Cammeron McLaughlin - Vice President, Investor Relations Karen Boone - Chief Financial and Administrative Officer Gary Friedman - Chairman and Chief Executive Officer.

Oliver Chen - Cowen and Company, LLC Matthew Fassler - Goldman Sachs & Co. Brad Thomas - KeyBanc Capital Markets Inc. Aram Rubinson - Wolfe Research Daniel Hofkin - William Blair & Company Matthew Nemer - Wells Fargo Securities Peter Benedict - Robert W. Baird & Co.

Cristina Fernandez - Telsey Advisory Group Oliver Wintermantel - Evercore ISI David Schick - Stifel Nicolaus Weisel Janet Kloppenburg - JJK Research.

Good afternoon. My name is Connor and I will be your conference operator today. At this time, I would like to welcome everyone to the RH Second Quarter 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. Cammeron McLaughlin, Investor Relations, you may begin your conference..

Thank you. Good afternoon, everyone. Thank you for joining us for RH’s second quarter 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 in addition to further details on the upcoming launch of both RH Modern and RH Teen.

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 results 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 the call over to the operator to take our first question..

[Operator Instructions] Your first question comes from the line of Oliver Chen with Cowen and Company. Your line is open..

Hi, congratulations on all the growth and the innovation. We had a question related to, Karen, your comments were helpful on the fourth quarter in dimensionalizing the growth you’ll see there.

I mean, do you expect the outsized EPS growth to continue into the earlier quarters of next year as you have the non-comparable benefit from some of the new product lines? And also, we were also just curious on the FX front, if the Chinese yuan is having any impact in terms of how you’re sourcing?.

Yes, so, on the first question we do expect to continue to have benefits from these new businesses and new stores. We’re not ready to commit to a specific level of EPS growth, but we’re very excited about the businesses and the stores. And do expect those to continue into and add to growth in both revenue and earnings in 2016.

And with respect to the FX front and the devaluation of the yuan, we do have – we expect to get some benefit. We’re a little bit hesitant to commit to how much just because a lot of our vendors are – a lot of the product cost that we have is raw materials and goods that are getting imported in, and so some of the savings are just on the labor.

So we expect there will be some impact, but we’re not going to commit to any specific levels just yet..

Okay. And, Gary, the RH Modern, congratulations, it looks really differentiated. What do you think we should think about for Teen and Modern as a percentage of sales over time or how should we think about how you view your market opportunity relative to your existing business? And I was also just curious. Thanks..

Yes, sure. Well, I think, there’s a logical point of reference out there for Teen. So you can draw conclusions based on that. And I would say, in Modern, there’s no logical point of reference, but it’s a significantly bigger market than Teen or Baby & Child.

So, if you stand back and think about the Modern business, and by the way, Modern could also have an aspect of Teen and Baby & Child in the future. So – but Modern is covering every aspect of the home except for those two rooms, so you’ve got living, dining, bedroom, bathroom, outdoor.

You’ll have accessories, textiles, window treatments, rugs, et cetera. So, I think about it as an entirely new business. It’s framed in a – we believe a very new and differentiated aesthetic that we have not really offered today. So we believe it opens up a whole new market in many ways.

As I mentioned, I think last quarter, we believe there’s an opportunity to really create a new market, because there’s really no destination in store that is aggregated all the categories and presented in an integrated fashion in the Modern market today from our point of view..

Thanks, Gary.

And, Gary, just a final question, what’s your vision kind of for the customer relationship management part of the future of retail? As you guys invest in your supply chain systems and you’re shipping in your CRM component, I’m just curious about a broader question about how you see that evolving and how it may have the most impact in your business?.

Yes. We’ve got a pretty large and complex strategy, I don’t say complex, but I think very logical strategy for how we think about the customer long-term, and have an integrated, not only view of the customer, but really a much more intimate relationship with our customers going forward.

We’re working across all channels of it now, and there’s aspects of systems that go to that. There’s aspects of the supply chain and delivery that go to that and things we’re doing on the supply chain and delivery side of the business. There’s aspects of the service level in the stores, and design services and so on and so forth.

That’s a very holistic strategy they we’re pursuing on multiple fronts. And when we’re ready, we’ll lay that out in a meaningful way to you. I think, if we told you everything we’re working on right now, it might be like a mind jump, it might overwhelm you. But we’re working on basically almost in every aspect of our business.

I think in a very new and distinctive way the innovation on the operational end of the business and on the service end of the business is, every bit as meaningful as on the product end of the business and the category and new business aside. But unless you wanted to watch an hour of video, we’re going to give it to you in pieces..

Thank you for that, and congrats on the most exciting stores in retail..

Thank you very much..

Thanks..

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

Thanks a lot, and good afternoon to you.

I want to start off just by getting an update on the performance of the land as the – I would say the first effort and the newest store format that you’ve got?.

Yes, Atlanta continues to exceed our original projections and expectations in that, so we’re very excited about Atlanta. Atlanta will also – Atlanta was built to receive both RH Modern and RH Teen, so we’ll be receiving those new businesses.

We’re going to give those to Atlanta in probably the January, February period just because we’ve got – we wanted to hold enough of the inventory to have into these four new next-generation stores, where we’ve got them somewhat merchandised differently, where we got a full floor of Modern, 15,000 square feet, 13,000 to 15,000 square feet depending on which of the stores you pick, and then also we have a freestanding Modern store.

So we’re going to hold on Atlanta, but Atlanta is performing above our expectations and will continue to grow and be impacted in a positive way with the addition of RH Modern will have a full floor in Atlanta, and RH Teen will have a half of the floor in Atlanta. So the store will continue to grow and ramp.

And then we have many other new categories and businesses in the pipeline that will continue to feed these new next-generation design galleries in the future..

And, Gary, it sounds like Chicago has some new features. On the video, you talked about some different things.

Can you talk about the rationale, the economics, the operation and execution? Does this add to complexity? Do you outsource that complexity? And how unique is when you’re thinking about Chicago, taking floor for Chicago than it is for that market?.

Yes, I’d first start with the view that we don’t do anything unless we can do it as well or better than anybody in the world. So, I’d start there.

I’d say, if you look at this company since we went public and take a look at anything we’ve done whether it’s new businesses, new categories, new stores, change the mailing cadence of our catalogues, take catalogue page count to levels that no one’s ever taken them to, open supply chain distribution, in-sourcing.

I think what people underestimate is how well this company executes. And I think what – compared to other people in our sector, I know it looks like we’re going so much faster, and it’s true and we are. And we’re doing so much more, and it’s true and we are. But we’re a different organization. We have different people.

And we have different methodologies and processes. And I think – and I think that like – I mean, to focus on, we’re adding a restaurant and a wine bar in Chicago. It’s so little compared to everything else that we’re doing that is so important.

I would just – we’re going to always do a lot of things, but a café and a wine bar and a store, creating a different kind of experience, it’s like a little test. I wouldn’t focus too much on it. We got the best partner in Chicago; the best restaurant operator is our partner. But just think about it this way, Matt.

We test, and prove, and scale new businesses here on a regular basis every season and every year since we’ve been a public company. We hit our numbers every year and every quarter. We do what we tell you we’re going to do. We’re not perfect, but we’re pretty good.

But I wouldn’t focus on a restaurant and wine bar in one store, and get worried about complexity. It’s inconsequential to the big strategic things we’re doing..

And then, finally for Karen. Are there any financial consequences associated with the launch of Teen and Modern in the third quarter? You talked about the sales and the ramp, and how that impacts Q3 versus Q4.

Anything on the SG&A front to think about as we model out the cadence of expenses through the year?.

No, just to give a little color more broadly, specifically with respect to Teen and Modern, no. What will have an impact – we do expect some modest deleverage in gross margins in the back half, but that’s more a function of the new DC that’s opening, that I mentioned on the video. So we have that 1.5 million square foot DC.

That will put some pressure on supply chain occupancy just until we anniversary that next year. And then shipping continues to – shipping cost continue to be higher as we mix in more furniture and there’s some higher parcel rate. So that will put some pressure on gross margins in the back half. It’s only modest for the half.

Q3 will be more pronounced than Q4, but we do expect to continue to have modest leverage and product margins and retail occupancy. So that’s a little – and then, on the SG&A front we expect to have a great leverage in the back half..

Got it. Thank you so much, guys..

Your next question comes from the line of Brad Thomas with KeyBanc Capital Markets. Your line is open..

Yes, hi, good afternoon. I wanted to follow up on the real estate side of things and with Modern having its own standalone location here. I was wondering, Gary and Karen, if you could give us an update on your thoughts on the potential for some of these concepts to have their own standalone locations..

Yes, I think that’s a very good question. It’s one that we spending a lot of time here on. We’re so early in Modern. As it developed and evolved during the last year as we really put our focus on as an organization, and again, we work very differently than I think any retail company at least I’ve ever worked for.

We work in a real project based approach. I think about us more like a technology company when we have teams that often come together and focus on big projects and bring them to life. And because we do it that way these things tend to evolve and we see a lot more and we can move a lot faster.

And as – we can just tell you, and I’ll put the fact here, so you can understand the perspective of how we work. When we introduced the idea of our RH Modern in our long-term plan to our board probably 18 to 20 months ago. It was planned to be a 120 page book.

When we focused the organization on it and began to work on it, then that’s when you really start to learn and things start to come together. And we started seeing opportunities we couldn’t see until we focused on it, expanded, and we thought it was going to be a 300 page book just a quarter ago.

Now, it’s going to be close to a 500 page book that will probably land somewhere between 480 and 500 pages, where final photography on it today. We just showed you, I think, it was about 40 spreads, I think in the video. So you just saw less than 10% of the book.

So you can just imagine, right, like, you just saw less than 10% of the book, most people launch books with like a 60 page catalog. And we’re lunching with 500 pages. So it’s hard to kind of think about the model. But as this come together, we started to believe the assortment could really deserve this on retail presence.

And first, we thought it was going to get us a floor, a half floor, and then in design galleries as it filled out, we thought it could take its own floor. We think, now, we think it’s a bigger idea than we thought about 18 to 24 months ago.

But I think that’s what happens in other kinds of businesses, right, like, if you think about Apple, how big do they think the iPod was going to be. How big do they think the iPhone was going to be? When they launched the iPhone, the average phone was $49, and everybody had a Motorola RAZR. They had a Nokia.

And then that phone changed everything, right, and the industry changed. We think, by comparing RH Modern to the iPod or the iPhone. But I would say that comparatively, if you look at our industry and you look at Modern, there is nothing like it. There is nothing like this concept anywhere in the world.

We’re the first ones to bring this comprehensive and complete of an assortment to a marketplace at one time. No one has ever launched the business with 500 pages. No one has ever lunched a business like this, especially store concept like this with 18,000 feet in a freestanding location or 15,000 square feet store.

Now you say like, well, cost is that really risky. I don’t know I look at everything else we’ve done right? We’ve grown RH from a business that was a few hundred million dollars to a couple billion dollars by making big important strategic moves. We don’t spend a lot of our time like a lot of other companies on little tiny incremental moves.

We look at big strategic moves and things that will change the markets, change our company, and that’s where we put our time, attention, and effort. And we think this is big. I think this can be as – I really think it would be as big as RH is today, and are bigger than we are today.

I mean, there’s no reason to believe that RH Modern can be a multibillion-dollar business in the U.S., and take your point to reference on anybody else doing anything, that are whether, I know, what, look at West Palm or anything else, which is business I’m familiar with obviously.

It’s doesn’t have anywhere near the assortment we have today that we’re lunching with. And so I think this thing is going to be massively disruptive and create a new market, and you may see freestanding stores. You may see it integrated. But we’re such at the early innings of this thing, but this is a big idea.

We’re not going to get it all right on the first swing, but we’ve got a lot in the pipeline and this could be – this book could go to 800,000 pages within 12 months. And we – this is going to be a big deal from my point of view, I think the most important new business we’ve launched in the history of this company. So we have big plans for it.

And we think as I said in the last call, there’s so many converging trends that create an opportunity for – to create a market. And I think we’ve identified those trends. We spent a lot of time on them. And the other thing is, this business is a business we know, right? Here’s another thing where you go wow RH Modern is like a branded business.

It is, but it isn’t. It’s every category that we’re already in. It’s – every product line that we’re already in. We know the percent of the business, it should be living room, dining room, bedroom, bathroom. We know how sizes sell versus other sizes. We know how finishes sell versus other finishes. We know the lighting business.

We know the window treatment business. We know the rug business. We know the bedroom and bathroom textiles business.

So the great thing about this and why we can go so fast is we know this business is a parallel business with a different aesthetic that can be presented in compelling way that I think is going to completely open up the aperture and the acceptance of the RH brand. So, sorry, there is little bit of a ramble, but we’re – I mean, this is a big deal.

This is – I think it’s the most important and significant new home furnishings business to be launched in the last 15 or 20 years..

That’s very helpful. Thanks. Thank you, Gary. And if I could ask just a financial housekeeping item, looks like payables was a nice source of cash for you in the quarter. I know that’s a goal for you this year to work with your vendors to try to extend terms.

Any update on the progress in those discussions with your vendors?.

Yes, we’re making progress. We have ways to go, I’ll say, but I’d say between the HSBC program we’re kind of opening up and offering it to our vendors, and then just some of the deposits that we used to have and making sure that as they grow we get some improvement. We’re making progress, but there’s still ways to go..

Great. Thank you so much..

Thanks, Brad..

Your next question comes from the line of Aram Rubinson with Wolfe Research. Your line is open..

Hey, good afternoon. Great results. Thanks for taking the question. Hoping you can help on the shape of your customer and customer adoption.

Specifically, where are, I don’t know, your demographics in terms of awareness trial? What are you doing with prospecting? And I’m just curious how business is to new customers versus existing and whether those existing customers are pushing the edges of the assortment.

I know those are a lot of things to think about, so I don’t expect answers to all of them. But I’m just trying to get a sense as to whether or not your business and what the shape of the adoption curve, I guess, is looking like..

Yes, Aram, this is Gary. And I’d say that we think about all those things and they’re all good questions. They’re not necessarily answers that we want to give out in a public way, because it’s educational tour competitors and others, and how our business is responding and how we think about it. But, again, I would just focus on our execution.

I think we’ve been pretty good at introducing businesses, introducing categories, expanding categories, dimensionalizing businesses, and reading and reacting to and responding to how those businesses develop and perform, and how our customer reacts to what we merchandise.

But so – those are just ongoing things that we do, and we’re constantly learning, we’re constantly improvising, adapting, improving as we go. So I don’t know if there’s anything specific you want to focus on those questions towards or….

You completely deflected it, which I understand it’s smart of you. So maybe I’ll ask another one altogether. The pace of innovation is huge, and of course, we all call for companies to innovate and then we get a little scared when they do innovate as rapidly as you do.

Maybe just give us a sense internally of the guardrails of what it is that you guys say no to, and what it is maybe that those things have in common, so we get a sense that it’s not like everything is getting green-lighted?.

Yes, I’d say, we say no to about 97% of the things we talk about..

And it’s also about….

So everything – I mean, just to give you a quick perspective. We go through two significant strategic reviews in the company a year. And as we go through those things we always have ideas that get surfaced.

Current things we’re working on, new things we’re working on, new things that come to the table, as thoughts connect we see new opportunities and new businesses. And we go through a very rigorous strategic process here, where every idea is dimensionalized and valued based on its financial value, its strategic value and its emotional value.

And so the financial value to the company is that sometimes a more obvious one, what is the revenue value, what is the earnings value, what is the cost reduction value, what is the efficiency value, when we think about the financial value to the company. Then we go into the – we rank everything on strategic value.

How does it position us in the market? What competitive – how does it create competitive differentiation? And how does it position us long-term to win? And so we go through many discussions around that. We try to value things strategically, and then we try to value things emotionally.

And emotionally, as it relates to two constituencies, one, our consumers had is what we’re doing? How will it connect with consumers? How – why will they care about it? And will they connect to it emotionally? And two is our people.

How will our people connect to this choice, this initiative, this strategy, because to get great people and to get great people to do great work, they have to really care about what they do. We would like to say inside, I mean, I shouldn’t say this publicly. By now I guess, I can’t, okay.

But we – they have to give a blank, right, about what we’re doing, and they have to feel connected and passionate to it. And so the emotional value is important internally and externally our people, it has to connect to our people and it has to connect to our customers.

And so we go through the process of taking whatever 50 or more ideas, and we go through a rigorous process to value all of those and then we force rank this.

And we say, if there’s – if we could only do one thing or die trying, what would we do right? If we could only do one thing and by the way as we value all those, there’s also with the financial value what is that – what’s the financial capital and the human capital we have to invest into each one of those that helps us dimensionalize, how we think about the complexity, the difficulty, the returns, and so on and so forth.

But then we try to see them clearly, right, and we debate. We spent a lot of time debating them and getting clarity in the value. Once we had clarity on how we see the value of each of those choices and then we force rank.

If we do one thing or die trying what would we do, we debate a hell out of that and then we pick one, and we align on that as an organization, as a team.

And we figure out what does that – what’s the human capital and financial capital we have to deploy against that? And what’s the return we’re going to get against that? And then we build the strategies. We take that and we translate it into a strategy into the tactical moves to execute it. And then we go to the second thing.

What’s the second thing we do are die trying? What’s the third thing we do are die trying.

And then we try to understand what’s the bandwidth of the organization? Do we have the resources? Do we have the capital? Do we need more capital? Do we need more resources? How do you create the risk profile, and we go to a whole risk assessment on each of these things, and we look for initiatives and choices and projects and strategies, where we have a great degree of asymmetrical risk to the upside.

So it’s probably not much different than how you guys – how investors manage a portfolio right? And except, maybe there’s not as much emotional connection to it. But we’re leading thousands of people here. They have to really care about what they’re doing to do great work..

That’s a great answer. Thank you. And I’m sure the emotions are on our side too, but it’s great to hear your passion..

Your next question comes from the line of Daniel Hofkin with William Blair. Your line is open..

Good afternoon. Congrats on the fine results. Just, maybe if I could ask a little bit of color on the quarter just big picture, not like little pluses and minuses.

But there were – if there were any kind of larger categories, or let’s say the friends and family event that you feel were call outs one direction or the other, and the trend over the course of the quarter.

Just interested also with, Gary, with your commentary on the video in mind, what you think might have contributed to the different growth rates between the channels, not necessarily you’re saying one is better than the other, but just what might have contributed to the difference? And then I have one follow-up question. Thanks..

[Multiple Speakers] Yes, I mean, nothing real surprising categorically how the business performed.

I mean, it ramps the way we thought it was going to ramp, I think I’d – when you stand back and think about what’s the difference this year versus last year and how we think about the business? Majority of our books were in home last year, late June, and a 100% by mid-July right? So there’s really two, three key points to consider.

One, our books this year – spring books this year had 1,300 less pages than last year, right? So if we just came back and think about that we – our spring books had 1,300 less pages than last year. So we had – that’s a pretty big move.

We had to be very scientific about how our business was going to perform quarter-to-quarter, week-to-week, category-by-category, because that’s a significant difference.

The second point, I’d say, to think about, as you think about the business and the big moving part strategically, beginning mid-October we will have two new businesses and 700 new pages versus zero in the same period last year, right? So we just came up against the period where we had 1,300 less pages.

And our business over that period, right, is basically performed in the mid-teens and then started – we expected to tail-off in Q3, because really the books were 100% in home mid-July, right; 70% in home late June, 100% in home mid-July. So the shipping, the revenue recognition and the deliveries on those really ramped in Q3.

So we come up against the build in Q3. And if you just look at our numbers from last year our business tailed off last year in Q2 to 14%, and then re-accelerated as we told you it would last year in Q3, and then accelerated to 22%, accelerated further in Q4 to 24%. And I think those are numbers that are pretty close to what we told you would happen.

This year, it’s a little different. The timing is different. The newness has got a different cadence to it. So here you’re going to see us coming up, just like in Q2 you’re going to see the business tail a little comparatively because of the timing of the new businesses and the ramp of last year’s book.

But the fact that – I sit back and I go, the fact that we could mail 1,300 less pages and still have double-digit growth is really meaningful to me, because what we’re doing here, and it kind of goes back to some of Aram’s questions and some of the questions that are earlier, we’re always testing, right. We’re always trying to fine-tune our model.

We’re always trying to learn. And our view was, as we got into the productivity and the ability to kind of learn about the – learn about fine-tuning the advertising aspect to the business and the model, we thought, eh, are we sitting on a business that maybe today – maybe today if we fine-tune it actually has an 11% or 12% or 13% operating margin.

If we just like on a run rate basis, if we pulled out, and it’s an interesting conversation, because there’s a lot of conversation around Amazon. And Amazon now is starting to try provide clarity and take investments out and future growth out, and what’s the core business operating on.

If we really look at our core business and we kind of dial and right size the advertising spend, if we really take a look at the investments we’re making to lay the track for the supply chain, right, for the future growth, which we have to invest ahead of.

If we really look at all the investments on the new businesses and we start to right-size that, if we’re acting like a private equity company, we said, we’re going to buy this company today. I think we’re buying a company that probably has a 12.5% to 13% operating margin. But we’re investing ahead of that.

And so, as we fine-tune this thing you’re going to see us start to understand, what’s the underlying operating margin as we get smarter here, as we dig into this model and as we fine-tune this model, and then, what are the pieces as we grow.

But if you just stand back and say, wow, they just reduced 1,300 pages and they’re still going to be in the double digits in Q3 when they’re up against the book ramp last year, I think that’s phenomenal. Then I sit there and I go, now we’re going to add 700 pages, not a re-contact, right, like a lot of companies will mail a book again.

And it’s a re-contact and it’s the same goods. We have 700 new pages of products hitting in late Q3, right. And that’s up against zero in the same period last year, so that’s going to put the business in a position to now ramp. We’re not going to get zero for those 700 pages, right. It’s all new content.

So that – and we have lots of data that says, what new content should – how it should perform, what’s the productivity per page by category, so on and so forth. And we think we’re relatively conservative in how we’re thinking about this. And then on top of that, we have four new next-generation galleries opening in October, November.

We have a new freestanding Modern store that’s opening. That’s a pretty significant size store in total, I think, indoor and outdoor square footage about 18,000 square feet; and two new baby and child freestanding stores opening.

So when you think about whether it’s category, those are the big moving parts, that business is coming around against the ramp last year, 1,300 less pages. Now you’re going to have 700 pages against no pages last year, all those pages are incremental right? And then you’ve got all this new real estate coming on board.

And those are the important dots to connect as you think about the business..

Yes. And then on the quarter specifically, the promo strategy was the same. Everything was pretty much as we expected it to be on your question on retail versus direct.

We’ve said many, many times that we’re channel agnostic and don’t necessarily care whether they order in the store, whether they order at home, especially based on how our shipping model works. But I would point you to last year’s retail growth was kind of an easier compare, retail only grew 9% last year and direct was 19%.

So, there’s always some of that going on. But we don’t, again, we couldn’t be more channel agnostic as far as carrying where the customer orders and when they choose to transact..

I think, the other thing it’s affecting that – could affect that a little right is, we’re making meaningful investment into design services, and we will continue to be. You saw on the video, we’re launching this fully integrated design intelliye [ph]. We studied architects offices, interior design offices.

And basically, we think we have a revolutionary new part of the store that will be launching, that will really enhance the customer interface and how they design their home, whether they’re doing it themselves, whether they’re with their interior designer, whether they’re with one of our interior designers, or whether they’re with an architect and an interior designer.

But because of our investments in interior design, we’re – I think we’re also bringing more customers into the store. We’re creating more transactions in the store environment. And how do you project that. I’m not sure, I don’t know. And honestly, quite frankly, I really don’t care. I don’t want to try to focus.

I don’t know we’ll have a bunch of statisticians here trying to track, where the transaction is happening, and why could, I don’t think there’s a lot of value. I think, we can watch those trends and we can react accordingly. But if it shifts one way or the other, we’ll add more service and more support.

But the adoption rate with cellphones and iPads and other things would tell you, it should go one way. But we’re really enhancing the store experience. We’re making really important investments in design services and our ability to service the customer at the store level. We’re building stories that no one has ever built before.

Our business could shift the other way. At the end of the day who cares. It’s really – our sales and earnings growing. As I said, Candine [ph] says that, while the left hand side of it, the equal sign is important. Okay, it’s really the right hand side the counts..

Fair enough. That makes sense. I guess, just kind of my other question is a corollary to all that as you think into next year and you guys already talked about the many more new store days next year with the additional galleries for the full-year, and then also all the new content.

Just thinking about the year as a whole for next year without giving specific guidance, what are some of the other things that ought to be positive or negative relative to your longer-term view. It sounds like potentially product costs could be favorable.

Are there any other things we ought to be aware of at this point?.

I think the thing we worry about like everybody worries about is, market instability. What happens with interest rates? What happens with the market? The high end of the food chain you’ve got people heavily invested in the markets. And if markets are in stable, I think that that’s something we’ll worry about.

And not a lot we can do about it, just be prepared to deal with it and what’s going to be the effect of rising interest rates? Will it effect big ticket? Will it expect the home buying? We don’t know, we’ve never, I don’t think the country has ever been in this long over a period of this low interest rates.

And so there’s unknown there, and that’s why, quite frankly, we position the company and tap to capital markets in opportunistic times, and built our balance sheet to be able to – to be able to executor our strategy in any kind of environment.

Obviously, we’ll for some reason the economic environment changes, and it dictates that we should change our strategy somewhat, we will. But the higher big level, those are the things we think about. We can see correlations between our business and the market.

And it’s interesting, as we all saw the market get beat up and then bounce back and go around. You can see our business week-to-move a little bit and that’s how does that – what does that mean long-term. We think, no matter what, we’re going to continue to outperform. We’re going to create new markets. We’re going to take market share.

And we’re going to do things into – do things better than our competitors, meaningfully better, not a little better, meaningfully better. So I think – that’s how we think about it. It’s like – but at the end of the day, the markets will do what they do, the interest rates are going to move the numbers around, the way they move the numbers around.

But 3 years from now, 5 years from now, 10 years from now there’s going to be people that win big and we believe we’re going to be one of those people..

Very helpful. Best of luck. Thanks..

Thank you..

Your next question comes from the line of Matt Nemer with Wells Fargo Securities. Your line is open..

Afternoon. Thanks for taking my questions.

First, directionally I’m wondering if you can just give a sense for how much the Q4 revenue growth guidance is driven by the new brands? And how would you assess the risk of getting that inventory delivered in Q4? I assume that it’s just based on when the stores open and when the brands launch, that’s it’s a bit backend weighted in that quarter.

Thanks..

Yes, I mean, well, the risk would be baked into our forecast, right. So whatever guidance we just gave you, we looked at the opportunities, we looked at the risks. We try to understand everything that could go right, and everything that could go wrong and put guidance out there that we believe that is the guidance we can hit.

So, I mean, that’s the way I think about it..

Okay. And then, just secondly, I’m wondering if there are any early signals from some of your books earlier this year that would show you that the more modern oriented product.

I think there were some new product lines that launched with outdoor that have more of a modern look to them, are potentially a leading indicator for how the business, the new modern business will do?.

Yes, that’s – I think it’s a very good question, Matt. As we articulated, we had both tested some Modern that we – there is product that we put in the outdoor book and in the indoor book.

They were originally developed and targeted for the RH Modern book and when we thought that we had an opportunity to get some early reads and early customer response to that. And I’d say, we’re extremely happy with the early reads, extremely happy. And that’s maybe why you saw this book go from 300 pages to 500 pages..

Great. Makes sense. Congrats..

Thank you..

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

Morning, guys. Thanks for taking the question.

Just a couple; first, just a clarification, so the Modern and the Teen products as that flows into back-half of this year, from a product margin perspective is that expected to be similar to the rest of the business or is it accretive, dilutive, how do you think about that one?.

Yes, we’d expect it to be similar. We don’t know exactly how it’s going to sell yet. But the way we have the margins planned, it’s implied in our guidance..

Yeah, okay. Thank you. And then, on the cadence of the 2016 openings, any early views as to how you think those are going to start to come through? I mean, could we see more in the first-half [ph] this year? Obviously, it was all second-half weighted.

Any view of that? And then when we think about the square footage growth, I think this year around 16%, presumably next year it will be higher, but how much higher, I guess, early thoughts on that? Thank you..

We haven’t guided that yet, but clearly it will be higher, because you will have more store months coming out of this year going into next year. And then, you’ll have more stores in the following year. So we haven’t guided square footage growth yet and we – I think we gave you directionally. And then, I think, we said six to seven stores last time..

Yes..

Yes, so we’re still looking at the same six to seven stores. I would say those of you that are probably in New York, probably read in the press or read online that there was unfortunately a tragic accident that happened at that location where a developer is developing a site for us.

We haven’t been involved in any of the construction yet, but there was an accident that I think the job and the meatpacking store got shut down for four months. So that was originally 16 planned openings, so could that slip into 2017, it might. We don’t know yet.

We’re trying to – the developer is trying to assess the new schedules of losing four months. But there is an unfortunate tragic accident. Then things like that can delay jobs like this. But it’s nothing that, I’d say, strategic, whether the meatpacking store in New York slips from 2016 into 2017, if it does, it does.

We have a really a good store in New York. This means that we want to be able to accelerate the business maybe as much as, as we had thought in New York, but….

Yes, and worth – weighted average worth in the mid-teens this year’s square footage growth and that will accelerate next year, the exact amount kind of depends on the timing of those openings. They are mostly back-half, again, there’s one that will likely be in Q2, but the rest of those will be in the back-half again..

Thanks, Karen. That’s helpful. And then just last question just on the marketing spend this year, obviously a lot of innovation, the concept is coming, a lot of that was planned, it sound like, that this Modern book was larger than maybe initially thought.

I mean, do you think the marketing spend this year comes in similar to what you spent last year, or those dollars grow a bit? Thank you..

We will – the dollars, I won’t give the dollars effect [ph] because those are still moving especially with some of the holiday books and things. But from a marketing spend and the leverage on the P&L, overall, we’re expecting to have on the year 600 less pages, because the spring books were so much lower as Gary mentioned.

So a big part of the SG&A leverage in the back-half is advertising, because we have so many fewer pages..

Got it. Thanks very much..

Thanks..

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

Hi, good afternoon. I wanted to ask this sourcebook for RH Modern and RH Teen.

How widely are those going to be distributed relative to the spring sourcebook as far as number of households in the penetration?.

Sure. I think about both of them. Teen, I think about more directionally, it will be circulated in the direction of the Baby & Child, because you’re mailing to a much smaller audience. So you’ve got a small universe you’re circulating to, and we’re going out there at a conservative kind of first mail against the universe.

So I think we’re probably in that 60% to 70% range, and we’re probably more in that 75% range against the home core book and interiors with Modern..

Thank you.

And then another question is as far as inventory growth of 29%, how much of that is related to Modern and Teens versus the core inventory? And how are you folks tracking on the core inventory versus last quarter?.

Okay. So on the core, it’s doing great. So we’ve made some investments to make sure that our backorders were down. So it’s doing fine. Modern and Teen, lot of that won’t, some of it’s on the water, but it won’t really show up until this quarter and into Q4.

So we do expect, because of the timing of some of those receipts, we do expect inventory, as I mentioned on the video to outpace revenue growth, just because we do need to make those investments in Modern and Teen inventory..

Your next question comes from the line of Oliver Wintermantel with Evercore ISI. Your line is open..

Thank you very much.

Gary, what do you think will be the impact of new concepts on shopping frequency or average order value for your typical customer? Do you expect your typical customer to spend more frequently – comes more frequently has been some more, or do you try to attract new customers with the new concept?.

I think, it’s going to be both. I think, our current customer is going to buy more. And we’re proving that with the expansion of our assortment over the years. And I think we will also attract new customers with this new aesthetic. So I think you’ll see a combination of both happen..

Okay, great. And then I had one for Karen. And I think when I heard it right, you’re guiding to free cash flow of positive within the next 15 months. Can you maybe just give us the drivers what do you expect is driving that from a working capital perspective, or top line, or bottom line growth? Thank you..

Sure. On the free cash flow what we mean by the 15 months just to be clear either this year or at the end 2016, for us, it’s kind of more meaningful to look at it on an annual basis. So we’ll get – if we don’t get free cash flow positive this year, it will – we will get really close, and if not it will for sure happen in 2016.

And it’s really a combination. It’s higher earnings. Some of the real estate investment spend is getting behind us. We expect modest inventory improvements. I mentioned before that we’re trying to improve working capital to our vendor terms. So if there’s no one thing that’s contributing, it’s a little bit of all those items..

Okay, great. Thanks very much..

Your next question comes from the line of David Schick with Stifel. Your line is open..

Hi, thanks for taking my questions and congratulations on the quarter. You talked a little bit about marketing spend and the leverage opportunity in the back-half.

I guess, my first question would be, Gary, as you think about the breadth as you’re continuing to evolve the vision of all the brand is, what’s the right level for marketing spend long-term for the umbrella if even that’s the right way to think about it, restoration? And then, just as a follow-up to the free cash flow question that was just asked, longer term, Gary, it was very helpful to hear your thoughts through operating margin.

And I know, Karen, you just talked a little bit about it, but long-term would free cash flow sort of move in that same function as Gary described or is there anything else at work over not 18 months, but over five years? Thank you..

The right level of marketing spend for RH core, I think in each of these businesses, we’re learning all the time like how do you optimize it. At the same time, the world is changing before us and we had to reach the customer, right, whether it’s through stores, whether it’s through print, whether it’s through digital, whether it’s through social.

There’s so many ways to address marketing spend today. And I’d say that the hardest job in America today, and in any company is probably going to be the Chief Marketing Officer. It’s probably why we don’t have one.

And so, as we – at the most senior levels of the company we are making those decisions and deploying those assets, because I think it’s very hard to figure this out right now. And I think there’s a lot of money that’s not been spent in a very intelligent way.

So at the most senior levels of the company we are paying attention to it, and we are digging into it. And we are trying to figure out how to optimize it, at the same time how do you grab share and how do grow business and how do you invest into the future.

And I think that this year – I think, by next year we’ll probably have the – we’ll probably know the baseline on core RH, I would think, like if we – from an optimization kind of growth point of view.

But we’ve got so many new businesses coming on, so whether it’s Modern, whether it’s Teen, whether it’s new businesses you will hear about in the near future that will be coming online.

And then the other thing that’s unknown precisely is, what is the impact on advertising spend once we rollout these new next-generation galleries, right, because there are going to be a massive billboard. And remember, it’s probably true at all of our competitors, but at least in our business today.

I think that 67% to 70% of our new customers come through our stores.

So if you just stand back and think about that metric for a minute, if that’s happening where it’s 80% 90% legacy stores today, small mall-based stores, what happens when you have these new next-generation galleries? Does it go to 90%? Does it mean you can mail less catalogs? Does it mean you can advertise differently? There are just so many things yet to learn, but one of the things I know for sure is that when we open Denver, Chicago so on and so forth, our business grows in these new galleries without mailing more books, right.

So the square footage and the impact of the real estate grows the business. So that inherently leverages the advertising.

Does it mean long-term you can actually mail more books or does it mean maybe long-term you should mail more books and you can even expand the market? It was just so much left to learn there, and there are so many things that are evolving.

And we’re just very curious and very critical, and very disciplined about how we allocate and how we place those bets. And that’s why today the marketing spend of the company is really controlled at the highest level of the company, because you’re really in unchartered waters in today’s world and environment.

And our company is in unchartered waters in our real estate transformation, the transformation of our direct business, the way we approach the market from a source-book point of view.

So a lot yet to learn, but all the indicators would say, there is a lot of leverage in optimization to expect in the future because of what’s going to happen with the real state transformation, and especially the things that we’re learning this year..

And then with respect to the long-term outlook for free cash flow, there’s nothing that would – that’s three years down the road or four years down the road that would make us think we’re not going to continue to generate significant free cash flow once we hit that mark.

I would say one thing that we expect to improve over time is inventory turns, as we have been growing by assortment and as we grow more by square footage. We do expect to optimize some of those inventory investments as we kind of learn from what we’ve introduced..

Very helpful. Thank you..

Thank you..

Your final question comes from the line of Janet Kloppenburg with JJK Research. Your line is open..

Hi, everybody, and congratulations on a great quarter. Gary, I wanted to get your thoughts on how you think about RH core. You have two new concepts coming on 700 pages worth of new merchandise, and as you said new concepts to be launched.

How should we be thinking about RH core and the level of newness that should flow into that segment of the business going forward? I love your thoughts there..

Sure..

[Multiple Speakers] And, yes, just one for Karen and you guys can talk us this. It sounds like we should be looking for SG&A leverage to be more significant in the back-half and the front-half because of your indications on the margin line – the gross margin line, if you could just help there? Thanks..

Yes. Janet, it’s a really good question. So it’s actually one of the things that we are talking about and debating internally. The core even though the pages were less, we had better optimization and better density in the books. So we had – we still had newness in the core business even with 1,300 less pages.

And so, with – one of the questions you can ask yourself is the long-term. Today, we believe Modern is a new business, and it’s the right way to address it. Long-term, is it a new business, but it’s really part of the bigger platform and just a bigger weight at the core.

One thing you don’t know is how the consumer preferences will change over time? How trends change over time? If things move more Modern, does Modern get bigger? Does the traditional businesses slowdown? How do you think about trends, if you think about all the trends in our business, whether it’s traditional, whether it’s industrial, whether it’s Modern, whether it’s mid-century.

So, honestly, I’m a little ambivalent about it. What we’re focused on is, how do we take these kind of – we’re pretty good at encapsulating anesthetic and a point of view, and then communicating that and positioning that in a market in a very clear and compelling way.

And as things change or shift, we should build a platform here that has the flexibility to maximize it and to move, right, not to have too much rigidity. So that’s why we’re early on here.

When I sit about – I sit there and I go, do I like Modern freestanding? Do I like Modern in the bigger store? How do I think about it strategically? I like it freestanding in select places, because I think what it does is, it breaks through the market.

So in LA, in Miami, in New York, right, like might you make a capital investment that creates a little bit of rigidity with the platform that that amplifies a business like Modern in some markets.

In most markets I think about Modern and I think about core, and I like them in the same box, because I can have core on one floor, Modern on another floor, all these businesses on another floor, and I’ve got a very flexible box that I can move and I can grow or shrink and position the business long-term.

I think the key is the breadth of the RH business, when you think of RH, how should you think about it? I think what you got to think about it as the quintessential taste in style leader for the home market at the high-end right? And that means, in Modern, it means traditional – updated traditional, it could mean many other things.

Lot of people say, oh you don’t – you guys don’t have much color right? You look on the blogs or talk to certain customers that are like us, there’s no color. They only have neutrals and grays, and so on and so forth. There’s a reason why we have that. It’s the biggest part of the market by the way. That’s why we had the best growth in the industry..

Right, right..

But there is a percentage of the market that is more color-driven, right? Just like there’s a percentage of the market that’s more modern driven.

And could you think about a business called RH colors in the future, and could we encapsulate color into a book and into a catalog? And could we explode color in a way in the home market that is, that no one has ever seen, right? And then you say, well, is that part of core or is that a new business.

And, how do you think about it? And so, I think about the broader home business and how do we take as much share and own as big a piece of the luxury home market long-term and how we encapsulate those businesses and what we call core, what we call new businesses.

It may change over time, right? I think you just have to be flexible and not rigid, and position yourself to kind of win, and move and adapt and improvise. I don’t know if that makes sense or not, but….

Right, right, that’s very insightful. Thank you..

Yes..

And then, Janet on the back-half, we do expect earnings and operating margins to accelerate and expand in the second-half even more so than the first-half, and that is driven by SG&A leverage being bigger in the second-half than first-half..

And will that….

And the biggest piece of that is advertising..

Will that expand into next year because of the ramp in store openings, Karen?.

That we really haven’t nailed down the strategy for next year. So, yes, we haven’t – we’ll continue to learn as Gary mentioned and optimize the marketing plan. And as soon as we do, we’ll have more to share on how that looks into 2016..

Okay. Well, thanks a lot and congratulations..

Thank you..

Great. Thanks..

We are now at the conclusion of today’s call. I would like to turn the call over to Gary Friedman for closing remarks..

Great. Well, thank you everyone for your interest in our company and I want to thank all of our team members across the country and all of our partners all around the world to support our efforts. We look forward to talking to you next quarter. Thank you so much..

This concludes today’s call. You may now disconnect..