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

Peter Benedict - Robert Baird Jessica Mace - Nomura Securities Daniel Hofkin - William Blair & Company Brad Thomas - KeyBanc Capital Markets Oliver Chen - Cowen and Company Lorraine Hutchinson - Bank of America Merrill Lynch Michael Lasser - UBS Matthew Fassler - Goldman Sachs Oliver Wintermantel - Evercore ISI Matt Nemer - Wells Fargo Securities.

Good afternoon. My name is Jennifer and I will be your conference operator today. At this time, I would like to welcome everyone to the RH Third Quarter Fiscal 2015 Earnings 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. And I would like to turn the conference over to Cammeron McLaughlin..

Thank you. Good afternoon, everyone. Thank you for joining us for RH’s third 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.

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'd like to turn it over to the operator to take our first question..

Our first question comes from the line of Peter Benedict with Robert Baird..

Hi, guys. Thanks for the question. I guess my first question, just quickly looking at the fourth quarter, you have got the revenue guidance up, obviously, but the earnings guidance was held. Just curious what's affecting the flow-through there relative to your previous expectations. That's my first question..

Yes, this is Gary. Let me try to take that. I think that the way we think about the business is, every quarter, especially Q4, always requires some level of recalibration versus our plan. That's because the environment is forever changing. The economic environment, the competitive environment, consumer trends, preferences, so many things.

We believe our success is based in our ability to improvise, adapt and win. And winning to us, if you stand back, and as we've articulated I think in past conference calls and past quarters, it's about two things. It's about gaining share, and optimizing earnings. It's about two lines in the P&L, the top and bottom ones.

And as we've said, every other line is a lever and creates optionality and opportunities to win.

So when we look at recent data and said, what's different, what are we seeing and what are we learning, and how are we improvising and how are we adapting, and how are we going to win, there's a few things that are different, and there's some new data that's affecting our thinking.

Some of the things that are created inside the company, that we have more control over shorter-term and then longer term, some outside the company that we're evaluating and figuring out how to adapt our plans accordingly. So there's a few things that are different from last year.

I think Karen alluded to some in her script but in the video, but it includes - we mentioned our circulated pages in the spring books are down year-over-year, and pretty meaningfully so.

And I don't think we've communicated this before, but if you just stacked the spring books last year versus the spring books this year, you will notice that the pages are significantly lower and the circulation was slightly lower this year.

Our data indicated that we could significantly reduce our pages circulated, without meaningfully impacting our top line so we had in the spring, versus a year ago, 60% less circulated pages. That's a meaningful move.

And as we have watched it throughout the quarter, our sense is that the new data would suggest that as the books from last year are built, our ability to comp that build the way we thought, we were a little off in those projections.

So we've got a bit of pressure that you saw at the end of Q3, and some projected pressure into Q4, depending on how the newness comes in with modern and so on and so forth. And that's the next I'd make is, the majority of our newness this year is tied to modern and teen, versus a year ago.

So you've got significantly more newness building earlier in the year, a lot less circulated pages, and less circulation, in our attempt to optimize our model.

And we are always, as you guys know, testing and evolving our source book strategy and our marketing strategies here, and trying to find the most optimal rate to go to market with our business. And so we have a difference in the newness cadence year-over-year.

And then our modern book, I think if you - I think we started the year telling you we are going to launch a modern book that was going to be in about the 300 page range, and then I think we told you it was going to get to the 400 or 500 page range, and it ended at 544 pages, 540 pages.

And because the book came together and many good ideas came together somewhat late, but we thought they were very important. We delayed the book a few weeks against our forecast internally, and then, because the book was significantly bigger, it took a couple of weeks to get through the printer and get through the mail system.

So we lost about a month in general from where we thought the books are going to be. That was different, and that affected our top line trends, especially coming out of Q3 and early in Q4. And then there's a few, what I call macro regional factors, that I think are important ones.

And I don't think you've ever heard us talk about the weather before, and I'm not going to talk about the weather, but there's some meaningful things that I think everybody has to have on their radar today, because they're the kind of things that could shift your business and change economic conditions, and you could place stuff incorrectly if you're not careful.

And here's some things that we're seeing, and the data that has changed from path one to, and we see the trends in Q4. In the areas where the economy is more dependent on oil and natural resources, such as Texas, such as Canada, and you can even throw in there Miami and parts of Florida, because they're affected by South America.

I don't know if we have communicated this before, but we ship - a third of our business in Miami is shipped to South America, and I'd say an even greater monomer business in Miami and in parts of Florida is influenced by South America, because not all the product we sell to South America leaves the country.

A lot of it is people buying homes in Miami, and condos and so on and so forth, and we're furnishing those homes.

So when we look at this the areas that are affected by oil, and then also doubly so with Canada and South America, you're affected by exchange rates, right? If you're looking at your spending power if you're Canadian, if you're South American versus US in exchange rates, you're meaningfully less wealthy.

You're getting a lot less value for your dollar year-over-year. So when you take just those three areas, when you take the Texas markets specifically, Houston, which is being impacted the most, when you take the Miami market, and you take the Canadian market which are all very important markets for us.

In the first half of the year, they were pulling down total Company sales a little under 2 points. And at that point, we knew it was a drag, and it doesn't mean those markets were 2 points lower, those markets were meaningfully lower. They were pulling the whole Company down a little under 2 points.

In Q3, that accelerated to 4 points, and that's meaningful, right? It's not just meaningful to us, I'd say it's meaningful to anybody who's thinking about what the US economy ought to look like, and how we ought to think about it.

It makes me think hey, should we be calling Yellen, and the department, and saying, let us tell you what we are seeing, because those things, from my point of view and I don't mean to make anybody panic, but it's important how we look at those. These are important markets, and markets that are connected to other markets.

Miami's connected to New York, so on and so forth, a lot of the investment that is happening in Miami is connected to New York. So we sit here and we say, wow. One, it was trading down the Company 2 points, now it's dragging down the Company 4 points.

So what do you do about that? Right? Do you just wallow, do just say, just button down the hatches, or do you say, how do you play the game differently? And how do you win in changing conditions, because you can either be a spectator and be on the sidelines and just report that's happening, or you can decide to get in the game and be a participator and do something about it.

And we have a bias for action in this Company. We are not good spectators, but we are really good participators. And so, we think that's a dynamic that has to be watched, and that's a dynamic that has to be reacted to, assessed and reacted to. And so we changed our game plan because of some of the things.

And the other thing that we've seen, and I think we all today, the great thing about email is we all have access to customers, and we can promote much more flexibly and much more cheaply than ever before.

The other thing is, you can really see what your competitor is doing you don't have to walk every mall to see what posters they put up in their windows or what they're doing, right? And all the analyst on the call and investors on the call, I'm sure you all have some sort of tracking this as what are people doing this year, what are people doing last year, and are promotions up year-over-year and so on and so forth? And look, any of you guys all pointed out last week that RH ran a big promotion.

Got it. We weren't trying to be shy about that, by the way. But one of the things that's happening is we track all the competitors' promotions, and we know what everybody's doing, just like you do. And we've noticed that there's been an uptick in competitive emails year-over-year.

And you have to look at the details to really get it sometimes, because you're just counting emails, you're going to miss it. If you're just looking at the generalities in the emails, you're going to miss it.

And many of the people in our industry today are sending multiple emails, and there's multiple messages, and there's multiple promotions being stacked on promotions. And when we look at the data internally, it is the most promotional environment we've seen, meaningfully so.

And it doesn't matter if you're looking at - and by the way, and then there's new players that are bringing a whole new dynamic to the marketplace. I tell the team look, I don't care if it's - who it is, whoever selling goods in our case, right, that's coming in, whether it's an online player, you can't ignore someone like Wayfair today.

They're doing big volume, they're not making money, but they have cash flow, and the last thing you want to do is let yourself get Amazoned by somebody. We're not going to allow that to happen. We're going to figure out how to play the game to win.

If you look at the promotions from everybody from Ethan Allen to Our House to the Pottery Barn to West Elm, and you can say are they all - who is the direct competitors, who is not.

At holiday time, if you've got stores in retail districts or retail malls, and there's thousands of people in those malls, and you're not doing something to maximize share, then you're a spectator.

So we've noticed a more aggressive promotional stance from all of the people I have mentioned, and we've stood back and said, the combination of all these factors I've articulated, whether it's we pulled back and circulated pages and so on and so forth. By the way, a lot of good things have happened here.

I'd start with the headlines, operating margins in RH in the third quarter were up 180 basis points over last year. Find me another person or sector that can say that. So there's a lot of good news here. But if you want to know the details of how we are playing the game, and how we are playing to win, there's a lot of moving parts.

And I'm just giving you some headlines. There's many other things. There's 1,000 moving parts in the Company like ours, and you're always looking at every piece of it and every line and every lever and every opportunity.

But when we step back and we take it all into context, and we say, how do we want to play the game? That during Q4 when mall traffic is seasonally high, and our home furnishings peers are aggressively promoting their business, we are making moves to optimize both our top and bottom lines, and to take share.

Period, right? And to optimize earnings, period. Right? How it landscapes, and Karen alluded to the landscape maybe differently, quite frankly as the CEO of this Company, I'm indifferent to how it landscapes. What I care about is what is the outcome, and what's going to create the most value? And our belief is taking share.

Our competitors can't get it back. Taking share is important. There's a reason why Amazon launched Black Friday before everybody else in the world, right? There's a reason why we launched the promotion we did last weekend. It was to take share. There's consumers, there's shoppers, and we're going to try to take share.

And so in the sense of that, that's the way it summarizes, it's maybe a long piece, but I feel like look, we knew it was going to be the big question. The landscape is different. The numbers may not all add up if you look at it in a traditional way. I think this is not a traditional time. I think this is a very unique and different time.

I think it's time where you've got to pay attention to all the details, and you've got to worry about everything. So because these are the times when you don't, quite frankly, something could change in the economy, something changes in the competitive landscape, and you wind up on the short end of the results.

So we think our results are going to be the winning results in the industry. We think our results in Q3 were we need the results in the industry, and we think our results in Q4 will be the winning results in the industry..

And our next question comes from Jessica Mace with Nomura Securities..

Hi. Good afternoon, everyone. And thanks for all the information, Gary.

I guess to follow on some the things you said about the environment, I was wondering if you could maybe give some specifics on what's given you the confidence in Q4 to increase your revenue guidance range, even despite all the factors you named, like the oil and the later source book?.

Sure. As of today we are ahead of Q4. That's why..

All right, great.

And then just secondly, you gave some good information on the success of the RH Modern standalone store in LA, and I was wondering if you - if there's anything you could share about maybe some other plans to roll out formats like that?.

Yes. We're really, really early in a lot of the data. I think as I said in my script, the level of innovation we have just unveiled in such a short period of time is really unparalleled in our industry. If you think about the last three months, we've introduced two new businesses, one which appears to be significantly incremental.

With the first store, we've opened, trending to 25 million in its first year. By the way, that's the first time in my career that ever happened. I've never opened a new test store that was tracking to do $25 million in its first year. By the way, the customer doesn't know that much about modern, this is just our initial assortment.

This is just our first book that we ran. We are going to learn so much here. The assortments are going to get so much better. The investments will make here, and the knowledge we will have here, to think that we're doing $25 million in our first free standing standalone store in Los Angeles.

And by the way, the store that's three blocks away that we thought we'd have some cannibalization in, is up more than double digits. To me, it's phenomenal and when you look at the numbers inside of the stores, where we've got a floor modern, and it's adding at a minimum incrementally in the new galleries, 40 points or more.

It really, really terrific.

So, but early, I mean, we're not in stock, the an initial assortment, vendors are ramping up, there's so much to learn here, so early, but really great news, right? And then we have four new distinctively different new stores that are intended to be test and provide data to enable us to assess future opportunities, and sharpen our strategic decisions.

And so far, every one of them is performing beyond our expectations, and gives us great, great confidence about the long-term strategy of this company.

Which if you just take the two big pieces I talked about in the video, the expansion of the brand, which is tied to modern and teen, and multiple other new things that we have in the works and in the pipeline for this year, for next year that we haven't announced yet in the following years, we are, as I'd say from a long-term point of view, on track plus, right? And you look now at the three new next-generation design galleries, all slightly different, all intended to teach us something unique and different, whether it's how we form as an anchor tenant a tenant in a major regional shopping center, how we could perform as a freestanding store, how we perform in the secondary market with slightly lower model and lower investment piece, how we - what happens when we have hospitality to one of these big environments.

On and on and on, so many new tests. First times we've integrated baby and child and teen into the stores, first time we've integrated modern into the stores, yet to put modern and teen into Atlanta, but now we feel really we already are outperforming in Atlanta, and putting modern and teen Atlanta, the numbers look different.

You look at what's happening with Chicago, and step back and say, what's different about Chicago? It's our best-performing gallery. I would tell you highly debated, highly debated real estate deal.

Probably the most debated real estate deal in the history of our Company and the history of our Board of Directors, right? Because people thought, look you're going into a residential neighborhood, there's not a retail store for five blocks, are you guys crazy? And we thought, look, there's an opportunity there was a good economic deal, we could test to see if we could be a freestanding location, and if we could, we be more desirable.

We'd have more optionality to places we could go. We would also be more desirable and more valuable to developers. But I think you have to ask yourself, what's different about Chicago, right? Like why is it the best-performing gallery? Well there's two things.

One, the gallery is located in a residential neighborhood, not in a retail district or center. I don't think that's why it's the best-performing gallery.

But the second thing that's really different, the gallery has our first foray into hospitality with our 3 Arts Cafe, right? Which happens to be just on its own a highly successful F&B operation, with an annual volume - everybody says don't tell anybody this, but it's tracking, I'll tell you, with an annual volume tracking to do $5 million per year.

There's not a name on the outside of the building. We didn't advertise the restaurant, the restaurant closes at 7:00 to 7:30 at night because we have a curfew agreement with the neighborhood, we don't - everybody said, you can never be successful, you don't really serve dinner. We are not serving hard alcohol, that was a big debate.

Everybody says you can't have a restaurant without hard alcohol, it's a third of the business. Yet you saw the picture of the line-ups outside every weekend. And just as a standalone, we have a $5 million restaurant.

I think the questions to ask are these - is the restaurant successful because it's in an inspiring store, or is the store successful because it has in an inspiring restaurant, that is driving more traffic? Or is it both, and we have created a unique and highly accretive experience where each amplifies the other, and you've got a whole new layer to this strategic view of what design gallery performance can look like, long-term.

So there's, from my point of view, there's so many things that we're learning, we've got so many new tests. But in all from a strategic view, it couldn't look any better today. From a tactical short-term view, right, is every fourth quarter a war? Absolutely.

You have, in this business, can you not pay attention to all those little things, and you have got to be ready to fight the fights, and you have to be into the details, and if you want to win in Q4, you have got to be highly engaged, and you've got to be willing to improvise and to adapt. And so that's the whole thing in a nutshell.

I'd say we won in Q3, landscaped a little differently, earnings were a little better, top lines a little softer, I think you've got a flavor that the top line was softer, and what we're doing about it in Q4.

So in Q4, top line might be a little higher, right? Flow-through might be a little different, but the thing I'd focus on is 2016, right? Because I sit here and I look at the team and I say, guys, we launched teen, we are really happy, we have launched modern, I've never seen anything like it, okay? I've never seen anything come out of the gates like this ever, okay? Ever.

Never opened a $25 million store in first year in trend.

And then I look at the performance of these new galleries, in the dynamic of hospitality, the dynamic of having modern in these stores, baby, child, teen, and think like, do we add hospitality to other galleries? Is there another lift? I think strategically in 2016, you think about the 50 to 60 months against 20 months, you think about what we've got in the pipeline and other things we haven't announced yet.

I think we strategically, today are the best positioned we've ever been at any point in time in our history..

Your next question comes from Daniel Hofkin with William Blair & Company..

Good afternoon. Thanks for all the color so far.

As it relates to the 3Q upside on earnings, despite the revenues and then fourth-quarter different flow-through, is merchandise margin a key swing factor there, because of what you're seeing in promotion, or is there something else in terms of other expenses that are maybe the timing is shifting a little bit? That's my first question.

Yes, so in Q3 on gross margin, this is Karen. Hi, Dan..

Hi..

Growth margin was right about where we would thought it be, and overall on operating margins, we're really happy with the expansion. A lot of that was coming from the advertising levers that Gary talked about. On the gross margin, there's a couple different moving pieces.

We did talk about that we had these non-comp warehouse sales that are mixing in a little bit lower, but our - the improvement in our core margins was quite low, so we're happy that our core business is performing like we wanted to.

We did have higher shipping cost and deleverage in the new DC, but we continued to see levers in the rest of our supply chain network and retail occupancy. And when we head into Q4, as Gary mentioned, we are going to be playing the game a little bit differently.

We do expect to have some pressure on product margins with the promotional activity, but we still expect to see good leverage and retail occupancy in those things. We'll have higher shipping costs. But overall, we think that negative gross margin of 50 basis points is going to accelerate, and have further deterioration in Q4.

But overall, still expect, obviously, you can see in our guidance, really good operating leverage, and fourth quarter and then to round out the year..

Can you quantify what you're thinking about in terms of the gross margins for the fourth quarter.

Yes, we think it will be about a 100 basis points..

Okay..

In total for all those factors. The two biggest being a little bit increased promotional activity and higher shipping cost..

Okay.

And then, as it relates to, were there any executional, aside from - clearly the bigger book and everything, but was there anything that you felt like, it sounded like maybe you felt like in hindsight, you cut back too much on circulation? But anything else that, looking back, obvious things that you would have wanted to do differently?.

I'd say we probably were too aggressive with circulated pages, in reducing pages circulated in certain categories, and certain areas, certain products. And the good thing about that, we can increase pages circulated really easy, right? So I would expect us to - you see a reverse of the trend of that next year.

And we have got good data to tell us what to focus our efforts, and how to think about circulated pages and circulation growth.

But we thought this year was a year where we had enough data to say, let's try to optimize this model a bit, let's find out what's the operating margin look like? Because we have been evolving here, we went from mailing 10 books a year to 2 books a year, 2 books to 1 book. Books that were 200 pages to books that were 3,300 pages.

We've been innovating at such a pace that the ability to continue to take the data and continue to learn, and continue to optimize, it's just in our nature. So you'll see us continue to evolve and learn.

And I don't think you ever get it 100% right, by the way, but is this directionally right, are we a Company that's going to perform significantly better than anybody else in the industry this year, year-over-year? We have the highest earnings growth any of our peers? We do.

So when we look at the top line, the bottom line, the operating margins, how we're going to perform this year, we feel very, very good about it. I think from quarter to quarter, because we have so many tests, so many things that we're doing. Yet we're very scientific by the way. None of it is back of the envelope.

We're in here debating and reviewing these things, and we have a lot of data that we're looking at. But you're never going to be 100% right on any of these.

The key is, are you strategically right on most of them or all of them? And I'd say strategically right now, we are right on almost all of them, and that's why I feel more confident than ever before..

Okay. Thank you. Best of luck..

Thank you..

Your next question comes from Budd Bugatch with Raymond James..

Good afternoon, Kary, Cammeron and Gary. Thank you for taking my questions. This is Bobby filling in for Budd. Two quick questions from me. Karen, I was hoping for little bit more color on the gross margin buckets for Q3.

Can you help us parse out a little bit, how much was shipping, how much was from the DC, and maybe a little color on how much was from the outlet sales?.

Yes, I will just go order of magnitude. The non-comp warehouse sales was the biggest drag. Then higher shipping costs, and then the deleverage from the new DC. I'll give you order of magnitude.

Then, on the flip side, the improvement in the core products margins, excluding those outlet warehouse sales was the bigger thing than even some of the leverage in the supply chain network for the existing DCs and in our retail occupancy. Part of that just being it's a lower quarter..

Okay, appreciate it. That's helpful. You talked about at the analyst day, starting to flex your shipping payment. You mentioned there was some room in there to help offset some of the shipping headwinds.

Have you started to look at that, or started to flex the costs yet?.

We haven't done anything in a meaningful way. We do think there's a lot of, if you look at us competitively versus our peers, we are extremely competitive with the shipping we offer, we don't have a lot of surcharges, or really many surcharges at all, and our shipping program is highly competitive. Over time, there's ways to optimize that.

We don't have restocking fees that our peers do. I think we're the leader in that space as far as the bargains and the customers, but is there a way to [indiscernible] that, sure. And with UPS, I think they - it's been widely known that they were increasing their parcel rate.

We were able to negotiate some great benefit in how that was going to impact us and delay some of the impact of that, and it's taken up our UPS rate table slightly on a couple of the bands..

Okay, thank you.

and lastly for me, when you look at the fourth quarter, it's great to hear that it's ahead of plans today, but when we think about the markets that you talked about, the Miami, the Houston markets that are facing the drag, what does your guidance apply imply for that drag in the fourth quarter? Is it staying the same as the third quarter at 4 percentage points, or do you expect it to deteriorate a little bit more?.

It's about basically the same as it dragged in the third quarter..

And we have a good read so far kind of how we are trending versus the third quarter, so far four or five weeks in..

Perfect. Thank you. That's very helpful and best of luck.

Thanks, Bobby..

Your next question comes from Brad Thomas with KeyBanc Capital Markets..

Yes. Hi, good afternoon. And thanks for all the color already. My question was going to be around modern, and I was hoping you could give us an update on how, maybe from a tactical standpoint will start to get the product in more stores, given how favorable the initial response is.

And perhaps as we think out to 2016, maybe you give us a little more color on what a lift it might be able to provide to the business?.

Yes, the first obvious one that Gary talked about on the video was that we do, or I can't remember when we talked about this, but we do absolutely plan to get it into Atlanta. So that store is doing quite well, and it doesn't have yet have modern and teen.

And then there's a handful of additional legacy stores, where we think there could be a vignette and some space in those. But the bigger thing is the space that will be allocated in the new full-line design galleries as we roll those out in each and every market.

There's space, as we've long said, those galleries were being designed for what's on the come, not just the existing product offer. So modern has been part of that playbook, and it has a nice home in the design of all those future galleries.

We're not going to necessarily quantify the exact lift for 2016 just yet, but we do feel really good about, based on the early reads, both in the markets where we have a real estate presence and the direct response that we're seeing.

We think that's going to be even more meaningful as we get better in stock in Q4 and into 2016, where we think that's going to be a really nice driver for growth in the years to come..

That's great, thanks Karen. And with respect to the galleries, it's really a diverse and different type of store you're opening, in many of the cases here.

I was wondering how much you are able to apply the learnings from 2015 here to something as soon as 2016, and with all this that you're learning, how this makes you think about maybe the pace that the company grows at?.

Yes, I think that's something that we learned, I don't know, I would say, two or three years ago, when we thought we were going to be opening 10 to 15.

At one point we were out there, saying we were going to open double digit number of galleries each year, and we quickly learned that there's so much to learn as we test different pieces, everything from how to structure the deals with percentage rent break points, to just other different factors within those deals on the lease side.

But then the execution, we have just gotten better and better on how we merchandise the stores, and how to plan going ahead, and then the product offering, the space allocations. And even with this latest crop, as Gary mentioned, we have a smaller mid-tier market. We have a non- traditional retail mall location, and then were anchoring a mall.

So I think every single time we do it, we're testing and then some things like the F&B experience, those things we can apply pretty quickly, but that's sort of why we have backed off from the 10 to 15 and started going at a more measured pace, so that we can incorporate all those learnings.

And thus far, there's even certain things we learned in Atlanta that could already be incorporated. There's things that we learned from Chicago that went into Tampa, just as we learned, we immediately applied..

Great. Thank you very much.

Your next question comes from Oliver Chen with Cowen and Company..

Hi, thank you. Karen, we have a question on revenue growth and the comp versus total revenue spread.

So for fourth quarter, will it trend in terms of the low single-digit spread? And then as we think about the dimensions of that comp, is it going to be mostly conversion and traffic-led in terms of the comp on traffic versus ticket?.

So we don't guide comp, nor do we really disclose traffic and ticket. We always say that so far every single quarter that I've been here for the last 3.5 years, we always generally see growth in traffic and ticket, which for us is average order value and number of orders. So I will say those trends are positive. We expected them to continue to be so.

On the comp versus non-comp or total revenue growth, I should say, versus comp, that 3 point spread that we saw in Q3 was a little bit higher, because we had the warehouse sales that I mentioned, that we moved from Q4 to Q3.

So that dynamic both had an impact on our margins, but it also made at least, about a point of that growth was probably attributed to that, and we won't have that recur in Q4. That said, the performance of the new galleries continues to just be quite strong, and we're very happy with that.

And as more of the volume in those new stores shift in Q4 we expect what had been a really small delta between - it will stay in the 2 to 3 point range.

The thing I want to make sure continues to be clear is that just when some of those new stores start to have the great performance in the non-comp bucket, things like Melrose getting into the comp bucket, Atlanta getting into the comp bucket, you're never going to have that many stores in the non-comp bucket at any given year and any given quarter..

Okay, thanks that's really helpful. And then when we do monitor and we do think about how you're strategically executing on promotions.

What's the best way to do this in a brand appropriate manner? Is it within certain categories, or is it going to tend to be whole store, in terms of how you would like that to evolve over time? And Gary, in the video, you mentioned home and hospitality, as the brand continues to evolve in terms of lifestyle, how does hospitality fit into the bigger picture, and what you think about art and hotels and clothing, in terms of how you're thinking about what RH means?.

I think that, take the hospitality part, a little bit to the other question, but when you think about building stores that are in the 50,000 to 60,000 square foot range, and creating a destination, creating a sense of hospitality, it's no different than bringing somebody into your home.

If somebody's going to visit your home, we've said that we want to blur the lines between residential and retail, and create spaces that are more home than store, if you will. If you're going to have somebody into your home, of course you going to offer them something to drink, possibly something to eat, and create a more engaging experience.

And to us, it's about how do you create destinations that people can be immersed in the lifestyle, can experience it, that want to sit with it longer, that maybe will discover ideas or products. And I think that's what we're seeing today in Chicago. So as I think about other things, the things that complement that, I think, are pretty intuitive.

We've integrated contemporary art into our modern stores. If you think about things that people may be responding to the fact that WWD ran an article on, and focused on apparel.

That was, by the way, an interview we did in our modern gallery when we opened, and it was supposed to be about RH modern, and somehow the writer decided to make it about apparel when she told us, it wasn't going to be about that.

I think everybody knows that we have a view that maybe long-term there could be an opportunity in that side of the business. It's nothing that's on the front burner, it's nothing that we're even remotely working on with any effort right now. So I wouldn't think about that.

I think about how you think about hospitality, where when all of a sudden, you take a store like Chicago, and it's the least traffic store and all of a sudden it's the best-performing store, I think there's something to learn there about hospitality inside a retail store, and how it can be integrated, and how we can drive traffic.

At the trends we're on today, which is trending to about $5 million a year in the hospitality side in Chicago, we're feeding about 450 to 1,200 people a day. Much of that traffic is incremental.

And we think that is providing a real synergy to the experience in Chicago, and there's really something to learn there, that we think is - which we think is possibly a big opportunity, when we look at it..

Okay.

And on the promotion spend?.

I'll refer to promotions and doing it in a brand appropriate way, I think we try to always do it in a brand appropriate way, whether it's our emails or our in-store marketing.

You don't see a lot of things on the street, you don't see - we try and keep the messaging clear, but for us, we're very consistent with our promotional events that we run, and we don't often deviate from those. When we do, and even going little bit deeper than we do, we see a great response.

So we have a lot of high-quality interior designers who work on projects for folks who have deep relationships with their customers and clientele, so I do think we have a way to execute and a way that is brand appropriate..

And I think you have to ask yourself what's appropriate in the world of promotions, right? We are in a promotional environment in the world. I think it's a permanent state of being, and I think it doesn't matter where you are in the economic chain, people want value, and especially when you're buying high-ticket. So I think it's here to stay.

I think everything that we do is brand appropriate. You don't walk by our stores and see big sale posters in the windows. You don't see big sales signs anywhere. You don't see a source book that's focused on price. You don't see ads that are focused on price.

It's really focused on design, and we think about our business from a design, quality, and value point of view. But you have to win on value. Make a mistake. So you have to first win on design, and you have to win on quality, and you have to win on value in that order, and you have to win on all three, if you want to have a customer.

So there's constantly different perceptions of what that value equation is, and we are going to always be evolving and always again playing to win. But I wouldn't let one incremental promotion in the fourth quarter change the way people are going to feel about RH.

I think about it more, is RH's numbers at the end of the day better than the competition? Are they taking share, and are they growing earnings faster? And is this going to be a more valuable Company? That's what I'd be focused on. We just beat our Q3 numbers that were on the Street. We just guided up in Q4.

We just told you we have exciting new businesses that we launched that are performing ahead of our expectations, and the new galleries, which by the way, many people couldn't wrap their head around the new galleries we were going to open a year ago, are the most exciting things in retail today, I believe.

And they're all performing over our expectations. Those are the headlines..

Thank you, really, really helpful. Happy holidays. Best regards..

Thank you..

And your next question comes from Lorraine Hutchinson from Bank of America Merrill Lynch..

Thanks. Good afternoon.

I just wanted to follow-up on the out of stocks in modern, and ask when you thought you'd be back in stock, and if you think this will be a gating factor to the early success of modern in the first half?.

Yes. It's going to build as we go. We've got a lot of new product, some existing vendors, some new vendors. With anything new there's going to be a ramp up period. There's some things that are going to go right, some things that are going to go wrong.

So we think in stocks are going to improve every week, and we'll continue to ramp and continue to be in better and better stock. I'd say, despite the fact that the in stock position is not great today, the demand is outstanding.

And you can only anticipate it's going to get better as our vendors ramp, and everybody starts to get some time under their belts here with this new business, and we continue to execute better. So any new business of this size and scope, you're going to have a ramp up period. We’re not making apparel, here this is much more complicated.

We're making furniture..

Let me just clarify, it's not that we were in and then we were out, it's really just a build of getting some of those most initial products. It's every week we get more of the initial runs of things, and a certain - we certainly want to be conservative with how we buy the inventory.

So some of it we started off with low buys, or a lot of it we started off special order, so we could read and decide what to stock. So that percentage of in stocks will continue to improve gradually, both through Q4 and into 2016..

Yes. And then look the best sellers in a new business are always going to sell out, and you're going to always have to respond and catch up with those. We've got our share. But I'd say it's nothing that we don't have experience with, right? We've grown this business through the expansion of our brand. I think we've proven that we know how to do this.

We know, the good news is supply chases demand. The most important thing in our industry is can you create demand? If you can create demand, you can get supply. The bigger issue is when you can't create demand..

Thank you..

Thanks, Lorraine..

And your next question is from Michael Lasser with UBS..

Hello. Good evening, and thanks for taking my question.

Gary, longer-term, what gives you confidence that some of the exogenous factors that impacted the business in the third quarter and into the fourth quarter are not more longer-lasting, and not more just unique to this period? Does it put the longer-term margin outlook at risk if the company has to be more responsive to the promotional environment and some macro factors, even as it's launching a lot of new products?.

You know, I think that we've proven that we can navigate through those changing factors. I tried to put the factors into perspective with how we're playing the game, and how the factors - a lot of these factors have been there. Some look like they've gotten worse, but generally I'd say, you have to look at it both ways.

We're being affected by certain things now. Oil's at the lowest price in I can't remember when oil was at these prices, that's there.

At some point you anniversary these things, right? So there's always pluses and minuses that you're navigating through in your business here, and there's always certain markets that are going to over perform, under perform. But there's certain things that are happening today that I think everybody's got to deal with.

And I think, again, whether it's how were dealing with it, how our competitors are dealing with these different factors.

I think the key is, can you be honest, do you see them, are you creative enough, and can you think about how to navigate through whatever economic landscape, in a way that you're going to take share and that you're going to win? And I think if you go all the way back to 2008 when the economy blew up, and if you think about where we were then and where we are now, and how we performed in the worst economic downturn in history, I don't think we're facing anything like that.

But we outperformed everybody by a long shot.

I think the key is like, is this Company positioned strategically to win, do we know how to win in the short-term tactical moves that you have to make, and do we have a strategic framework here, that is going to continue to build distance between us and other people, that's going to continue to disrupt markets, and take share.

I don't mean to make anybody too worried about this stuff, right? But sometimes maybe I tend to be overly transparent, because look, we've got shareholders and supporters on the phone, and I think it's important to know how we're playing the game. We can speak less about stuff and pretend like everything's just always great.

I don't think - I don't think that's the right way to build partnerships. I think, we tell you when things are working, we tell you when things are not working, we tell you when we make changes, we tell you when the changes are working, we tell you when the changes are not working.

And in aggregate, I'd stay focused on what is our performance and what is the outcome, and then what does the strategic framework of this business look like? And I'll tell you what I said before. I've never felt more confident about where this country's positioned and what our outlook looks like than I am today..

And then my quick follow-up is, as you raise the guidance for the fourth quarter, was all in response to what you saw from the promotions, from the increased promotions, or was it based on the performance of the new design galleries and the launch of modern?.

It's a combination of everything, right? You've got brand-new business, modern books got in, the majority of the modern books got in, in mid-November, right? So you've got that business ramping. You've got in stocks coming in, you've got stores that just have modern. You've got that Boulevard.

These stores just got modern, and you have got that business ramping. You've got teen ramping, you've got new galleries opening.

Every week or two we are opening some of these new stores, and so, it's a combination of all those factors and all those trends, and where we are quarter to date, that gave us the data to say how do we see the quarter, based on how were going to play the quarter..

Understood have a good holiday.

Okay. Have a great holiday. Thank you..

And your next question comes from Matthew Fassler with Goldman Sachs..

Thanks a lot. Good evening and congratulations on getting out on what I know was a very busy quarter for you. By first question, both my questions actually, relate to modern.

Can you talk about the modern customer? The customers actually buying and engaged in that brand, and what the overlap looks like between your legacy Restoration Hardware customers.

Do you feel like you're engaging a new cohort here? Is this a loyal customer from the past who's going back and shopping modern? Anything you're learning about how this might be extending the customer base? I know it's early days, but you presumably have some data..

The early data would tell us that it's opening up an entirely new market, it's bringing in new customers, and it's accretive to our current core customers. Meaning that they're finding things in the assortment that they like that they can integrate into our current assortment.

And so, I think we're seeing a hit on multiple levels, and that's why we're seeing the early response that we're seeing today..

That's great, and if I could follow up, you gave some numbers, I believe, in the video, about the lift that you're seeing in stores that are getting modern. If you could talk about just what that cohort is right now, and essentially what the modern presence at retail looks like today? Obviously you have Beverly Boulevard, you have the new galleries.

Where else have you brought it in, and when you put some of those numbers up there, what store base did that refer to?.

Yes Matt.

The way to think about it is where we've opened new galleries, in Chicago, Denver, and Tampa, if you take those three, where - and the way we think about the business, right, we start in each of those markets, we have the legacy store that was doing trailing 12-month volume of X, and then we've got an internal model that says, look, the core business based on showing more of the core business, based on showing the categories, like showing the outdoor business on the roof, so on and so forth, we have math that says that the number ought to go from X to Y.

And whether it's baby, child, teen, so on and so forth.

When you look at modern, right? And you try to isolate the core business and where the core business should be performing, to how our data has told us it will, and then you look at modern and how incremental it is off that base legacy store, so if you took the base legacy store in Tampa, Chicago, or Denver, modern is adding 40 points or more of incremental volume on top of the base legacy store.

And that's incremental to the lifts we would've expected in all the other business and categories, whether it's expansion of core, outdoor, baby, child, teen, et cetera, et cetera..

Great. I appreciate the color. Thank you very much.

And your next question is from Oliver Wintermantel with Evercore ISI..

I just had a question, excuse me, on inventories.

I know it's up because of all the newness, but from a working capital perspective, where do you think we will see some relief on the inventory growth?.

Yes, so we have been talking about the cadence of inventory for the year, and really, nothing's changed. We continue to expect to have year-over-year inventory growth ahead of sales growth in Q4, mostly because of the cadence of newness.

Last year, with all the newness coming in the spring, receiving it, selling through it, and then a lot of our chunk of newness coming in the fall, and just not really a good compare year-over-year, we do expect to have higher inventory growth and sales growth.

But that delta right now that we have, 10 to 25, that 15 point delta will certainly narrow by the time we get to the end of the year..

Got it, thank you. I just want to go back quickly on the gross margin side. I think on the second quarter call, you said that the gross margin, the duration would be higher in the third quarter than the fourth quarter. But today, you said that it's a little bit higher in the fourth quarter.

And just want to - is just promotional the big difference there, or what is driving the difference?.

Yes, that is the biggest difference..

Got it. Thank you very much..

Thanks..

And we do have time for one final question. And our final question for today comes from Matt Nemer with Wells Fargo Securities..

Afternoon, everyone. I've got two.

The first is, given the success of food and beverage in Chicago, do you have time to integrate hospitality into the 2016 vintage of stores, and would you potentially retrofit stores like Atlanta? And then secondly, Karen how does the Austin store opening a little later than expected impact the fourth-quarter guidance? Thanks..

Yes, as it relates to hospitality, we do, Matt. We're reviewing plans and opportunities right now, and we also have opportunity to add hospitality to the existing galleries that we have already open..

And with respect to Austin, very similar to Atlanta last year, although it was - Austin was scheduled to open in Q4, just like Atlanta last year. You see more impact demand more than all packs shipped, because we would have had some volume in there, but it's not hugely significant.

There's something there, but I think everything we see with the modern ramp and the new stores, and early reads in the quarter to date, we feel good about the guidance, even with Atlanta pushing to 2016..

Great. Thanks so much..

Okay. Well, that’s it. Thank you, everyone for your interest and we look forward to talking to you in the New Year and happy holidays to all..

Thank you..

Thank you for your participation. This does conclude today's conference call and you may now disconnect..