Cammeron McLaughlin - VP, Investor Relations Gary Friedman - Chairman and CEO Karen Boone - Chief Financial and Administrative Officer.

Adam Sindler - Deutsche Bank Steven Zaccone - Cowen and Company Budd Bugatch - Raymond James Jessica Mace - Nomura Securities Daniel Hofkin - William Blair & Company Neely Tamminga - Piper Jaffray Aram Rubinson - Wolfe Research Lorraine Hutchinson - Bank of America Justin Kleber - Baird Cristina Fernandez - Telsey Advisors Matt Nemer - Wells Fargo Securities.

Good afternoon. My name is Dennis and I will be your conference operator today. At this time, I would like to welcome everyone to the RH First Fiscal 2015 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.

I would now like to turn the call over to our host, Ms. Cammeron McLaughlin. Madam, you may begin your conference..

Thank you. Good afternoon everyone. Thank you for joining us for RH’s first fiscal 2015 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 as well as the launch of a new business.

Before we start, I’d 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 these 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..

And our first question comes from Adam Sindler from Deutsche Bank..

Good morning everyone. Congratulations on a very nice quarter. And I very much enjoyed the new Modern furniture, a lot of it looks great. First question, does the $4 billion to $5 billion in guidance include the impact of Modern? And then I know your work with your manufacturers is very important to your process.

Do they have the capacity to handle this or are you going to have develop new relationships and potentially just how that will impact the balance sheet through inventory?.

Yeah. I’ll take. This is Gary. When we give you our long-term guidance we have many new businesses embedded into that assumption. And so RH Modern is in that assumption. And then there is vendor base and as it relates to new vendors most of Modern is scaling on our current vendor base with some new vendors added in some categories..

Excellent..

With respect to inventory, we do expect this year to have inventory flow a little bit different than it has in prior years just because we have a lot of the newness and investment are coming in the back half. So whereas in the past, we’ve had a lot of inventory growth at the beginning of the year that works through it.

This will have kind of two different cycles of inventory, so we will grow inventory ahead of sales at the end of Q4..

Okay. And then just secondly on Atlanta, you mentioned exceeding expectations.

Anything specifically driving that or sort of just taking more share than expected across the board?.

I think we’re really happy about it. It’s just how Atlanta is ramping. Now that it’s been opening -- has been opened for several months and we’re getting into the season where a lot of our investments in outdoor square footage and that category, is now - you were beginning to see traction.

We opened Atlanta as you know late in November and now -- and we’re thinking about the bet we made in outdoor furniture and outdoor growth and space we gave that too. We didn’t expect to see that business really become impacted until the spring, summer months.

Now as we are heading into the -- as we’ve seen the business track into this we’re very excited about how the business is tracking versus our expectation. And then the other way to think about Atlanta is Atlanta was engineered and designed to hold RH Modern. So RH Modern will be another incremental layer of business for Atlanta.

And then the new business we've not yet announced this year but we will by the time this call, this quarterly call and the next call, will also be affected in a positive way as that new business gets layered into Atlanta. So we would expect Atlanta to continue to ramp. And at this point, it's ramping ahead of our expectations..

Excellent. I appreciate. Thanks so much..

And our next question comes from the Oliver Chen..

Hi. This is Steven Zaccone on for Oliver today. Want to extend our congrats on a solid result and also the Modern announcement. We were curious on Modern.

Do you think this will be an incremental customer to RH or is this going to be like increasing spend from existing customers? And then piggybacking on the supply chain, is there anything to think about here in terms of longer lead times and then as this business faces the customer, any difference in pricing or the margin profile?.

Let me answer the first question, which is kind of two questions in one. New customers - bring new customer to RH and will it become incremental spend to the existing customers. I think the answer is yes to both.

We -- I think if you saw the video, you saw the product aesthetics that we currently don't have in a position in the market that we’re not in. So we expect this to really open up the aperture of the brand to attract a lot of new customers. And in many ways, we expect RH Modern to create kind of a new business in general, right.

And it’s one thing to say I'm planning to share gain. And I wanted to take some of the share of RH Modern. I wanted to take some of the share in whatever category. It’s another thing to create a market per category.

And when we look at the Modern market today or we look at the -- we feel these trends that are -- and the ones I talked about in the video that we believe are going to set up the opportunity to make a market.

If you were shopping for modern home today and you had to go out into the marketplace and you just built a new home or you bought a home or you remodeled your home in a modern aesthetic you had to say, you woke up in the morning and say, I need Modern furniture and home furnishings, where do I go? My sense is that you really draw a blank, right.

It’s an even more fragmented market than the one that the core RH interiors business has been competing against. Because there is no one that has dominant assortments in any of the categories and then has multiple categories and integrates those categories into a lifestyle point of view.

Now in the video, we gave you a little teaser of the products that we wanted you to see how unique and different the products are. I think what’s going to be as impactful if not more is when you see these products integrated into a lifestyle as you will when you see a 300 plus page Modern book being mailed in the second half, later this fall.

And I think when you see that and you see if you see the store or any of the floors, you are going to see an entirely new visit. It’s almost like it didn’t exist. It’s almost like in some ways before the iPod there was no MP3 business, right. Before smartphones there was no smartphone business.

People had cell phones but the smartphones created a whole new category.

And as we look at these big trends and architecture or how the millennials live, the aging boomers and want to stay youthful and the impact from the antique markets and the reproduction markets, which were influenced quite frankly by the estate sales and generations that passed, right, all these things coming together at one time, I believe create an opportunity to create a market.

But if all those things happened and no one provided a complete shopping experience the market could be smaller. I think with the combination of all the trends and what we are doing and what we are launching is going to create a whole new market..

And with respect to the question on supply chain and lead times, as Gary mentioned because a lot of the vendors are on our current platform, we certainly have some new ones, we don’t really expect a significant change. I will say that anytime we add newness sometimes there can be hiccups along the way of something that we have.

It’s a runway train and it’s doing really well. It takes us while to get caught up and catch up with that demand. So there could be those issues with some of these products but nothing out of the ordinary and different than our kind of typical newness that we introduced. With respect to pricing, it’s pretty much about the same.

There is certain categories that are a little higher or little lower but on the whole, it will be very similar to our core business..

Okay. Thanks very much. Very helpful detail. Thank you..

Sure..

Our next question comes from the line of Budd Bugatch..

Good afternoon. How are you? That was a new one. Thank you very much. I too love the Modern. I have a little experience with that. So congratulations on the new category and the new products.

Just a question, a little bit piggybacking on the supply chain, do you have enough distribution capacity to handle it, do you will need to anything more on that and what additional load will you be putting on the vendors? You said you wanted to extend terms I think in your part of the presentation, Karen?.

Yes. So, we are adding 1.5 million square foot DC in Northern California in the coming months. Actually, it’s opening this summer. So that was planned for partially for Modern both to keep up with the growth we have in the core business but also knowing that modern was coming, so we should be very good on supply chain capacity for a while.

With respect to AP and vendors terms, that’s something that we’ve been working on and working with our vendors. In the past, we’ve worked with really small vendors we do, sometimes we do deposit terms with them where we pay in advanced the PO.

As we’ve grown with them, we have been working with many of our vendors to try and extend those so that as we grow they grow with us, we kind of all benefit. We get a little bit more leverage off of the AP base..

So you end the year typically at around 60 days, somewhat averaging a little bit above a little bit below and the first quarter usually coming around 80 days.

Where do you think you will wind up the year in terms of payables? What’s the goal at the end of the year?.

We can’t -- we are not going to commit to that yet just because we saw that. Having finished all those negotiations with the vendors, it is not something that we want to cram down their throats and then have them really hurt. We do consider them our partners. So it is not something that I can commit to at this point.

As far as the specific number, we have certain internal goals that we will work towards but it really depends on that partnership with the very important partners in our business and how we can make sure that they are still going to be fine and able to most importantly get us the product.

And if they need more support in the short-term versus the long-term with raw materials and stuff and that’s how we help and make sure that we are growing together. And most importantly, again is making sure we have the product to get to the customer.

So that’s something that’s certainly a goal for us, so we won’t jeopardize that relationship and getting that product..

I would just keep it simple and just think about it from the perspective if I were to think about.

As we scale our business, both RH and on our artisan partner, vendor partner side, we both have bigger more profitable businesses and we have much more flexibility as it relates to working capital and so, I think you will see us over the next couple of years be able to be much more efficient with working capital and it’s going to be because our vendor base has also scaled with us and the benefits that you would get with scale you should assume that we will get those kind of benefits..

Gary, would that be both on the inventory efficiency side and a little bit on the payable expansion side, both as how you would…?.

Yeah, absolutely, yeah, both sides..

Okay. One last question and I will turn it over to others. You mentioned, I think the extension of art out of, I just think the New York facility, the New York operation into the RH Modern facilities.

Can you talk a little bit about what your thought process is on that?.

Yes. We think that the contemporary art platform that we built the online platform and the one Gallery we have in New York, we think as we think about Modern and as we think about that the art business, we’ve always seen those as merging together.

And that the modern business in the way it is going to be displayed and presented, it creates a natural integration point, which will give us more points of distribution at retail for the art business long-term..

It would be very interesting to see how you guys execute that. Congratulations on the quarter. Best of luck going forward..

Thank you so much..

Our next question comes from the line of Jessica Mace from Nomura Securities..

Hi. Good afternoon and congratulations..

Thanks, Jessica..

My first question is on the new outdoor collection. I was wondering if you could give us some feedback at how it’s doing, especially as it contains some more Modern and contemporary elements.

What kind of response you’ve seen from the consumer and how that should help our expectations for the new business?.

We are very, very happy. The outdoor business has been our fastest-growing category so far this year and obviously we made investments there with product expansion. And we teased it a bit with some of the RH Modern collections that we initially, we were going to hold for the other book and we thought let’s integrate it, let’s get some early reads.

So you obviously saw some collections there and we are very pleased with the initial response because it’s having good indications as to how the consumers is going to react to, kind of the new aesthetic.

I think the other thing we saw where we if you look at the cover of the current interior’s book in the opening spread and you look at the cloud sofa and of some of the new crystal halo light fixtures, the big hoop fixtures and stuff we seeded that book with some of the product to get reads and tests.

And we were very, very happy with the early response to -- early response to that aesthetic in some of those tests in both the outdoor book and the interiors book.

So they both bode well for the fact that there is a customer out there that wants a more contemporary Modern aesthetic and we think it’s going to just really open up the opportunity of the brand..

Great. Thank you. And then my second question is on the Source Book and the timing this year.

So if you could give us maybe a little bit more color in how that should help shape our expectations about the second quarter? In addition on the cost side, maybe how the Modern Source Book in the fall should guide our expectations around advertising savings from that period?.

Yes. The cost part of it and the cost is all baked into our modeling and our guidance that we provide to you. One of the ways to think about the timing of the goods this year versus last year, last year we mailed all 3,300 pages bundled together at one time all in the first half.

This year when you look at the newness, more than half of the newness is tied to for the year. More than half of the newness for the year is tied to RH Modern and another new business category that we will be announcing shortly, and so more than half is coming in the second half of the year, more than half of the newness.

So you’ve got some timing in Q2 where you had kind of all the newness coming in, in Q2 last year. So we are up against that, right.

So even though some of the books are in early like outdoor or Baby & Child mailed separately, you’ve got a little bit on the interiors book where you got some earlier deliveries than a year ago, you are still up against the -- if you are thinking about a bridge, you are up against all the newness in that hitting in that quarter and beginning to ramp.

We don’t have all the newness this year in that quarter. So that puts a little bit of pressure on demand and some of the revenue in Q2. But then as we come through into Q3 and into Q4, you have this new business is hitting with more than half of our newness for the year, and so you are going to have a fixed step-up..

Great. Makes sense. It’s very helpful. Thank you..

Our next question comes from the line of Daniel Hofkin from William Blair & Company..

Good afternoon. Congratulations. Great results. Just wanted to ask a little bit of a follow-up on the books.

And just first question would be, how you felt about kind of the little bit earlier flow and also some of the mailings were separated a little bit like outdoor for example? How you felt that worked this year versus the timing last year? And then I have a follow-up question on related to starts..

Yes. We are very happy with the decisions we made. I would also just couch that and say we are going to learn from the data and continue to make adjustments. We get smarter every time, every season and every year we do this. So we think we pulled the right levers.

We think we can do it even better next year that there is -- it will be continued to be opportunities as you think about the flow in the books..

Okay. And in terms of kind of as you think about I guess the demand related to versus the booked revenue if you will, the revenue that you actually booked versus just in the short orders.

How was that kind of flowing versus your expectations? In other words, earlier to earlier booked shipments ought to lead to earlier demand but doesn’t necessarily show up right away in actual revenues.

So just curious how that should -- how that impacts itself the second quarter? You talked about the newness being heavily concentrated in 2Q last year, but just curious how that other dynamic?.

Yes. The way I think about it is, based on our results in Q1 and based on what we know Q2 to-date and I will let Karen build on this.

But how we are performing today is ahead of our expectation, which gives us confidence in how we build that bridge into Q2 and that marry that with our expectation for the incremental revenues and profitability that the new businesses will create.

So that’s why you saw increased guidance for the year and increased guidance by more than our beaten Q1 just based on the underlying data and trends we have in the core business.

And then add that to what our expectations for the new businesses and to the newness that we add, which is relatively formulate again how we think about newness and incrementality..

I would say that your specific question on demand and timing and how different this year than last year, we always with newness tend to have demand ahead of the actual ship build and revenue and that’s kind of no different than it’s been at any other year. What is very different this year is, as Gary mentioned, so much of the newness.

Last year all of it was in Q2. And this year lot of it’s going to be in Q3. So where you would expect when you’re landscaping the back half of the year, demand might be nice in Q3 when we launched this, but you won’t actually see a lot of that revenue shift until Q4 so that just heads up on getting the rest of the fiscal year..

And if I could just stake one last one and just regarding overall store performance. I have to assume with this level of comp, you are seeing kind of the same strength of the cost. Most of the openings will last several years, interested in that general account as well as New York flat iron specifically? Thanks..

I think we communicated that the New York store was the one store that had performed lower than our expectations and as we added square footage there. And we believe that is really due to the fact that the only time we had meaningful square footage expansion without changing the location and the customers seeing a different physical environment.

So our view on that one and it’s really the only outlier is that the customer didn’t recognize a change in the business yet actually come into the store and then realize, oh, my gosh, you have two more stores as opposed to see significantly different physical expression of the brand and that attracting new customers and also communicating to existing customers, oh, my gosh, something is new with RH, let me go check them out.

So you won’t see doing expansion like that again..

Got it. Thanks very much. Best of luck..

Thank you..

Thank you..

Our next question comes from the line of Matt Nemer from Wells Fargo Securities. Mr. Nemer your line is open..

Let me go onto the next question..

Our next question comes from the line of Neely Tamminga from Piper Jaffray..

Great. Good afternoon. Gary, just wondering if you could help us out a little bit on RH Modern, very intrigued with what we’re seeing on the video, the pricing.

Can you talk to us a little bit about the pricing and just the skew complexion a little bit? So for shopping Modern out there and obviously your modern is a very different interpretation of modern that we think of no other midcentury modern designers like Eames and Nelson and Herman Miller et cetera.

How is your pricing going to compare with some of those attritional sort of thought of modern designers? And then maybe relative to what you also have existing in the assortment? That’s my first question..

Sure. First, the pricing advantages and I think the disruptive pricing models that we’ve had in the core business will be the same in the modern category.

I think you are going to see versus the price points that you see in the modern market or to the trade were going to be a significant value and were going to have I believe overall very disruptive pricing position in the marketplace.

And then as you -- if you think about the marketplace as it is, there really is no fully assorted, fully integrated modern concept that exists, I mean anywhere in the world quite frankly.

You have people that, you got to whether it’s B&B Italia or other ones that they have upholstery and then they might have few lights, a couple of items here where you’ve got -- you can design within reach. I’d say it’s very item-driven business. You walk into one of their stores and it’s very much not a lifestyle.

It’s presented like an item business also. And you’ll see this business presented in a fully integrated lifestyle and a model that’s very similar to the core RH business and the interior business. So think about all the learnings and everything we’ve accomplished with RH.

And then creating a mirror image brand, right, that is targeting the modern segment. And because I think it will be like nothing else in the world, I think it’s going to create an entirely new market.

So I think you’re going to have a lot of people that are buying modern today that are having a hard time buying it and finding the price points very high and the value creation very low because the lack of synergy and scale that exists. And so that’s going to create -- I think that’s going to create market share gains for us there.

But just as importantly I believe, it’s going to create a new market. I think it’s going to motivate people who may be weren’t thinking about furnishing their home or buying new furniture furnishings.

I think it’s going to inspire our people to purchase just like, it’s no different than I believe that all of RH’s growth over the several years has not all been market share gain. I don’t believe they are really high growing companies are just taking market share.

I think the ones that are really performing at a higher level are doing two things, taking market share and they are creating a new market..

Could you speak a little bit to the pricing relative to ‘15 assortment?.

Yes. I’d say similar to slightly higher in some case..

Okay. And then one more question on the assortment, the complexion, for whatever reason when I think of modern, I think maybe of an assortment that would just skew more towards accent pieces, chairs, décor versus straight-up sofas.

So is there something in the margin implication to of RH Modern if you skew, if I’m right, if you skew little bit more outside of the traditional sofa-type pieces from a rate basis?.

Why would you think that? Why would you think….

I don’t know. I just do..

Why do you think people that live in a modern home don’t have sofas?.

No, I think that they do have sofas. I don’t know for some reasons I just think it’s aesthetic -- that has more of like aesthetic pieces too. I don’t know accent pieces. But I could be totally off on that.

Just wonder if there is a margin implication here?.

I think there is a probably a little bit of a more minimal list view in modern home, right. And that each piece is the thing of beauty and less clutter and so forth. I think categorically you need places to sit.

You need sofas, you need chairs, you need dining chairs, you need dining tables, you need beds, you need bedroom, you need case goods, you need lighting, you need ceiling lights, table lamps, floor lamps. You need Rugs. And I don’t think the assortment is going to be meaningfully skewed any differently, right. You need bathrooms.

It’s just like -- whether you give a classic home with a classic aesthetic or you have a modern aesthetic, you got all the same number of living rooms, dining rooms, bedrooms, bathrooms, outdoor space so on and so forth. It’s just everything just got a different aesthetic and point of view might be presented in a more minimalistic way.

That’s how I think about it..

Right. Thank you. And then for Karen, on inventory, the elevation of inventory because of the newness, how should we think about the spread patterning to the balance of the year? Thank you..

Yeah. It will grow a little bit in Q2, just like it normally does for the spring. And then it will work through kind of the spring inventory and then we will make some additional adjustments in the Modern and other newness that we’re having.

So it will kind of -- it will grow a little bit more in Q2 than it will definitely grow a little bit more in Q4..

And I don’t think, just add to that, is that this is just the very beginning of modern. This is our -- going to be our first book, our first freestanding store, our first retail presence on floors where it worked. We’re going to get so much better than what you see in interest book.

The pipeline of development behind this and the excitement and enthusiasm in the designer world, the artisan world, all the people that contribute to us building this platform, in this collection of product, I mean, the pipeline is every bit as exciting. It’s not more exciting than what you’re going to see when we come out of the gate.

We think about as most people launch a new catalog, like with 64 page catalog or 84 page catalog. And it’s like a launch of a new business. If you think that most businesses out there -- whatever ones you want to that are home furnishing based catalog, my team’s saying don’t start naming them, it will be like that.

But just think about it, just stand back and think about it. Most of them are 64 pages to 120 pages. And they are kind of item businesses. And they have a little bit in each category. We’re coming out with 300 plus pages, a separate web experience, a 15,000 square foot store in L.A. right. I mean, this is going to be a real business, right.

And that’s just the beginning. This is just the beginning. I would expect the page count this book to ramp, the retail presence we will invest more space, not less. I’m more excited about this than any new thing we’ve ever done. And I would say our organization is too. And that doesn’t mean we lost any enthusiasm to the core business.

It’s just as a new kind of business opportunity. We sit -- when we sit back and when we look at the trends and we look at what’s happening out there, you look at the influences of architecture, product design, how people are living the millenials, right. Look at -- I just bought a modern house in L.A.

It means, if we all -- I think it is going to be a unique and transformative time in the industry and I think we are going to leave this timing and the shift..

Best of luck out there. Thank you..

Thank you..

Thanks Neely..

Our next question comes from the line of Aram Rubinson from Wolfe Research..

Hi there. Thanks for taking my call. I saw the video. It’s terrific. Two questions, one, Gary on the video, you used the word luxury, I think maybe three or four times. I’m curious, because I think you believe that’s a bit of limiting term.

So if we were to think over time in terms of architecture, are we going to be going up higher inside of that $4 billion to $5 billion to achieve it? Are we going to be kind of dipping down? It’s more of a math.

How do we think about where you’ll be in that good, better or best pyramid to get to the $4 billion to $5 billion?.

Yeah. I think, that’s a good question, Aram. I think when we think about the $4 billion to $5 billion, that’s really North America and that’s as we’re positioned today. Let’s not do anything to move the positioning of the market place.

And we really like the luxury positioning that we’re establishing in the marketplace because the spent by the wealthy and affluent customer is meaningfully and exponentially greater than when you go down market. So it’s not that we don’t think long term.

There is opportunities to do other things and create other businesses that will take our expertise, our taste level, style and capabilities and think about other markets. But we don’t -- but that’s not in any of our numbers when you think about $4 billion to $5 billion. The $4 billion to $5 billion is really triggered by two things.

It’s triggered by the expansion of the product offering that we know of today. And we think we’re relatively conservative like the RH Modern ended up itself to take $4 billion to $5 billion up. Yes, it could. Will we commit to that today? Not yet, we have no data yet, right.

So -- and I think we’re relatively conservative with how we’re positioning RH Modern and how that will open up the aperture of the market. And so the portability is really based on the continued product expansion and what we know today that we are working on that is in our pipelines and the real estate transformation in North America.

That gets us to $45 billion in mid-teens.

Beyond that, there is international opportunities that we think, I think all of you know we hired, Head of International New Business Development, Doug Diemoz and he’s been traveling the world, meeting with potential partners, looking at real estate, looking at opportunities and putting together the international blue print for growth for RH.

And we think the business we build today will be just as dominant internationally as it is today in America. So, we are very enthusiastic about it.

We are just trying to be smart about capital allocation and where do we put the next dollar, where do we get the return in international, thinking about how we scale international, how much capital it takes to build the infrastructure, what does it really take to break into a new market? Do we do it ourselves, do we J.C.

it, do we franchise it, do we license it? We are building that blueprint and want to be really smart in how we are going to generate the best returns based on what we know about our business today. And then beyond that we think that there is other business opportunities and other things that we are looking at working on to that.

We haven’t talked about that might address new markets, new categories and other things. So, $4 billion to $5 billion is just to help everybody, think about the current business and the model in North America. It gets much bigger when you take it outside of North American.

And then there's other incremental businesses and things we are working and developing for the long-term that will continue to fuel growth long-term..

I had a second. I will ask it. But if you feel like we’ve spend too much time you can just move on. You’ve got a long product cycle. You've been on the business now actually last six, seven years with your new look and design.

Can you characterize the relationships that you have with your customers? Are you seeing repeat business the way you would expect? Can you talk about client selling opportunities? I’m just trying to get a sense now that you are seeing more years of this business, what you are seeing from a relationship standpoint?.

Yeah. We do. The buying cycle -- what really drives our business is the event buying tediously, life stage events. So if someone either buys a home, remodels a home or redecorates a home, that category, that life event is a big, big driver to our business.

And then on top of that if you see when you look at our customer over a five-year period and you take their biggest purchase week, you see a big peak and that is you look it on each side of that for several years you see that fall-off right pretty big.

And so, we are trying to position ourselves to maximize the market share when people have that meaningful event in their life. One that they buy home or they remodel a home and they redecorate their home. Now back to time your point on the luxury customer and how to think about it.

The wealthy and affluent customers and especially the demographics or the higher end of that generally owns more than one home, right. So thinking about second and third homes and how we play in that lifecycle and how we capture that share is really key.

The services that deepen the relationship and create an ongoing repeat customer, whether it is again another event like they’ve bought a second home or when they moved, the deeper relationship is built around a lot of ways. One is with the general service we gave them and experience they have and that’s affected by the new Galleries.

I mean, think about most of our business over the last several years has been driven out of all this little mall stores, right? The perception of our brand has been shaped by a completely different business that was opened in small mall stores, right? And you think about the new experiences that we are building and how those experiences will shape the perception of the customer will create a net.

When people wake up in the morning, three years from now if somebody decides to move or remodel their home, I think they are going to think completely differently about us in a couple of years than they do today. And just as they think completely different about us in any market where we've done one of these new bigger galleries.

So, we think that’s highly important thing than things like interior design services. And the investment we are making their and the different level of service and what you are going to see evolve.

I invite you and anybody else to come to our new store in Chicago when we open Chicago and Denver, we have some of these next new, next-generation Galleries are going to have design ateliers and a whole section of department that looks like you walked into an architect or interior design offices and setup with all the samples as watches and all that capabilities and technology to support a different level of interior design services and that’s a big investment.

You will see us move that forward. You might even see us long-term get into architectural services where we can help them think about their space differently and how to create a different kind of space.

We like to talk internally about not just creating and selling products but how do we move from creating and selling products to conceptualizing and selling spaces.

And so when you hear about other new businesses that are coming and we’ve talked about RH Modern not RH Modern, RH Kitchen before and we’ve been working on developing a kitchen concept that we believe will be able to when we launch that business transform your whole kitchen, not just daily pops and pans and knives and forks and things like that but be able to transform your kitchen.

And so there is going to be levels of services, product categories and then the overall positioning and presentation of the Galleries and walking into that, that experience that I think is going to continue to transform the brand, continue to build the deeper relationship with customers and continue to open up the brand to new customers who don’t even think about it today because their point of reference is a 6,000 square foot store in the mall.

And the last time they were in that store, they were stocking stuffers seven years ago. So the opportunity to create a forced reconsideration of this brand through the real estate transformation, the additional new services, the additional new businesses and categories, we are going to continue to introduce.

Interesting, we are still at such an early stage of this transformation. I mean in almost every market, we have a little mall store that was built for entirely different company..

Thank you for that answer..

Our next question comes from Lorraine Hutchinson from Bank of America..

Thank you. Good afternoon. It seems to be a lot of focus in the market on a simple new store productivity calculation and I was hoping that you could just discuss the lift that you are seeing in the direct business in the markets where you have transform to the real estate into a design gallery..

Yeah. We have seen a lift in every market where we have opened one of the new format Galleries. Atlanta has been no exception to that and has even been on the high end of the range that we’ve seen. But one of the most key things about the new store productivity is we’ve kind of tried to make sure everyone understands a few things.

One, when we have closed stores in the market and where just in general in that same period and in Q1 and Q4 of last year, since we’ve had Atlanta opened, we do have three stores in the non-comp base that has zero this year and there was revenue last year, so three of those stores are just a drag on that number.

The other thing we’ve tried to make sure everyone understands is the ramp period, both from a demand to ship sales but also just the way Gary described.

We do expect these stores to ramp up with Atlanta specifically, making sure you have time for all the categories to have the time in the sun whether it’s outdoor or holiday or all those things that are part of the core assortment and where especially we are investing significant square footage and for the books to be in home.

So in Atlanta, when you are there and in the market no one knows it’s there yet. And once we get the books in home which raises further awareness of the brand, those are all things that contribute to the ramp..

And I would say those piggyback will return same. This is important point to understand in how we measure our business. We really are looking at the market lift, right.

We can say that consumer behavior is going to continue to change and there is a lot of people I believe in the retail business today that are making very poor strategic long-term decisions because they are not -- they don’t understand that it’s just the consumer behavior shift because of technology, right.

I mean, today, we look at it, we go, we make an investment into transforming the real estate end market, whether it’s LA, Atlanta, you name it, Scottsdale, Arizona, whatever that market is. What the retail lift is today first is what the direct lift is today is going to change, okay. The devices are going to get better.

The speed on all the devices is going to better. Consumer behavior, whether they -- again whether they ordered online or ordered in the store and what that dynamic is, I think if you worry about that dynamic, you are going to miss the business opportunity and you are going to make that decision through your business long term.

I did my video where a lot of people, 10% of retail sales exist online today. Do I think it’s going to be 20 down the road? Of course, I do, okay. But the fact is it’s only 10 today. If it excess, the retail stores are really, really important.

But when it becomes 20, and because devices are better and our activity is better and it’s -- and all of a suddenly whatever market, LA, New York, Atlanta, you pick it, and all of a sudden the store business might shift and store business might flat and the store might go down, but the direct business goes up should you care about that.

I can’t control technology and how technology is going to change our lives, okay. But what I can control is our assortments and the presentation of our assortments in the marketplace and be completely agnostic to how the customer trend. I remember that it would be like in the old days when we used to go to banks and there would be tellers.

And then all of a sudden there is ATMs right, and you could have been sitting there going, oh, my god, the teller business is down, the teller business is down. No shit, excuse me but people are going to ATMs, of course the teller business is down.

In retail, before there was the Internet, if you were in the catalogue business, they had to buy everything in your store, right. There is now another channel and that channel is evolving faster than anything right. Like technology is changing our lives massively should I care where they transact or why they transact, where they do, not at all.

Should I build smaller retail store because they are transacting differently and then have a worst presentation, physical presentation in the marketplace, I think that kind of strategy is idiotic.

I really do, because people want to see things and people want to interact in a three dimensional nature and that’s why we’re ambivalent to where they transact, and that’s why I make my point about, it’s not about the Internet, the Internet is a channel. It’s going to change things. It’s going to shift things.

But retailers that are penetrating to shrink to greatness, I think they are missing the whole point. I mean look at who are the Parker, look at Lenovo’s, look at all these people that started online. Now were the Parker is on the cover of stocks company magazine.

It’s more innovative company in the worldwide, because they were the first built on the Internet brand that all of a sudden decided to do retail stores. I mean the most innovative things they are doing retail stores, I am trying to take that away from where be Parker, but think about that, right. They are building retail stores.

Retail stores are always going to be important, but otherwise if anybody had been to a ice pick theater or a movie, what’s happening with the movies industry and movie theaters? Why the hell would anybody go to movies? You can watch any movie you want at home, on your iPad, TV and so it’s worthwhile. We are social creatures.

We don’t sit alone at home all by ourselves. Nobody, we are not going to see a future ever I believe where people are sitting home all by themselves doing everything online, I think people will think that by good luck. Your strategy can really miss.

I think the physical experiences in the world are going to be even more important than the online experiences because we are social creatures. And I think the retailers that have the very best fiscal experiences in the world tied with the very best virtual and digital experiences in the world are the ones that didn’t win, not one or the others.

It’s physical and digital. That’s the world. But I think so many people spent too much time in their models, in their business trying to get like how much is in the store and how much is online, but the key is how much of the market are you getting.

What’s your overall growth, right? It’s like some people are saying our direct businesses up this and it’s the fastest growing division, our direct business is the fastest growing division who cares, of course it is. It’s like they would be like saying the teller business is up, the teller business. The ATM business is up.

And I am running the ATM division. What to do? What is the Bank of America’s business versus Citibank’s business? That was important. That’s how people ought to think..

I haven’t seen an app yet that lets you sit on the couch. So it seems like the strategy is like….

Great point on the direct lift..

Thank you.

Just maybe one more for Karen if I could, the port impact, did that play out as you expected, the $10 million to $12 million hit in the first quarter and will that revenue be recognized in 2Q?.

Yes. It’s a great question. We actually at the end of the day when we looked at all the orders, we actually were able to move through a lot more of the receipts and things picked up in April. So that $10 million to $12 million impact that we originally estimated was only about half that. So we’re able to get things through.

Now when we look at the transit times for currently right now, they are still a little bit slower, so there is a modest impact that could shift to Q3 from Q2, but overall it was only about $5 million impact that’s actually flopped into Q2 and a little of it’s probably going to even more forward to Q3. So not a huge impact on Q2 one way or another..

Thank you..

Our next question comes from Peter Benedict from Baird..

Hey, guys. This is Justin Kleber on for Pete. Thanks for taking the questions.

Karen, I wanted to ask about the second quarter guidance and how you guys are thinking about gross margin directionally as you lap the strong performance last year which I recall was helped by the software 4th of July promotional event?.

Yes. The biggest thing for Q2 to headline is the kind of significant change in the newness introduction. So I will start with the topline.

And just reminding that when you think about Q2 this year versus last year, even though the books are home, in home earlier this year than last year because over half of the newness is being introduced in the second half, the sales composition is just a little bit different.

We do expect to see modest gross margins leverage in Q2, partially because of that friends and family event last year, but also just because of what we are seeing just in trend. So we do expect to see modest gross margin leverage in Q2 and then even into the second half..

Okay.

And then just wanted an update on some of the supply chain initiatives, specifically the in-sourcing of the furniture delivery hubs, can you guys just remind us how many markets have been in-sourced, maybe what percentage of your furniture deliveries do you control to-date as compared to either last year or few years ago? And then just as a part of that question, when you in-source these hubs, are the benefits more I guess financial in nature or are they customer facing? Thanks..

Sure. We in-sourced one more hub in the last quarter. So with that, we are about 58% of our deliveries are in-sourced and we expect to have one more by the end of the year, such that by the end of the fiscal year. We will be at about 60% of the deliveries we control. And your question on whether costs or customer service facing, it’s both.

So we do think that there is a better customer service experience and then there is some cost benefit. We’re at a point now where we’ve done a lot of the big market. So the immediate leverage that we get from kind of controlling some of that in the cost efficiencies, those big markets are behind us.

But now we still see ancillary benefits with the customer experience with even other kind of things like returns and damages and shrink and other things, just we’re controlling more of the inventory. And then again, all the customer benefits that come from us having more control over those folks and who’s interacting with our customers..

All right. Thanks guys. Best of luck..

Thanks Chuck..

And our next question comes from the line of Cristina Fernandez from Telsey Advisors..

Hi. Good afternoon. Gary, on the video, you alluded that it should open more RH Modern’s standalone stores besides one plan for L.A. Could you think about how many of these did you have and just in general, how are you thinking about standalone stores for some of these market concepts like Baby & Child and little one.

Here’s a concept that’s going to be announcing the fall until you bridge the cap confirming the real estate that you currently have?.

Yeah. Good questions. So specifically, let’s just talk about L.A. and talk about the logic and why there’s going to be an RH Modern standalone store in LA. We built Melrose. It’s not one of the next generation design galleries. So Melrose does not have all the square footage.

And we knew when we were moving to Melrose, we kept our location on Beverly Boulevard as we knew we need the space for RH Modern in that marketplace. Also in that marketplace, we have a free standing Baby & Child store because we don’t have the room in Melrose.

So there is going to be combination here where we will -- way the brand maybe aggregated under one roof and there is going to some places where the brand is disaggregated into separate pieces, right and separate standalone. My sense is we’re going to continue to evolve. We’re going to learn more.

If Modern ended up itself, in a free standing location, deserves to be free standing long term then we will adjust our approach. Today, we’ve said we have a floor that’s going to be dedicated. Just take Atlanta for example. We have three floors of the interior business on floors one, two and three today.

That’s showing based on their core interiors assortment and category presentation in the store that was rugged and window driven another categories. Look four is a small faces and four or five is Baby & Child. So in that store, it was always thought of and designed that RH Modern would be on the third floor.

And then the other business that we are announcing is engineered to take half of one of the floors in the business. But as we’re learn and grow, today we have some Baby & Child that are freestanding we’ve got and we have Baby & Child now in Atlanta integrated.

Whether it’s Baby & Chile Modern, the new business that we’re talking about other categories at the business, we will continue to test and experiment which is the best way to optimize the business, not just from a revenue point of view but from a profitability point of view.

So there could be a decision at some point say hey Baby & Child which is on store front is more optimal than the Baby & Child on the fifth floor. And we have plenty of things in the pipeline that we could use the square footage for and same discussion around modern. So -- and that’s why you’re seeding different test.

The great thing about the big stores is the real estate deal, the financial construct of those deals give us a really a long-term advantage and a pretty low cost overhead structure for stores of that size and so we have lesser flexibility how do use that square footage.

And we will continue to test and learn and use the square footage in the most optimal way and augment with additional square footage outside of the big box if we believe that’s right and appropriate..

And our final question comes from the line of Matt Nemer from Wells Fargo Securities..

Afternoon.

Can you guys hear me okay?.

We can, Matt..

Hey Matt..

Okay. Great. I just had a quick follow-up on Modern. You mentioned that the prices would be -- you think will be disruptive in the market. I'm curious about speed to delivery. My impression is that some of the high-end specialty folks that you talked about earlier had very long lead times. It’s almost a custom business.

How do you think it can compete on speed?.

That’s a really good point, Matt. It is very much a custom business on the Modern side and the lead times and the wait times are a real disadvantage to the people in the marketplace today. I think we are going to compete on speed just like we would our current business.

Now when we are launching, we are being relatively conservative on inventories absence, how and where we find itself. I'm sure we are going to be long in a lot of it. I mean, 100% of the size can be longer. We are going to oversell 10%, overbuy and underbuy. And so our lead times and our delivery will be optimized in the first 6 months or 12 months.

But after that, I think you think about it as we are -- it’s going to be a huge competitive advantage versus how the marketplace exists and operates today..

And then just one quick follow-up, do you have a roadmap this year for changes to the website and the digital experience? I know that’s something that you've kind of been thinking about making some changes to it. I’m just wondering if we should expect anything big this year or more fine tuning? Thanks..

Some things will be bigger than others. I think we have a long-term strategy and we will continue to evolve and change the website and so the launch of the Modern site is going to include some new features and service so forth, but nothing that I would say is kind of massively revolutionary.

I mean, I think it’s going to continue to evolve and be better and we will continue to focus on leading and not following..

Great. Thanks so much..

Thanks, Matt..

Thank you. Well, thank you everybody for your time today. We are very, very excited about our future and the year ahead and our future ahead, and I appreciate your time and attention and support. So have a great day..

Thank you..

This does conclude today's call. You may now disconnect. Thank you..