Good afternoon. My name is Jessie, and I'll be your conference operator today. At this time, I would like to welcome everyone to the RH Second Quarter Fiscal 2017 Q&A Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. Cammeron McLaughlin, Investor Relations, you may begin your conference.

Thank you. Good afternoon everyone, thank you for joining us for RH's second quarter fiscal 2017 Q&A conference call. Joining me today are Gary Friedman, Chairman and Chief Executive Officer; and Karen Boone, Co-President, Chief Financial and Administrative Officer. 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'll find additional information regarding these non-GAAP financial measures and a reconciliation of these non-GAAP to GAAP measures in today's financial results press release. A live broadcast of this call is also available on the investor relations section of our website at ir.rh.com. With that, I'll turn it over to the operator to take our first question.

[Operator Instructions] Your first question comes from Steven Forbes with Guggenheim Securities. Your line is open.

Good afternoon. So, I wanted to -- I guess I wanted to start with the supply chain redesign, right so you mentioned four into three is Mira Loma the one you anticipate closing and I guess given the lease expiration, which I believe is 2020, what type of financial impact should we expect if any as you guys work through this whole process of optimizing the supply chain?

Sure. This is Karen. It is Mira Loma which is Southern California and because the lease market down there is quite favorable, we actually don't expect to have a significant charge-related to that. We're still going through the process; we've just notified all the employees that it's been a sensitive topic. So, we're treading lightly on that, but we are marketing the building and again because there is highly favorable rental market down there, we don't anticipate having a problem finding a sub-lessee to take over that with relatively small loss, if any.

Okay. And then, just as a follow-up regarding in-home delivery, so maybe Gary if you think about, the long-term impacts and I try to digest them as well, right could the optimization of the last mile potentially being be net neutral or even net accretive to the business, the margin, and the market share, given the potential benefits tied to lower returns’ damages plus the potential sales opportunity of getting the RH associ into the consumer’s home. And then on that topic maybe if you could just touch on where you are with any in-home delivery tests if they are out there today and how those tests have evolved, if you can comment on any of them?

Sure. Well, I think we've been commenting for a quite a while that we believe that, we believe it's important for us to be have more control than less control as it relates to the customer experience. And the way we view it is the -- the opportunity B2B inside a customer’s home, the opportunity to make a positive impression not only in the delivery, but possibly in the after sale market is a huge opportunity. And, we believe that's just something we should have more control of than less control of. And if you think about the home delivery industry and the architecture of kind of third party home delivery operations; they are really not architected for the luxury market. I think you've got to go back and say no one’s really scaled this business today. And we're really the only ones at the luxury market with any kind of scale and actually any opportunity to even take this on; and because of our scale today, we believe from a cost point of view, and you can't just look at it from one dimension, you have to really look at it holistically, what is your revenue benefit you are going to have from having a significantly better delivery experience and customer experience, what is that impact on -- as we mentioned in the letter and you just mentioned now and returns, exchanges, damages so on and so forth, and what is the cost to deliver it. Today, if you stand back today if you say, we really have two markups in the process, right. We have a third party delivery company who is also hiring third party truckers. So you really have an opportunity and everybody is making money, right. People are not losing money doing this for us…

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

Yes. Good afternoon. I want to follow-up about the delivery network redesign. Gary, what is the right number of distribution centers for you to have longer term, as you continue to grow this business and as we look at your inventory levels, about 600 million, with I believe most of that being in the DCs, how much do you think you could further reduce inventory by optimizing that delivery network?

We think we're in the early stages of evaluating and redesigning and architecting the right supply chain for the business long-term. And from an inventory perspective, we believe that there is meaningfully more of opportunity to turn the business faster to have a much greater return on invested capital from an inventory perspective in the business. And exactly how that winds up and how many centers and how it's architected, we will reveal that as we come to those conclusions. But we're not done with the work; we're not done with optimizing the inventory, we think there is meaningfully more impact to make here in making this a much more efficient capital model.

Great and if I could ask a follow up on the New York gallery with the timing of that opening being a little bit up in the air, how should we think about that in terms of guidance and modeling in the next couple of quarters? Thank you.

Well I think today, I mean if anybody goes down to meat packing district, , we'd think it looks a bit like a war zone today. All the streets have been torn out, they are doing all the infrastructure work, they were supposed to be done in the spring, the spring was turned into the summer, the summer is now turned into the fall, now turned into late fall, and if you talk to people in the ground, they think it might be next spring. So, we're going to take it kind of month-by-month, I'll be in New York tomorrow, I'd be walking in the site tomorrow and we will be evaluating it. When I was there few weeks ago, you couldn't cross the street. People don't have access to the sidewalk. So, as it relates to, if it comes out of the model, I don't think it's going to be a significant impact, we feel confident about our guidance, but we'll update you as we know more.

Great. Thank you.

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

Hi Gary and Karen, thank you for taking my questions. Just first of all, it looks as though you've run some limited time promotions over the last few months. Just curious if that’s simply part of your inventory initiatives or if you plan to be running that type of promotion with any regularity going forward?

Sure, well we've always said that there is regular kind of clearance activity that's going to happen in the business. Moving to membership does it mean that we're never going to discontinue product and refresh the inventory. So there is always going to be, there is always going to be kind of a summer clearance sale, a winter clearance sale, and events to kind of clear through inventory. So just think about that as kind of status quo that will always be part of the business. And I think we also mentioned in the past that as we evaluated membership, looking at the impact on kind of the higher ticket business or the lower ticket business, we clearly on the lower ticket business -- it took a bigger hit and we began testing and have now implemented kind of sales for things like our home furnishing business and so on and so forth where the crossover point to buy a membership doesn't quite hit the price points, and we were losing part of the business there. So, we've re-implemented that part of the business, but that's a much smaller part of the business. We didn't want to lose it, because that's an entry into the brand, so those are some of the adjustments I think we talked about at several quarters ago, but – and then you do have a third layer of yes within kind of the regular sale cadence of the business, the seasonality of moving through, moving through seasons, moving through some of the products that we are using that to move through the skew, the part of the business that's not going forward as we rationalize the offering.

That's very helpful. Thank you. And as a follow-up I was curious whether you can provide any color on the impact from Harvey in Houston area and also whether there will be a potential delay to the upcoming Florida gallery from Hurricane Irma? Thank you.

Yes. Like everyone in Houston, it was a pretty devastating event and our hearts go out to all the victims of that significant storm. We were down I think for six days in our business. We’ve opened. The business is slowly recovering; I think there is still a lot of chaos in the city and a lot of issues with transportation and lot of people recovering from the event. So, we lost roughly a week of business in a pretty significant high volume store and that's factored into our guidance and we expect the business to kind of rally back. As it relates to the Florida market, our teams are buttoning down the hatches, everybody is prepared for the storm and so we don't have any more information than anybody else does at this point to know the business impact in Florida.

Understood. Thank you, again.

Your next question comes from Oliver Chen with Cowen & Company. Your line is open.

Thank you. I had a question related to just modeling the free cash flow profile for the back-half where will be kind of the biggest drivers we should focus on in terms of free cash flow for the back-half. And Gary on the comments from the remarks that it look like in the RH interior source book you had swung a little too far towards the contemporary static, if you could elaborate on what happened there and some guardrails going forward and just give us some more clarity about the opportunity and that's how is fine line as you are balancing innovation and newness in surprising into lighting versus décor?

Sure, sure, well I'll take that part and Karen will address the cash flow part of the question as it happens inside organizations, you can overly tilt and shift one way or another as you focus on big opportunities and I think what happened here with the focus on building the RH modern business and the up it that's from the organization, I think that, I think it really skewed kind of our perspective and our eye a bit, I can somewhat get tired to things it shouldn't get tired off in our business, so where we can't get bored of ourselves, we can't get bored of the things that really drive our business. But the fact is that not only the internal shift with us, but I think also with all of the designers and artists and manufacturers we work with globally, who are really an external part of a product development platform. I think everybody started to develop product with a more modern point of view, a more contemporary point of view, it's what we were all working on is what we were all excited about and I think we just shifted the core book too far. I think as we take the interiors book it's really important to evolve great brands slowly, great brands usually don't swing around. They are like watching a clock, you can if you look away from it for a few hours it moves, but you never really saw it move. And I think if you picked up the book we mailed last fall and you pages through and compared it to previous books, it really shifted too contemporary and it really took on a look too much that came to storage modern in the first 60 to 80 pages. And so while…

And then Oliver on cash flow, the biggest two drivers in the back-half number one is, certainly inventory. We're continuing to see that the number come down by the end of the year it's going to come down to even more than we've already had to-date. And then the second is really just earnings, we have more earnings and power net income is bigger in Q3 and Q4 than it is in the first half and then there is some other, smaller working capital items that are contributing, but the biggest two would be just earnings and inventory.

Okay and Gary as we all get ready for holiday and retail has undergone this revolution and disruption, what are your thoughts for catalyst for you for holiday and you can optimize your store traffic. It's kind of, did you, how did you feel about your assortment in terms of balancing price points, it sounded like there could be opportunity there just curious about traffic in holiday and thoughts on a year-over-year basis what would be most different? Thank you.

Sure, well last year we really pulled back and we've said look long-term that we still carried some of the legacy RH with us over the years and part of that was just added the necessity as we are transitioning the business. We needed to hang on to certain things and partly the holiday piece of the business was important. But as we transition this business from a typical mall-based retail home furnishing business to really a luxury interior design platform, holiday really, the at least holiday the way it was previously characterized doesn't really fit in the business. So there is a new layer of holiday home décor layer of the holiday, an elegant gift giving aspect of holiday that we're working on that you'll see us layer in. I think last year as we really pulled the plug and we pulled it, pulled it out of the galleries we took the hit. I'm kind of glad we did when we did its now beyond us and it's over. And so, as we evaluate what do we bring back in how do we brighten up the mood of the business and the presentation during that time to maybe pull more people into the business. We're working on that, but it's a fine line, we really we're not a Christmas church key business anymore. We are not the place you wake up and look for stockings, steppers or you wake up and you look for this and that, we still have some of that in our holiday catalogue, but it will continue to be a smaller and smaller part of the business as we go forward. This is not what we're trying to be famous for. So, and hence it nor does it there is a line up with our…

And it sounds very good. Thanks for the details. Best regards.

Thanks Oliver.

Your next question comes from Charles Grom with Gordon Haskett. Your line is open.

Thanks, good afternoon. When we look at your implied gross margin improvement in the second half, up I think it's 300 to 400 basis points, and then compared that to the front half of the year which is up about 400 basis points on average. Can you walk us through the step changes that you are going to see across the core merchandise margin improvement the savings that you are expecting to get from the DC consolidation and then finally the changes that you, the change that you are going to do from the rerouting of the outlook products?

Sure, I mean we probably won't break out a ton of detail on each of those pieces, but I will say that as we enter into the second half, we did go ahead and give a lot of detail in the back part of the press release that actually showed guidance for Q3 and Q4 margins. The delta if you just look at what we were up or down versus way throughout the year it's a lot more about what we did last year in the second half that it was is about this year, we're now in that 36.5% to 37% gross margin. So, that's up roughly 400 basis points in the third quarter really have to do with last year we had few rationalization. We had the floor set. We were doing formal sell off to make room for all the design [indiscernible]. And then, in the holiday period we didn't have as many of those things in both period membership was ramping. So we weren't getting the benefit of that revenue and in the second half we are. So, you'll see that, the change is more about last year that is this year we're getting back to those 36%, 37% that you know is more normal for us if you look back at couple of years before 2016.

Okay so just the dovetail, so you are not assuming that you are going to get some of the $15 million to $20 million that you talked about from the outlet changes, could that be upside or that is more of a 18 months?

So that is, that's most in transportation, I was mostly just talking to on the older is some modest improvement, it's obviously in early stages that we are already seeing transportation savings in the markets where we're not bringing that merchandise all the way back to the DC that's part of the reason why we were able to save and get out of the DC as we are taking up outlet space in the DC. So that reverse logistic decision has benefits all up and down the P&L and certainly an occupancy which rolls up in the gross margin and shipping transportation which is up a gross margin so that in there as well.

Okay, great and just a follow-up, that's helpful. Just on the membership rates, I'm just wondering if you guys would be on to speak to the renewal rates that you are seeing and what the churn is on that, how that's standard and thanks?

Really because we're the only specialty retailers ever done this, outside of Amazon and Costco and a few others we're the only one made a move to membership that didn't start out with membership this way and there is no benefit in us creating a roadmap for anybody else follow-up. So we're not going to say a lot about membership other than the fact that we made a very brave move, a lot of people thought it wasn't going to work. We're in a position to tell you today that it is working and the renewal rates are positive. And the membership growth is positive. So other than that we don't need to get anybody else a roadmap to simplify their business and gain the benefits that we are going to gain over the next couple of years because of that.

Okay fair enough. My final question just, if you do achieve the $4 billion to $5 billion that you've outlined and we look at your profitability today and compare that to where you were few years ago and that's probably not a good way to look at it. But when you look ahead where do you think the profitability this business could be, when you think about the savings that you could do in the top-line that you could generate?

We said, we can have the industry leading operating margins we think, at one point we are characterizing mid-teens and well that still looks achievable, what we don't know when we look long-term is the industry going to change is there going to be other competitive pressures or is there going to be more beneficial for us to be more sharply priced and go up and create bare market, how should we think about it, so we are leaving some flexibility. I would say if nothing changed over the next 5 to 7 years could this be a mid-teens operating margin business, yes it could. The model would say it could today. But I think we want to, we don't want to get boxed into that and I think that, look we're in a world that you have to remain flexible and fast and you have to improvise it after and overcome there is some many things changing. We just want to have a great model that allows us to win and if it means winning a 15% operating margins 12% operating margins 11%, 10% operating margins. I don't know if that should really be the guiding, the guide post for us. I think the guide post should be how do we maximize the market share of this business and the overall profitability of this business and has a viable brand that can win forever for us as long as we're guiding this business or beyond. And we can all see it today, as talking to some or the other day and I said oh my god the desert, the department stores and CAG Amazon, the desert department stores, Amazon is wrongly accused right, the department stores have been dying forever. It's been a slow deferment from a lack of innovation and from very rigid business models that couldn't adapt and innovate. And we just believe today, you've got to build the very flexible model and you've got to be able to deal with the business and make the right kind of changes to win for the long-term not win for the short-term.

Great. Thanks very much and good luck.

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

Hi. Good afternoon. thanks for taking my questions. So first question Karen I have, just look at the guidance that we all want to and thanks for the few chart, it definitely is suggesting of a positive up tick in trend in the business. But, what is your view, how should we think about or how should we, what is the risk you are really managing against to achieve that guidance through the balance of 2017?

Well, I think we all have the risk of any kind of macro moves in the business. So, there is the aspect of what we don't know. We think we got as we are now, as we now cycled a year of membership we understand what that looks like, we've made the adjustments that we needed to make with the model. We are architecting through some pretty big moves through the supply chain. I would say we, as we get further through this, we have more control rather than less control. So we feel very confident about the guidance in Q3, Q4. We as any company does we have our internal list of opportunities and risk and the opportunities far out way the risk when you look at our Q3, Q4 plan. But there is a lot of uncertainty I think with and it is the political environment and all they noised around that excuse North Korea and those kind of things could they affect the consumer if all that hence shortcut. But I think we're in a good position where we kind of look at the back-half and we would say there is more upside the downside, we feel very confident the numbers we put out there and we got our arms around this model. We've now as I said in the letter, we're past most uncertain times the transformation that we just kind of led this company through. And we're glad we did and we now, we are more right than wrong with our assumptions and we really like the model we see evolving and as we look into next year, we see more upside. And so we're still are at the very early stages of in decision with some or other day that said, talking about the…

It's very helpful. And then, just a quick follow-up on that. And as we think about, again, reflect upon what seems to be a nice stabilization in the business now. How should we think about the cadence of gallery openings into the next year or so, couple of years? And also probably what happens with the -- how about this, especially now it seems like you are through what had been the outside clearance activity, how does that business evolve over time?

We said, the outlook for the gallery openings would be 3 to 5 years. And we think that's the right number as we've said before these are really -- we're in the development business now. We're really not in the kind of the mall leasing business where you are taking 50-feet of frontage and an already built box and you fixing the store and building the store front, right? It's not what we do we have to find pieces of property or existing historic buildings and go through entitlements and go through city councils and all these things that to take longer. I look back and I think how naïve we were when we went public and we had our first couple of big gallery deals, when we said, oh, we can open 10 to 15 of these this year. And I remember one of our biggest shareholders who by the way who is stuck with us the whole way. And he said really Gary do you think you can really manage opening 10 to 15 each year what about like 4 to 5. These seems like pretty and we just didn't know enough, and we are overly enthusiastic and the numbers were seducing. And we thought we could go fast and we are on that high road train as a public company. And I think we are just as so much smarter now. And we have a lot more scar tissue right in. And look I'm one of the biggest shareholders of the company. And if I look at this, I don't want to play a short-term game. I don't want to raise after fast growth just to know it's unsustainable and we want to build a company that has long-term sustainable durable growth. We want to build quality…

Thanks for the details. I appreciate it.

Your next question comes from Matthew McClintock with Barclays. Your line is open.

Hi, yes. Good afternoon and thanks for all the color today Gary, I really appreciate it. I need to bring this back to the distribution centers going from 5 to 3 or 5 originally 3 just because I have two questions. And it's largely because you seem to be going in the opposite direction of what the rest of the retail industry seems to be doing. So the first question on it is this more a function about less growth meaning going to 3 to 5 stores per year, is it more of function of skew rationalization or is it more a function of underlying efficiencies in your supply chain. And then the second question is, I know you have another facility in California, but how does this impact delivery times or the potential for delivery times or the potential for out of stocks just thinking back to last year grand it was a little bit different situation there, but how those risk and have a meaningful impact on your business? Thank you very much Gary.

Sure, well when again nobody is really signed the product we are selling. And so you see, you got to be careful comparing kind of what we are doing to what Amazon is doing or what other people are doing. I mean we're kind of building an interior design platform. We are doing home and projects and yes we still sell someone just a sofa or chair or what not, but the jobs the average orders are growing the kind of business we're running is very different. So, designing the supply chain to support the business we're in is very important. And we're really focused about on inventory optimization return on capital and the customer experience. And you can get a sofa to most market in two to four days, right? I could argue, you could run this company with one DC, we don't think that's the right way to run it. But, you can get a product across the United States in three days, right? And so, how it should be architected long-term, we definitely think it's a multi-unit kind of a structure that optimizes time to customer. But, the inventory duplication in four, five while we were on a path to go eight DCs. The inventory duplication and the capital drag of that and the bloat on our balance sheet was going to make this company kind of impaired for a long time. And so, we are designing a supply chain really for our business. And our business doesn't look like anybody else's business out there today. People ask us like who is the competitor and I believe we are building a brand with no peer. Put somebody up against us today and say who is really offering the quality, the breadth of assortment, the integration of aesthetic, the kind of retail experiences we are building. There is not a real good peer. And so, we've got -- it was just different requirements for our business and there are other businesses. And we are building a supply chain for our business to win in our business. So, it's going to look different, just like our galleries look different. When I started this company, we had 106 galleries and we were doing $350 million a year. Today, we have significantly less galleries, doing $2.5 billion, right? That's a different company. And so, more will be revealed as we go, but we don't think we are going to -- we think we're going to positively impact the customer experience. The more DCs you have, the higher your in-stocks go, right? It's lot easier to carry inventory in one DC. You are always in-stock, the goods are always in the right DC. When you have two, it's twice as hard, when you have three it's three times as hard. When you have five, it's five times as hard. It's really that simple. People think it's not, but it is.

And I think the point about the product being so much different and what everyone thinks with Amazon, it's a big deal if you are too paced through your book isn't there in two to three days, but so much of the high-end furniture business, it's customer ready and even if it's not custom, people will wait an extra two to three, maybe four days to get in the market. And that's just a tremendous savings for our occupancy cost and our working capital over time.

We have over 70% of our upholstery business is special order.

Thank you very much for that color.

Thanks.

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

Good evening. Thanks a lot for taking my question. So, we assume kind of a modest rate of new store productivity or the contribution between the brand comp and your total sales growth. For the third and fourth quarter, it looks like you're guiding there maybe a mid-single digit brand comp on what are progressively easier comparisons. So, what would make the business slowdown just from a brand comp perspective?

So as we enter into the second half, you are right, we expect to know always maybe a point or two new store growth which is non-comp, so the delta between total sales and brand comps that we don't expect that to be much big anymore now that we are going to pass the outsize outlet growth and water works is in the comp base now going forward. So you are right on kind of where the guidance implies and really we are up against last year it's kind of an apples-and-apples and last year we were doing some [indiscernible], we were coming up against that. And our guidance is our guidance that's what it implies. I still think it's a pretty healthy top-line and total growth.

Very healthy. But, is there anything that would cause it to slowdown in the back half like Gary mentioned that you are not going to bring that all the knick-knacks that you offered over the holidays, but maybe some of them, so that should be a positive driver. But, is there an [off-fit] [ph] to that?

Yes. Look, we are trying to be conservative. And we feel confident about the guidance we put out there. So, if you look at the core business over the first couple of quarters, it's roughly 9%. And if you look at the guidance in the back half, when you take the mid-point, it's not too far off that. We are just trying to be conservative as we think about our guidance.

Okay. My follow-up question is on the gross margin math, it does look like you are expecting between 200 to 400 basis points of gross margin expansion in the back half of the year. Your outlet margins as you indicated in your release are going to improve, it sounds like you are also getting some gross margin contribution from lower return rates, lower cancel rates. So, are you seeing if we exclude those factors, are you seeing better selling margins or because of the way the membership program also coupled with some of the sale activity, their selling margins are a little bit lower still.

So, in the back half about 2/3rds of the gross margin improvement is product-related so much margins. And then, the other -- the rest is coming from transportation the things that we have been talking about with our reverse logistics and such and occupancy. So, the 2/3rds that's kind of the product margin improvement is coming mostly from the core business.

Selling margins.

Of selling margins.

Yes.

Outlet business will have a modest drag, but that was really a half one thing hasn't got that inventory down.

And what's driving the big improvement in selling margin?

Just being up against everything that you saw -- we said and described it ad nauseam kind of last year what was happening in the business and we are anniversarying all that.

Okay. Great. Thank you so much.

The next question comes from Cristina Fernández with Telsey Advisory Group. Your line is open. Cristina Fernández: Hi. Good afternoon. I wanted to ask about the hospitality cost, you talked in a lot about having substantial cost over the next couple of years. But, should we think about this being more front-end loaded as you build the organization and lessening as we move into 2018, 2019?

I think I will take it just as we said it. So, over the next couple of years and as we are building out the hospitality organization and we are building on a base of one, right? So, when you think about the pre-opening cost and the investments you have to make to build kind of a national -- kind of restaurant and hospitality platform. This significant cost to get it up and get it going, it's all embedded in our guidance.

And there is really two pieces as Gary said. There is the organization which is building that team and once that's in place that team will kind of execute everything. But then, it becomes if we have three as we do this year but last year, we didn't have any because Chicago was in 2015, we were going from having zero in 2016 opening to having pre-opening relate to three -- if we have three next year obviously at least that piece of it isn't as big of a drag and it just ends on which ones and how many…

Yes. And it depends on what, say following the quarters, if we have a bunch of galleries falling this quarter, there is going to be more of a drag because there was just a big pre-opening expense on a restaurant.

It's not unlike when we had the first big galleries and we have pre-opening rents and pre-opening cost of getting all the furniture there and everything set up. The first time we had it, it was kind of a big deal, but now we have that 3 to 5 every year and it anniversaries itself and eventually it starts [celebrating] [ph] growth.

It's much more people intensive business, if you just look at our Chicago gallery, I think we employed somewhere around 40 to 50 people in the home furnishing, so it's design part of the business and we have over 100 associates running the restaurant, right, which is 10% of the business. Cristina Fernández: It's helpful. And then, as a follow-up anymore thoughts into Waterworks and how you could integrate that into the RH core business going forward?

Yes. We will talk about that when we are ready to kind of reveal that plan and that strategy. But, we think it's the best bath and kitchen brand in the world. We are so proud to be associated with it, and we think there is tremendous upside in that part of that business. And it will -- long-term, I think we can amplify that business on our platform and insists nothing, but upside when we think about it long-term.

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

Great. Thanks very much for taking my question. So just quickly going back to the gross margin, I did say you are seeing some really nice benefits to your returns, cancellation, exchanges from moving to the membership model? When did this inflict, was it something you guys starting to see, and in 2Q was it a little more recent, 1Q, we are just kind of curious on the timing of that?

We are really starting to see kind of maybe halfway into the membership. It's hard to see trends when -- because when the cancels come in or returns come in or things come in, you need to know hat period they relate to. So, it takes a lot to make sure the data is clean. I will say that some of those items are don't necessarily impact gross margin, something like a cancel. It just impacts convergence, so whether or not a sale actually becomes a sale. But, it has benefits downstream and things like the call centers from people calling in our people everything, so not all of it's -- some of its convert, what we call conversion written orders to your demand to sales. And then, obviously transportation with things like returns and exchanges. It's significant that does hit gross margins, but it's kind of all over up and down.

Yes. And some of these things have a waterfall effect, right? Like returns and things you really got to look at, almost rolling 12 maybe a 12-month kind of calendar because it waterfalls down right. The sale you make today doesn't necessarily return tomorrow, it might return two months, four months, six months down the road. So, you got to really look at these things over time. So, the -- we liked, I think what we said is, after we were kind of six months into it and two quarters into it, three quarters into it, we are saying that we like what we are seeing, we like what's happening underneath this -- underneath the business. And clearly, it was -- there as was an effect on the fact that we were giving a bigger discount, so we are taking the margin hit, we were taking $100 in membership, but we couldn't book that. We are taking a hit on the gross margin line, we couldn't book. The membership fees, we had it amortized over 12 months. So, there was funny things and timing there which we are trying to explain. And then, we also made the decision to begin to rearchitect our operating platform and rationalize our SKU count, which created kind of noise in the model, if you will. And I think as we are now starting to cycle that and we have cycled membership and we have got now the kind of the waterfall and the trailing 12 months data and all these trends, now, that you can see the trends much more clearly. The noise is kind of going away from the business and we got enough data, where you say, okay, that's real, that doesn't look like a three-month trend. So, we are very confident and how this is kind of revealing itself. And now, that the data is here, right? It now -- it presents you with -- you can see a lot of things you couldn't see, many more opportunities that we are very, very excited about as we think about designing and architecting the operating platform for this new business model.

Got it. That's very helpful. And then, just a quick follow-up, are you guys still expecting to pay down the $100 million second-term or sorry, second lien term loan?

Yes, absolutely. Absolutely.

Okay, great. Thanks very much for taking the questions.

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

Good afternoon. And thank you for taking my questions. And that was an interesting pronunciation. I guess, Gary, I do want to understand, make sure I understand on the outlet situation. You have I think 28 outlets now, some of them are short-term and that number has moved around. Do we expect more outlets, less outlets and just a kind of a profit driven model for the outlet as well, or how do we think about that going forward? I do have one follow-up.

Sure. What we are trying to do is look at the outlets and integrate it fast. And it's really one business, it's the RH business and the outlet part of the business is really got to be thought about holistically, right? And how do we optimize the overall profitability of the company and optimize return on invested inventory. So, we are at the early stages of architecting the right number of outlets in the model, right? Let's say they are more supporting candidate, the short-term moves we are making some of them are well positioned for the long-term. But, Jim Thompson who runs -- he runs our outlet and reserve logistics businesses. We are working with his team, redesigning that network to really optimize the business. And they are doing a great job. I mean they have really done an excellent job in helping move through a tremendous amount of inventory in short amount of time. And really long-term when you think about our business, we are going to have 60 to 70 kind of dominant galleries in kind of major metropolitan areas that will drive a significant amount of business as well the direct component of business in that market. And the idea is to really think more like a fully integrated market strategy where -- whether it's the gallery, the outlet, the home delivery network, how is it all integrated as a business model inside a market and optimize the profitability of that market. And clearly, was not very efficient to just pick-up returns take them all the way back to a distribution center, process them in a distribution center, hold them and then pick them again and have more transportation to send them to an outlet in a market. So, we have completely changed that model, the new model is significantly more effective and we also believe it's going to be accretive to gross margin because we are going to eliminate about four or five touches of the product of moving it, right instead of taking the product from a gallery to an HDL then an HDL to an outlet. And then, process in an outlet and put it away and then pick it again and take it another outlet, you are going to eliminate multiple legs of transportation, multiple touches. And once you take something out of a box in our business as you know, it tends to look worse than -- the far you move the more times you touch it. So, we are really designing a market strategy that can just optimize the overall business and try to liquidate product end market. And we think it's going to be significantly more accretive to strategy and profitable strategy.

I understand all of that. And my follow-up is kind of a detailed question, Karen, do you give us under the asset based product facility what the excess availability was at the end of the quarter?

I will look it up on my -- it's because of the amount of inventory coming down. It will be in our 10 filed tomorrow.

It will be filed tomorrow.

But it's not -- but the availability of $600 million, you can't just take 600 times the amount of outstanding because it is an asset base calc. So, I don't have it on my finger tips. It will be in the Q tomorrow.

And the letters of credit outstanding it's about the [indiscernible] was at the end of the first quarter?

There was about 15 to 20 or so.

Got the same. Okay. All right. Thank you very much.

Sure.

Our final question is from Adam Sindler with Deutsche Bank. Your line is open.

Yes. Good evening, everyone. Thanks for taking my question. Clearly, very positive surprise on the free cash flow guidance for the year. As you move past 2017 and all the work you are doing at the outlets, how should we think about operating cash flow going forward and working capital specifically? Do we expect detail from a lot of these optimization work that you are doing? And then, secondly, just to confirm, in the diluted share count that you report right now, what if any of the convertible stock is included in that.

Sure. So, obviously the share count was really fast. We don't -- we won't include based on GAAP and just -- we wouldn't include it and tell the stock price was above, so we would issue those shares. There is 3 million shares underlying the 2019 and 2.5 under the 2020 to the extent that stock over 116 or 118 bucks you have 5.5 million shares come back into -- to the extent of the converted come back into the share count at that time.

Okay. Thank you.

Yes. And that assumes that the company wouldn't pay the converts off.

Right.

So, we have the option to pay down the converts with cash.

Okay. And then, on the free cash flow?

Yes. We were a little -- you won't see certainly the mix extent of cash listed, if you look at how much inventory is coming down that something that won't be repeated, we won't pick that same kind of significant step change next year, but we still obviously expect to be positive free cash flow and generate significant free cash in the future. So, we will certainly give more guidance on that as it comes. Our profitability will rebound next year that also will be a nice driver, next year we don't have things like margin is getting hit so much with [indiscernible] and outlet. So, while we won't have as much inventory, we will as much -- a lot more profitability.

Excellent. Thank you so much. I appreciate it.

Sure.

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

Great. Well, thank you everyone for your time and we look forward to speaking with you next quarter.

This concludes today's conference call. You may now disconnect.