outflows? And is there a delta with the new concepts? And then also Gary, you mentioned quality and service as a theme.

How will that interplay with the financials in terms of margins, or how you see traffic and awareness building? And finally I wanted to ask you a little bit about supply chain. And supply chain feels like a great long-term opportunity as well as ongoing. And how that may intersect with the customer experience. Thank you..

Okay I'll start with the inventory one and that one very similar to what we have been saying is the business does require a night in stock position so we will continue to make inventory investments to make sure that strategy improves that in stock and make sure we aren't having high back orders continues on that bath.

We are really happy with the investments we made last year and actually one of the reasons we were able to navigate some of the port issues in the back half of 2014, having made some of those investments and then we will make investments for the product, the newness and some of the product categories that Gary talked about.

So on the year, we do expect to continue we hope to grow inventory slightly ahead of sales very similar to what we did actually the last two years.

So that really won't change and we won't see significant improvement in turns until we start to grow more of the square footage and start to kind of optimize those inventory investments and have a little less newness and growth by square footage as opposed to offer..

Okay, thank you..

Let me try to take up your other two questions. I think one was related to the theme of quality and service and how that will impact the P&L.

I think we believe that as we position this company at the luxury end of the market and position the brand there that there's an opportunity to continue to elevate our service and elevate the quality experience that our customers get. We're making multiple investments and we'll continue to and they all have pretty good return timing.

So – but let me just talk about some of them. When you heard about our push into design services. We're finding out that as we invest into offering a very high quality level of interior design the payback on those investments is very quick and it differentiates us in the market.

And as a lot of people today it's interesting, a lot of people say they have three design services and not many people have really certified and qualified interior designers on staff, where people that are qualified to go in and do somebody's home.

Many times I think other people out there that are in the industry that say they have design services are taking some junior person who may be as good as visual merchandising and letting them into somebody's home and trying to give advice on how to design a home or other people may have people who think they are good at decorating and they call them an interior designer.

We're building a world class kind of interior design platform and we believe we have the credibility to do that, because I think if you look at the execution in our galleries we execute as well as world class interior designers the way we present in our stores.

But we think there's opportunities to elevate the service, to add installation services, to be more full service like an interior designer. The question is at what point do you charge for that service and how high do you take that service before really it doesn't make sense to do it for free.

So we're doing a lot of work around interior design service and believe we can elevate that effort over the next several years. Some other things that we're focused on is the continued in-sourcing of our home delivery hubs.

I think I've mentioned in our past calls is that our bias is to have more control than less control and to have more control of every aspect of our business all the way to the customers. So we continue to make investments and to take control of our supply chain based on that final delivery.

And that kind of piggybacks on to another key investment we're making and a system that we're rolling out this year and that's our new final mile system.

I think we've mentioned this before, but it's a new scalable state-of-the-art delivery and scheduling platform that provides visibility to all aspects of the delivery cycle and it enhances the customer experience through improved inventory accuracy and scheduling sufficiency.

Today we're dependent especially where we have third parties on systems that don't give us full visibility that we don't, we have communication gaps and visibility gaps throughout the system and we lose efficiency and it impairs our ability to deliver world class service and it's also more costly.

So we think that there's significant opportunities as we rollout final mile which should be fully rolled out by the end of this year and we'll be seeing, we believe, big impacts and payback on that investment.

The other thing that we'll be implementing this year is a sales force customer relationship system, management system and it's really the leading customer relationship management solution that will provide a single view of the client for galleries, all of our stores and our client service centers.

It elevates the customer experience by enabling associates to service clients faster and more accurately with seem less access to order, product and other key information and including the customer's the lifetime value. So we can see the lifetime interaction and value of this customer. And today, we don't have that, right.

So we're still today operating kind of in the dark ages from a customer relationship management point of view. So when we rollout the sales force system this is going to leap frog ahead. We're also – we have some other thing that we think will just improve the operational performance of the company and execution of the company.

Well first let me finish on the supply chain. The last piece is our new distribution center in Northern California. We talked about this, it's a new 1.5 million square foot DC in Patterson, California. It's the next planned step in the long-term growth of our network and it's a really next generation kind of distribution center.

Each one of these we get smarter, we get better, we execute better, we take learning from those and we can then take those learning into our existing centers. But all of this gives us the ability to continue to grow the company and get this enhanced flexibility.

So we're building a network that we believe gives us the ability to grow and the ability to be flexible and to accept new businesses as the new ideas and not have a supply chain that locks up then. And then the other investment we're making is into a new Oracle financial system.

We have a planned replacement of I think what do we have, Lawson, it's an aging financial system, very aged and this is really state-of-the-art Tier 1 solution from Oracle that will give us better data, better reporting and better information throughout the organization and be able to manage our financials better and be able to manage the business better.

So a lot of investments that all of these will help us raise the level of quality, service and execution throughout the company. So I think that kind of ties into the supply chain question also..

Yes that's really helpful.

It sounds like really great infrastructure developments and Gary just as a follow-up, where were your lead times roughly and is there a way to dimensionallize what the big opportunity is on that overall kind of lead time picture as you look to efficiently match supply and demand?.

Yes, we're doing a lot of work there. Ken Dunaj, our Chief Operating Officer has recently taken over inventory management. He has a new leader in that area of the business.

I think we have more intelligence, more energy and passion behind inventory management than ever in the history of our company right now and these guys are working all the way up the supply chain and really creating interfaces with our vendors at a level of really sophisticated company. So you'll hear more about this.

I mean there's many things we can talk about here. But it's kind of the next step of evolving this company. We've been able to position ourselves where we are today because we have run a product to market that really didn't exist and in many cases we created a new market.

I've always said that furniture this quality has never been made in these quantities before, so we're building a new railroad and initially it was a lot of muscle and hard work and investment to kind of scale this in the early stages.

Now we're in a position where we're making more meaningful investments, system investments, on both sides with our vendors and internally here and connecting those and building a kind of supply network and a supply platform that we think will be very unique in our industry.

So all of that should help us with lead times, help us with inventory flow, the way we're systematically placing orders now, all of it will I think we'll get better.

And the other thing I'd think about is, you think about our company, remember our business and I said this a few times before, our business has been growing horizontally, not vertically meaning, we've been expanding our product offerings, expanding into new products, new categories, new businesses.

That is always less efficient because you have so much newness.

As we start to shift and again not meaning that we aren't going to have continued newness and new businesses and categories because you just heard me talk about the fact that we have two new ones that we're going to introduce this year and we have another one next year possibly two next year.

So that will continue to happen, but as a percentage of our total assortment, it becomes a smaller percentage. And then as you think about the vertical growth we will shift to we will start opening stores, new and bigger stores. Our square footage will grow so the square footage is about growth coming from the existing assortment, right.

So that's where you start to get leverage on the inventory and you start to have much more predictable, your business becomes more predictable, your turns get faster and you have much better use and returns on that working capital on that inventory.

But how we've been growing the company has been the least efficient way from an inventory point of view because when you grow horizontally and you have the percentage of newness we have, every inventory buy that's new is some degree of wrong, right? It's either over bought or under bought. It's never right.

The vendors it's the first time the vendors are making it so they aren't efficient yet and it takes a really a good year to really start to optimize any new product or category investment or business investments that we make. So we're still cycling through all of that newness of last year.

But each year, the newness becomes a smaller percentage and each year, we will be ramping up the square footage growth and the percentage there and so the business model will change here, it will become a lot more efficient from an inventory working capital point of view..

Thank you. Thanks for sharing all those details. Appreciate it..

Your next question comes from the line of Brian McGough with Hedgeye. Your line is now open..

Great, thank you I appreciate you guys taking my question. So I hate to waste my time here on like a knit picking number question, especially with having you on, Gary. But one thing is on the square footage growth rate for the upcoming year.

You had mentioned in the video Karen how it looks like you'll be coming in at around 27 and that's down from low 30s call it that you had previously given. I've gotten about a dozen e-mails there asking what's going on there. And I guess I'm wondering, as far as the size of the store being added, I'm assuming those haven't changed.

I'm wondering if maybe there could be any slippage by a month or two, just as you mentioned you're dealing with local landlords and just a different group than a mall REIT.

And then lastly, I guess, I'm wondering how many or how much of that to be driven by fewer legacy stores being closed which are maybe staying open for maybe in the back half of the year when you open up these new concepts that you had hit on, Gary that you'll have real estate available in order to show your new stuff..

Yes. So you're exactly right. Our original target was 30% to 40%. We kind of started to ratchet it that down throughout the year. As we did see some slippage, there is one pulling the design gallery specifically that was going to be in Q4 that bumped into 2016. But in addition to that there's two things going on with the legacy stores.

One is that we originally plan to end 2014 at about if you go back we originally at the beginning of this year said we're going to end this year at 7% and we ended at 10%. Part of that is some of these legacy stores we thought we might close when we opened Greenwich we thought we'll closed Westport, but we kept Westport open.

So there's been a few where, you know, in our original plan there was a few other legacy locations this year that we are going to close that we didn't. So that having higher base this year makes the growth next year smaller and then there's a couple other small stores here and there in our plan.

And for example, Baby & Child is not in the Greenwich market. It's not in the [indiscernible] markets where we have whatever you call it first generation full line design gallery, if there's not a Baby & Child expression we still want Baby & Child in that market.

So the play between some of those smaller ones we might still have 30% square footage growth, right now our best estimate is 27, but I would say if anything there's upside to that and now I don't want to miss 2015..

Great. That's all I needed. Thank you very much, Karen. Thank you..

Thanks, Brian..

Your next question comes from the line of Daniel Hofkin from William Blair & Company. Your line is now open..

Good afternoon. Just to go back to the, let say the plan your next year as you're seeing it at around seven.

Do you feel just big picture, similarly confident about all of those opening next year or is there like a number where you'd say okay these are highly likely and then there's one or two that have a little potential flexes, so we can have a sense for kind of a confidence? At a roll that would be my first question..

Yes, I think I would say today we feel very confident about the seven and I would just hate to qualify anything, but they are development jobs. So could something move? It may, but we also have some other opportunities where something might come forward. So we think we've got the pipeline well positioned.

We believe seven is the number we will hit next year and that how we see it today..

And I would just add that, whether it's seven or six, the way if there's a store that was going to be in December, we're going to have demand for that store, but it's not going to have a big meaningful impact on revenue next year.

There's what I think is the important thing is to know that all of the stores – the store that we're adding this year in 2015, all of the stores we're in 2016 we have a lot in the pipeline already for 2017, that we're kind of hustling, like there's been a lot of work done on the real estate, for instance, we have nine leases signed and a lot more deals we've identified and it's moving along.

We're extremely pleased with the economics we're getting in these lease deals and the locations we're we've been able to secure. So I think just making sure if you're looking out in 12 months trying to be laser specific, this is going to be a harder one to model.

But I think the long-term growth in that 20% revenue and the operating margin expansion we expect from this strategy is quite strong..

Yes, and I think that one of the points I made on the last call is we managed the business to optimize the earnings and the performance, right, and this year honestly I know people are really focused on the revenue slowing. Could we beef up the revenues and spend more to drive more and we could.

We believe that the way to optimize the earnings of the company this year, right, the crossover for the optimization and is to see pursue the plan we're on.

And what we don't want to do is become victims to short term kind of thinking, right and say let's try to jack-up the revenues and spend more add costs and temporarily have higher revenues and not optimize the earnings of the company.

I think what we're building here is a really durable business, right that will stand the tester time and that will dominate its market and whether something moves between quarters or between a year here, from our point of view is long term shareholders and my point of view is the largest shareholder is not the right way to think about our business.

The right way to think about our business is are we constructing something that's durable and is lasting value that will dominate its marketplace and win and I would tell you today I'm pleasantly surprised that we're guiding operating margins in the 10.3% to 10.6% range.

I don't believe anybody had us modeled in the mid tens and I believe our guidance looks as good as anybodies else’s guidance in our industry today, and I don't think anybody would have thought we'd even get here, right.

And by the way the other thing I'd say is that since we've been a public company in the two years that we've given you guidance at the beginning of each year, we've materially beaten the earnings guidance that we've given you.

As our top line moved around up and down, absolutely, and is this stock volatile, absolutely, straight up between $55 and $100, right and that's why I made the point about traders versus investors because we manage this business like investors. We manage this business like it's the last place we will ever work and we own 100% of the company.

And we believe we will build the best company the home furnishings industry has ever seen, with the best model and it will be the most durable business that we have and I think this is going to be a great long-term investment. But I'll tell you, look I've got it, but stock goes up and down, makes us all feel good or bad again short term.

But I think what we say here is we have to look beyond these bumps and we have to make decisions to build the great enterprise and that's what we're doing.

So whether it's seven or six next year, whether the sales are 14 to 16 this year, you know and accelerate and its – we have a business today that is going to have a mid tens operating margin, that’s growing faster than anybody in the home furnishings industry. We have the most exciting new strategy.

We have the most exciting new stores that the retail industry has ever seen and this is going to be a big win. It may not happen exactly to everybody's timing, as you think about this over the shorter term. But over the longer term, this is the place where we believe that it's the right place to invest if you're a long-term shareholder..

That's great. I mean, it's clear that you at least in terms of whatever delays there are, it's largely related to if not totally related to factors not related to the internal store performance or the website performance.

The other just very quick question is are you explicitly in your guidance for the remainder of the year assuming the kind of recapture related to the port issue that you have talked about or is that potential upside if you will?.

We have it in our guidance. We characterized 10 million to 12 million. There may have been other loss demand that we didn't characterize because we could have given you a higher estimate and talked about what we might not get back quite frankly of the 10 million to 12 million. That's what we believe will shift from Q1 to Q2.

And I'd also say that in the back half for the next year where we've got two new businesses launching, I would believe that we're on the more conservative side versus aggressive side and how we're planning and forecasting those sales, right.

And if you look at history and you look at it how we're guiding earnings, right, we beat earnings by a significant amount each year. So we don’t guide – from our point of view we don't necessarily guide earnings really aggressively from an annual perspective, right. That's how I think about this, if you look at history here..

Much appreciated, thanks..

And your next question comes from the line of Aram Rubinson had from Wolfe Research. Your line is now open..

Hi thank you for taking the call. This is Cody Ross filling in for Aram. So you have given increasing importance to generating free cash flow.

What are you guys doing to drive that results and what types of goals are you aiming for? Is there a working capital to sales goal that you guys are aiming for in accounts payable ratio? Any color upon that would be great. Thank you..

Yes, I would just say that that is one of the higher priorities for me and I think we feel pretty good that we have our eyes on the prize. We've kind of talked about that 12 to 24 months. So I guess three months is passed, so I should take it down by three months on each end, but I think we feel very good about it.

Those initiatives across-the-board in the company, everything from some of the inventory stuff we're doing, and how we're managing the source books, to how we're managing vendor terms. All the working capital line items are kind of being worked on.

But we're not going to go disclose it to any specific internal target, but I would just say, we feel very confident that that important goal is kind of around the bend..

Great, thank you. And just one quick follow-up on that.

Are we in any way seeing a slowing or sacrificing of growth in order to help drive free cash flow at all?.

No, absolutely not. I think the benefit of some of the real estate strategy is how much the landlords are willing to contribute on the capital front, but what to convert, a lot is do and I alluded to this on the call, there is certain instances where it doesn't make sense financially for the unit economics of a specific deal to take their capital.

If the returns they require on that capital, hurt the deal and make the four wall contribution and the occupancy not as good for the long-term, we now have the flexibility to use our own capital where it makes or to use their capital where it makes sense.

So we're really balancing the free cash flow goals with that long-term operating margin target in check. So I think it’s been a really nice way for us to balance and make sure we're really optimizing each and every deal..

Great. Thank you very much. I appreciate it..

Thanks..

And your next question comes from the line of Lorraine Hutchinson from Bank of America Merrill Lynch. Your line is open..

Thank you, good afternoon.

With the two new businesses launching in the back half, should we expect incremental catalog or advertising spends to becoming true to support that business?.

Yes and those are in our guidance..

Okay, great..

The timing will be a little different..

I think I alluded to in our prepared remarks on the video that we're decoupling some of the books this year, decoupling Outdoor, decoupling Baby & Child and based on our learning. And these two new businesses, we are decoupling from the big mailing, right. So the way our books will flow and hit the marketplace will be different than a year ago..

And I know it's early on the outdoor launch, but you mentioned modern and contemporary furniture there.

Have you gotten any reaction to that?.

The books are just getting in home this week..

This week..

Okay. And then lastly, Karen, on the port issue.

Are you seeing congestion in East Coast where most of your deliveries were diverted to or is there some other delay that’s coming through?.

No the biggest thing for us is significant portion of our imports do come through the West Coast, but we really, I mean, back in April of 2014, almost a year ago we put mitigation plans in place. So we were not that heavily, of course being slowed down, but we diverted a lot of our goods through the East Coast ports.

We took that reliance from over 80% on the West Coast down below or around 50% and increased our weeks supply to kind of manage through that. So we were pretty, we navigated pretty well through the end of 2014. In February things started slowing even more and all of the congestion.

So really for us, it's just some of the receipts that 10 million to 12 million for us is receipts that we thought would land in the latter part of the quarter in Q1 that are now going to shift into Q2.

So of course is there some loss demand, sure, but for us we're characterizing it more of a shift versus a significant loss and we don't, of course we have cancels when we have back orders and things on special order that are taking too long, but so far we feel pretty good that that's just going to come in Q2 and shift..

Great, thank you..

And your next question comes from the line of Cristina Fernandez with Telsey Advisory Group. Your line is now open..

Hi, good evening. In the past you've talked about revenues shifting to retails from direct, as the new stores open.

With the learning that you've seen from the last couple of stores, do you still think that's the case or has the consumer behavior changed that perhaps direct will be the main driver going forward?.

The retail as we open these new next generation galleries will be the majority of the driver.

There will times, for example, when we launch these two new businesses this fall, those will be – the majority of the business will be all direct, right, because we – besides Atlanta we won't really have a presence of those businesses at retail, until we open Chicago, Tampa, Denver and Austin.

So we will continue to grow and offer new businesses and new collections, it depends what the ratio of the next generation stores are, right. So as the ratio of the next generation stores becomes bigger, you'll see the business shift more towards retail.

On the other hand, we also believe that there, there is just behavioral changes that are happening in society as technology accelerates and we have faster devises and mobile devices and you can shop any which way and just – as we all develop new habits, right, we get comfortable with new channels and ways to shop.

So as I said an underlying shift that is moving towards direct, but remember, 90% of all retail sales are done in retail stores today, right, only 10% is done in direct.

So we're unusual being 50/50 and we like the way we're positioned, but retail, we still believe is the most important channel going forward if you want to maximize a business or a market..

And I would just add just because I got to bang this drum. That for us as a reminder, very little is cash and carry in the stores, a lot of its being shipped from the distribution center. So we really – our retail galleries are a showcase, they are a show room, they are an opportunity for people to come in and interact and look at the product.

But we absolutely know that as people go home and then order from the comfort of their living room. So we don't really think there's a huge difference in our profitability. The brands are synergistic with – the channels are very synergistic and move together.

So we don't really care where they order, because of course we want to maximize all of our profitability. But if they order in a store or they order online, a lot of times they're going to the store it's still getting shipped direct. So it's not – so we don't focus internally about trying to drive it to one channel or the other.

We work on making on sure all of the channels are maximized and that our retail experience is making – all that product is available for them to consume..

I think Karen makes a really great point. At the end of the day, we really look at the productivity in the marketplace. We look at the capital we deploy in a market with a combination of our investment into a gallery, into our advertising through our source books and our electronic marketing and so on and so forth.

I mean, I think the fallacy you hear today and it kind of surprises me as all these companies want to talk about, well their direct business is growing faster and this is happening and their direct channel is their most profitable channel. Well, it all depends on how you're allocating cost.

I don't know how you make more money when sales shift from retail to direct, right, because your occupancy cost doesn't go down. Your overhead doesn't go down. So I think there is a lot of companies that are out there.

In fact it goes up in some cases, you're seeing in certain people that are now just getting into the direct business and everybody is all excited because they are growing their direct business and they are missing their earnings, right, because they are finding out that it's expensive to handle the goods, to ship the goods and so on and so forth and fulfill the goods.

And so, its – honestly, I think there is a lot of old math and old thinking that's in the industry. At the end of the day, you've got to build a platform that can serve the customer wherever they want to shop that presents your brand better than anybody else and it should matter where the customer transacts at the end of the day.

Look if all sudden we're worried, when virtual reality comes to everybody's homes in so many years, I just came back from the Ted conference, right and we're virtual realty is going, we're going to be sitting in our homes, being in a different world, it could be probably in four to five years you can be in a Restoration Hardware, three dimensionally, right, sitting in your living room.

Should we care if they place the order in a store or from their couch? No, we shouldn't care and I haven't seen one retailer yet that has said Oh, look, our direct business makes more money and we're growing that faster. I haven't seen their earnings growth, but they talk about it a lot. I haven't seen one yet.

So we look at the business holistically as a multi-channel platform and we look at it by market and how do we maximize our revenues in each market and maximize our profitability in each market..

As there are no further questions. This does conclude today's conference Call..

Great. Well thank you, everyone for joining us and we look forward to talking to you next quarter. Thank you..

You may now disconnect..