Rh (RH) Q3 2019 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the RH Third Quarter 2019 Q&A Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions]. Please be advised that today’s conference is being recorded. [Operator Instructions]. I’d now like to hand the conference over to your speaker today, speaker Allison Malkin. Thank you. Please go ahead.

Thank you. Good afternoon, everyone. Thank you for joining us for RH third quarter fiscal 2019 Q&A conference call. Joining me today are Gary Friedman, Chairman and Chief Executive Officer; and Jack Preston, Chief Financial 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 opinion only as of the date of this call, and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Also, during this call, we may discuss non-GAAP financial measures, which adjust our GAAP results to eliminate the impact of certain items. You will find additional information regarding these non-GAAP financial measures and the 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 Web site at ir.rh.com. With that, I'll turn the call over to the operator to begin our Q&A session. Operator, we’re ready for questions.

[Operator Instructions]. Your first question comes from the line of Michael Lasser. Your line is open.

Good evening. This is Atul Maheswari filling in for Michael Lasser. Thanks a lot for taking our question. So if you look at the guidance for the fourth quarter, you’re calling for 5% to 6% sales growth. Why shouldn’t sales be much higher than this given you’re cycling the 10 percentage point decline from December last year due to the stock market volatility and now also Ski House launch at the marketplace?

Well, that’s what we guided and we're cycling a 4 point drag from exiting holiday and some other promotions.

You can essentially add 4% to our guidance and in essence think about an adjusted revenue growth rate.

Okay. Thank you. That's very helpful. And then as my follow-up RH clearly has got a lot going on right now with all the new gallery openings, you have new concepts being rolled out, hospitality and now we also have planned global expansion. So how do you manage the sequencing of all that's going on just to ensure that there are no execution-related hiccups going forward? Thank you.

Well, we execute the way we've been executing. So I just looked at our past performance over the last couple of years and I think we've beat earnings guidance 8, 10 quarters in a row. So we're not worried about it.

Okay. Thank you.

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

Good afternoon. So, Gary, I wanted to start with RH International, right, and maybe if you can just comment on your current thinking around the number of international development projects the business can take on, right, within a single year? I guess I was sort of assuming as I was modeling out the business that you would do one, but is that right? Would you do more than one in the year? Are there any sort of capacity restraints or people restraints as we start layering in the potential impact of RH International into the model?

Well, we expect to start with one to two a year for the first year or two and believe we can ramp it from there. But from a capacity constraint point of view, we're not too concerned about it. We're opening in Europe first, focused on the UK and Paris and a few other kind of adjoining countries. So we don't see it as too much more complicated than opening new stores quite frankly. We run our business as a showroom business. We don't really stock our stores. We set up our galleries and take orders basically. Service customers do design jobs and take orders. And the fulfillment side of our business we've simplified greatly and we don't see much complexity beyond that. So I don't think this is like 10 years ago opening an international business or 20 years ago opening an international business. It’s a much smaller world today. Everybody communicates the same way, everybody speaks basically English today especially throughout Europe and all the European countries and everybody knows our brand there. So we don't see a whole lot of complexity. It's just across the water. And the biggest thing we're figuring out is how much of our product needs to kind of be housed and distributed from Europe, how much of it can actually travel across the water from our East Coast DC? But there's people running businesses similar than ours – similar to ours today. Every one of our vendors shifts to Europe today. And a big part of our business is special order. And that ships directly into countries from vendors. So there's – it's not as complex as you might think.

Thank you. And then just a quick follow-up, Jack, maybe for you. In the release mentioned 200 basis points of EBIT margin expansion in 2020. But any color you can provide on the revenue growth outlook? Is it just fair to assume to expect sort of be within the long-term guidance range of 8 to 12?

Correct.

Thank you.

Your next question comes from the line of Curtis Nagle from Bank of America. Your line is open.

Thanks for taking the question. First, just a quick model question just in terms of the 200 bps of margin expansion next year, just want to make sure that's a net not a gross number. And then I'll follow up with another quick one.

So what do you mean by that Curt.

It’s a net number, Curtis. What we're saying is at least 200 basis points of margin expansion next year.

That’s right.

That's the minimum we would hope to achieve.

Understood. Great. Thanks for clarifying that. And then maybe just a question for you, Gary, maybe a little more I guess qualitative. Just kind of looking at the model, I think one of the more interesting things that you guys have done over the past few years is beefing up your collaboration with known designers and artists and kind of bringing them into your ecosystem. How important have this been to the growth of the brand? Do you have people coming in like specifically to ask for guys like Timothy Oulton and how do you see that continuing to develop over the next few years?

Sure. I think it’s one of the things we did when we pivoted the brand in 2009 and '10 and kind of turned the business kind of upside down or inside out, if you will. Most vertically integrated brands and ours was what I call an inside-out model where we had 50 or so designers designing internally inside the company and then we present that externally. And what we did is we really turned that model inside out and we call it an outside-in model now where – we realized it and it was really a light bulb that went off kind of watching Apple and went Apple launched the App Store and if you had looked at what Apple did and everybody went to – what was it, it was the CFCC [ph] conference. And Apple was the only one not going there and Apple did their own conference and seemed to have the best attendance in the highest quality designers and developers in technology. We're all designing for the Apple platform and Apple focused on building the very best platform to amplify the work of the very best people in the world. And that's when the light bulb went off for us where we changed our model. We don't have any designers internally in the company anymore. And we really have what we call a curation platform. And now instead of our product and our innovation being limited to 50 people or in that area inside a company that would have to live in Corte Madera, really the best people in the world can design and collaborate with us and we can amplify their work across the best platform. So our focus is really building the best platform and building the best relationships with the best people. And I would say we’re just starting to hit an inflection point where at the highest end of the market, people that I think many would say might have never designed for a platform, you're going to hear about new names, see new people inside our books and on our Web site that are amongst the very best people in the world that will help us take the brand to another level of quality, taste and style. So from our point of view, it's one of our real competitive advantages. And I think we've especially over the last decade have our efforts on focusing on building the best platform; best physical platform, the best online platform, the best print platform, the best service platform with interior designs and you'll hear about other things that we're doing that kind of enhance our services to really amplify the work of very best people. I think now that we're a lot more visible and now that we have more of our larger physical stores, it's hard not to believe what we're going to do, right? It was different than when we had a lot of small mall stores. You had to be a big believer to say we were going to take the experience and the quality to an entirely different level. Now I think people see it and believe in it. So, again, as I said we can have a tipping point where you have just more and more people coming onto the platform, because we provide the most leverage for anybody in the industry today at the high end of the market.

Okay. I definitely appreciate it. Thanks very much.

Thank you, Curtis.

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

Hi, Gary. International is a big opportunity. What are your thoughts when you think about a market like Germany versus France and also as you really think about the supply chain and delivering to the customer, the delivery network there as well as how you're thinking about the supply chain with these and how those may evolve in the context of your expansion plans? Thank you.

Sure. Well, Germany clearly is one of the biggest markets in Europe and France is I'd say the most fashionable and probably has the most influence on taste and style and maybe a brand cache in all of Europe. So our view and we believe the UK will be our biggest market. And again, I think just about rivals France, London and France from just kind of a global view and global awareness, so two very important cities. So we're going to start in the UK. I think we're going to do something completely revolutionary and unique to introduce ourselves into Europe in a way that no retail brand has done before. And we believe it is right to follow that with Paris and with France and make a statement there, especially as this is the center of the fashion world. And Germany is also on our list. When I articulated in my letter that we have five to seven locations that we're in negotiations on and pretty close to closing quite a few, Germany is right on that list. We're looking at two locations in Germany right now, one in France that would be Paris with two in the UK. And then we're looking at other cities in Europe; Brussels and Madrid, Barcelona, other key cities where it's really the right place to kind of start our brand and position the brand from a design perspective, also looking at Milan because it's a center of taste and style and where really the biggest home show in the world is, the Salone show in Milan.

So, Gary, as you do that, you've paid a lot of great attention to your delivery experience here in the U.S. Do you anticipate that being a big piece of the puzzle just to ensure that it's a luxury experience when you touch the consumer at the home in these markets?

Yes, absolutely. Again, the world is getting smaller and smaller every year. And Europe has more complexity as far as trying to sometimes delivering in some of those cities. The infrastructure is a little more challenging. The good news is, everybody’s home in Europe has furniture and furniture is being delivered and has been delivered for longer than our country's been on the planet. So it's not like it’s an entirely new practice. What it is, it's new to us. And as we've studied it, we think that it's not going to be too much more difficult than kind of opening a new area in America or opening in Canada. The world has just gotten that much smaller. So the real key is where do you position the DC, what's the most effective way to kind of cross borders, how do you manage some of the administration complexity? But what we feel confident about is the work we've done over the last three years, more than three years now here on really architecting an entirely new operating platform and simplifying the business from a distribution network point of view and kind of re-architecting the reverse logistics and supply chain part of our business and focusing on elevating and simplifying the home delivery part of our business, we just learned so much and feel so confident from an operational perspective. And our leaders in the business today are just kind of real forces I think in the industry. And I think we’re in many ways re-conceptualizing the way supply chains are being looked at and executed at least in our part of the business the way home deliveries being looked at and executed in our part of the business. And we’ll bring all that same thinking to Europe. We maybe initially a little bit more constrained just because we won't have all the volume and leverage we have, but our business is going to be pretty concentrated in certain markets just as it is in the U.S. today. So pretty quickly we'll get scale and leverage. And the good news is, we're really good today and only getting better, right, and I think that's reflected in our operating margins. We've guided to 14.2 this year. We're saying we're going to have at least 200 basis points of operating margin expansion next year. That would tell you we’ll be somewhere above 16, 16.2 or above. And all of that is inherent in the work we've done over the last three years. And what we've learned and really now the culture we've built from kind of an operational service culture that I think is second to none in the industry today, maybe second to none in the world, we don't know yet. We haven't spent enough time over there, but I'm just really confident in the team we have and our ability to execute and continue to innovate and improve.

Okay. And our last question, Gary, Waterworks has continued to be another impressive part of the business. What are your thoughts about that operating margin opportunity in terms of enhancing that and the integration pieces that are most important for the next few years?

Yes. With all the work we've had to do with redesigning and architecting the operating platform and kind of enhancing the gallery experience and launching really kind of a revolutionary, integrated and hospitality platform inside our business, we had our hands full. And honestly Waterworks has been operating no differently than Waterworks operated when we bought them. There really hasn't been any integration of the business today in any meaningful way that would create any amplification or leverage in that business. So we now believe it's the right time to focus on Waterworks. We believe it's the right time to begin to integrate that business onto our platform and amplify that business onto our platform. And we think it's the best brand in the industry and we think it will render the RH brand more valuable. And we believe Waterworks on our platform is no different than any of the great artisans in the world on our platform. We amplify their business and render them more valuable based on the platform we're building, which is really kind of second to none in the industry today.

Thank you. Best regards.

Thank you.

Your next question comes from the line of Seth Basham from Wedbush. Your line is open.

Thanks a lot and good afternoon. My questions are around gross margins. You guys posted some strong performance in the third quarter. And I was hoping to get a little more color on the drivers behind that performance.

And you're referring relative to our guidance not necessarily --

Correct.

Yes, because obviously we beat last year by – not beat but we increased gross margins by 170 versus last year and versus the midpoint of our guidance is up 140 basis points. A few factors there I guess relative to expectations. We are seeing continued strongness [ph] in sort of product margin piece of our business. We are – we talked about the operating platform and the savings that we're getting there, the 15 million to 20 million that we've talked about. We continue to learn about the full impact of that. And I think we're seeing just, again, happily surprised that there continues to be leverage in that part of the cost of goods sold. And then frankly as we've said before, we give a number – the guidance we give versus what we have internally. Obviously, what we have internally is higher. I think in this case, there was just a bit of conservatism and we did – we were proud of the result. We did a great job and it's just probably again our internal forecast is generally higher than what we guide.

Got it. That's helpful color. We'll take that to me when the fourth quarter gross margin guidance unchanged. Your internal forecasts are higher and the pricing power will persist, which is good news. Last question on the topic related to tariffs is that you imply that there is little to no impact on the business. Could you state whether or not you saw for the full price business units decline or increase for the quarter?

Yes, we don't give that level of data. But I'd just say, look, you've got to – our business is expanding at a pretty healthy pace. Our gross margins are expanded substantially. I think we're the only ones in our industry that's meaningfully growing operating margins. Most are trying to kind of hold on where they're eroding. And I think what you're seeing is the – I’d say the emergence of the RH brand as a luxury brand that has the potential to generate luxury margins. And we just have a completely different business model today. We have a different brand today. The connection we have with the customer, the membership model that we have, the physical environments we're creating that are multi-dimensional with integrated hospitality, the design services that we offer where we have real interior designers doing your home not a visual merchant or someone that’s right out of school. So we just have a completely unique and differentiated brand and platform, and it's allowing us to get better margins. And as we continue to position this as a luxury brand, it’s why we said we have clear line of sight at 20% operating margins in the company today. And when I say clear line of sight, we know we can get there. We can probably get there faster than most people believe. And it's just a question of how we want to invest along the way and how we want to kind of keep building. And it's not that 20% is the target or the endpoint. We looked at our five-year plan. 20% is not the not the endpoint, not by any means. So if you think about the operating margins that many people run at luxury brands, it can be 25% to 30%. And I'm not saying that we’ll get to 30% today, but I would say 20% is visible and very doable and 25% is likely. So when you put that together with the long-term growth algorithm and the brand being able to play internationally, there's no one like us internationally. We have less competition internationally than we do in the United States. I think our biggest competitor in the United States of the higher-end is probably $300 million or $400 million. So the impact we have – the impact we will have and the disruption we can cause internationally I think is exponential comparatively with the U.S. where you actually have more developed competitor base. So tariffs to us are – they're not a big headline inside our company today. I mean it might be a big headline in companies that are kind of trying to squeeze the lemon and hold on and maintain operating margins or not let them slide further. And that's just not who we are. It's not what we're building. This is an entirely new business model that has massive potential. And tariffs are kind of a short-term episodic kind of distraction. They’re not anything that we look at strategically. We've got lots of flexibility. We can source in many different companies all over the world. I still believe China is a great partner. I still have faith that a trade deal will be worked out. But if it doesn't work out, we have lots of optionality. So not a big headline when you're thinking about RH.

Wonderful. Thanks a lot and good luck.

Thank you.

Your next question comes from the line of Oliver Wintermantel from Evercore ISI. Your line is open.

Yes. Thanks, guys. Gary, you were talking just now about operating margins in the 20%, 25% range and up from 14% today. Can you maybe help us understand how you maybe on a path how to get there, is that more on the gross margin line or is that really leverage from the SG&A line or does the business have to change materially to get there? Just help us maybe understand that a little bit more how you think to get there? Thank you.

Yes. Did you get a chance to read the letter yet?

I did, yes.

Okay. Well, that gives you a path to 20, just basically right there. And so if you just take those pieces with some enhancements – and then if you kind of just think about the business, the last point I made there, every time we transform the legacy gallery to a design gallery and we expect in the first few years to double the business, that provides leverage across our entire platform. But as I pointed out, meaningful leverage in occupancy, meaningful leverage in advertising and I know advertising is in SG&A, but I wanted to point it out because it doesn't mean – just take any market where we might have $15 million gallery and we opened a big gallery and over the first few years it gets to 30 million. We're not mailing any more source books into that market. We're not doing anything differently from an advertising point of view in that market. But we're doubling the volume in the market. So you can do the math on that pretty easily. Your ad cost falls in half [indiscernible] cost leverage in our new galleries, and especially with our new development model where we're able to really kept very little depreciation in the next galleries that we're going to be doing going forward. And so just right there you think about – and then you take that volume and leverage it across the whole corporate SG&A, right, and the entire supply chain. And when you look at our business and you look at – the very healthy percent of our business we talk about what percent of our business is special order now.

We don't.

We don't, okay. Let's just say we have a big percentage of our business that’s special order, right. So that inventory spins very fast and has a very high return on it. And you just kind of do that math all the way through the model as you expand the model and get to 60 to 70 design galleries in North America. And then think about the fact that around the world, we're starting with the new models not the old models. You have to remember if you start with the fact that this was a very different company with very different earnings. When I took over, it was negative 5% and we kind of got it to 7% and then we hit – we hit the downturn and we had to scratch backup from 0%. And today most of the people that are home furnishings businesses of a scale in North America have operating margins of probably 5% to, I don’t know, 8%, maybe someone has 10%. And today we've got 14% going to 16%, 16.2%. And so it's just – we're not starting with having to kind of build up, like we're starting with the new model in these countries. And we're starting with really, really great brand awareness and brand power. So we think we're going to ramp relatively quickly when we go internationally. We're opening internationally with all the leverage in real estate development model that we're executing here. So that's what kind of gives us a lot of leverage long term. And the growth in the kind of the corporate overhead is going to be relatively minimal over the long term, and we’ll make investments and we'll keep expanding businesses and things like that. But in some ways you could think about us in a way like a technology company from the perspective of we also run our business in a very project-based point of view. So just as Apple might shift a lot of resources to developing from an iPod to an iPhone or an iPad, we shift internal resources to develop RH Beach House, RH Ski House, RH Color and so on and so forth. Those are not kind of new businesses with new infrastructures and new organizations. It's just really the leverage of the flywheel we built that will provide a lot of gross margin expansion and operating margin expansion. And then you put that on this kind of new massively more efficient operating platform we've built. I think people probably underestimate the work we've done over the three and a half years. We basically took the entire leadership team, cross-functional leadership team of the company, spent three and a half years re-conceptualizing and white boarding an entirely new operating platform. I've never been with a company that’s ever tried to do that. Usually, the methodology is let's go hire a consultant, let's hire McKinsey or Boston Consulting or Bain, take your pick whoever they are. Let’s bring the consultants. Let them interview everybody in our company. And then look at our supply chain, look at our business and come back with a thousand page report and charge you $2 million or $3 million and say, thank you very much. Good luck. If you want us to help you, execute this. We can kind of be around and try to usher you along for another few million bucks. And it usually becomes a plan nobody believes in. It's not the plan the organization conceptualized. Nobody really stopped work long enough, got out of their silo functions long enough to really look at the business cross-functionally to really build something entirely new. And that's what we did. And it was painful at first, right? We pulled the car into the pit after we blew a tire when we launched RH Modern. Everybody is expecting us to kind of change the tires and come out back into the race. And we decided to stay in the pit and build an entirely new car. The stock went all the way down to $25 a share and people thought we were nuts. But we decided we were going to kind of stop and focus and conceptualized an entirely new business platform. And we built it, not one consultant, nobody from the outside. Everybody from the inside and everybody that knows this business, but everybody was forced to work in an entirely different way. We got all the brains in the game, all the egos out of the room. We broke down every silo. And if it moved, we measured it. If it didn't, we painted it. And we built an entirely new company. And I think we'll all see how the results unveil over the next several years. And when our operating margins got to 10, a lot of the analysts’ reports said, oh, they’re at – their operating margins are the highest performer in the industry and that person is slid back. We don't think 10 operating margin is sustainable. When we got to 12, same story. We don't think 12 operating margin is sustainable. Now we're at 14. I'm sure a lot of people don't think 14 is sustainable. We just told you we've got at least 200 basis points of operating margin expansion in the model for next year. As Jack just said, that's probably not our internal forecast. So correct, it's not sustainable. It's only going to get better. So I think this is a new business, a new model, a very differentiated brand with an entirely new platform and brand proposition. And so it's going to be fun.

Got it. Thanks very much and good luck.

Thank you.

Your next question comes from the line of Tami Zakaria from JPMorgan. Your line is open.

Hi. Congrats on another strong print and thanks for taking my questions. So I have two quick questions. The first one is, do you think the two distribution centers you have in the U.S. are enough in the medium term to support your sales and the momentum in the business you’re seeing especially if you go into Europe in 2021?

Yes, we’ll probably start to expand the footprint in the distribution centers over the next 12 to 18 months. But you’re really talking about kind of space expansion, not so much new distribution centers in new markets we think we're kind of well positioned. So as we go into Europe, we're still sizing that up. What percent of the SKUs should we start with for our European expansion? But just like any other business you can use kind of the 80-20 rule, maybe ours is 30-70; but directionally the top 30% of our SKUs drives 75%, 76% of our revenues if you've got a good portion of those skews that are special order. So they really never hit a DC. They just get cross-docked and go to a customer, so just like we don't necessarily house a 100% of our SKUs in both distribution centers; that will just slow down the turn. If you think about what's really different in our company, we have four furniture DCs that are 100% of the SKUs, right, that made no sense. Now we have one DC that has a 100% in SKUs and one DC that has a significantly smaller percentage of SKUs. And so when we open in Europe, I think about it that way. We probably open a distribution center that has maybe a third of the SKUs and then the other two-thirds gets shipped from Europe. So that's why I say it's not as complex as you might think. And we're not housing the goods in retail stores. We’re not replenishing retail stores. We set up our galleries and it's like setting up a beautiful home or hotel lobby, right, like nothing really moves. Once in a while we get a customer that wants to lie on top of the bed. We've got to kind of fluff up the pillow inside the gallery. But our business is not – I think back in my days at the Gap and I was restocking shelves in backrooms and having to move floor sets because all of a sudden whatever collection blew out, you have empty racks and now you've got to try to move the whole store around and you're trying to stay in stock in all these styles, sizes, colors, so on and so forth. We don't do any of that. It’s a much simpler business on many levels. The hardest part of our businesses is actually delivering the stuff to the customers' homes which we believe we've leapfrogged from where we were and probably leapfrogged much of the rest of the industry. But it's not as complex as I think people think it is. For us we kind of look at it like, okay, we're going across the pond and we're opening in London, then we'll open in Paris and we’ll open beautiful galleries. And again, we just kind of got to set them up once, right, nothing moves. Nobody steals anything. Nobody walks out with the bed. Nobody moves a bed or a sofa. All the mirrors and lights stay in the same place. What we do is we show up and we service the customer and provide an outstanding experience. And then on the backend, we have to execute and get the goods in the customer’s home. And for the bigger part of our business, which is furniture, again, you're talking about probably the top third of our SKUs that we have to focus on, not the entire assortment. And then out of that you've got a meaningful percentage of that, less than half more than a quarter that special order. So it's a different kind of model.

Got it. That's helpful. And my second question is, how should we be thinking about the tax rate next year?

So, Tami, we haven't obviously guided to that level yet. We've provided obviously for this year the update to our guidance. The tax rate we did the prior quarter was to 21% and we clearly beat that this quarter, given the stock option activity. I think – again, no specific guidance. I’ll tell you internally we’re using 20%. It could be better than that to be honest. I think it's a function of the stock price, right. So we've got a lot of people holding options at relatively low prices. And so the stock continues to perform. I'm sure people are going to exercise options and sell stock. We've pretty widely distributed option plan within the company and that's – that’s really what drives it. So as our stock has performed, as our stock went from 50 to 100, 100 to 150, 150 to 200, more activity in our stock option plan and that drives a lower tax rate. So it’s probably – I'd think about is simply if our stock stays at this level or continues to go higher, we're going to probably have a high activity in our option plan. If our stock drops to $50, it will probably slow down and we’ll pay more tax. It's not too much more complicated than that.

Got it. That's super helpful. Thank you.

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

Great. Thank you. Good afternoon. Gary, I was hoping you could talk a little bit more about the Guesthouse as we look ahead to – it’s opening in 2020, and if you could tell us a bit more about what you hope that experience to be like for guests and maybe how it may fit into the long-term business model? Thanks.

Yes, not a lot to report yet. We wanted to let you know we're obviously opening it this year. We'll do a more fulsome explanation. But I'd start with the fact that everything we do is intended to render the RH brand more valuable, right, and position RH’s thought leaders, tastemakers and place makers inside our industry. And that's what the Guesthouse is designed to do. We believe we can – we've re-conceptualize an entirely new market. We’ll create an entirely new market for travelers seeking privacy and luxury and security in many ways. So if you think about privacy, privacy today is something everybody has given away with social media and with the Internet for the most part is taken away. And it's what people talk about most is being at risk is our privacy. So hard to find privacy today, hard to – not too many people are selling privacy today. So we're creating a concept built around privacy and luxury. A lot of people have asked me because it hit the real estate press, right, and that's the way we had to start talking about it a little bit because we signed a lease and in that public documents that talks about RH building, hotel concepts that people ask me, I hear you opened your hotel in New York and I say no. And then they say I mean a boutique hotel, and I say no. And then they say, well, what are you doing? I say we’re creating a Guesthouse and we’re trying to re-conceptualize hospitality and do something no one's ever done. And then they say, oh, so I got it. It’s going to be a showroom for your products, and I say no. We have a 90,000 square foot showroom 20 steps away, why would we do that. In fact, it's not going to have any of our products. And that usually is what twists everybody's head around a bit because it's too expected, right. And if you do something that people expect and consumers expect, you'll never surprise and delight them. So we're doing something that I think nobody can imagine. I think it's going to elevate our brand. It's going to be amongst one of the best things we've ever done and one of the most innovative things done in hospitality in years. So we're very excited about it. And the first one is in New York. The second one I wrote in the letter is in Aspen. There are two epicenters for taste, design and wealth and that's where the wealthy and affluent visit and vacation. Aspen is one of those global epicenters. And I think this will again be another thing we do that creates a global conversation that continues to elevate the RH brand as we attempt to climb the luxury mountain. I tell our team internally here that – and if you think about almost every – I think every luxury brand in the world today, all the best luxury brands whether it's Hermès, Louis Vuitton, Chanel, you name it, on and on, Christian Dior and all the others, they were all born at the top of the luxury mountain. They started there. And we obviously didn't. And we're one of the few that is trying to make the climb to the top of the luxury mountain. And the people at the top of the luxury mountain quite frankly don't really want you to make that climb. They don’t really invite you to their party. You're not from the neighborhood. You don't have the background. And to make that climb, which I don't know a brand that has from the level we started at, to make that climb up the luxury mountain you have to do things that create a forced reconsideration. You have to do things that force people to respect you, that force people to tip their hat. And I believe that's the kind of work we've done throughout our entire journey, step-by-step. We've taken another – climbed another rung up that luxury mountain. We've only done things that have rendered our brand more valuable even if they were painful, like taking the car into the pit and going from a promotional model to a membership model and changing how our brand is perceived or opening really inspiring spaces and galleries when the world was shrinking and closing stores, we're opening the most inspiring architectural environments in the history of retail or integrating hospitality into our galleries the way we have. And the Guesthouse will be no different. It will be a magnificent statement of our brand. We believe it will create a global conversation and set a new standard. And not only that, what happens when you do work like this is it challenges your organization in a way that kind of just executing the same thing every day doesn't, right? It forces you to think differently. It forces you to reach higher. And that's why by the way why we started in New York. A lot of people said, like, gosh, why don't you open your first Guesthouse somewhere where everybody is not going to pay that much attention where you can make mistakes, where the critics won't be so harsh? And we more operate from the Frank Sinatra model and believe that if you can make it there, you can make it anywhere. And that's why it's important to start in New York. You start in a city like that, it brings out your best work, it brings out your best thinking. And I think what you'll see when we open the Guesthouse this year is something that's entirely new, entirely unexpected and I've just told you entirely too much.

Well, I appreciate it Gary and looking forward to seeing it when it opens. I was hoping I could ask a quick follow up on Color and if you could just give us a sense of how big you think the scope of that new category may be next year? And if you think you need to make changes of significance in the store to highlight that product in the store next year.

Yes. Well, I think if you – our brand is a lot of times picked on for not having much color. People usually say, RH doesn't like color. Gary Friedman doesn't like color. It's not that we don't like color, it just so happens that the vast majority of the market is colorless. Why is it colorless? Because humans are generally colorless, right. We’re shades of light to dark. The world is generally colorless, except for some green. The ocean is actually colorless. It’s the reflection of this sky. And so what are we most comfortable with? Neutrals. Is there a market for color? There is. How big is it? It's not that big. If it was, it's significantly smaller than clothing and I learned that the hard way back in my Pottery Barn days when I think I could chase the fashion color palettes and all I did was create a hell of a lot of markdowns. And so we think color will be additive to the brand. Today, nobody is waking up in the morning saying I want some colorful furnishings and saying I'm going to RH, like zero. We're basically a neutral-based brand. Is there a market, is there possibly another 15% to 20% of kind of opening up the aperture of our brand? I think so. I think it could be up to 20%. I think it will take several years to get there. And we have to do this in a really smart way. What we don't want to do is confuse the brand and un-focus the brand. So we're doing it in a very RH way. It's very architectural. It's very disciplined. It's very structural in its approach. It's very intentional in its approach. And it's done in a way that maybe one or two interior designers in the history of the world have executed color and that's who we’ve studied. One primarily who has really influenced – by the way I see the world from an interior design point of view more than anybody else and that’s Anouska Hempel who is an interior designer that was really the Godmother to the boutique hotel trends. Everybody kind of gives Ian Schrager credit. Actually Anouska Hempel was before Ian Schrager. She just launched in London with the Blakes Hotel. And if you look at some of her work and she uses color, it's in a very architectural, very disciplined way. We've studied her work. We’ve studied one other person’s work. Honestly I don’t think too many people do color very well. So we have to do color as well as we do neutrals, we have to do it within the point of view of our brand and we have to do it in a way that it elevates the RH brand and renders the RH brand more valuable. We can't let it un-focus us. We can't let it kind of distract from the core business. We have to beautifully integrate it and it has to amplify what we do. So not easy. We've been working on it for five years. We thought we were going to kind of get it done the last couple of years and it's just hasn't got there yet. We think we're very close and we'll be ready next year. But it's like anything else we do. Everything we've done is kind of a test and we learned. You can have all the ideas in your head that you want, but you don't really know anything until you do something. And so we tend to learn by doing. We spend a lot of time deeply thinking about anything we do. And we try to conceptualize it. We try to kind of move our vision, translate our vision from vision to a strategy and figure out then how we can bring that strategy to life. But honestly until you do it, you don't really know that much. And so it’s no different than RH Beach House or RH Ski House. They launched as relatively small tests. The source book that’s 100, I think 120, 140 pages. Very different than how we launched Modern. We launched at 545 pages. That didn't go so well. It gives maybe a little bit too much complexity. But looking back we're glad we did it. It cost us $20 million to keep customers happy. We kind of botched some of the execution, but it's a huge business for us today. But if you look at Beach House and Ski House, we tested them very small. We're learning a lot and we know what's working, what's not working. We will expand the assortment to optimize the mailings, optimize the web presentation and begin to then test and move some of the best collections into our retail galleries. That will be the same thing with color. We try to integrate color into the RH core book, into the interiors book at least 5x and probably 30 days before mailing the book we just yanked it because it was un-focusing the brand. And so we decided to capitalize it in its own book and we'll call it RH Color and it will kind of get its own part of the Web site or its own Web site integrated to our portal of the world of RH which you'll hear more about that later that we'll be working on and introducing later this year. But we’re presented in a way that people will know we're in the business, will be in the business in a very distinctive way. But we'll test it, we’ll learn, we'll do some things right, we’ll do some things wrong. But we get smart really quick here once we get data, once we get real feedback and then we accelerate the learning curve and we start to accelerate the business. So we're hopeful. We think we're going to do color better than anybody else in the planet, except for maybe Anouska Hempel, the one I named interior designer. But we’re hopeful. But I don't think it will start real fast. I think there's just nobody waking up in the morning thinking about us for color. So it will take a couple of years to kind of habit be known and habit grow. It’s no differently with Modern. Today if anybody is thinking about Modern home furnishings or furniture, I think everybody is thinking about us. And so as color will ramp and we'll build a bigger impression in people's minds and we’ll be able to integrate it into our galleries in a really beautiful way. We've got a lot of concepts and things we've been thinking about on how we'll do that. So I'm super excited about it. But it’s not going to change everything the first year.

Very helpful. Thank you so much, Gary.

Yes.

Your next question comes from the line of Zach Fadem from Wells Fargo. Your line is open.

Hi. This is actually David Lance [ph] on for Zach. Thanks for taking our questions. So on the evolution of the real estate strategy, I was curious to see how you think about the opportunity as it stands today and in particular whether you see an opportunity in some of the smaller domestic markets, like Columbus or Minneapolis in relative to the sales lifts that you've seen in some of the larger markets that you have?

Well, we have obviously opened in Minneapolis. We're opening in Columbus next week. So what's the specific question, David?

I guess just more clarity around kind of some of the lift and what you've been seeing in some of the smaller domestic markets in comparison to some of the larger markets?

Yes, the list basically the same. The biggest difference is, if do we or don't we have hospitality integrated? Hospitality integrated into the gallery gives us a greater lift, not just from the hospitality business, but the traffic the hospitality business drives. So we've been really, really consistent plus or minus 10% or so. We haven't really had any surprises per se whether it's small market or smallest. I guess the smallest one we've done is Kansas City in Leawood I guess and the biggest is New York. New York was really a two step. New York was a legacy gallery that we expanded kind of four years before or something like that to like call kind of a design gallery. We tripled the size of New York in its previous location in the Flatiron, went from one floors to three floors and then we more than doubled the size of New York again. And so the math has been very consistent. It's within a band as you might expect. And sometimes it's a little different just on how the business is actually growing that year, right? So if you looked at the gallery that was converting in a year where the business might have been growing at 15%, that gallery lifted bigger. It was the year where the business grew at 5%, that gallery. That number also influenced the lift, right. So it depends on what we're doing with the assortment strategy, with the marketing strategy, so on and so forth around the business. But we've got enough of now. We're very consistent, it's very predictable. And what’s very different than other people and why it hasn't worked for other people, most people they taken a 5,000 square foot assortment and they put it into a 20,000 square foot flagship in Manhattan or Los Angeles or San Francisco, name any city, and it still performs like a 5,000 square foot assortment. You might get a little bit more sales. But what we have today, it's very different. We have probably 200,000 square foot assortment and less – I think today less than 5% of the assortment is in our legacy galleries, right. You can only go in and probably see 5% to 8% of the assortment today in a typical gallery. So when we go from showing 5% of the assortment to 30% of the assortment, we know that math and we know what that lift is. And so in each of these markets, we look at not only how big the gallery is really but also how are we presenting at each category, how many collections in each category do we have, how many living room presentations, dining room, bedroom, bathroom. We understand the math and the productivity. And so these prototypes are designed very scientifically, very mathematically and we have a lot of data. And because we now have a real proven concept and a high productivity concept that can perform on multiple levels, right, multiple floors, most retailers can't, and it can use rooftop space and garden space with our outdoor furniture business. We're really very desirable to developers. And we're proven and now we're more desirable. We have hospitality. That's really valuable to a developer because it drives traffic into their development. And we don't just have any hospitality. With many markets that we're going into, probably the most beautiful restaurant in the market and one of the most productive restaurants in the market, if you look at our hours, we're not really open some of the peak hours for dinner. We close relatively early and we don't have a bar. So when you look at our productivity and you take the alcohol component away from it, you look at our hours of operation, we’re probably as productive as almost anybody out there, and I think it's because we're building beautiful environments. We have amazing hospitality and we have really high-quality consistent culinary experience in food. So that just – it's only going to make the gallery performance better going forward as we expand the offer with Beach House, Ski House and Color. We're not going to do zero with any of those. So they are all going to be incremental, right, and they don't even have to be in the gallery to be incremental to the gallery, right, because our galleries can sell beyond the four walls of the store. So we feel more confident than ever about the real estate strategy and it really doesn't matter. Again, whether – our lowest volume markets are about $10 million, right. So our lowest volume stores are probably about as productive as many of our competitors’ highest volume stores. So many people would like to have a $10 million or $12 million gallery store. We look at those as kind of our lower volume ones. But when $10 million store will turn into – go from like $10 million to $17 million to $18 million in year one and then to $19 million or $20 million in year two and keep growing, but we tend to on average by year three double the business if we have hospitality and less than that if we don't have hospitality.

Great. Thanks so much for the color. And just one follow up for me. On outlet sales, they continue to expand. Curious if you could talk about any additional drivers beyond the DC liquidation and to the extent you think the outlet sales could be cannibalizing your full price business?

No, we don't believe it’s cannibalizing the full price business. The outlet business is basically always been a return business, right. So it's mostly a return slightly second quality product. Sometimes we get some new product if we have long inventory or discontinuing things. But really what we've done over the last several years is just reduce inventory in the company, right, I think versus our five-year plan from three years ago where the company has about $500 million less inventory. If we were turning the business at the same rate we were in 2016, I think today we’d have about $500 million of inventory, right. So you can think about it is, like-for-like company. We took $500 million of inventory at cost out of the system, right. That's how much more efficient we are. The company has gotten significantly bigger on $500 million less inventory. So we've used the outlets to kind of help us liquidate that inventory, right, and drive down that inventory. And so as we think about it going forward, we actually think that – it's funny you're asking because we were just in a meeting day before yesterday in here thinking about, okay now where do we go from here? What does the outlet business look like for RH as we go forward? And not that we want to build a big second quality brand or do anything to kind of render the RH brand less valuable, but we've never really kind of looked at it in a real innovative way. We've made it massively more efficient. Next year it will be massively more profitable just because we're not going to be driving so much revenue at low price through it. But we now have some new kind of thoughts, new visions and ideas for that channel that where we can probably even drive some long-term incremental revenues. Next year, it will probably be a revenue drag, but long-term incremental revenues and incremental profitability. It's never been used for anything besides liquidating returns and damages.

Okay, great. Thanks again for all the color.

Yes.

And your next question comes from the line of Bobby Griffin from Raymond James. Your line is open.

Yes. Good afternoon and thanks for taking my questions. Just one quick clarification first. Is the 20% operating margin target inclusive of the international expansion or is that just for the North American business?

Well, there’s some international expansion. We'll launch international in '21 or '22. So as you go forward, international will be part of that. So I don't really kind of separate them out as we model it.

Okay. I guess the other way to ask, Gary, do you expect the international margin profile to be similar to what we're used to seeing here in the U.S. business I guess is the other way to ask it?

Yes, we do. As we've modeled it out, there'll be a little bit of start-up cost if we open a DC again, but we're not going to open a giant DC. So we'll have some investments, we'll have some minor overhead, some boots on the ground internationally and there'll probably be some slightly higher preopening costs which initially we won't be able to leverage the local teams who have sent more people over. But again, once we get a gallery up and running, it's pretty self-sustaining pretty quickly. So initially, if we're right on the volume – what's interesting here, Bobby, and for the rest of people on the call that we probably haven't talked about, if you think about going into the UK, right, the UK is, what is that, population is 61 million or something like that, California has a population of 40 million, yes, 68 million to 40 million, significantly more people in the UK, a very high demographic. You look at California, we have lots of galleries, right, and yet we're going to open in the UK with initially one and then we'll have two, but you're going to have – it'd be like think about New York. If we just opened one gallery in New York and we didn't have anything in New Jersey, which we've got multiple stores, we didn't have Connecticut, we didn't have Westport, we didn't have Philadelphia, we didn't have anything that’s in that geographical region or just take almost the entire East Coast or the entire West Coast, [indiscernible] bigger than 40%, 50% more people in California. In California, we have a lot of stores where we’re doing about 450 million in California today. 450 million in California and we only have one market with the big gallery and that's Los Angeles, right. We don't have Orange County, we don't have San Diego, we don't have San Francisco, we don't have Northern California and Marin County, we don't have Silicon Valley, we don't have the East Bay, Walnut Creek area. California once we transition the galleries will probably be a $700 million market for us, right. So we'll over time double the retail business and we'll get a lift in direct. So, if you think about starting in the UK, I looked at it and what is that a potential than $1 billion market? What if I had a potential $1 billion market and I opened just one big store in LA? It's going to be a giant store and the direct business is going to be huge, right. And so we think because of the size of the markets and the fact we're opening with these really dramatic retail experiences within assortment that is really disruptive that we're going to ramp very quickly and get really good leverage in the international growth. It's not – it'd be one thing if we were opening little galleries, right. It's very different. It's one thing if we're going in opening 7,000 square feet stores opening in London with the 7,000 square foot store in the Greater London area like four or five 7,000 square foot stores and opening in these other markets with these little stores and then having to come back and redo them. We're opening in these massive markets and we're going to open with incredible brand statements and with an incredible assortment. So I think we're going to do really, really well. And then all the math on our internal models even at our conservative side, our return on invested capital and our operating margins and earnings look really, really good. So we don't see this as being any kind of real drag to the business side. I know for some businesses, they roll out internationally, they're not really making money or they've got a drag or they've got to wait five years to make money. I hate to say anything’s impossible, but call this close to impossible we'd have to have such a swing and a miss like in these markets. And I just don't think that's going to happen. Not based on the work we've done and what we know about our brand today, how much we export to those markets today, et cetera.

Okay. I appreciate the detail, very exciting and look forward to seeing one of those stores once they're up and running.

Sure.

And I guess secondly for me, I just wanted to go back to the comments about product margins. Could you maybe just help me get a better understanding or help us get a better understanding of the fundamental drivers driving better product margins and then within those drivers, the sustainability of that? Is there a concern that at some point of its price, the consumer becomes – you get too pricey for your core customer or is some of the drivers difference your volume becoming a bigger part, working with fewer designers but doing more business with each one of those designers? Just help me frame the product margin discussion better?

Well, our product keeps evolving, right, and we keep kind of climbing the luxury mountain, the quality gets better. With better quality, prices get higher, but while the prices get higher, they’re still massively disruptive inside the marketplace. Start with RH Modern, the average price of furniture in RH Modern when we launched was 30% to 50% higher than our core business, right. And it's wildly successful, but it also had higher quality. We used it as a platform to kind of take another step up from a quality point of view. And so – and I don't know, if you look at the value of Hermès globally, what's Hermès, like $80 billion or something like some market value. And there is a lot of people that want really high quality product. And I think if you just study American business over the last whatever period you want to, 10, 20, 30, 40, 50 years, people trade up, people will pay for better quality. They just won't pay more for the same quality. They'll pay for better quality. So what's evolved in our business is the quality has gotten better, the design has gotten better, the taste has gotten better, the scarcity has gotten higher, the desirability has gotten better. We're just a more desirable brand today. We are a more admired brand today. We have higher quality products today. We have better designed products today, we have better – it's presented in more aspirational spaces today. We've got an aspirational hospitality concept that drives thousands of people into our galleries that are now seeing that really high quality, high taste, inspiring – presented inspiring spaces. So it's – in many ways, we're creating a new market, right. And when you're creating a new market, you've got a lot of leeway with what should the price be. I mean, I don't know. You hold up a Birkin bag against every other bag in the world, is it cost too much? Is it too expensive or is it the most desirable bag in the world? That's the way to think about it.

I appreciate it. Best of luck in the fourth quarter and happy holidays to everybody there at RH.

Okay. Happy holidays, Bobby.

Thanks, Bobby.

Thank you very much. And there are no further questions at this time over the phone. Presenters, you may continue.

Okay. Well, great, thank you everyone for your time. We wish all of you a happy holiday. We look forward to hopefully seeing some of you at our Columbus opening next week. And if not, we'll see you in the new year. Thank you so much.

And this concludes today's conference call. Thank you all for participating. You may now disconnect.