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

Chuck Grom - Gordon Haskett Steve Forbes - Guggenheim Securities Geoff Small - Citi Daniel Hofkin - William Blair Michael Lasser - UBS Curtis Nagle - Bank of America/Merrill Lynch Peter Benedict - Baird Brian Nagel - Oppenheimer.

Good afternoon. My name is Jessie and I will be your conference operator today. At this time, I would like to welcome everyone to RH Second Quarter Fiscal 2018 Q&A Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session.

[Operator Instructions] Thank you. Cammeron McLaughlin, RH Investor Relations, you may begin your conference..

Thank you. Good afternoon, everyone. Thank you for joining us for RH’s second quarter fiscal 2018 Q&A conference call. Joining me today are Gary Friedman, Chairman and Chief Executive Officer; Ryno Blignaut, President, Chief Financial and Administrative Officer; and Karen Boone, former President, Chief Financial and Administrative Officer.

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 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 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.rh.com. With that, I will turn the call over to Gary for some brief opening remarks and then we will begin our Q&A session..

Great. Thank you for joining us today. Before we start, I would like to take a moment and welcome Ryno to his first call with us. We are very excited to have him joined team RH. Welcome, Ryno. And I would also like to take a moment and thank Karen Boone who is also on the call with us today for 6 tremendous years of leadership.

We will all miss her bright light and we are very, very happy for her and her family in this next chapter and we know she is close to just up the road, but couldn’t be more happy for you, Karen. And this is the first call we have ever had to financial experts on the call.

So this will be a little interesting, but we are all here to answer your questions today. And with that, I will open the call..

Operator, we are ready for our first question..

Thank you. [Operator Instructions] Your first question comes from Chuck Grom with Gordon Haskett. Your line is open..

Thanks. Good afternoon.

Just first question is on the revenue miss in the quarter, along with the downward revisions to the third and fourth quarter expectations just can you discuss how much of that came from internal decisions, particularly the SKU rationalization versus perhaps external factors the consumer macro etcetera?.

Hi, Chuck, this is Gary. I think as we have mentioned in the letter, it’s very hard to be precise given the inventory optimizations last year and it’s even harder to be disappointed when you got gross margins up 800 basis points year-over-year. And so as we have said, we have got a clear focus in optimizing our business model.

I mean, this is the year where we are going to manage the business with the bias for earnings versus revenue growth like any retailer and almost all do, you can always pull levers and promote the business.

So, we could easily put a lot more revenues on the – there is a lot more revenues this quarter and we could post a lot more revenues in the next two quarters, but it would be at the expense of optimizing earnings and we are in at plenty of time from my point of view, so I have told the team here, I said, look, you have got people here with the client, hey, guys, you have got people here with the client if you look at our industry, we have got a lot of people declining operating margins, but they post a couple of points of incremental revenues and everybody thinks that raising it.

That’s not what we are focused on right now. We are focused this year on optimizing this new operating platform, this new operating model. So, when we hit it back to growth next year, we have got the best business, the best brand and the best operating platform in the industry. And that’s what we are doing.

And you have decisions day-to-day and week-to-week in this business and our decisions are going to be made with bias for earnings versus revenue growth. So, people are unhappy with the fact that we took earnings up 14% and took revenues down 2%. Honestly, that’s their problem.

Our focus is to optimize this business this year and to position ourselves through the long-term, so….

Okay, great. It makes sense.

And then just to pivot towards next year, when you think about all the moving parts that you are going to have going on in the business as you pivot back towards growth, in order to bridge to that mid-teens goal that you guys brought forward a year or today, how should we think about the most appropriate revenue run-rate for 2019?.

Yes. Well, everything is still the same. Our long-term targets as we stated is 8% to 12% revenue growth with earnings growth substantially, earnings growth is substantially better than that.

Obviously, we think in the short-term, it’s going to be substantially better than our long-term targets from an earnings point of view, but you are going to see us aggressively pivot back to revenue growth next year and we have been holding back a lot of ideas. We decided to make that decision right.

Look, I couldn’t be more happy you have got a company that has went through a massive, massive transformation, right and created an entirely new business model here. And our results are massively better than we or anybody else anticipated.

We came into this year and our first outlook will for 9% to 10% operating margins and everybody thought we are crazy and now we have raised the numbers for the third time and the numbers are 0.8 in the 11% to 12% range. And so we have made a big step forward and the step to the mid-teens is a very short one away.

So there is more upside in this model than we anticipated. It’s coming faster than we anticipated.

And so I wouldn’t be surprised if our long-term outlook becomes an more robust long-term outlook we just want to get a couple of more quarters under our belt and it’s going to be very clear what this looks like and look it’s going to be a model that rose 50% to 70% more earnings than anybody else in our industry when we are done..

Great. And then just my last question is you have talked about accelerating the pace of the new designed galleries in ‘19, I am curious if you have sized up the opportunity long-term both here in the U.S. and international in terms of the total number that you think you could do over the next say 3 to 5 years? Thank you..

Yes. Well, we said we are going to accelerate the growth, because it’s a development of the prototype, so you will really start seeing it in the out-years, right, as we do these deals and as we start to ramp up our pace, though. ‘19 I think from a new store point of view will be something like ‘18 and they would start to see it ramping beyond that.

One of the points we have put in the letter was as we have talked the fact that we are developing secondary market gallery at 10,000 to 18,000 square feet and our predictions are right and that test works that, that will open up, it will open a significant amount of more market, but I think the real thing we would look at long-term.

And as we think about this company is we would be clearly seeing $4 billion to $5 billion opportunity maybe greater in North America, but if you stand back and you look at the distribution of wealth globally, the distribution of wealth in America, you have got one-third of the billionaires live in America, I think it’s 15% to 20% whichever ever report you look at percent of the millionaires live in the United States.

And if you look at somebody’s business like LVMH right who has got a collection of luxury brands, very large business that is well distributed globally, 25% of their business is in North America.

So as we have been focused more on this global opportunity, we think the opportunity for RH is very, very big and it gives the confidence to put at an initial number of 7 billion to 10 billion and that number is from my point of view, very conservative, but as we look about the long-term runway and long-term sustainable growth on what we believe will be the best operating model in the industry that will be super efficient from a capital point of view.

We like where we are going. So, nothing has changed..

Okay, great. Thank you and Karen, congrats on your retirement..

Thanks..

Your next question comes from Steve Forbes with Guggenheim Securities. Your line is open..

Good afternoon. So, I wanted to start with the new product development.

Gary, you mentioned RH Beach House and RH Color is within the release, so can you touch on how you plan on introducing these new categories to your customer? Is it catalog only will be in future galleries? And then I wanted you to touch on Waterworks, right, you think about where we are relative to the acquisition a couple of years ago? Yes, can you discuss whether there is a larger integration effort around this brand on the horizon here?.

Sure. Well, you will see us in ‘19 launch both RH Beach House and RH Color. The way to think about those is RH Beach House, well one let me answer your question specifically.

As we do when we launch all new businesses that we launched with a Source Book that will be launched with a lot of identification on the website and possibly an adjunct website that’s integrated if you will and as well as some of the product in the stores we will do some testing I think.

I think if you think about – kind of think about the opportunity there the wealthy and affluent customers generally have more than one home and that all the data says that the second homes have twice as many bedrooms as the first homes, which has a huge opportunity to sell in this markets, whether it’s beach house, whether it is ski house, but thinking about targeting second homes and presenting goods and presenting collections that are specifically focused on those homes and presenting ideas that clearly give people ideas how to furnish their second homes.

So, we are very excited about that. We are working on it for several years. RH Color, if you think about RH, we are kind of famous for neutrals and there is a reason for that, that’s by far the largest percentage of the market, but there is a good percentage of the market that is a Color driven market.

And for us over the last decade, we wanted to have a real point of view, we wanted to stand for something, we want to dominate something and also sometimes it’s hard to integrate Color. It’s got to be done with real spot and real focus. And over the last several years, we have been developing this strategy and this concept. We feel very good about it.

We think we are going to come to the market with a very exciting assortment, Color-focused, fabric-focused, that will be presented unlike anything else in the marketplace that will make a big impact. And I think it could open up another 25% for the brand. It can be a very important part of the brand long-term.

So, you will see us come after that aggressively and we think it will amplify the brand and open up the aperture for the brand. So, you will see that be introduced with this own standalone Source Book and integrated into the website and you will see an impact, if not select store – if not all galleries, select galleries to start with..

And then just a quick follow-up on the reverse logistic network, can you just touch on where we are right, yes, obviously gross margin here is benefiting from a variety of different factors, but where are you specifically as it relates to the outlets – the build-out of the outlets and capturing that benefit associated with the reverse logistics?.

Sure.

The way I think about the three big pieces here, you have got the redesign of the distribution center network redesigned, that I’d say we are 80%, 90%, we have got a couple of more moves that you will hear about later this year as we optimized the distribution center network over the next 12 months and then if you kind of think about the outlet and reverse logistics redesign, I’d say we are probably two-thirds into that.

The real key is having with one that we have changed a lot of the process in reverse logistics we stopped sending product back to distribution centers. We have them coming back to the local home delivery centers and then going to outlets, but our outlet architecture does not directly mirror our revenue architecture in the U.S.

And so we are building that out and trying to get to – how do you get to equilibrium, how do you handle and dispose of returns and damages in the most cost efficient, margin efficient way, handle it the few times, move it the least amount of times and optimized the margin and turned the goods in the most efficient way.

So, I think we are two-thirds probably to 60% through that and over the next, let’s say, 2 years, we will finish that out and get to equilibrium. And so there is still optimization to go there and margin enhancement and the biggest opportunity is margin enhancement, inventory reduction, turn improvement.

And then when you think of the home delivery, customer experience re-conceptualization work that very, very beginning there with our test in the bay area. I would say, we couldn’t be more excited about the early results and from two levels, one, from just a customer delight point of view.

I mean, I used to only get letters about kind of us still have goofing up delivery and now I am getting letters and pictures from customers about how excited they are about the experience and it’s a complete transformation. And so we are beginning to measure the data.

We like what we are seeing early on with reductions of returns, increase of stick rates, reductions of exchanges and so on and so forth been able to service the customer and want to make sure it’s perfect when they get it, but for some reason, there is something wrong.

We will be able to dispatch medics in minutes, not weeks to customer’s home to resolve an issue. So, we think it’s long-term. It could be the most valuable thing we have done long-term from a revenue enhancement, cost reduction, returns and exchange reduction, improved stick rates so on and so forth.

The biggest thing we do and it will be a multiyear project, I think it’s going to be 3 years to 4 years to tackle the entire country, but we will perfect it, we will then go to another market, we will learn, we will perfect it and I would imagine as we get better and we learn more, we will probably go faster, but right now, it’s not about making it a little better, it’s about a massive leapfrog beyond what anybody else does..

Thank you..

Your next question comes from Geoff Small of Citi. Your line is open..

Hi, Gary, Ryno and Karen. Thank you for taking my questions. I just wanted to also touch on the gross margin which obviously came in meaningfully better than you had planned.

I was hoping you could break out the 800 basis points of improvement between the full-priced selling, the lower outlet revenue and the supply chain changes and just also curious how the back half gross margin opportunity breaks down between those factors?.

Well, it’s no different than we articulated in the letter, right. It’s really coming from better – full-priced selling, improvements in the supply chain, but it’s significantly on the product margin side, you are seeing massive improvements there.

And so as we look at the back half, obviously we started to cycle some of the margin improvement, right as we come around in the quarters, but we think we have got – we still got meaningful product margin improvement and we will see continued supply chain improvement. So we obviously we had enough confidence in the numbers.

We took the numbers up in the second half and I believe that there is a meaningful upside as we look ahead and again even more meaningful upside as we look into next year..

Thank you, Gary. That’s helpful.

And on the topic of the acceleration in sales growth targeted for next year, can you help us understand what you are looking for in terms of comparable brand revenue growth and also the level of contribution from the new initiatives across the gallery openings, the expansion in hospitality and the extension of the RH brand?.

Lot of questions in that question, if you think about the impact of – let’s start with the brand expansions and the product expansions, I mean we are very efficient I think at introducing new products and expanding the brand and because we do it the way we did it through a source book and online we don’t take the inventory risk initially, so we get very good return on investment as long as we are more right than less right from a product point of view, from a customer acceptance perspective.

So we should expect really good flow through at least that’s what we have always had on any of these businesses. So that’s how I would think about that piece of it. Opening the new galleries is highly accretive.

You are talking about meaningful revenue pickup on a modest generally rent increase and so on and so forth, so the return on investment and the profitability returns on the new galleries is very accretive right from the get go. And then hospitality will continue to be less and less of a drag on our P&L.

We had to initially build the team and the leadership team and then kind of corporate structure of hospitality to be able to begin to open multiple units that reaches scale somewhere around $50 million to $70 million in hospitality sales is when we started to have corporate SG&A in hospitality more in this kind of targeted range where the de-leverage goes away.

So we will hit that number sometime next year and begin to leverage hospitality and we expect hospitality by the fourth quarter will be clearly profitable all-in, right. There is the business that explore a well level today is very profitable.

We just have to – we should get enough scale to offset the initial investment and that begins to happen in the fourth quarter. So we have got – we have very profitable business in hospitality at the four wall level. We have been fine tuning it.

And the other thing I would say is you have got to be careful when you think about something like hospitality that’s a brand enhancer that drives traffic and what – it’s all fitted in an integrated way. How do we would really think about, we have always thought that this business in an integrated way.

What are the other contributions we drive, so clearly we drive substantial traffic, we drive 3x to 4x more traffic into a gallery and a gallery that has hospitality than a gallery that doesn’t have hospitality.

Our numbers show that we get an ex-list for every dollar of hospitality we drive, we get ex-in its growth on the retail side and we have got really good metrics around that and it’s very consistent. Obviously, I am not going to say what that is – we don’t need to give anybody a blueprint what to expect.

But when you look at it with the – at an integrated fashion and the incremental revenue that drives it’s massively accretive to our business model. And you would – you would do it every time you could. So the key here is executing really, really well.

We always are saying that our company that anything we do has to render everything else that we do more rather than less valuable and that’s true for – especially true for hospitality. Hospitality has to render the core RH brand, more rather than less valuable.

The only way it would render less valuable is we had poor quality and poor execution, right.

So the experience has to be stellar, the quality of the food has to be stellar and we believe that’s what we are delivering today and we are bringing very thoughtful and focused about building quality into the DNA of this experience and then being able to ramp from there, so big test for us will be RH New York.

So that will be – by far will be our highest volume restaurant in the company, we think it’s a spectacular setting. I mean it’s the – I think it’s the most beautiful rooftop in all of New York, if not all of the world. It’s got views of Downtown and Freedom Tower and it’s going to be incredible.

I think it could be the hardest table to get in the entire city. So it puts a lot of pressure and a lot of focus on us to execute at the same quality levels that we have in all of our other hospitality experiences and that’s what we are committed to. So but we know with each one of these, we are learning a lot.

We have done our big test and new learnings. I just couldn’t be more proud of Brendan Sodikoff and his team. I mean it’s not a lot of people can scale this quality of the hospitality experience the way they have and so we are just going to be really focused, really thoughtful.

But the good news is, the financial model now is unveiling itself, it looks way better than we thought and it’s now a real investable business..

Thank you, Gary. It’s very helpful. Best of luck in the third quarter and Karen best of luck in your retirement..

Thanks..

Your next quest comes from Daniel Hofkin with William Blair. Your line is open..

Good afternoon.

Just a quick question I guess when you talk about potential acceleration a little bit in the second half, is that relative to the 8% kind of underlying comp that you reported in the quarter or is that total revenues as how are you thinking about that, that’s my first question?.

Yes. That’s total revenue..

Okay.

And then in terms of longer term store targets, can you update us on your thoughts there domestically and what that split might look like between the two main types of new galleries you are talking about?.

Well, we have said last time that we believe by two-thirds or so of the forward galleries will be the new prototype, right which is I want to say to you that’s really the – our best thinking of the past 5 years, everything we have learned from category space, allegations, flow, different experience from stores, the hospitality experience and how we think about rooftops and gardens with furniture.

And I think we have really got a superb well designed and efficient model. It’s going to be no less spectacular than anything you have seen us build. It’s just going to be way more efficient from a build point of view and from a productivity point of view.

So – and so those you will see those start to ramp and those will be kind of the dominant part of our rollout and they are just more predictable from a time and cost perspective and the capital efficiency of those new format stores I think will be the best of anything we have done.

In addition to that, we will continue to have what I would call refer to as bespoke galleries in the major markets and New York being one of them.

That obviously is opening here this week and galleries like San Francisco or if you look at Austin and Chicago, etcetera, galleries that are really tailored to a market, that really optimize a market and then optimize the brand presence in the market, what they communicate about the brand and regarding design leadership, our respect for great architecture we would say we are obsessed with great architecture in this company we will either find it readapted or rebuild it.

And these kind of iconic locations I think communicates something about our brand and makes it very hard for others to emulate.

And then we have got what I’d call bespoke galleries – indigenous bespoke galleries that are really targeted to kind of key second home markets where they are wealthy and affluent visit and vacation and places like the Hamptons where we have a gallery today and we may do something more spectacular long-term in the Hamptons, but very successful in the Hamptons.

We are opening in Yountville something that’s very indigenous to Yountville in the integration of food, wine, art and design.

You see food and wine becoming more dominant even than design, because that’s the valley and that’s the language to speak there, but I think it’s the number one tourist attraction right behind Disneyland in the state of California, but it’s the number one attraction for the wealthy and affluent customers, more people travel to the Napa Valley than almost anywhere.

And then places like Austin and other places like that, you will see us focused on those again really, I mean, we have – with great returns in those markets, but we have an exceptional brand building right with the wealthy and affluent customers. And then, we are working on the secondary market stores.

We look at some of these secondary markets beyond that kind of 60 to 70 we initially have targeted.

And as we study those and get closer to those, we see a lot of opportunity and we see these markets kind of dominated by regional or small local players that we think we can be very disruptive, but you just want to size to that potential of the markets appropriately have the right capital investment and make sure you have the right returns.

So, that’s what we are working on next and those successful that could open up the market for us, I don’t want to say exactly how many yet and see how well they do. And then obviously, international will be the next big step and could be really the next big idea for the brand.

I mean, I think our brand internationally will be even more disruptive than it is in the U.S., because you have got significantly less competition..

Great. Thanks, Gary. I appreciate the color. Best of luck..

Your next question comes from Michael Lasser with UBS. Your line is open..

Good evening. Thanks a lot of taking my question. So Gary, you mentioned that in the letter that, revenues were a little short of expectation.

So, if you broke that down between members and spend per member, how did each one of those components compare to what you expected, do you recruit fewer new members than you thought or each one of those members spend less than you thought?.

Yes. Again, I mean, like when you have got this kind of massive margin differences, it’s not in those finite details, right. I mean I have been doing this for 40 years. I have never had gross margins increase 800 basis points in a quarter. I have never had gross margin increase I think 500 basis points in a quarter.

I don’t know if there is anybody in our industry that’s ever forecasted sales with 800 basis points of margin of improvement and focused on optimizing earnings, right. And so, I wouldn’t get lost in the details here.

I kind of stay motored up and say like what is this model looking like? I mean, just stand back for a minute and you look at our revenue growth and say, I mean, the only person I think in our industry that grew revenues faster than us this quarter despite the fact we have by far the best earnings are the people that don’t make any money.

Okay, so got it, there are some big market caps out there, but businesses that are not profitable and we have got a funny market today and it’s like no different than when we decided to make the move to membership. I said look, we have to be willing to margin and held for a heavenly cause, right, when I get to a better place.

No different than this quarter, humans are creatures of habit, right, we are all retailers, I mean this habit that twists that says revenues, revenues are a little softer than we thought like we can do this, we can do that, we can do that and it’s like we are not going to do anything. We are going to optimize earnings.

We are going to make decisions with a bias for earnings and we are going to fine-tune this model. It’s maybe the only chance in my life that I get to do this and by the way, this maybe the only team that has ever done this.

I have never been into retailer that is focused like this on optimizing the model and no difference in the move to membership and the value unlock that membership focus – that membership created, that the long-term value creation of creating a leapfrog model and then pivoting back to growth, then pulling growth levers, not moving back into promotions, but I think we could have easily drove a lot more revenues.

We beat earnings by learning. So, that’s not – it just means – I think we just look so different on every level like what we are doing. I mean, it’s like whether it’s a move to membership, whether it’s building to galleries we are building when other people are shrinking stores, I mean on and on and on and on.

I mean, I think look I told the team, I didn’t really care what the stock did today. I said look our stock could go up $20, go down $20 like where our revenues are lower than guidance. We took revenues down 2%. We took earnings up 15%. I will take that trade any day. It may not be what the external world expected.

It was better than we expected slightly different on revenues only because we are trying to sit here and forecast revenues with 800 basis points of margin expansion. As the model goes and then we adjust it as we learn we are adjusting it, but we are adjusting it, we are taking earnings up and so….

I would ask you that just to make no mistake that we are super happy with membership that is the game changer for the company and that….

Game changer, membership revenues are up..

Yes. Membership should grow generally with sales. The math is such that you are always going to become a member.

We would – I would add that as interior design services has taken off, these new galleries and average order value increased, you wouldn’t expect to that $100 with a much bigger order size, but overall membership, we couldn’t be more pleased with how it’s performing and what it’s done for our business..

Yes, I feel like we are kind of look back here, people are going to look back here and realize what we are doing and that – what we are doing right now, well somewhat unconventional for our industry is going to prove to be, I think transformational for industry and transformational for a business and brand long-term, but this is just another quarter and another step in our journey.

The biggest news that’s going to happen this week is our brand is going to arguably open the most innovative retail store in the world in the most important city in the world.

And even though when the last time that was done, I guess once if I look back it was probably 35 years ago, 32 years ago when Ralph Lauren has opened the Rhinelander Mansion on Madison Avenue and I think that changed everything for their brand.

I think when people see what we have just done in New York City and that the echo that’s going to create around the world and how that’s going to elevate our brand, I think it’s going to make a huge difference, something that you can’t do with digital advertising, something you can’t do with anything that anybody else is trying to do or how they are trying to market their brands.

So, I tell if you really want to see where we are going, come show up this week in New York..

And as you more transform into this newer model, is there a point at which you expect that top line will become more predictable, the ability to predict the top line will become easier? And are there levers that you would push to grow membership on some of the more mature galleries that have been opened?.

That of course it’s going to be more predictable. Yes, again, that sets the whole point, like again, if I ask everybody on this call, name retailers that have improved their gross margins by 500 basis points or more in a quarter.

I don’t think anybody has even got one they can put on the list, let alone name somebody’s improved margins by 800 basis points a quarter.

This is – we are going through different times, not about the knits or knots in the sales forecasting, it’s about are we developing a leapfrog operating model and platform that will put us in a position to dominate and win long-term. That’s the key here. Don’t get lost in the details you are going to miss the forest here.

The key here is, what is this business look like, what is this model look like and what is this value the company is going to be over the next several years, we think the value is going to be significantly higher because of the work we are doing.

So we have got to start this that’s massively volatile today for everybody that’s looking at it from a short-term point of view, that’s not the game we are playing. We are playing a long-term game and we are playing to win long-term. We run this company like we owned 100% of it, right..

Understood. Thank you so much and good luck..

Thank you..

Your next question comes from Curtis Nagle with Bank of America/Merrill Lynch. Your line is open..

Good evening. Thanks for taking the question.

So I was just wondering if you could just quickly go into the free cash flow guidance, so you are maintaining $260 million, right and it’s over $260 million, it looks like the first half came in maybe a little late, so just hoping you guys could maybe mesh out how you think the rest of the year is going to play out and do you still think that inventory will be a source of funds?.

Yes. So our $260 million is still our number and again I would point out it is better than $260 million, inventory we are still tracking at $450 million to $475 million.

So we do expect it to still be a source for us this year and obviously not as big as last year, but it’s still tracking in line and our forecast has always called for more of that to come in the second half versus the first half as we worked through going from four DCs to two DCs and some of the receipts of getting the inventory received in the right place.

And we have continued to make progress in making sure with our SKUs that we don’t have every SKU in both DCs some of the lower velocity SKUs are now only in one DC and some of that again was affected through receipt verses sales..

Yes. I would say Curtis neither earnings nor cash flows would be below our expectations, neither one of them. The only one is the top line is a bit below our expectations..

Got it, okay. That makes sense.

And then just a quick follow-up, I guess what are we expecting for the outlet business, I think you added another four stores, how does it perform – how does sales perform for the quarter and where do you think you are going to end up by year end in terms of total top line?.

Yes. It’s – well the outlet business is evolving as we are trying to kind of design the network and reach an equilibrium, right, without – equilibrium without a lot of transportation costs, right. So we are – and it’s completely new model that we are designing and building.

And so it’s going to take us I think right till the end of next year to kind of really get the model all fine tuned, get all the other stores and all the right markets and optimize that business. So we think we have got continued margin enhancement opportunities, cost reduction opportunities and transportation in the outlet business..

And we do have in the press release, you can see that we do disclose the dollar amount of outlet revenue was about $38 million this quarter and that was down from $51 million last year this time, that’s going to continue to be smaller number than last year into Q3 and Q4 as well, it will be below last year’s overall outlet level.

But again, as we grow the business and put the outlets in the right location, we are not expecting that to be a big growth driver long-term, it’s really just the way we dispose of our reverse logistics inventory..

Okay, understood. Thank you very much..

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

Hi, this is [indiscernible] for Matt, could you talk more about your real estate strategy, specifically how you are thinking about your exposure to the mall and at what point can or will RH be largely out of the mall?.

That’s not necessarily the goal. I think it all depends – I think you have to ask yourself which mall, right. Then there are some really productive shopping centers in the world and once said, the best developers are investing into and no different than we are creating next generation shopping destinations for consumers.

So we have no kind of headlines as if we don’t want to be in the mall. I think most of the press that talks about a lot of the decline in sales is about secondary, tertiary malls in the United States that are losing Sears, losing J.C. Penney, losing whatever anchors, all the retailers that are kind of a big part of the decline and the decay.

But there is a lot of developing centers that are really fantastic and will continue to be fantastic, not even stronger long-term. So let’s start there.

But I would say that we will look at every market and try to stay what’s the optimal location in the market for the brand today and long-term and where you are making the long-term real estate decisions is not just where exactly where you think things are going.

We made the decision to do the deal in the New York and the Meatpacking District right 5 years ago, right. And now the projects got approved, developed, built, delayed because of the street is under construction. But we – I think we are pretty good at figuring out where things are going.

And now you have got the Whitney Museum that’s opened right across the street from this now since we have – our hope was always to kind of anchor kind of the Meatpacking with kind of the luxury business that there wasn’t really any luxury in the Meatpacking and in fact with the Whitney come in and we can anchor the other point is Meatpacking at Gansevoort Street where we are going to have our first guesthouse at 55 Gansevoort.

We could tilt the street and create a luxury destination now Hermès took the corner across the street from us Loro Piana took the other corner.

Pastis is reopening across the street from our Guesthouse and I think we are going to find is that the Meatpacking is going to be kind of one of the great retail destinations and traffic destinations in New York City for years to come. I mean they are all kind of different to live in Chicago.

We made a bet in really the most affluent neighborhood in all of Chicago. We are into the middle of Gulf Coast in a historic building. And so we – and we believe the Gulf Coast is a good long-term bet and great long-term bet. So we – if there is an opportunity to do at bespoke location that speaks to the brand, that’s great.

We will not do that, if it means compromising revenues and earnings because we don’t want to be in a mall. I think people that are too black and white and linear with decisions like I will never open a retail store or will never go into a mall, they are just going to miss opportunities.

You have got to keep your mind open and you have got to really do the math on all these things, you got to understand where the investments are going to be made and where things are going. So that’s where I respond to almost anything when somebody says, I will never open a retail store. This all, I will never open a mall.

I mean like that kind of thinking is going to miss a lot of opportunities and leave your mind open and just try to be as smart as you can and maintain maximum optionality and make the best out of your business. So I mean at Vanity malls, like kind of good luck to the retailers who want to take that strategy.

There is a lot of – there is going to be a lot of great shopping experiences coming..

That’s very helpful. Thank you..

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

Hi guys. Congrats Karen and welcome Ryno.

First question just around – I am curious Gary, around the supply chain to support the new concept launches, I mean how much of that is kind of the piggybacking or leveraging kind of existing vendor partnerships and relationships and how much of that is striking up with new folks, that’s my first question?.

It’s really 100% is existing relationships..

Okay, great, that’s clear.

Circling back to the member conversation, I mean do you guys ended last year with a little of 400,000 members, you were adding net around 25,000 a quarter, I think that was the pace last year, is it safe to assume that pace has continued or do we – when should we expect a leveling off of that, I am just trying to understand maybe where you are sitting right now in terms of member count?.

Yes. Actually you will – you should expect an acceleration of that pace. So what – well, you have got the dynamic. Again if you think about that SKU rat, right.

The SKU rat brought down retail, brought down average orders, accelerated individual transactions and it would accelerate something like membership, right and now we are anniversarying that and so you have got membership growth slowing although it was still positive.

And now you should expect as we cycle around membership growth will grow faster, it will accelerate..

Okay, that’s helpful. Thank you. And then last one, just the tax rate that’s assumed in the second half adjusted earnings guidance, what should we be thinking there? Thank you..

We are using 26%. We are not assuming any benefits from stock option exercises in that number for the second half. We just saw the main driver of the 4% in the first half..

Yes, okay. Alright, great. That’s all for me. Thank you..

The last question we have time for today comes from Brian Nagel with Oppenheimer. Your line is open..

Good afternoon. So, Gary you have spent a lot of time on this call than in the letters talking about the prioritization of profit over revenue and the strategy behind that the effects on the results here.

Just wondering could you maybe articulate a little more within that strategy, no specific product decisions, market decisions that have made – been made.

And as we are thinking about that, is it more a function of with – is it more of this transition period where you find that balance and then going forward it will be less for trade-off because the business will actually be operating under that philosophy?.

Correct. Yes, I mean specifically we have held back. What we said ‘18 will be a – remember, we cannot set 2017 is about execution, architecture and cash, right.

And we said we wanted to execute our new membership model, right, architect a new operating platform and optimize cash by increasing revenues and earnings and decreasing inventory capital spend, right now it was 2017.

Then we said as we got through that, based on that focus, we are able to begin to see opportunities that we just couldn’t see before, right. And we said we are not done here, we need more time to focus and we then when we came to the 2018, we said 2018 will be about a continued focus on execution, architecture and cash, right.

And so by doing that in ‘17, we said we weren’t going to launch any new businesses or brand extensions outside of RH Hospitality.

In ‘18, we had things planned to launch, okay and then we said, look, we need more time, we wanted to focus more here because we think the long-term opportunity of building a massively differentiated model and more efficient model is it’s once in a lifetime, I mean once you get back on the tracks running it’s hard to do the work we are doing, you need all the brains in the game, you need a complete collaborative cross-functional effort and it takes the time and attention of every leader at the top of the organization to lead the organization through the kind of massive change we are leading the organization through.

It takes an inordinate amount of focus and discipline.

So, we said 2018 will be a continued focus on execution, architecture and cash that businesses that we were going to launch in ‘18, we held back, right and we have focused for another year and that’s a tough trade-off, because we are in a business where a lot of people just get overly focused on the top line and never focused on the bottom line as they just never build great model and this will be the last – I am sure it’s the last retail business I ever lead or build, right.

And I have always said since I was a stock boy at the GAP and I grew up in the retail business and I used to get these stupid memos from headquarters telling us to do this and do that.

And I just do think about like all these knuckleheads at corporate, like don’t they know what inefficiencies are up there they are driving, like I mean, don’t they understand the business, they are wasting this money or doing this non-optimized things, I have said, one day if I grow up and get to run a retail company like I am going to try to make it great and try to make it super efficient and not stop the dumb things and I have got a shot to do that.

And this is it. And that’s what I am committed to do as the leader of RH and what this team is aligned and focused on doing it and we couldn’t be happier with what we have learned. We couldn’t be more ecstatic about what we are accomplishing, but once again, because we are unique and we follow our own path, we are hard to understand.

And so but we are just trying to be super clear to you guys like we – I mean you can read all the letters in the last 2 years, I mean, it’s laid out.

In 2017, focus on execution, architecture and cash, 2018, a continued focus on execution, architecture and cash that we will manage the business with a bias for earnings versus revenue growth that we will hold back, the launch of new businesses and category expansions and so on and so forth. So that’s what we are doing.

We could have launched RH Color and RH Beach House this year, because we are doing a lot of other things, but we wouldn’t be able to get to the business model. I mean, we are in an industry today, where most retail business models, operating margins are declining, not growing. They are declining.

You have got people going from the 10% range to the 8% range. You have got some people the names that they have gone from 15% to 4%. You have got allocation of capital in trying to shift sales try to grow sales online and all people are doing to shift new sales from retail to direct and creating a higher cost model.

And I think it’s all because people are running around working real hard and all the wrong things and they are not disciplined and they are not focused and they are trying to win and get a pat on the back quarter-to-quarter. We are not doing that, okay. We might be one of the few retailers in the industry that truly have a real long-term view here.

And that’s how we are leading the business – reflects leadership in the business, look I am by far the largest shareholder in the company if you take all of my options and incentives right. So I have got a big stake in the long-term, not in the short-term.

And our leadership team has just the same incentive and motivation and we want to do great work, great work that we are going to be proud of, great work that we are going to be inspired by, great work that is going inspire others in this world to try to do great work with their lives. And so it’s a different game, not a quarter-to-quarter game.

And by the way kind of even though we are playing the game like we have the best earnings growth in our group and I don’t know if anybody really has much more of a better revenue growth, maybe somebody who has got 1% better or something like that, but not with the earnings, they are generally with flatter declining operating margins.

So as investors don’t want to reward those people are probably just short-term investors. They are probably moving money around.

And so we have had the same long-term investors for many years here, including the people that are inside the company, and that’s how we are making the decisions and I think our long-term shareholders are going to be greatly rewarded..

Thank you for all the color. I appreciate it. Good luck..

Sure. Thank you..

And I would now like to turn the call back over to Gary Friedman for closing remarks..

Great. Well, thank you everyone again. I want to welcome Ryno, I want to give Karen a big ovation and send off, goodbye. She has been a great partner of mine for 6 years and thank you for everything, Karen.

And I just want to say to our entire team, all of our people, all of our partners, all of our shareholders that are on this call that we are vastly unveiled in the most important city in the world that I think will make everyone proud.

And for those of you that aren’t here, I hope you get here soon, because this new gallery even though I have been designed – I have been involved in every detail for 5 years is it’s just taking my breath away.

I think it is truly the most innovative and most inspiring new piece of retail work this world has ever seen and the most important city in the world. And I couldn’t be more proud of the work we are doing. So, I can’t wait until everyone sees it and those of you are there in New York City come by and say hi, we will be here all week.

We have got a lot going on and the official opening to the public is on Friday. We will be here all day, and yes, come say hi. So, thank you everyone. I appreciate your time and interest..

Ladies and gentlemen, this does conclude today’s conference call. We thank you greatly for your participation. You may now disconnect..