RH (RH) Earnings Call Transcript & Summary

Thanks. Good afternoon to all of you, and thanks for being with us on this Q&A conference call covering the second quarter of 2020. With me on the line today are Gary Friedman, our Chairman and Chief Executive Officer, and Jack Preston, our Chief Financial Officer. Before we begin, please let me call your attention to our legal disclaimer: we will be making certain statements today that are forward-looking within the meaning of the federal securities laws, including statements regarding our business outlook and other matters referenced in the press release we issued today. A number of risks and uncertainties are involved in these forward-looking statements, and actual results could differ materially. For a more detailed description of the risk factors that may affect our results, please refer to our SEC filings as well as the press release issued today. Please also note that our opinions are reflected in these forward-looking statements only as of the date of this call, and no obligation is undertaken by us to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Additionally, non-GAAP financial measures may be discussed during this call, which adjust our GAAP results to eliminate the impact of certain items. Additional information regarding these non-GAAP financial measures, and a reconciliation of these non-GAAP to GAAP measures, can be found 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'll hand the call over to the operator to begin our Q&A session. Operator, we are ready for questions.

Good evening. Gary, in the letter you mentioned that you expect revenue growth to trail demand by — I believe the figure was 5% to 10% — during the third quarter. I'd like to begin right there, just to frame how the back half shapes up given where trends stand now. I'm not sure whether you can address how much of the narrowing between that expectation and the 16% gap in 2Q comes from demand actually being fulfilled versus a more organic shrinking of the difference between the demand comp and the revenue comp. I say that because I think you noted that you anticipate satisfying most of that demand across the coming three quarters. So any kind of detail that would help us model or walk through that across the three quarters, as we consider working off this unfulfilled demand over the next three quarters, would be useful.

Sure. I appreciate the question, Steve, and I'll do my best to add some detail, and perhaps Jack can fill in a few pieces; but if you go back to when we last talked with you, a quarter ago, we anticipated that revenue would trail demand comps by roughly 10 to 12 points, and what actually occurred was that the gap widened recently, reaching 16 points during the latter half of the quarter, as our demand truly sped up. It sort of broke away from our trends and our inventory flow. So a considerably larger gap accumulated, and as you consider it, we're responding as fast as we can. When you look at how demand built month-over-month, as we set out in the letter, planning for something like that is difficult. It began with a broad view — the pandemic struck in mid-March, mid to late March, and our revenues fell by roughly 40 points. Over a three month span, a bit more than three months, our demand went from 40 down to 40 up, roughly speaking, just in terms of direction. That's an 80 point swing, and we reacted very fast to the downturn, and according to our analysis, we had no idea how much longer our galleries would stay closed or what the effect would be, but we wanted to move quickly and we did — we managed to cut receipts and delay inventory. Then, as demand grew, we thought, wow, it looked promising coming back from down 40 to down 20 to down 10 to up 7, and then it simply soared. So, starting from that point, we're behind. And then you layer on top of that the reality that the pandemic affected everyone. It affected every nation on earth. Every single one of our production partners globally got impacted, and they experienced disruptions — things like workers being blocked or facilities shutting down, and similar issues — in North America, in Asia, in Europe, and in South America. So right now, I'd say we've got fairly solid visibility, assuming nothing shifts dramatically going forward. Whether demand keeps rising each month, I'm not certain. I doubt it. That said, I can't rule out that it might. The opening two weeks of September have gotten us off to a decent start, and what makes September different compared to a year ago is that, back then, we carried a larger proportion of what you'd call clearance inventory — older products we were eager to move. So over last Labor Day, we held something like a Labor Day promotion featuring that clearance stock, and we managed to sell those goods off, which provided a boost. That, in a sense, has made the trends look slower. Looking only at the first two weeks and wondering what the coming weeks hold, I can't say for sure. It's odd — I've never really devoted much attention to our business on a daily basis. But things have swung so wildly from one day to the next, and we're figuring it out as we go. So when we think about the back half, what we anticipate is that we'll be watching the expected flow of inventory. We ought to begin catching up, narrowing that gap, and after that, we should begin moving past it — right — and see a favorable restocking. As for when we'll more or less be caught up and fully worked through this, likely by the close of the first quarter, possibly the second quarter of next year. What I mean is, our product isn't something that can be produced and shipped very fast. Consequently, lead times for many items can stretch as long as six months, in certain categories — and obviously, for us, it's nine months. So what we're doing is attempting to offer you our best assessment of how we believe this sort of demand will turn into revenue, and I think we'll be right in terms of direction, though as I often say, every plan we put together here is wrong to some extent — the real question is whether it's more right than wrong — and I believe it will be more right than wrong, provided our demand trends don't shift dramatically. I don't know — Jack, would you like to add something? Yes.

Please proceed, Jack.

Actually, no, no — I'd say that went really well.

Oh, right. So maybe this is a question for you, or for Jack or Gary, whichever wants to take it. If I look at second-quarter gross margins — obviously that was a major area of attention for us and for investors as we entered the quarter — and when we consider the increase to the long-term guidance, the 25% EBIT margins compared with 20%, versus the 22% you actually achieved, what gross margin level makes sense for this business? In other words, is there still substantial room, whether we're talking about delivery, damages, or diverse engineering, and across the entire supply chain — where should the margin profile sit for that long-term target as it stands today?

We're not sure whether we've landed on the correct margin structure, honestly — it comes down to imagining what could be achievable. My guess is that no one covering us would have predicted this; I doubt any analyst out there is modeling a 20% operating margin within the coming five years. So if you're asking what the right number looks like, here it is: a route to 20% became visible to us. The speed at which this would play out depends largely on how appealing your product is in terms of margins, correct? So what we're observing now, having shifted — shifted away from relying on one supplier for rugs toward sourcing them directly — is a substantially transformed business with a substantially different margin profile, and that is elevating the business. We've discussed with you all the idea of annualizing the faster clearance of goods via our outlet division. Twelve months ago that pulled margins down; it has now fully washed through, and what we're seeing there are margins I'd describe as more normalized. Let me begin by pointing out that those margin figures — the 21.8 and the 47.5 — were achieved while our top line stayed level, whether you're looking at it through gross margin or operating margin. So here's what's happening: in that letter, I said we now anticipate hitting 20% operating margins in 2020 alongside 5% revenue growth, and the reason I put that out there was to hand you a floor — a floor for this year. It seems unlikely to me that our revenue growth would drop below 5%. That said, if every store were to close once more, there's really no telling what this pandemic might bring. From what I can see, conditions appear to be improving rather than deteriorating. Consumers have grown accustomed to wearing masks at this point, and social distancing has become routine for people. In a lot of markets, you're seeing case counts decline, so I believe we can say with reasonable confidence — and you can work out the figures yourselves — that if you calculate what 5% revenue growth for the year implies, it comes to roughly 18% for the back half. So at this moment, we tend to view that as a floor. When revenue is expanding like that, we're at ease operating at a 20% margin. If you set aside the pandemic and everything going on with COVID, I'm genuinely pleased to report that our top line stayed level during this quarter. The benefit is that it strips away the distractions, letting us observe our core business model and enabling prospective investors to see and appreciate the foundational model we've established here — one we've put money into over five years, essentially rebuilding the whole approach and steering the brand toward a more luxury-oriented identity. In my view, chances exist across each element of the business's margin framework. We're only beginning to lift the product up. You'll be hearing shortly about significant strategic actions we'll take to keep raising the RH brand and establishing it as a luxury name in the market. That, I believe, will unlock additional product margin potential. It can also tie into margin shift potential. When item prices rise while the cost structure stays the same for moving goods through this supply chain. Another consideration is that we remain fairly early in reworking our real estate. Each time we redo a gallery in a given market, essentially — during the initial year or two, though I recall a few extending past two years, but the first one to three years, and typically just one year, we achieve double the retail revenues in that market. So consider the leverage you'll gain on the — portion of the business, plus on the SG&A portion at the corporate level. Thus, we can envision a fairly obvious route, and we're fairly sure over the long run that we now spot a chance to reach a 25% operating margin for the business. That presupposes spending on international expansion, and it presupposes it won't be entirely — it won't follow a perfectly straight path. Certain quarters will involve launching a new distribution center abroad, which will create a temporary drag. I doubt the drag will be large enough to heavily affect the company, since we aren't merely launching a DC while revenues tick up slightly. We're launching a DC on a whole new continent, and I expect revenues to climb quite rapidly. So I believe that will settle down before long. What I'd offer is this: look at the period starting in 2016. As I said earlier, Modern launched right at the end of 2015. Here's how I'd frame it—the moment you go public, it's as if you've put a car out on a track, and once you're running that quarterly circuit, your field of vision narrows. For 12 or 13 quarters straight, I'd argue we were close to faultless as a public company. Then we had a tire blow out. Most companies, when a tire blows, take the car into the pits, put on a replacement, patch up whatever else needs it, and more or less get back out on the track. Our decision was different: we rebuilt the whole car. We knew going in that this decision would draw heavy fire. We even framed it as marching toward a noble mission. That car stayed in the pits for roughly a year and a half, if I recall. Hardly anyone had faith in what we were creating. Our stance was: what people doubt, that's precisely what we go out and do. We brought in around $1.2 billion, bought back 60% of the company, and put an entirely new vehicle on the track—one with a jet engine, essentially. As a result, we've now catapulted ahead of every competitor in our field, right.

At a 20% operating margin or above, no matter where that lands, we're going to have — what I really appreciate is that 5% revenue growth; our plan had been a bit above that. So the reality that we're sitting at 20% this year. It's just that the underlying business model has this systemic shift. It truly has nothing to do with COVID whatsoever, right. Plenty of companies are going to see a very temporary boost to their business, and once things change and sort of return to normal, there may be nothing systemic there. We now have a 20% operating margin floor on essentially flat to up 5%; so now when you consider the business growing at 8% to 12%. Over the coming several years, you consider where leverage in margin will come from in that model, if you consider continuing to elevate this brand up to the luxury mountain and the sort of leverage that will produce — the key becomes — it's among the reasons why in the second half, right, we chose not to mail our call books. Because honestly, first, we'd be mailing and potentially generating incremental demand, and we don't have product for it. The newness, since the factories are behind, would be delayed; so having back orders is costly. And we thought, let's use this time and concentrate on the next few really big moves. So all the time and energy it would normally take us to develop the seasons and develop the books and launch everything, we're actually going to redirect that time to rebuild every category in the business, and we believe we can lift the floor up there, right. If you consider it, if we truly do our job well, there might be 10 or 20 comps in the core business simply by going category-by-category, down to the detail and re-architecting the assortments, which you don't get a chance to do when you're sort of just running the business; and so, and then, focusing our time on architecting the web portal, the world of RH, which we think will be a leapfrog, and focusing our energy on launching in Europe. So, I think what's different about RH in many ways and what's unique about us is, we invest really with a long-term view; and I think that's why we have one of the best performing stocks since our public offering in 2012. It's funny, I was doing an interview with someone for a magazine, and clearly this person had been talking to a bunch of short sellers or non-believers in our company — I could just tell by the tone of a question. So I told them, look, your tone tells me plenty — lots of people feeding you their emotions, I can hear it. My suggestion was, let's begin with facts instead. Because frequently, when you consider an organization like this one, one that puts money to work with a long horizon in mind, the share price tends to swing around in the near term, yet over the long haul it can genuinely deliver. So I said, let's shift away from emotions and toward facts. Here's a fact, I told them: our company became publicly traded on November 2, 2012, at $24 per share. Since then it's climbed — no idea where it finishes tomorrow, but based on today's close, the value has grown 14 times over in a span of slightly less than eight years. During that stretch, few publicly traded companies have performed better; it beats LDMH. It beats Home Depot. It beats Starbucks. It beats Nike. It beats Lululemon, and it even beats Apple; plus, depending on tomorrow's closing price, it beats Amazon. And honestly, I doubt anyone even acknowledges this, correct? I doubt anyone pauses to sort of rev up and examine the long run and ask, what exactly are they up to? My sense is people become stuck in a near-term perspective, that quarter-by-quarter magnifying glass, and the larger picture stays invisible to them. But we make an effort to rev up and take in the entire chessboard, correct? We make an effort to spot each move, and within our company we like to say, don't move until you see it, correct? So — ever since we pulled the car, which is now a jet, out of the pit in late 2016, early 2017, essentially we've accomplished everything we promised you we would, correct? And we've likely now delivered — we're about to deliver 20% operating margins. I mean, five years sooner than, I believe, any analyst expected from us — Wall Street, or seven years in anyone's model, many folks projected something like 17% five years out, 18%; we figured we were two to three years off. And at this point, it's sort of a reset, correct? What we're saying is we've got a new floor plus a route to 25% operating margins. There's no mixing up the sequence here. I mean, I can't hand you every last tiny piece of the puzzle. But what I'd say is, if you examine our track record and take in the big picture, we're an organization that 20 years ago launched this journey as a company close to bankruptcy with a $20 million market cap. Not sure exactly, but tomorrow we'll likely sit at a market cap of roughly $7 billion; so we believe we're a genuinely strong bet. So my sense is this: if someone's horizon is genuinely long, and they focus on the overall picture rather than getting caught up in emotions, weighing what's actually true against how they happen to feel, then I believe they'll end up quite pleased that they put money into RH, provided they're willing to keep that position for somewhere between 5 and 10 years. My reasoning is that during such a stretch, we should rank among the strongest holdings anyone could own. That response went beyond what you were looking for, I realize, yet everything I just described reflects how I see the broader situation, so.

Thanks, everyone.

Hello, folks. Much appreciated for fielding our questions. A fast one for you, Gary — in that letter, you pointed to proof that certain customers are leaving cities and purchasing vacation properties, or perhaps a third one too; it’s tough to picture a business that might be in a stronger spot for that over the coming couple of years, perhaps. So, could you expand a bit more on how much of a demand push that represents — possibly difficult to determine — yet how long-lasting might that expansion prove to be?

Right. We attempted to spell it out in the letter, and honestly, nobody really knows — your best guess matches ours — but we do appreciate the numbers we’re seeing. Since this pandemic has dragged on for so long, I asked my physician a few weeks back how much longer he figured we’d all be wearing masks, and his answer was a minimum of 2 additional years. I replied, seriously, another 2 years? He told me, yes, you need to consider the arithmetic. He explained it would require — he mentioned 270 million individuals possessing antibodies or vaccinations to reach herd immunity, correct. And in all likelihood, a vaccine won’t arrive before the spring of 2021. Getting 270 people to herd immunity would need a minimum of 18 months even moving very quickly. So, according to him, we’ve experienced a fresh behavioral change that he believes will persist for some time. None of us could have pictured that at the start, and now it’s beginning to add up, right, along with the numbers and the shifts. I’m taken aback by how fast folks reacted to this pandemic — judging by what’s happening in the housing market, how swiftly they went out and bought vacation properties to escape cities, and so forth. And I wouldn’t claim it’s entirely outside cities — simply acquiring second homes so they have a place to retreat to. A lot of them still keep their urban residence. Beyond that, there are those relocating to suburbs — actually, entirely new suburbs were taking shape. I mean, I spoke with some individuals about how there’s an entirely fresh perspective on suburbs in Silicon Valley. A great number of them are discovering they can work remotely far more often, so they’re relocating and purchasing properties in Palm Desert. Palm Desert is now somewhat being recharacterized from a retirement community into a suburb for lots of people, right. Younger folks are heading where they can obtain a larger house and enjoy extra room. There’s a feeling that with fewer crowds, there’s likely greater safety, and so forth. And who can say when we’ll all be traveling once more. That’s our largest open question regarding international. Unless we’re willing to head to Europe and spend 14 days in quarantine, we can’t go. So I ask myself, will things just bounce right back, or is this — there have to be some genuinely lasting shifts in how people behave, and how long will those stick around? When you consider the home purchasing and home furnishing cycles, neither one moves quickly. And I really believe our position is strong for this moment, thanks to what we offer and our distinctive skill in interior design, which lets us step in and guide someone, and we’re handling more complete projects now than at any point before. What people want is a solution that cuts down on time, and that’s something we deliver. So, as I mentioned in the letter, my guess is we’ll see an elevated level continuing through 2021, though I can’t be sure. Nothing like this has ever crossed my path, honestly. Perhaps the air escapes the balloon faster, or perhaps there’s — it’s a lasting transformation. Once you get people pondering something, it might open up an entirely new market around the home. Just consider it: how many folks aren’t heading out to dinner right now, or only a small number are going out to dinner. I came across a figure showing OpenTable reservations have dropped 50%, roughly in that ballpark. I’m dining out. I’d say it’s 80% lower than before. We’re visiting the homes of people we’re close with for dinner, and my sense is that when a shift like this occurs, people visit others’ houses, then they notice someone else’s place, and they think, wow, their home is far nicer than ours. Darling, we need to renovate our place, since we can’t invite them over for dinner until we improve our home. You see, what’s fascinating about people, correct, is that we’re constantly sizing ourselves up against others — our clothing, our cars, our neighborhoods. Our house, how big it is, every tiny detail. The places we visit. Where you spend your vacation. Oh, I visited Pepperie, oh right, we visited Pepperie as well. All those things that people do. And therefore, I believe this attention on the home and the sheer time individuals are putting into the home, with entertaining now centered on the home, might build an entirely new sense of what a home should be — that yours needs to be significantly better, and your home must be fully furnished and look a hell of a lot nicer. Because you’ll simply be hosting more guests and logging more hours there. So that might turn into something just like a lasting transformation. But as I mentioned in the letter, I have no idea how to prepare for that sort of thing. Taking a big gamble doesn’t sit well with me since I lack certainty. Therefore, our approach to putting money in will be highly deliberate; rather than having demand pursue cost, we’ll keep letting cost pursue demand. Building an enormous expense base around 40% demand comps, only to watch it drop to 10% and then stall, isn’t something we want. That said, I believe this situation has lasted far longer than anyone in this room anticipated, and it comes across as more lasting. At minimum, it seems destined for a lengthier existence, though we can’t be sure. Either way, we’re in a fine position. What I mean is, over the long haul we’re fond of how our business model works, whether this turns out to be more temporary than structural, or anything else.

Understood. That was a considerate response, so thank you. Perhaps a fast question about how the company is financed. You've retired the convertible notes. My impression is that you're aiming for something around 1x to 3x leverage. What's the outlook from here? Will you keep carrying less debt than you could? How does the balance sheet shape up given margins are exploding?

Right — the thing is, we're simply going to produce a tremendous amount of cash. Because of that, the way we're financed will look quite strong, and — as the letter stated, we'll stay opportunistic regarding where capital comes from and where it goes, since opportunities and dislocations always show up in markets such as this one, whether they last a short while or stretch into the medium term. Keeping options open appeals to us; so, we'll just have to wait and see. Once more, we'll have to wait and see how long these interest rates stick around. From an investment standpoint, our approach — despite doing Europe — is that, surprisingly enough, the initial handful of galleries won't need much capital except for one. That single central location, where we're piecing together four buildings into a single one, will demand somewhat more investment, similar to New York. Paris, though, doesn't require such heavy investment. Nor does RH England. The ones coming after, we've completed and signed two additional deals, don't require heavy investment either. After that, in the U.S., we are — you'll watch us begin to accelerate. More prototypes are coming, and since we've now essentially refined that model, our approach there will involve less investment. Then, considering the prior couple of years, certain stores demanded heavy investment; there was RH New York, and there was the initial development of the new prototypes, correct; those — since we'd been working on them for ages and revising constantly, much like creating a brand-new iPhone, right; that store amounts to an R&D effort. Consequently, plenty of capital went there. Same with San Francisco — plenty of capital. Our initial guesthouse in New York, once more resembling an R&D effort, absorbed plenty of capital. Once you move past all that, we have fewer galleries that demand heavy investment, and afterward, as the letter noted, our results will shape a fresh sort of credit profile for the company, one that will turn us into a far more valuable development partner for whichever developer, right. That means they'll achieve a superior cap rate on the rents and credits we provide compared to what other tenants give them. Which generally lets us secure more TI, cheaper rents, and so forth. And it truly benefits us when it comes to our development projects closer to home, since we ought to be able to achieve stronger cap rates. It's just like — we offloaded Minneapolis right in the middle of the pandemic, which is insane. At first, when other folks back out, given the situation out there, we're going to land a bigger, larger price than what we quoted, like if someone backs out, hey, I'm saying, this is short-term. We're fine. After that they returned and we finalized at a 5.5 cap. And I believe originally when we — I mentioned that property a few years back, I believe in New York, our plan was to place $1.8 million in rent on it and unload it for $33 million, then said, we've chosen to place $1.4 million in rent on it and unload it for $25.6 million. Yet the reality is we achieved a 5.5 cap, and that happened prior to us jumping to 20% or beyond 20% operating margins along with the cash flow profile and the return on capital profile that you will witness, I mean, I believe there's a possibility we'll surpass 50% return on invested capital this year. And that had been a long-term target. I didn't revise that long-term target, since I felt like — you begin that ridiculous math when we're going to have something like 75% return on invested capital. But it will be a genuinely strong model as we sort of transition and no longer have as many capital-intensive projects. So, and even — consider our second guesthouse that we're constructing in Austin, which is a joint venture development and a highly capital-light guesthouse. And we can sort of arrange a deal like that, since we were already building and possess the designs and plans for the first one. So the development partner said, understood, that seems fantastic. Alright, I'll structure this sort of deal; and the very, very first one in New York, folks thought we were crazy, like, what are you guys going to do? And folks still think we're crazy. I believe once they witness it and then you'll understand it; but, so, we appreciate the capital profile of the business; we appreciate what the — as we forecast the new cash flow model, the new return on invested capital, the capital requirements of the business, I think it resembles a model. Honestly I never would have pictured it would look this strong. Back when I first got here, honestly, it was mostly a bunch of us gathered around that table constantly, you know? We'd be saying things like, alright, if we can reach a billion dollars and pull 8%, if we get to that point, we've made it. So if someone had told me then — I mean, fine — you'd build that sort of top luxury design platform globally, and we'd be sitting at operating margins above 20% with a cash flow model like the one we have, constructing the kind of galleries we're constructing — we aren't putting up lousy tiny junk retail spaces. What we're doing is developing buildings. These things, they'll still look fantastic 50 years from now. So honestly, it's somewhat astonishing. Inside our company we say the lesson my career has taught me is this: remarkable, extraordinary, amazing work can always be monetized, whereas ordinary, unremarkable work is genuinely tough to monetize. What we've figured out, then, is that by concentrating purely on producing truly extraordinary, remarkable, amazing work, a model and a business can always be built around it. I believe the iPhone taught people that, right? Consider when Apple gave the iPhone its incentive push. The typical handset in this country, I think, ran $59, and that was the Motorola Razor. Apple launched it as a $600 phone at that moment. It stayed $600 for six months, then they cut it to $400.

Yet the key idea is that there was so much more, and we then figured it would never succeed, it would never succeed, and later it turned into arguably the top-selling handset across North America, and afterward everyone claimed, oh, they will never sell in China. A $600 or $800 phone will never sell in China, and it ended up being the top-selling phone in China. So another lesson we have picked up over time is that if you produce exceptional, remarkable, amazing work, you truly can build a brand-new market. And we have come to understand, over time, that consumers desire superior products. If your work is genuinely much better, customers will happily pay. We are seeing that with Tesla, correct. Consider Tesla's results as a new automaker. That man had never made a car previously, yet he made a remarkable car — compared with everything else available, it truly is extraordinary, and it is establishing a completely new market. So I believe what we are doing resembles efforts like that. In a way, we are building a new market for the high-end home consumer, and that market has sat behind what you might call an iron curtain created by the two trade design centers and showrooms, which suffered from a lack of accessibility, a lack of transparency, and a lack of scale. Consider that. In the upper tier of the market, accessibility was missing. You could not even visit them without an interior designer or a retail license. That is a great market — I will take a market missing accessibility and make it accessible; next, transparency is missing, which means someone walks into a showroom. No prices are listed. You cannot work it out. There are codes; designers get discounts; discounts get handed out. They will not give you a discount. The fellow brings a designer, so it is so tangled, and beyond that I think they lack scale and the capacity to bring everything together. So you must visit roughly 20 separate showrooms to furnish your house. Then we arrive with something accessible, and lovely, and transparent, correct. We eliminate all of that — such as who receives a discount, your designer, is it this individual, is it that one. And beyond that, by the way, we provide design services; so that is a help. And beyond that, we possess scale. And we have stitched it all together so it delivers time and value to the consumer, and time is the ultimate luxury, correct. Nothing matters more than time. I would say to folks here, the way we allocate our time matters more — actually matters more than the way we allocate our capital, since I can always go raise additional capital, but I cannot — I have never worked out how to obtain additional time. Okay, so I believe what we've built is going to bring about a completely — I think we're bringing about a completely new market for a business, and at this point we find ourselves in a situation where, although there could be a systemic move toward the home and an emphasis on the home. Should that take place while we're sort of developing into the brand we want to be, you could truly see an upward file here. Yet we don't require that to take place in order to generate a great deal of value. Should it take place, we'll be like super charged.

Thanks very much guys. Appreciate it.

Yes.

Hey, thanks. I wanted to ask about how you keep that 20% operating margin objective intact, which is quite something. Could you put that in a longer-term context, given that you’re pursuing RH residence and, clearly, RH guesthouses as well? How should we think about how the margin structure evolves as you move further into those areas? Would you consider those channels to be additive or a drag? Is the operating margin structure something you can hold onto? Thanks.

Yes. I’d say we look at it from two angles. First, we believe those efforts will raise the RH brand and make it worth more. So how do you create high-end luxury brands? I remind our team that nearly all the truly great brands began at the peak of the luxury mountain — LDMH, Gucci, Canoe, to cite a few that come straight to mind. They’ve been luxury brands from day one. We started nowhere near that. Oxydol laundry detergent was on the front of our catalog 595, right. So now we have to grow into luxury, and that means doing things that generate a four, three perception of the brand and lift it in the minds of the right consumers. Whether that’s an extraordinary guesthouse experience we think will open a completely new market for customers who want privacy and luxury, or the RH3 luxury yacht you can charter in the Mediterranean and Caribbean — sure, not many people can use it. But I promise you, when we built the RH portal and you see it on our site, and you see our guesthouses and the other initiatives we’re pursuing, the way that brands us, right. We don’t have a marketing department, because we say marketing is often putting lipstick on the pig, right. People take something ordinary and try to dress it up so it looks better than it actually is. We say it’s not what we say, it’s what we do that defines us. So the brand gets built through our work, right. We hardly run ads — maybe one or two here and there in a home magazine such as Digest or similar. But mostly it’s the work itself. Our galleries are our work, the remarkable experiences in our stores are our work, our web portal will be another expression of our work and how we tell people what we do. And I believe the guesthouses and the residences, if executed really well — and who knows — they’ll raise the brand and support our climb up the luxury mountain, because they’ll be so extraordinary that the very best people in those fields will have to tip their hat. Again, we’ve learned that when we do extraordinary, remarkable, amazing things, we can usually find a way to monetize it and shape the business model. Right now, even though we haven’t opened a guesthouse, the handful of people inside hospitality whom I’ve shown it to have reacted with, oh my god, do you know how much you can get for those rooms, oh my god. And if they’re only half right, we’ll do really well. But these aren’t just separate new businesses to evaluate on their own — you can’t think about them in isolation, you have to think about them in integration and how they make the RH brand more valuable. It’s the same error department stores made over the years. If you visited Stanley Markets at the start, they’d tell you the restaurants were never meant to be the main profit engine. They were meant to bring high-end female consumers into the store more often, so they’d pass through the shoe department and buy very expensive shoes and other items, and viewed in that integrated way, the restaurants were quite profitable. But if you examine things separately, you can err and miss the larger picture. It’s no different than — quite frankly it blows my mind how many retailers right now are talking about shutting stores and keeping only a website, right. I guarantee you, when people begin closing stores, their website traffic is going to plummet. And then they’ll discover the cost of acquiring customers through digital marketing. The cost of marketing an invisible store online — good luck with that. All the digital native brands are opening stores. So these other pieces — guesthouses, residences, other things you’ll hear about that we’ll test and incubate — they’ll generate a big conversation around our brand. They’ll be extraordinary, extraordinary pieces of work within their own industries. And they’ll elevate the RH brand and render us more valuable. I think we’ll also find they become real businesses in their own right, and if that happens, right, the ecosystem expands. If not, we’ll have a handful of them, and they’ll stand as tremendous examples of our work that raise the brand. But I think long term, now that we’ve spent more time on them, we’re going to find they are businesses, and we won’t pursue anything that destroys value here, right. We don’t want to suddenly try to build an 8% operating margin business while holding a 20% to 25% operating margin business — that would just pull the whole thing down and destroy value. So the goal is: can we build things in an integrated way that lifts the entire margin profile of the business? That’s what hospitality does in our current galleries. If you look at hospitality on its own, you might think it’s a drag. If you do the integrated math properly, and look at how many people become purchasers, then integrate that and take the extra flow-through and view it in an integrated way, it’s a really good model. But you have to do the math on all of it. So we’ll test these and try these and learn more. But one thing I know for sure: they will elevate the RH brand. They will create a conversation at the highest end of the market, and that’s what’s really hard to do. No one has ever climbed the luxury mountain before starting where we started — ever. I can’t name one brand. Most brands go down. So this requires a different kind of effort. You won’t do it by just running some ads in magazines and things like that. It’s really our work that has to define us here. That’s the only way we’ll earn the respect of the consumers of the very best brands in the world.

That’s useful. As a quick follow-up, when I think about what’s been pushing demand higher during the last few months, I’m curious whether you can help us gauge how much comes from the deurbanization trend, how much from changes in second-home markets, and how much is simply the broader housing market doing better — or whether it’s mostly the pandemic and people staying hunkered down. I’d just like your take on what’s driving this recent strength.

Yes. I’d say every one of those. Yes, it’s all those factors combined. I mean, again, we were at — that’s 8 or so before this pandemic. Sure, so before COVID hit, we were at plus 8. Then we fell 40. At this point, in the core business, we're roughly up 44, or something like that — though August was 47, and for the first part of September we're up 44. I mean, absolutely, there's a big shift happening. What's unclear is how much of it is permanent versus just short-term; and the important thing, I believe, is that you should operate assuming it could be short-term, because otherwise your model can get thrown off. So we're fine — we're not attempting to fine-tune every single thing in this environment. Correct, this situation is short-term. If you decided to alter your approach and go after each individual transaction, fine-tuning it while burying yourself in the details, you might squeeze out an extra 3% to 5% in sales. But then, suddenly, your attention lands on the small stuff, and you've wrecked your approach — correct? — and before you know it, the momentum collapses and you're sitting there thinking, great, what now? You'd have to tear apart how your business is built and halt what you're spending. So, we're fine with where we are. No sales are being chased by us. Not a single item went onto promotions. Some demand is slipping past us; we're aware that the backwater race we're running means we're losing demand. You've got it right there. But no worries. I really don't want to be known for something like, wow, weren't they amazing while the pandemic was going on? Would you even recall them — think, gosh, nobody posted better figures than they did back in those pandemic days. Whatever became of them? Ah right, over the long haul they more or less wrecked their model. From our standpoint this looks like a temporary step forward that could deliver lasting structural upside for the household. That's our hope, though if it doesn't pan out, fine. Our lens on the model stretches way out, and honestly I take real pleasure in the fact that, hey, our top line held steady this quarter — thank goodness. Alright, I'm not getting tough questions from everyone along the lines of, "Where did the margin land? What did it end up being? And what sort of leverage is tied up in that?" What I mean is, revenue hasn't increased whatsoever, and our operating margin is 21.8%, which takes into account a 40 basis point blow from the pandemic, along with a 90 basis point blow from water works. That works out to about an 80 basis point blow, hospitality confirmed start-up mode. There's an additional blow coming from certain one-time investments we're making; so once you factor in those pieces, that shows us, yes, 25 along that path. So continue down that path. Don't overlook the small stones related to the pandemic. Let's ride this wave as best we can, but I don't believe the business remains up 40%. I really don't; it could stay at this level for a couple of years. Perhaps a new water line appears, I'm not sure. I mean, I suppose this is tough to predict. It hasn't been all that long. I mean I've never witnessed anything like it. So, like, I don't want to overreact to it and mess up the last kind of decade of work; so, we're adopting a very long-term perspective here; we're not rushing around with our heads down attempting to run the business week-to-week; we're not pulling any levers. There are no promotions happening here. Just trying to build a — build the finest brand of its kind anywhere in the world.

Great. Good luck. Thank you.

Thank you.

Hello, and thank you for taking my question. Congratulations on the momentum throughout the company and the promising outlook you've described. What I wanted to ask is whether you could provide some insight into how we should consider certain expenses and SG&A during this year's back half. On one hand, I'd assume there might be additional sales originating from ecommerce or web orders rather than from physical locations, which could help costs. You're also not sending out the source book — and on the other hand, fingers crossed, the sales book looks quite strong. What's the right way to think about costs for the remainder of the year? Thank you.

Yes. Clearly, we'll see some savings when it comes to advertising expenses; and over the near term, we aren't going to attempt to pursue and fine-tune revenue. We believe we have sufficient, and from a supply standpoint we're already pursuing it. So we believe the choice we're making is correct — it isn't as though we're neither mailing the book nor doing anything at all. The book isn't being mailed, and instead we'll put our time, energy, and resources toward investments in other areas that we believe will deliver genuine long-term value for the business, rather than mailing into this situation, exerting lots of effort, and possibly gaining a small extra bump or none at all, mailing into it while either lacking the goods or with the customer already optimized. So, and incidentally, something else we're interested in learning is — perhaps the books aren't as productive as we believe them to be. So let's use this period to test our approach, sort of add it and back into it, and we'll obtain some fresh new data suggesting that perhaps when we launch the portal, and perhaps since we're constructing all these large new stores, we can mail fewer books. And so there's plenty of motivation around sort of testing and learning for the long term. So, but we're placing many investments into long-term growth. Placing many investments into international, placing many investments to elevate and expand the product. You've likely read, if you haven't, that we completed a small acquisition of a business that we disclosed. So for competitive reasons we aren't saying much about it. But we believe it will elevate us, and the talent and the acquisition will keep helping drive our sort of product capabilities. So that's what we're focused on, and then we truly want to do our finest work at introducing the brand internationally in Europe, since that opens a whole door, correct. Suppose we begin showing that this brand is capable of succeeding without requiring an extremely lengthy, drawn-out buildup — for instance, if we take our brand into international markets and it gains traction at something close to the rate of any typical market where we previously had no presence, such as Canada, where we launched galleries. That alone would mean we can — it would establish the foundation for this brand to reach $20 billion worldwide even if nothing else were firing on all cylinders, correct. So once more, my thinking runs along these lines: provided we can establish ourselves abroad, and provided that across a span of several years we can build momentum in England and in France, and afterward throughout Europe plus Spain and other locations, Germany and so forth, that would in all likelihood serve as a truly strong signal of what lies ahead when we shift over to Asia, Australia and South America along with the rest of the globe. And what makes us feel positive is that our sense of timing rests on the fact that the world keeps shrinking at an exponential rate, correct. Thanks to the visualization occurring online via every platform, social media, interest and all the rest of it, the world keeps shrinking. The world is converging on a single tempo and manner and so forth. Therefore, I believe all of this will genuinely work to the advantage of superb global brands; hence we are putting money into all those areas, and in spite of those investments, once again, we expect to once again perform rather strongly when it comes to profitability and margin results.

And Brad, this is Jack, I'll jump in briefly here. Gary mentioned — when you look at that 20% model, at the floor, it suggests roughly 5% revenue creep. You can also work out what that means for H2 op income, and that comes to 22.2% with 700 basis points, right. Again, that's simply the math implied by the forward guiding. We aren't telling you how it breaks down between gross margin and SG&A, obviously we're not guiding, but naturally, as you pointed to, the sourcebooks, that benefit would naturally, I'm going to see it come in more during Q3 than during Q4, since that's when the mailing would happen; so I just want to...

Yes, that’s a valid observation.

And from a timing standpoint, factor that in as you consider the quarters.

Excellent. That was quite useful. I appreciate it, Gary. And thank you, Jack.

Yes. I appreciate that.

Wonderful. Thanks so much. The substance and detail here are excellent. Gary, when you brought up the topic of building brands — a number of those being premium labels — if you examine lots of labels, worldwide labels, there's a category they refer to as demand creation. So considering that your catalogs run roughly 3.5%, 4% of sales, you're fortunate enough to have about another 600 basis points available across all those various spaces such as RH3, guesthouse, and hospitality, correct, in order to develop that. Therefore, I suppose what I'm asking is whether that's the proper lens through which to view it? To what level might you raise that demand creation as a percentage of sales, given that you now enjoy the benefit of this additional margin? And then, regarding what you said about the catalogs, might the catalogs at some point shift away from content-only product only and become a tangible embodiment of, in a sense, the world of our age and, in a sense, the Lifestyle Content Magazine? So those are a few of my questions. Thanks.

Yes, you've got some tasks here. Incidentally, our entire leadership team is present in the room. Yes, it was like, yes, okay, you think the way we think. So, yes, it's right on every point. Yes, so, precisely how we approach it.

Alright. So assuming that's what we get, just one tiny item — actually, I've got two quick housekeeping questions. I realize this is a minor effort and you've got far larger ones going on right now. But what's the status on RH Color? And then, as a follow-up, what share of the transactions you're currently processing include interior decorating services? Thanks very much.

Right, we don't disclose the interior design percentage.

We have given it. But we don’t.

Yeah. Yeah. It's a huge piece of what we do. But for competitive reasons, we're not sharing that at this moment; plus, regarding color — color is likely something you should ask me about in the following quarter; we've got a number of off sites and hours we're dedicating purely to assessing all our main value-driving strategies and initiatives. We have quite a lengthy roster of opportunities, and it comes down to how many we can tackle simultaneously. How do we order them. What's the emotional, strategic, and financial worth of each one, and that's how we allocate our time along with human capital and financial capital; so, we're enthusiastic. I mean, I really — it's sort of a blessing to say, hey, this thing, don't send the book out at this moment. Don't complete all that effort, like have everyone pause and let's take every talented person in this company and truly look at the board — truly arrange things in the proper sequence and truly concentrate on these — the upcoming handful of major priorities that can transform everything once more. I genuinely think that if we spend our time smartly across the coming six months, we can genuinely transform the core business from a — purely a comparable sales standpoint. Like, if it's you need — you truly need every leader focused, myself included, correct. So, and we have so many items to address, so many opportunities, and we've also added plenty of fresh talent, and we possess far more capacity to accomplish more; but it requires everyone collectively and truly concentrating to shift the major priorities. If not, folks are grinding away on all these minor priorities, and they have somewhat of a range in how they organize things, and it — ultimately it doesn't truly shift the needle much; but within the brief period, we began concentrating on a handful of the categories, I believe, if you were seated here with our senior leaders or with product, I think everyone's eyes are truly opened wide and we think, wow, there's plenty of opportunity here. And beyond simply the product itself, but also the physical representation of that product in the market, we've got ideas and chances to take action. Currently, we are — I'd say, we excel at showing the product physically in an integrated manner. We're somewhat hard — kind of difficult to shop by category at present, right. You visit one of our large galleries and attempt to shop for lighting, you attempt to shop for — you've got to sort of walk the entire space; and we don't even carry the full assortment in a structured manner, and sure, the web assists you there and the book assists you there. Yet folks continue to have a strong desire to actually view the products. Therefore, we have numerous concepts centered on creating various tangible expressions of categories in a manner that we believe could also be hugely disruptive. Perhaps I ought to offer everyone a little hint so you can mull it over, probably, since — I will discuss one where our thinking is a bit further along just to illustrate the point, such as, we believe, if you visit any of our standard galleries, older galleries, any of our older galleries, they display a single assortment of outdoor furniture on the floor for half the year. Correct, and when you visit our large design galleries, we display 20 to 24 assortments throughout the year, roughly that number. However, they are not all located together. A few are on the rooftop, a few are in garden patios, a few are on terraces, and we currently have, what we have 45 collections, approximately that, by next year, we might have 60, 70 collections of outdoor furniture; we have a concept in development that could launch sooner than — in fact, I enjoy mentioning it, since it gives us a quicker deadline. So, everyone is staring at me here in this room. They are going to be like, okay, here it comes. So, now we have to move really quickly, but we are developing a concept named RH Oasis and it is going to be a standalone outdoor furniture experience unlike anything anywhere. It will be astonishing. And we will dominate the category not just in outdoor furniture, but shade and fire and heat and textiles and items presented in a manner in a setting you cannot even fathom. And I believe it will be hugely disruptive and beneficial to our business and if you sort of consider that, and you consider like wow, there is something you can do, is there RH Illumination, is there RH — is there RH Chair Upholstery, is there RH Furniture, is there, it is like I think it continues endlessly, correct. And everyone is saying, oh, here he goes, like the entire thing; but you know, you can suddenly begin to envision an RH Compound, this wonderfully cohesive experience with these separate experiences around the categories that let you shop both ways and lets us convey our brand in a manner nobody has ever witnessed. And so, so we have these projects that we are working on, that we are piloting and that is why we must keep everything in perspective like, where does RH Color fit in. Well, like we have a whole lot of things, like you select from, how many can you handle simultaneously in what sequence. What's the secret to doing it truly effectively — like, I suppose, if somebody sitting in this room were staring down at me and asking me to explain it to them? If I actually told them what we believe, they'd think we've lost our minds — they're literally looking down at me this very moment. But take another huge concept — it's not as though ideas are in short supply around here; what everyone lacks is hours in the day, and the real question becomes how we dole those hours out. What I genuinely appreciate is that this pandemic, in certain respects, is handing us permission to redistribute our time in a radically different manner, and I suspect we'll end up more correct than incorrect when we assess how our human capital was deployed across the coming 6 to 12 months. Perhaps we'll discover that, well, genuine breakthroughs exist here, and maybe we'll be directing our hours — who can say — perhaps we'll learn this 2 years down the road, or 3 years down the road. We're shipping two-thirds fewer books — turns out we simply don't require that quantity of books — and then, as you put it, they can take different forms, with every lifestyle articulated in its own way. There are numerous approaches to accomplish this. The encouraging part, I mean, is that we're sort of perpetually dissatisfied, perpetually in motion, perpetually innovating, perpetually acquiring knowledge. We grow sharper and sharper, and I believe we'll continue discovering superior methods for carrying out what we do. So, plenty of developments lie ahead.

Thank you.

In the same way that folks will look ahead, 90 days out, and on each of these conference calls they ask me things such as — indeed, RH is on its way, when will RH Illumination arrive, when will this arrive, when will that arrive. Yet a great deal is going to arrive across the coming five, ten years; we are not going to exhaust our ideas here.

Many thanks. Well done to everyone in leadership. What you folks are building truly is extraordinary. I felt I had to mention it.

I appreciate that. Thanks.

Yes.

Good evening. Thank you so much for taking my question. There are two quick ones, and they might be for Jack. First, could you give us a clear breakdown of what drove the gross margin expansion in the second quarter? And then I have a quick follow-up.

Well, aside from what Gary already covered in the letter, we did mention 490 basis points of product margin, so the remainder would be shipping expense and occupancy expenses, and we achieved a little leverage on each of those. And we won't be providing much more detail than that.

Was that simply a result of there being less discounting and fewer promotions during Q2?