Ladies and gentlemen, please stand by. We're about to begin. Welcome to this Williams-Sonoma Inc. Third Quarter 2015 Earnings Conference Call. [Operator Instructions] This call is being recorded. I would now like to turn the call over to Ms. Gabrielle Rabinovitch, Vice President of Investor Relations, to discuss non-GAAP financial measures and forward-looking statements. Please go ahead.

Thank you, Shannen. Good afternoon. This call should be considered in conjunction with the press release that we issued earlier today. This call may contain non-GAAP financial measures that exclude the impact of unusual business events. A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures and our explanation of why these non-GAAP financial measures are useful are discussed in our release. This call also contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which address the financial condition, results of operations, business initiatives, trends, guidance, growth plans and prospects of the company in 2015 and beyond, and are subject to risks and uncertainties that could cause actual results to differ materially from such forward-looking statements. Please refer to the company's current press release and SEC filings, including the most recent 10-K and 10-Q, for more information on these risks and uncertainties. The company undertakes no obligation to update or revise any forward-looking statements to reflect events or circumstances that may arise after the date of this call. I will now turn the conference call over to Laura Alber, our President and Chief Executive Officer, to discuss our third quarter fiscal 2015 results.

Thank you, Gabrielle. Good afternoon, and thank you, all, for joining us today. On the call with me are Julie Whalen, our Chief Financial Officer; and Pat Connolly, our Chief Strategy and Business Officer. We're pleased to be discussing our third quarter results today. These results speak to the power of our brands and our ability to execute our customer-focused strategy. We delivered total net revenue growth of 8% and EPS growth of 13%. Looking ahead, while the retail landscape and consumer demand has been more volatile, we believe our balanced portfolio of differentiated brands and strong multichannel platform positions us for ongoing market share gains, and we are confident we'll deliver strong performance by focusing on what we do best, bringing innovative, functional and beautiful products to market, delivering exceptional customer service, developing our brands and managing our business to ensure we create sustainable value for our shareholders. Over the past few years, we've articulated our vision to double the revenue of our business by growing domestically and through global expansion. We have a very deliberate approach to building brands, and we are always investing for the long term. Over the past several years, we have incubated new concepts and entered new markets, and these initiatives are now contributing to our results. Our portfolio approach gives us a competitive advantage. We are not limited to a single look, and our range of tasteful aesthetics allows us to address a broad market. In our home furnishings brands from Williams-Sonoma Home to Pottery Barn, West Elm, and our developing Rejuvenation brand, we present a carefully edited range of aesthetics that stand for quality, good taste and product innovation that addresses the lifestyles and life stages of today's consumer. We are pursuing distinct strategies to grow each of our brands, and we…

Thank you, Laura, and good afternoon, everyone. We are pleased with the results we are reporting today. During the quarter, we delivered revenue growth of 8% and earnings growth of 13%, further demonstrating the power of our portfolio of high-performing brands and our multichannel approach as well as the continued success of our long-term growth initiatives. In the third quarter, net revenues exceeded our expectations, increasing 7.8% to $1,232,000,000, with comparable brand revenues increasing 4.5% on top of 8.7% last year. Revenue growth in the quarter once again far exceeded growth in the furniture and home furnishings industry. Net revenues in our e-commerce channel grew 7% or 22.7% on a 2-year basis to $628 million and represented 51% of net revenues, with growth primarily resulting from the continued strength we are seeing in the West Elm brand. Net revenues in our retail channel grew 8.6% to $604 million, which reflects the momentum we are seeing from our long-term growth initiatives, particularly in our international operations and West Elm. Excluding the growth of our international operations, our retail channel grew 4.3%. During the quarter, across both channels, our international operations saw revenue growth of 46.5%, reaching $80 million, and West Elm drove revenue growth of over 22.8%, including comparable brand revenue growth of 15.7%. Gross margin for the third quarter was 36.6% versus 37.7% last year, with pure merchandise margins only slightly down to last year and remaining essentially flat year-to-date. The year-over-year gross margin decline reflects lower selling margins, particularly associated with higher franchise revenues, which are dilutive to gross margins but accretive to operating margins, as well as higher shipping and fulfillment-related costs, partially offset by occupancy costs, which leveraged 60 basis points to 12.9% of net revenues or $159 million. As mentioned on our last call, this quarter,…

[Operator Instructions] And our first question comes from Daniel Hofkin with William Blair.

Just a couple of questions regarding the environment, maybe to the degree that you're able to kind of parsing out your -- the overall consumer spending pattern versus competitive factors, either brick and mortar or online, versus areas where you feel like maybe the execution could have been a little bit better. You talked about some areas within Pottery Barn. I'd be interested, as it relates to Pottery Barn and the Williams-Sonoma brands in particular, kind of how you would divide up the performance, again, around just the overall consumer landscape, competition and your own performance and opportunities to improve that. And then I just have one quick follow-up.

Sure. Thanks, Daniel. It's Laura. Now I have to tell you, I'm optimistic about the holiday season. Yes, we've seen some retrenching this fall, and retailers, and even some really good retailers, have given some mixed reports out there. But there's also a lot of good news out there, too. And we know that our customers love their homes, and the holiday season is a time to decorate, entertain and also to be generous with gifts for your family and friends. And I believe that consumers will shop at retailers that they trust and who have compelling products and in-store experiences. And I think as you go to the stores, whether you go to a mall or a great street, we're going to be top of the list in terms of destination. It's really hard, I think, to resist going into our stores during the holiday season. They are, in my opinion, holiday wonderlands. Our Williams-Sonoma stores are, I think, part of people's holiday shopping tradition with their amazing tastes and aromas and wonderful gifting assortments this year. And Pottery Barn has incredible decorating and beautiful trees on display in their stores right now and inspiring tablescapes. For Pottery Barn Kids and Teen, I can't help but think that those great nostalgic gift assortments will give our customers a great alternative to electronics. And West Elm has distinctive and chic entertaining and gift-giving options at a great value. The other thing that makes us different is that -- small thing, but across all of our brands, we have free giftwrap in store and we're ready to offer that high-touch one-on-one service that people are looking for. I believe our online experience and service offer there is equally compelling. We spent so much time looking at our gift assortments and the gift experience online, and also personalizing that digital experience based on our consumers' preferences. So in summary, we're always looking for things we can do better. We've been preparing all year for this holiday season, and we're excited and ready to serve our customers.

Okay, great. And then thinking about looking out over the -- I mean, I know you haven't given guidance for next year, but hearing you guys talking about some of the additional investments on a number of fronts, if you think about next year, does it make sense to think about sort of maybe a lesser rate of operating margin expansion relative to what maybe a typical year might be at this early stage?

Yes, Dan. This is Julie. Obviously, you're right. We have not given guidance for 2016. We're not prepared to do that today. But what we are excited about is investing in the future and our future growth. And I think today's result is a great demonstration of some of the things we've been investing in that have actually come to life, like our international growth.

Our next question comes from Peter Benedict with Robert Baird.

I guess, first, just, Julie, how are you thinking about capital allocation these days? Specifically, I'm curious kind of your view of buybacks and how opportunistic you're willing to get when the stock is down.

Our approach for capital allocation has not changed. We're going to continue to be balanced and, first and foremost, invest in the business because that's clearly where we get the biggest returns. And then with excess cash, share it between buybacks and dividends. And so our approach to that has not changed regardless.

Okay. And then one quick follow-up, just on the fourth quarter tax rate. It looks like it's implied north of 40%. Year-to-date you've been more like 36%, 37%. Is that international playing a bigger role there? Or are there other factors that we should be thinking about in terms of taxes for the fourth quarter?

Sure. With our quarterly tax rate, it's always subject to variation. In the prior quarters, including this one, we did have some favorable tax resolutions, and we also had, which is fantastic, some higher-than-expected earnings from our international operations, which has a double benefit of lowering our taxes. But going forward, given the size of our Q4 business and the -- and our expected mix of earnings in Q4, we looked at the sensitivities and believe that this time our tax guidance is appropriate. Of course, it's possible on the year we could end up with a lower tax rate, but it's really still early in our largest quarter to make that call. But the good news is we do expect and have seen that, over time, our tax rate will decrease as our international business becomes larger and more profitable.

Next question comes from David Magee with SunTrust.

Yes. Can you just talk a little bit more about the inventories? And did they meet your plan at quarter-end, and what your expectation would be at year-end?

Yes. So our inventories, as we said on the call, grew about 12.5%. We feel good about the in-stock position at 10.7%. Of course, there's always pockets of under and overstocks, but we believe this level of inventory on hand leaves us well positioned for the holiday selling season. I think we have to remember that from a guidance perspective we don't necessarily guide inventory levels, except to say that we're focused on maintaining in-stock inventory levels to ensure great customer service. And we think we're well positioned for the holiday season as we enter the new year. So we feel good about the inventory.

Okay. And then just a quick follow-up. The -- in the overseas sales, international business, are you seeing gross margins that are comparable to domestic, above or below? Just sort of curious there.

We haven't provided or disclosed that. If you're referencing what I was alluding to in the script, that's associated with our franchise revenues. And our franchise revenues -- obviously, the details of our deals are confidential and competitive, but what I can say is that franchise deals have a different revenue model than a regular customer sale. And depending on the deal structure, these transactions can be dilutive to gross margin but accretive to operating margin. So the higher the franchise revenues in any given quarter, they put more pressure on the gross margin. But I would not make that conclusion per se with company-owned stores. But we haven't disclosed that.

Next question comes from Chris Horvers with JPMorgan.

So following up on the first question and thinking about the wider comp guide for the fourth quarter, 2% to 5%, historically more like a 3% to 5%, 4% to 6% kind of a range. Have you seen change in the momentum in the business? What's behind the wider guide for the fourth quarter? Was there a change in trend that you're seeing at the end of the quarter that you're trying to put into the guidance? And basically, any thoughts there.

Okay. Chris, I'll take it. This is Julie. I think what's important to remember is that this quarter is always so difficult to read. Our revenue guidance reflects our best estimate 2.5 weeks into the largest quarter that we have, and it reflects our possible range of outcomes across all of our brands. It's also important to remember that the Williams-Sonoma brand becomes a larger piece of the mix this quarter than in other quarters, and historically has had lower comps than our pure home furnishings brands. So the other thing is that we've had great revenue contribution from our international businesses. And as we head into our peak season, our international business is expected to take on less importance relative to our domestic business. So that, plus with the customer always seeming to shop later and later each time for the holidays, the business is hard to read 2.5 weeks into the quarter. So we felt that it was prudent to hold our guidance on the year, and this is how the comps played out.

All right. So holding the guidance for the year was -- so the 2% to 5% fell out of that equation based on what you did year-to-date.

Absolutely.

Okay. And then was the gross margin performance, relative to your own expectations for the quarter, in line with where you thought it was going to be? And was there any hangover from the returns and damages side that you saw in the second quarter?

Yes. From the shipping and fulfillment-related costs side, it is where we thought it would be. The part that's a little bit of a surprise is the higher franchise revenues, which is a great surprise to have, which as I mentioned puts -- unfortunately, is dilutive to the gross margin, but it's accretive to the op margin. So optically it looks "worse" on the gross margin line, but everything else was within our expectations.

And we'll go ahead and move to our next question from Matthew Fassler with Goldman Sachs.

My first question relates to the impact of the international business in Q4. Julie, you alluded to the notion that it would be smaller in the fourth quarter than in the other quarters, but it was 3 percentage points in Q -- the delta between total and comp store sales, which I presume is -- or total and comp brand sales, which I presume is largely international, was over 3 percentage points in Q3. It was over 2 percentage points in Q2. It's very, very small, less than 1% in the guidance when you look at the difference between your guided total sales growth and the 2% to 5% comp brand growth. So is it really going to be that small during the fourth quarter? Is there room for that number to move around a bit?

Well, I mean, that's what our expectations are today. Also, in Q3, the new West Elm stores contributed to that delta between the comp and the revenue growth. But obviously, we'd love to see that not be the case. But given the size of Q4, it's likely that the outperformance on the international revenue side will not be as pronounced relative to the comp.

And then if you think about the impact of the international business getting bigger within the mix on the gross margin rate and on the SG&A dollars, can you give us a sense of how much of that dynamic -- I understand it's accretive to earnings, but how much that dynamic would have impacted margin rate within the various factors that moved it around in Q3?

Yes. I mean, we haven't quantified the exact basis points of how much of the gross margin was associated with higher franchise revenues. I, however, did list it first, and so we do put things in order so you could tell it's very material. Also, when you look at the SG&A, there has been occupancy and employment leverage and a leverage across the board. And specifically within the retail channel, you see it materially from the other side of the franchise equation because, basically, you have the hit to gross margin and you have essentially no SG&A. So the profit drops to the op margin.

So presumably, the reason -- presumably, if international revenues are smaller in Q4, that could be a reason for gross margin to be down less?

Presumably, yes.

Next question comes from Greg Melich with Evercore ISI.

I want to follow up on gross margin as well, but understanding the shipping costs a little bit more and sort of where we are in that transition. I know that it was a pressure last quarter. Was it greater this quarter? And if you look at it, I imagine, that's showing up in the e-commerce business with the continued decline in margin there. So just talking through -- or just maybe, is that still a profit center for you, shipping? And where are we now in that curve as the market changes?

Okay. We are not disclosing the incremental shipping and fulfillment-related costs, except to say, similar to what I said to Matt, that it's one of the main drivers of our lower gross margin, it's the second thing I listed. And we did indicate in our call last time that we'd expect this would continue into the back half of the year. It did continue as we expected. And we expect that it will continue into Q4. It's important that we're incurring these out-of-market shipping and multiple deliveries on a single order to ensure high customer service levels. And especially throughout the holidays, we think it's important to continue to do that. Longer term, once we have completed the regionalization of our distribution centers and we have implemented the necessary technology, which includes inventory tools that will allow us to better forecast our inventory flow and space capacity requirements by DC, brand and channel, as well as future system enhancements that will give us better customer order visibility, we will see a reduction in our supply chain costs. But even more importantly on this point, we believe further developing our supply chain today to be more agile and adaptable will enhance our sustainable competitive advantage. So it's going to put an even greater distance between us and our competition and enable us to provide the best customer service experience in our industry. And we are excited about the future.

And you mentioned, I think, repositioning inventory as part of the cost of that. Is that unusually elevated right now because of what you are doing? Or is that sort of -- do you expect that to be an ongoing thing while we build this out?

Yes. So I think it's important to think about the higher levels of inventory required to be sufficiently in stock regionally. This is a competitive advantage as, longer term, it not only, obviously, minimizes being out of stock, but it lowers our delivery costs and improves our delivery time to the customer. Our primary objective has been to be in stock to serve the customer. And so we've been increasing inventory levels from a position that we thought was negatively impacting sales. And we also want to get our merchandise, particularly our larger items, to our customers more quickly. And so we're accomplishing this through regional distribution. Over the immediate term, this increases our inventory levels, but longer term, once we've implemented the necessary demand planning tools that I mentioned, we'll be more effective at inventory allocation between the distribution centers, allowing our inventory levels to moderate over time.

Next question comes from Neely Tamminga with Piper Jaffray.

This is Kayla Wesser on for Neely today. My first question is, the amount of newness in the catalog for core Williams-Sonoma appears to have really stepped up as we begin getting ready for the holiday season here. Just wondering if you could speak to whether this strategy is helping you acquire new customers or reengaging lapsed customers.

Thank you for the question. We have been really focused on our products pipeline, and on the last call I mentioned that we're going to have a lot of new instructions in Q3 and we did and they're working. And we have what I think is a very exciting holiday assortment, a combination of great entertaining and also gift-giving ideas and across a wide range of categories where I think our customers have grown to love us for the nostalgic candies that we sell, but also always want to see the new things that we have. We've seen strength both in our proprietary products, but also in our branded products. And we've developed incredible relationships with a lot of these key brands and really are the place that people want to buy gifts for -- in the holidays. And so we have equal optimism around branded as we do around proprietary products for this holiday season.

And then a follow-up on Pottery Barn Teen. You mentioned some weakness in textiles in Q2 and Q3, and I know that it shifts more towards gift giving in Q4. Just wondering, though, if we think about your bedding and textiles business, have you -- do you feel like you've identified the issues and fixed them, or is there still some more room for improvement in holiday and even into Q2 and -- Q1 and beyond?

I always think there's more room for improvement in everything. We're very self-critical. The assortments that we have coming, I think, are gorgeous and really differentiated. There's a lot of people watching what we do and getting into this business, and that competition makes us better and makes us differentiate. And also, our -- there's not a lot of people that have our supply chain. We're vertical, so we can get better costs and our scale allows us to deliver better value: cost, quality, relationship. And so as we look at next year, we see some clear opportunities, highly competitive, so I don't want to go through the details of such. But we see some clear opportunities quarter-to-quarter for PBteen.

We have time for one last question from Cristina Fernández, Telsey Advisory Group.

I wanted to ask about the customer satisfaction scores, particularly at Pottery Barn. I know those had deteriorated a little bit last quarter just given the inventory issues. Have you seen that improve? And also, how much do think that weighted on the Pottery Barn comp this quarter?

It's a great question. Thank you for that. Customer service is our primary objective, and our goal is to build a capability that delivers the most convenient and damage-free experience in the furniture industry. And over the past 3 years, our Pottery Barn furniture sales have grown tremendously. We're going to deliver a ton of furniture into our customers' homes this year. We've always done this better than most, but we see opportunity to take our capability to the next level, much like we did in e-commerce 5 years ago. And so we've been investing, as we've talked about, and advanced our delivery platform beyond the current state of the art. Every customer piece of feedback that we get we not only fix with the customer but we root cause it and learn from it and make sure that we're not -- we don't have a bigger opportunity. And customers are very demanding and they are going to continue to expect more, and that is why we're making this such a focus, because we believe we have the opportunity to totally disrupt the furniture business with our world-class delivery.

And then a follow-up. As far as promotions, you talked about the merchandise margin being slightly down versus last year, but fulfillment costs being higher. And I know a lot of it is related to the inventory issues, but how much the free shipping promotions were a factor this quarter?

It wasn't a factor at all. It's not an issue from more free ship or lower shipping income levels. It's 100% due to higher shipping costs from our decision to provide the best level of customer service by shipping out of market and having multiple deliveries on a single order.

And that does conclude our question-and-answer session for today. I'll now turn the conference back over to Ms. Alber for any additional or closing remarks.

Thank you all for joining us today, and we really appreciate your time and your continued support. And we look forward to speaking with you again in March. Happy holidays, everyone.

Thank you, and that does conclude our conference call for today. We thank you for your participation. You may now disconnect.