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

Peter Benedict - Robert W. Baird Adrienne Yih - Wolfe Research Brad Thomas - KeyBanc Capital Markets Inc. Adam Sindler - Deutsche Bank Brian Nagel - Oppenheimer Matt Fassler - Goldman Sachs & Co.

Jessica Schoen Mace - Nomura Securities Budd Bugatch - Raymond James Oliver Chen - Cowen and Company Steven Forbes - Guggenheim Securities [No formal presentation for this event].

Good afternoon. My name is Kyle, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the RH First Quarter Fiscal 2016 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] Thank you.

I’d now like to turn the call over to Ms. Cammeron McLaughlin, RH Investor Relations..

Thank you. Good afternoon everyone. Thank you for joining us for RH's first quarter fiscal 2016 Q&A conference call. Joining me today are Gary Friedman, Chairman and Chief Executive Officer; and Karen Boone Co-President, Chief Financial and Administrative Officer.

Prior to this call, we posted a video presentation to our Investor Relations Web site IR.restorationhardware.com, highlighting the Company's continued evolution and recent performance.

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

These forward-looking statements involve a number of risks and uncertainties that could cause actual 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 opinions 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'll 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 Web site at ir.restorationhardware.com. With that, I will turn it over to the operator to take our first question..

[Operator Instructions] Your first question comes from the line of Peter Benedict from Robert Baird. Your line is open..

[Indiscernible] relocating much of that to other different floor or are those items -- a lot of those items part of the SKU rationalization?.

Hey, Peter, we missed the first part of that question.

Can you repeat that?.

Yes, sorry.

It's around the first floor product that’s getting replaced by the Modern in the fall, where is that product going? Is it going to a different four, or is that part of the SKU rationalization?.

Yes, that will -- those products will be marked down and just in a floor model sell off activity. So they’re still very productive SKUs that are in our stores. Our stores generally reflect our most productive assortment..

And just to clarify the remodel and refresh of the floor set is we’re talking about the legacy gallery, so they really do only have one floor, so it's really just taking certain products off and replacing it with other products. It's not necessarily that it can go to a different floor..

Yes, the front third of the stores will become RH Modern, and part of the middle of the floor will be some of our new interiors collection..

Okay, good. That’s helpful. And just the one -- the other follow-up would be you mentioned simplifying the supply chain. I was just wondering if you could give some more color around that. You mentioned it in the video, but any more color on how you’re doing -- what you’re doing and the timing of that would be helpful. Thank you..

Sure. I think our bias today after a pretty fulsome review is to really simplify our distribution points and hold inventory in fewer distribution centers as opposed to spreading it out across multiple distribution centers. Our previous plans were to continue to open more distribution centers.

Our analysis says that the inefficiencies and extra inventory you had to buy-and-hold to be in-stock across multiple DCs was causing us inventory deleverage and bloating our balance sheet and also making it difficult to be in stock in the right DC, driving DC to DC transfers up, transportation costs up, etcetera, etcetera.

So, our view is to hold inventory in fewer locations, in fewer DCs, and that will improve our in stocks, reduce our working capital needs and inventory, improve our return on invested inventory, and simplify things for both our internal teams who are leading and managing inventory and our vendors..

Okay, great. Thanks for that Gary..

The next question comes from the line of Adrienne Yih from Wolfe Research. Your line is open..

Thank you very much. Good afternoon. Two quick questions. The first one is inventory, obviously, growing faster than sales. Can you give us some color qualification on what is the content and composition of that inventory, because there is still delay elsewhere, and then my second is a follow-on to that.

What percentage of current orders are being fulfilled within an acceptable delivery window and do you feel like the worst of kind of a delayed inventory is now behind you? Thank you very much..

Sure. Let me take a couple of those points and I will let Karen also address it. But as Karen’s addressed earlier, we expect inventories to significantly come down in the back half of the year. Some of that will be from the actions we’ve just articulated and that we’re taking.

We are -- I think way past the worst of the issues with RH Modern in the launch. The in-stocks today at RH Modern are sitting at slightly above 80%, and we expect those in stocks to reach 88% by the end of August and 91% in September, and 95% in October.

Our current total company backorders are running at some of the lowest levels that we've experienced in the last couple of years. Some of that is due to the fact that we have some of the highest inventory levels compared to our sales growth, so that is one of the outcomes. But overall, I'd say, our execution is significantly better today.

That's why you see the difference that Karen articulated as far as the cost as it related to the RH Modern issues and some of the customer experience issues we were dealing with, mostly related to Q1 and lower in Q2..

And then with respect to the composition of the inventory, it is the overstock, if you will, the 27% that we were up. We had as kind of said, we were 30% at the end of Q4, we were going to stay at about 30%, so we’re a little bit under, but that is all core and interiors and outdoor and overstock product.

Some of it, I’d say the composition of it is very healthy goods, we don't have to mark it down very low to move it. But we are getting more aggressive and that’s what we were talking about accelerating some of the SKU rationalization efforts.

So the SKU rationalization is getting rid of SKUs that we don't think we need any longer in the assortment, so there is certainly some of that. The other stuff we work through by the end of the year just by lower receipts on some of our continuing product..

Okay, perfect. Great. Thank you very much and best of luck..

Thanks..

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

Yes. Thank you for taking my question. Question about the outlook for sales and what has changed the most in terms of how you're looking forward to sales for the balance of the year, as we think about the difference between the new 1% to 3% guidance in the prior low-to-mid single-digit guidance? Thank you..

Yes. Well, I think we articulated that as one really being the macro factors that are affecting the luxury market that we believe is an accelerating headwind. And I think that's seen pretty clearly across our industry and anybody who's serving that luxury market today.

The other issue that I think it relates to is, as we pushed out the fall books and as we -- the spring books to fall, as we're looking at the early trends there, we believe we probably are -- take a bigger hit in the short-term than we had anticipated. And so I would expect that to affect us in Q2 and Q3.

So we’ve taken sales down further, because of the shift out of the book. And third, the other -- one of the other key issue here is the longer selling cycle that we’re seeing with RH Modern while we're very happy with the adoption rate, we're very happy with the average order size.

One of the learning here in a very early first several weeks of the program is that the urgency to close the sale, that has been kind of artificially imposed with end of sale events is now not there, right. So you've got projects are getting bigger, but they are now transacting over a longer period.

So what we've done is we've -- as we reforecasted the business, we've got an effect where you're pushing sales in each quarter forward and that includes pushing sales from Q4 into next year, and so that has an effect on us taking down revenues for the year, especially when you compare it to last year's Q4 where we were highly promotional..

Got you..

Just specifically that reference, the Grey Card, I know Gary mentioned RH Modern at the beginning, so I just want to make sure that description was regarding Grey Card..

Got you. Thank you very much..

Your next question comes from the line of Adam Sindler from Deutsche Bank. Your line is open..

Yes. Good evening everyone. I guess, first, on the SKU rationalization. I know when you sort of launched Modern initially, you talked about going light on total product that you’re going to sell, because you only need to see how sales trends develop and that's why you’re light on inventory and chase the sales.

Is the inventory rationalization in Modern or is it across the board was my first question?.

Really across the board. It's not really that the SKU rationalization is -- it is not really focused on Modern. Just a few things obviously in Modern, we missed on and we might be disappointed, so you’ve got really small issues there. It's really across the broader business, and how to optimize inventory across our broader offering in RH interiors..

Okay. The follow-up to that is I know everyone does a lot of work around their own sort of in-stock checks. As you talk about in stock at close to 80% today or above, we did our own work last week, and over 760 SKUs came with an in stock of 60%. Several categories were in the 40 range.

So, what are we missing there? And are you -- close to a 100% in stock in other categories or sort of as we think about in stock as you discuss it, how do you define that?.

Well, in-stock and the products where it says be in-stock and when I -- I don't know how you’re characterizing special orders, which is a big component of the upholstery business..

This is excluding special orders?.

Excluding special orders. Then I’d tell you maybe go through and count all the SKUs as maybe take a portion of the SKUs and you’re in some categories were better than other categories. But we look at this every day..

Of course, so that means -- but that’s the question, right? And so I guess, even the last follow-up to that is, is that as you look at this, there was pretty significant variation between some of the categories, is it limited to certain vendors? What categories are very good and which categories are weak?.

It is more related to collection within the categories. So, we’ve several collections that have significantly longer lead times as either there is production issues with those or we may have under bought those and they’ve performed higher than our expectations. So, there's obviously quite a few SKUs, so 700 SKUs is in anywhere near the offering.

So maybe your sample is little SKU, just by which categories or how you counted it, but 80% -- slightly better than 80% is the current number..

Okay. Very good. Thank you. I appreciate it..

Yes, across all the SKUs, yes..

Okay..

Your next question comes from the line of Brian Nagel from Oppenheimer. Your line is open..

Hi, good afternoon. My question, may be two parts, but with what’s all what’s going on and the steps you’re taking to strengthen the business now, is there any thought given to potentially slowing down? Recognizing you’re still early in the rollout of large [indiscernible].

But has there been any thoughts to intentionally slowing that down further? And then, related to that with the changes to the outlook today any -- how should we be thinking about the capital generation and funding the growth over the next few years? Thanks..

I’m not sure we heard the word after you said slowing down.

What we -- slowing down what …?.

Well, the question I’m asking is, I don’t know what you heard, so I will ask again is that with all that’s going on now and the retrenchment steps you’re taking, is there any thoughts of slowing down the rollout of the large format stores?.

I think we mentioned that we were going to be in the last call or two, we were being more selective in real estate and only doing very favorable deals right now and that's why we took the growth numbers down in real estate, but based on what we've communicated most recently that's where we are not taking down any further than where we are today..

Yes, we’ve four this year, two were in Q3, two were in Q4, and then we have 5 to 6 that we're looking at for next year depending on where some of the latter ones in Q4 fall. So it's really not big.

We’ve a couple of other ones that are signed that we will probably push to 18, but to us that feels like a much more measured pace than what we were looking at even 18 months ago, two years ago..

If you step back here, we ,look look about retrenching or if you think about the action for taking, this is not a Company that all of a sudden its running negative 10 or 15 comp. We are still performing in the positive sales growth versus very aggressive numbers over the last several years. So we see these moves as short-term in nature.

We believe moving the book out is going to have a pretty significant drag on Q2 and Q3.

The book begins to get in-home in the middle of Q3 will be all in-home by the beginning of Q4 and we expect the business to begin to accelerate in Q4 and are very optimistic about the content in the goods, and we’re going to have the most significant refresh of new product at retail in the history of our Company and we’re going to remodel the stores and install design ateliers, expand our design services.

So I wouldn’t think about that the fact we got a broken top line model. We've have some difficulties in the short-term. We're taking some actions to fix those. We're making long-term investments that we think are right for the business and the brand long-term.

So, we feel very good about the long-term strategy, very good about the real estate strategy and the product expansion strategy..

And then with respect to the capital generation, we feel pretty -- we feel like we’re in a really good shape as far as where the balance sheet is right now even after the acquisition of Waterworks our cash on hand we funded that from existing cash balances and we're projecting to end the year with significant cash available and plenty of room on both our back to back line and a lot of time left on our to convert.

In addition to that, we feel really good about our cash generation just internally in our free cash flow. We think that this year just given some of the short-term factors we’re experiencing were kind of tapering off and as far where we will be really positive free cash flow or slightly negative or about breakeven.

So that’s still something that we're chasing and we’re very committed to, but we don't have any concerns about the long-term capital generation of the Company..

Yes and I think I’d say, because it's come up quite a bit. A lot of people are trying to point to another company that try to get off promotions and change their strategy and have similar worries about our move to a membership program and to the Grey Card. This doesn't resemble that other company, right.

That of the company lost a third of their revenues and it's not happening here. That’s not even though we've taken revenue guidance down, you’re going to see this company -- there's multiple reasons here for the revenue guide down. We're not happy about it, but it's not a broken model.

This is going to be a business that reaccelerates as we get into Q4. Some of that reacceleration will be masked, because of longer selling cycle and we’re up against the most promotional Q4 in our history.

But we will come up against the kind of missteps that we had with Modern in Q1 and into Q2 and I think I’m as bullish as I ever been when I think about this Company cycling into '17..

I appreciate all the color. Thank you..

Yes..

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

Thanks so much and good afternoon. I want to focus a bit on Grey Card and the selling cycle and what you think it's done to a -- you talked about the change in urgency given that you don't have the artificial deadlines associated with the sales.

How prolonged of the selling cycle essentially become and related to that I’m wondering if the insight on the deferral of the fee is what seems like it probably would've been embedded in your numbers and I know there is a significant drag on the P&L this year was originally contemplated in your guidance? Thanks so much..

One, it's very early and these are in our press release and video. We are pleased with the adoption rates and higher average orders Matt, but we believe that the current selling cycle is longer with data that kind of says that it is.

And as these transactions are not closed with the same urgency as artificially imposed promotional deadlines and that’s I think we probably should have done a better job anticipating that we’re seeing it, but at the same time we’re seeing the flipside of higher average orders, meaningfully higher average orders with Grey Card.

And so we're very encouraged about that. but it's going to take us a few quarters to really understand what’s happening here. We've got to get far enough past our most recent promotional periods, right. So we're not that far past a very promotional fourth quarter and promotions that were still happening in the first quarter of this year.

So I think we got to get a full couple of quarters away from that to start to change behavior and expectations with our customers and reestablish those expectations.

I think changes hardly requires building new habits and we will keep you posted, but at this point we're optimistic and again, if for some reason, we're really wrong here and we see the business really decelerate, we think we're given away a lot of -- a lot of business long-term. We can always turn promotions back on. This is not like do or die.

This is not like we made a change and if it doesn't work we're just going to kind of stay the course and drive the business down. That’s not our goal here. We think this is a right long-term move for the Company.

We're making long-term decisions and investments for the brand and business and we think they’re the right ones, but for some reason we’re wrong.

I can tell you being I think I’m still the biggest shareholder in the Company, I’m going to change course and we will make decisions that are the right decision for the business, the brand and the shareholders. But there are some short-term pain for long-term gain and we believe we're going to have long-term gain here.

And so to take us a few quarters and we're going to have to cycle through it, but we think we’re going to come out, you’re going to see in the fourth quarter the business started to accelerate.

It's going to be slightly masked, because the push in revenues it's going to be slightly masked, because we’re eliminating stocking stuffers and nostalgic knickknacks in the stores at holiday.

So, we’re going to give some low-quality, low-margin business back, but I think you'll see in our operating results as we get into Q4 the Company is going to look very different as the books get in home as we finish the remodels and the resets as we rollout design ateliers in all the stores as we've expanded our number of designers as they went through new training and education.

And we have, what I believe is going to be the most compelling product assortment we've ever had at retail and the most productive. Remember, one of the data points we have here is we now tested RH Modern and we tested in several stores. The most significant test, I believe we try to point out was within New York City.

In New York City we had a clear arbitrage move where we took off the floor of existing core and if you can only imagine that the goods in New York City being our highest volume gallery, are all a highly productive -- are most productive goods. So we took a third of the assortment and put on a third of the assortment that we had no data on, right.

So that was the biggest risk in my mind, that was the biggest single risk we look. If we would have taken up a third of the product in New York City and put a new product with no data, not even known if it's the best of Modern, we had no data on the Modern. My sense is New York could've been easily down 10%, right.

We could had a negative arbitrage instead we're up 35. And New York has the strongest growth in the entire Company and it's been driven by RH Modern. Now New York is New York. New York is not some of the other markets. We don't expect to have the same response to Modern, but we also had a very similar response in a different way in Los Angeles.

We opened a freestanding Modern store three blocks from our Melrose gallery to again right there with New York, our highest performing galleries in the Company and we didn't have a negative effect on Melrose. We had an incremental lift. So we believe we created a new and bigger market. We now have data on the product and what products sell.

We now know what is the best of Modern and we've now done the math and we know what products to take off our current gallery floors, our existing legacy galleries and we’re going to remove about a third of the product and replace it with a third of the best of Modern.

We believe there's a meaningful positive arbitrage there that we think it's 35% across all the galleries, of course not. We wish they all acted like New York. We don't expect them to if there a third is good as New York or a quarter good as New York, you can do that math.

But there is going to be a positive arbitrage that we have here at retail and we’re going to support that with marketing and an expanded book and deeper mailing. So we feel very good about it and so ….

And then Matt, with respect to your question about the deferral of the revenue, you're absolutely right. That has been contemplated in our guidance. It has been for a while that’s how it was designed.

But we're trying to do, because that we received a lot of questions and confusion on that as that membership fees, so the revenue we're retaining from the customer when we design the program and we are going to a deeper discount rate of the 25% off than we typically do other than last Q4.

That was -- that membership fee is intended to offset that, but because we're recognizing it over that 12 months period. There's obviously a step up and ramp up of that time period were recognizing it. We didn't necessarily quantify the margin impact, because we had zero data.

Now we are going to try to be clear about what exactly that looks like and the complexion that has on our gross margins just from a peer having that revenue and it’s all being a 100% deferred versus having the sales now come through at the 25% discount.

It's really just going to be about a year until we build up and are starting to recognize the full months of revenue for the corresponding product sales..

So my follow-up, I promise will be very brief, because you guys are very generous in answering my first question.

So, Karen it sounds like the changes to the outlook that are incremental then would be the inventory rationalization $0.30 to $0.35 and then the residual reflex or just the core business sales etcetera given the environment, is that accurate?.

And the push forward of sales going to next year..

Yes, I mean, it's really sales which is kind of overall environment and the longer selling cycle with Grey Card, sales is the biggest one and then the incremental expense items as we did have some SKU rationalization inventory optimization in our forecast, we're just going a little bit quicker and a little bit deeper, so its having more of an impact and then our delight cost are a little bit bigger obviously than we first anticipated, but that’s only about the $0.08 or so on the year..

Got it. Thank you so much guys..

Your next question comes from the line of Jessica Mace from Nomura Securities. Your line is open..

Hi, good afternoon.

My question is just a quick clarification on the previous question to understand that the $0.30 to $0.35 in the Grey Card membership deferral cost only reflects the accounting of that revenue, the incremental sales push forward is a separate impact on the guidance, is that correct?.

Yes, absolutely correct..

Okay. Thank you. And then, my second question, I was wondering if you could just talk a little bit about the decision to open more outlets and how that fits into the overall strategy? Thank you..

Sure. That’s to support our more aggressive stands in rationalizing our SKU base and reducing our inventories..

And a couple of those are very short-term leases. So we got some great occupancy deals, we can move through the inventory and get out of those. It's not necessarily that we plan to open that many outlets year over year over year..

Yes, as I mentioned we believe we can offset some longer-term investments in opening new DCs, longer term. So we were scheduled to have a shovel in the ground this year and begin construction on another distribution center.

And we believed it was better to accelerate the SKU rationalization move through inventory and believe we could probably push out the next distribution center 2 to 3 years and in total with inventory and saving in capital probably over the next two years to save the Company about $200 million to $250 million..

Great. Thank you very much..

Your next question comes from the line of Budd Bugatch from Raymond James. Your line is open..

Yes, thank you very much for taking my questions and I apologize for getting into some of the weeds, but I just want to make sure I got the numbers right.

If you collected $6 million in Grey Card fees, that implies about 60,000 members is that correct and how did that portray over the quarter?.

Yes, it is 60,000 and we got a little and we didn't launch until the middle of the quarter, so that’s over a six weeks time period. And we’re not going to probably get into the specific week, but at the very beginning we had people buying the membership without even buying a sale yet, so -- just because they were so excited.

So there is certainly a little immediate pop and then it was a little more normalized..

And the other thing I would add to that is ….

And so turn of the revenues, how much of it -- how much of the revenues would you attribute to Grey Card, the $455 million revenues, what would be corresponding Grey Card associated revenue?.

That we’ve not disclosed and don't plan to at this time, but I would just say it’s a much larger percentage of the dollars. But then there's certain orders that are very small dollars that those folks are the one we expected and who wouldn't buy the Grey Card..

I see and I think in your presentation you said $0.34 in the first quarter was due to the accommodation costs and the Grey Card deferral and if I did the math right, it looks like $0.27 for the accommodation of the $0.30 that you’re seeing for the year, is that right?.

$0.27 was the -- what were basically about Modern and other customer accommodation. That’s the amount in Q1 and then we're only expecting another $0.03 in Q2 and then again we don't expect to have much of that beyond Q2, because our back orders and in stocks will be back to kind of a normalized level. So that issue is about $0.30.

Then separately we did have about, call it $0.08 or so from if we had been able to recognize the $100 at the same time as those sales instead of deferring it over time that would've been a benefit and we expect to continue that throughout the year, and that’s the $0.30 to $0.35 range [multiple speakers] items..

Yes and that got me to the $0.34 I think you said was in the first quarter pull forward, right?.

Yes..

And that would get you to the $0.29. Okay.

Next question on the savings that you’re expecting the $20 million, when will that start to appear? Is that starting already or is that -- and how much is there of a charge -- of the severance charge?.

That's an annualized number that will start later in -- some of it has started, but it will start in Q2 and there will be a severance charge and it's still we haven't disclosed that yet, but we will disclose it as part of our Q2 quote..

I see.

But is it -- so is the $20 million net of the severance or is that above the severance?.

That is above the severance. We are pretty -- the severance we’re kind of considering one-time in nonrecurring..

I see. Okay and you had talked, Gary, about increasing the number of designers and the training to the designers and I think that’s all great.

Can you give us maybe a feel of how many designers you have now and maybe what the growth of that is over last year?.

Yes, we haven't disclosed kind of the designers we’ve, but we have the design team in every one of our galleries today that’s proportional to the business and we’re expanding that effort and we’re -- there is two things to think about as we mailed the fall books, one, the other point I think that that’s probably not everybody is not aware of, but the mailing of the fall books will really be the first real advertising of the Grey Card and we will also have significant marketing behind our design services and our new design ateliers.

So we’re -- if you’ve seen Chicago or seen the video in Chicago, we are seeing some of our newer large galleries, the next generation galleries we opened.

We tested these design ateliers, fully integrated spaces for architects, interior designers and customers to plan projects and plan their home and the project -- and their designs and so we’re very pleased with the results and what we're seeing in the average orders in those locations and we’re rolling that out to the entire company, as well as expecting to have an uptick in design projects because of that and are ramping up and expanding our training and education in that area.

But the other thing is that to remember is that the books are going to go out and for the first time ever you’re going to see our catalogs that show the regular price and then the Grey Card price.

So previously if you did take an example of our cloud sofa, our cloud sectional, say with $10,000 you would have seen $10,000 in our books previously and the only customers that would've known that that sofa was on sale if we were having an event previously or even today people that are on our email file and our email file is not as big anywhere near as big as our mailing file and we will be mailing meaningfully past the number of people on our email file.

And they will now see instead of the $10,000, they will see regular price $10,000 dollars, member price $7,500 and the $2,500 savings on a $10,000 item. We think that's very compelling.

So the Grey Card launch is only been supported with email, which is limited and we ran a couple of ads and we've done some online advertising in retargeting some of the so forth, but we think the big impact is going to happen when we mail these books this fall..

I got you. Just a couple of other questions, if I could. Karen, in your guidance for the second quarter gross margin, I think you have 210 to 310 basis points of net other.

Can you help us as what that net other might be?.

Yes, so we’ve -- one, we’ve kind of quantify the very specific items within product margin that we've been talking about. So the SKU rationalization, the Grey Card membership, and the customer accommodation, there's also just we’re up against a much lower discount rate from last year.

So when we look across and know that now we have a 25% for the entire year discount rate, when you come up against different periods that have more or less promotions from the prior year. You’re going to see more or less just kind of general upside or downside in the gross margin depending on what we're anniversarying.

Q2 is one of the lower discount rates last year. Q4, for example, is one of the much higher, so it's just going to change and have some variability and how much of sort of other product margin we have.

The other two things are we step up our retail occupancy both from the outlet openings, but also we start a little bit more preopening rent for some of the full line design galleries, and then the DC occupancy with that Northern California DC, that wraps in Q3. So that’s when we, those stop having a drag in our DC occupancy..

I see.

So that 210 or 310 is much of that's the Grey Card differentials or the Grey Card numbers, is that what you’re saying? Is that the way I look at it?.

It's retail occupancy, DC occupancy, a little bit more product margin and a little bit of shipping. So it's a hodgepodge of direct..

I see. Okay. And in often times you give this order growth in numbers.

I didn’t -- if I missed it, I apologize, but do you have an idea of order growth and backlog today?.

No, we’ve never given..

Last quarter, at the Q4 we gave ….

Oh, demand. Yes, we did for Q4, just because it was such a big delta between because of the Modern issues that created all this demand. That’s not something we plan on giving going forward, but it’s a much more in line where that delta isn't nearly as wide as it had been in the past. So again, that was such an anomalous result.

So we gave the demand versus the shift of revenue for that one period..

Okay. Thank you very much. Thanks for taking my questions..

Thanks, Budd..

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

Hi. Thank you. We had a question regarding the guidance and what does the guidance assume in terms of your thoughts on how the demand environment may evolve, just because there's a fair number of variables that aren't necessarily within your control and the environment seemed to get a lot worse than people had expected.

So as we think about risk management and the demand environment does get worse, what are some levers you can execute on just to manage the business in a tougher than expected scenario? And also related to that question is, does this new guidance incorporate a continuation of the demand environment now or does it have other factors you contemplate happening? And then I know, Gary, you talked a lot about the last mile a little bit in your prepared remarks.

It sounded like you wanted to engage in the degree of vertical integration just to ensure that the customer experience is holistic and executed in a luxury like fashion, so I was just curious about your thoughts on what’s your diagnosing the business need versus what exists now in terms of how you execute all the way to the customer? Thanks..

Sure, Oliver. Let's try to start at the top of your questions. The demand environment, the evolution and we have -- we believe we’re taking what -- how we see the consumer responding today, which we think that there's definitely a slowdown.

We've incorporated those trends in our go forward guidance and we believe we’ve been appropriately conservative in how we guided. So that's how we think about it. If there's a another meaningful step down, we're not anticipating that today. So if there is another meaningful step down, we will have to reevaluate our business.

But there's obviously multiple levers that we could -- we can pull in the business whether it's reducing orders and reducing inventories, so inventories grow slower. We can always become somewhat more promotional. There's even with the Grey Card there is ways to promote.

You just saw -- just recently Grey Card members get generally 10% off clearance and we increase that to 20% off clearance for a limited time to accelerate the movement of clearance. So there's things we can do there and other promotions we can also run if for some reason we get into a scenario where there is another meaningful step down.

But we kind of look at it as kind of a continuation of the current environment and then we got the bridge of all the actions we’re taking and movements that are happening whether it’s the book moving out, the selling cycles now, we know are longer, so we’ve suggested for that.

We’ve adjusted, now we’ve got a few weeks where the books were in-home last year and we could see where the business is trending and it looks like we didn't anticipate the business to fall as much when we came up against the books, so we’ve I think appropriately taking that down.

So we feel pretty good about the top line and the demand and how we forecasted that today. And if there's not a change to the current environment, I'd characterize it as conservative when we look at it in the back half of the year. So, I'd say today if I had to characterize, I think there's more upside than downside as we get into Q4.

It’s the book get in-home and the galleries -- the legacy galleries are all remodeled and the new goods are out in the floor. And the first time we’ve broad-based advertising of the Grey Card and the 25% off of the Grey Card gets you. As it relates to the final mile and how we think about that, it's a continuation of what we articulated before.

We’ve a bias, I think at the high end of the business and you’re working the luxury end of the business, there were higher expectations from our consumers and we have a bias to take more control than less control, especially as it relates to entering the customers home and delivering products into a customer's home.

So today we mostly generally all outsourced that last delivery, it's been a cost decisions in the past not a service decision.

Obviously, we believe we can deliver better service if there are people and it's our equipment and its consistent and so we are testing that right now in the Bay Area, and we are ramping up and doing a -- we’re going to do a complete test and understand the impact that we believe we will make it long-term, we will be making investments to take more control and elevate the customer experience.

I mean, if it was -- if you’re making cost decision, right, you would probably outsource your sales force and Oliver galleries, right. But we have people come into our home and there are people, and then we're going to their home and they’re not necessarily our people.

And so, we think we could probably long-term do better job, does it pencil out in every single market where the volumes are lower.

It may not and will as we look at this more, we will make those decisions, but the goal is to operate at a luxury level and have the best service in the industry, we believe we’ve the best product, we believe we’re building the best retail environments in the best print materials and we are building the best Web site experience and its all got to be first class, it's all got to be best-in-class..

Okay, and that’s helpful. Really helpful..

And Oliver, with the final mile, I’d say that we’re now underway with the last modules of that -- its kind of bigger program is in the pilot. We’ve been on it now for over three weeks and that is going really well. We’ve had no issues, we're seeing great benefits from the centralized scheduling.

We have better inventory visibility, which is not only good from a control and shrink end perspective, but also just in getting better information to the customer. And we're now using the paperless, where everything else before was paper and pen, when you get a delivery now, it’s all done on the tablet.

So we’re really pleased with how that pilot is going. It took us a little bit longer to get there. The rollout is going to be going through 2017, but so far we couldn't be more pleased with what that’s kind of enabling with somewhat -- prior to that, we couldn’t see a lot of product and see a lot of the things announced.

Just lot more systems versus manual processes that we had in the past..

Great. Our final question, Karen and Gary, about inventory SKU rationalization. Just the science of matching supply and demand, whether you -- is it -- it's risky either way just because you want to make sure you are rationalizing the right items to get the right goods at the right price at the right time.

So, should that for modeling purposes, Karen, will this continue to weigh on gross margin on the back half? And then, strategically, how do we get comfort over making the right decisions here, because it's probably iterative in terms of determining how to optimize across different categories and price points.

And another concern I had is if there's items you get rid of that were actually traffic stimulants that are just hard to decipher until you figure it out later. I’m just curious about those topics as it applies to risk around what seems like a very good decision to sell more with less, but it's just not easy in retail..

All good questions and all of our strategies here and decisions are based on lot of math and science and a lot of data evaluating the selling of not just the products, but the collections, the number of sizes, the number of finishes, things are carried in and so and so forth and we’ve been testing collections versus collections, finishes versus finishes, what happens when we edit sizes or finishes, how much transfers to another size or another finish, what’s the right amount to optimize the top line and optimize the bottom line, so again we’ve new data every day, as we're making these decisions and working through it and we think we’re going to be a lot more right than wrong.

But it's not absolutely perfect science, its -- but we’re generally pretty at good making these kind of decisions whether its adding product or editing product.

So, but it's all based on the math and the productivity of the SKUs and the investment behind SKUs and how much it cost to carry the inventory across the network should inventory be in all four DCs and three DCs, two DCs, one DC or no DC. We look and it should be marketed in the books, in the stores, just online.

There is multiple things we go through here. We don’t just decide we're not going to like it, we're going to mark it down. It’s all math..

Yes, and Oliver, I’d say too there is different flavors of it that just like Gary said you know there's certain items we might have three sizes in and there's one size that just doesn’t make sense. So it's not going well together.

There is finishes that aren't selling as well and then there is SKUs that are going away out of the assortment altogether, because they’re highly unproductive, but there's also one where we’ve decided we can have it in one DC and so it's part of the stocking strategy. So, its multifaceted.

It's been -- certain things going to special order, certain things going to stock, we’re always doing those kinds of things. This is a much bigger effort to really take a target of look at the overall inventory. The two ways that we're doing that is clearance and these outlets. So we have a big clearance event going on now.

We are going to just keep many things on clearance in Q3 and then have another clearance even in Q4. So when we kind of talked about that $0.30 to $0.35, its more pronounced in Q2 and Q4..

Okay. That’s helpful. Gary, and just lastly, you’ve a really great view of retail.

How do you think Amazon has kind of impacting the way maybe the RH consumer is just thinking about the retail experience overall and expectations kind of shifting in terms of consumer touch points and frictionless shopping, kind of generally as well?.

Yes, that mean specifically on Amazon, I think about a couple of ways. One, every -- almost every consumer is becoming an Amazon consumer, because of the breadth of their assortment and the simplicity that they bring to the consumer for many goods, and especially durable goods and that you need in and repeatable purchases.

So, look I'm a big Amazon customer. It is Amazon serve the customer at every level in a way that is relevant, I'd say, no. I don’t think Amazon is going to be the only retailer left on the planet and I highly admire them.

They’re, I’d say, short-term they’re advantaged, right, because they don't have the same earnings hurdles that many traditional retailers have today. So you have retailers that are out there, they’ve been making 8% to 15% operating margins and all of a sudden Amazon is coming in with 1% or 2% operating margins and eating their lunch.

I mean, it would be an interesting world to see if all the other retailers lower their operating margins to 1% to 2%, what would the fight look like. So it is a little bit of an unfair fight, right, because Amazon is not being held to the same standards from a profitability point of view.

But today the market's allowing that and actually rewarding that. So, I think their advantaged. Listen, I think Jeff's is a very smart guy and he is using that advantage for all it's worth. And he has been using it and he has been killing them. So god bless.

I mean, it's we can all learn from a lot of that -- a lot of things that Amazon has done and what they continue to do. So we are big students of Amazon and big fans of what they do. As it relates to our business, I think it's more protected, right.

If you think about the fact that we’ve a hard time getting these goods, we are -- product of this quality is never been made in quantities, we are building a new railroad, we have a powerful platform of designers, manufacturers, -- so we’ve got advantages of our own and we like the advantages we have.

We also think we’re -- just like Amazon is reinventing online retailing and we are learning from them. We believe that we're reinventing physical retailing and we're building advantages that nobody else has on the physical side of the world.

So, but look today -- everything is changing in our industry and if you're not a complete student of the entire retail business, no matter what channel, you’re going to get behind. So, we just -- I think we just announced we’re hiring a new Chief Digital Officer. We just hired someone, they haven't started yet.

They’ve got great experience here in that area. We're making to other significant investments to upgrade our digital strategy. But I think we're about as well protected against the Amazon effect as anyone. I don’t want to jinx us by saying that, I don't want to motivate Basos and his team to come after us.

But I wouldn't pick us, we would be way down on the priority list if I had his job..

Thank you. It's really helpful. Thanks for the illumination and best regards..

Thank you..

Your next question comes from the line of Steven Forbes from Guggenheim Securities. Your line is open..

Hey, guys. I think I will start with a question for Gary.

I guess, how would you assess the organizational capacity for change in an absolute sense and how, if at all, does the New York structure influence future innovation and the Company's ability to avoid disruption to the customer experience?.

We like to say that we have to be willing to start today's reality to create tomorrow's future. It is part of who we are at our core and part of our values.

I think if you look back at the last point in time, the markets were difficult and whether it was 2008 and 2009, and the actions we took in we simplified our business, we kind of redesigned our way of doing business, we turn the model upside down and went from an inside out, kind of design driven, sourcing driven model to a platform model that what I call an outside in model that we were building the best platform and we bring in the best thinkers, designers, and developers in the world to sell in this platform.

I mean, we’re always kind of unfinished and on the move and it is in our DNA to constantly innovate and improve. So this is just who we are and I think the organization will change as we are making and it begins with the Co-President structure.

Its really designed first and foremost to kind of leapfrog the business forward and the way we operate forward, and to really break down silos that naturally build in organizations as they grow.

I don't know one company that goes through growth periods with management structures that don't become siloed and when you become siloed you become less efficient and you wind up getting people working really hard on all the wrong things because they don't have a holistic view of the business and understand all the interconnectedness.

The view here is that the Co-President structure is going to operate as thought partners and operating partners in the business. It's going to have a much more holistic view. Is going to be allergic to silos and its going to break those things down and work through problems in a more holistic manner and in a much more integrated fashion.

We are already seeing it happening.

The team has spent time together and relooked and remapped out and assess the organization, assess the architecture of the organization, and how we are working and its simplified how we’re going to work and believe we can just move much faster and be much more decisive and eliminate a lot of the redundancies and inefficiencies that just happened.

They happen everywhere in every company, I've ever seen. And I think it's part of the process of kind of shedding your old skin and looking at things fresh and new all the time and that's what we're doing and again its part of our DNA.

We are a Company -- if you think about it when we went public, we just introduced our first new gallery in Beverly Boulevard is our first new resto and now that’s not even in our portfolio anymore as a Restoration Hardware. It's now in RH Modern for God's sake and we built the store three times the size of Melrose.

And we are engineered for innovation and constant improvement. So it's just who we’re and I think by the way it is going to have to be the norm to win in the future. Everything is changing around us all the time, how we communicate, how we move, it's like -- moving from point A to point B, used to mean in my generation, you had to have a car.

In my daughter's generation, everything is about Uber. It's about a different way to communicate, it’s a different way to move through the world. I like to tell people here that, I go to breakfast with my daughters and they order their French toast before they take a bite 35 friends have liked it on Instagram.

It's just a completely different way to communicate and I think you'll see us adopting these new ways and its adopting change faster than others and lead rather than follow. But -- so we're very excited about all the things we're doing. I mean, I know it’s a tough day. It’s a tough day for our shareholders and myself being one of them.

But we don't like to disappoint. We don’t like to miss our numbers.

We came out of the gate and we were kind of the perfect public company for three years, and but there's -- change is needed now and we're making those changes and I think the changes we're making and the investments we're making, whether it's the new galleries, the investments in Modern, the design ateliers, the new books that we have, relooking at organizational structure, relooking at our supply chain network strategy, all of it is -- it reminds me of '08, and '09.

I think this is another leapfrogged moment for RH. I know there is going to be people on the sidelines that think that the model is broken because we just missed guidance that we just gave you, apologize for that. But I think you'll find that we are very quick learners and we adapt and change very quickly.

And I think we're going to be sitting here a year from now and its going to be a very different tone and you’re going to be seeing us moving very quickly and creating much more separation between us and anybody else in our industry.

So, there is a lot of people out there that are making restructurings, that are announcing bad earnings, that are reducing costs and workforce, and there strategies of where they're going next are not real clear, besides kind of we’re going to work harder, we’re going to focus on our core business or we’re going to close stores or we’re going to do things like that like there's no real offense.

We have a big office here. We know how to play offense. We know how to build businesses and we know how to win. We make mistakes and we learn from them and we will change quickly and -- but don't underestimate us..

Thank you, but then just a follow-up, given all the change you outlined, has anything changed as it relates to the margin drivers underlying your long-term operating margin target?.

Not at all.

I think what we’re going through with the organizational changes that we're going through with a network redesign of the distribution centers with how we think about inventory and capital requirements and needs and capital investments, long-term if we're more right than wrong and on these assumptions, we -- those numbers to prove conservative, but today there's no reason to change them.

The product expansion strategy is working. Modern was not a demand problem. It was a supply problem and we're fixing that. All of our new galleries are exceeding our performance in our plans.

And we -- like I could tell the team may feels like, for the most part our brand is invisible in the marketplace except for places like Chicago and Los Angeles, and the markets where we've done these new big galleries.

When we change the physical impression of this brand, it's going to massively change our top line and our operating performance and nobody has got a strategy like that in retail today. I don’t think anybody has a similar strategy or better long-term upside.

Again, painful day, don't like being here, but we made some mistakes and we’re adjusting and we will be back from here..

Thank you..

Yes..

There are no further questions at this time. I will turn the call back over to Gary Friedman..

Okay. Well, thank you everyone. Again, we look forward to better performance in the future and we will fight hard to make that happen. So we look forward to talking to you next quarter..

This conclude today’s conference call. You may now disconnect..