Williams-Sonoma, Inc. (WSM) Q2 2016 Earnings Report, Transcript and Summary

Welcome to the Williams-Sonoma Inc. Second Quarter 2016 Earnings Conference Call. [Operator Instructions] This call is being recorded. And I would now like to turn the call over to Beth Potillo-Miller, Senior Vice President, Finance and Corporate Treasurer, to discuss non-GAAP financial measures and forward-looking statements. Please go ahead.

Thank you, Matt. Good afternoon. This call should be considered in conjunction with the press release that we issued earlier today. Our discussion will contain non-GAAP guidance, including non-GAAP EPS and operating margin, which excludes the impact of unusual business events. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP financial measures and our explanation of why the non-GAAP financial measures may be useful are discussed in our press release. During the first quarter of 2016, we incurred a onetime reorganization charge related to the reduction of headcount, primarily in our corporate functions of approximately $13 million or $0.09 per diluted share. This charge was recorded as SG&A expense within the unallocated segment. The remainder of the discussion today will reference full year guidance related to EPS and operating margin on a non-GAAP basis, excluding this unusual item. 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 2016 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 releases 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 would now like to turn the conference call over to Laura Alber, our President and Chief Executive Officer, to discuss our second quarter 2016 results.

Thank you, Beth. Good afternoon, and thank you all for joining us. On the call with me today is Julie Whalen, our Chief Financial Officer; and John Strain, our Chief Digital and Technology officer. John joined in 2006 as Senior Vice President and Chief Information Officer and was promoted to his current position in 2014. Welcome to the call, John. Not on the call today is Pat Connolly, who most of you know after 37 years at Williams-Sonoma, retired last month. I want to reiterate my deepest thanks to Pat on behalf of our management team and all of our associates for his many contributions to the company. Our executive team isn't like that of most ides [ph] with an average of more than 10 years at the company and several of us with much more. So we've all worked together very closely for a very long time and couldn't be happier to see our colleague, Pat, begin his well-deserved retirement. Now I'll discuss the second quarter. In the second quarter, we delivered revenue growth of 2.8% and earnings per share of $0.58. These second quarter results once again reflect our competitive advantages, a portfolio of strong brands, a balanced multi-channel model, successful growth initiatives and a relentless focus on operational improvements. West Elm, Rejuvenation and Mark and Graham and our global business had strong year-over-year growth, and our improved supply chain execution contributed to our earnings results. We made substantial progress against our operational initiatives, which helps elevate our customer service levels, reduce costs and drive down merchandise inventory. We also continue to make progress across all of our brands in the area of corporate sustainability. One example of our company's commitment to responsibly sourced products is that West Elm was just recognized as one of Fortune's 7 world changing companies to watch for its pledge to make 40% of its product assortments Fair Trade Certified by 2019. We believe our values differentiate us and that the customers care about how their products are made and we will continue to lead in this area. Despite this progress on our strategic initiative, the retail environment has softened since we last talked, and our sales are being impacted by a more cautious consumer. While we are confident in our long-term strategies across the company, we believe it is prudent to modify our outlook for the remainder of the year. Julie will provide more details about our guidance later on the call. As always, our focus is on what we can control, which includes our supply chain and inventory initiatives delivering innovative products at the best value. Our marketing strategy is to increase new customer acquisition and enhancing the retail experience. Let me first talk to you about our supply chain initiatives. Our supply chain has been one of our core focus areas and for good reason. We believe it's critical -- it's a critical component of the customer experience and ensuring customer loyalty. And it's also one of the biggest cost drivers and areas of potential opportunity for any large tier furniture retailer. We're happy to report that our efforts in logistics are resulting in improved customer metrics and have reduced our costs. We're seeing significant improvements in 3 key areas. First, we've reduced the number of deliveries per order and increased on-time deliveries. We're being more accurate on our promises and more efficient in our deliveries. All this is resulting in improved service levels and reduced escalation calls to our care center. And with several projects lined up to provide further improvements to customer order visibility, we are confident that this trend will continue. Also contributing to shorter delivery times is our new Southeastern distribution center in Georgia, which is now approximately 50% full and is shipping approximately 40% of our Southeastern volume. Delivery time for customers in this region have improved by 3 to 5 days and as inventory levels ramp up in this facility, the fulfillment percentage will grow with further improvements in delivery time and service levels as well as reduced freight costs. Second, we're seeing similar improvements on the inventory side. We have reduced queue counts by double-digit percentages and total merchandise inventory by 6.6% versus Q2 of last year. These reductions are driving efficiencies throughout the supply chain, enabling us to achieve faster customer order fulfillment. With the continuous execution of our inventory initiatives, inventory has been more effectively regionalized. So we are seeing fewer out-of-market shipments, reducing our freight-out expense, decreasing our in-transit damages and reducing customer delivery times. And third, our operations teams have made impressive progress streamlining the returns process and injecting more lean manufacturing principles into our upholstery manufacturing operations in America. Our focus on continuous improvement in these areas is illustrative of our passion for being effective and efficient operators. We have been relentless in our search of further optimization opportunities, and a path to continued improvement in our supply chain has never been more clear. We believe that our approach is working, and we look forward to further executing against our objectives. In March, I spoke with you about how we would transform our marketing. One key area of focus is digital innovation. We're seeing a transition in the marketplace that plays into our strengths and competitive advantages. We have advanced multi-dimensional attribution models that guide our investments, and it has led us to surgically cut our catalog circulations to rebalance and to optimize our investments into digital channels as they continue to evolve. As a result, digital marketing has become our largest investment channel, outpacing our catalog and store-based marketing investments. Furthermore, because of our portfolio of strong brands with large and diverse user bases, we are uniquely positioned to continue to acquire customers profitably without chasing our competitors with unprofitable investments. A big part of our digital story is our innovation. Our proprietary modeling, based on customer profiles and interactions, drives our ability to target audiences more effectively and profitably. We know that relevant marketing drives engagement with targeted audiences converting at 3x out of non-targeted audiences at half the cost. The breadth, depth and detail in our house file [ph] provide us with a material advantage, and we are partnering with great companies to help to advance and take advantage of emerging personalization capabilities for custom segmentation and targeting. Another part of the transition towards digital is the growth of our mobile channel. Across our brands, our mobile traffic is substantially up as is our conversion. Specifically, we have focused on functionality and ease-of-use improvements to our mobile sites in the areas of checkout, registry and furniture buying. I'd also like to update you today on the progress we have made around our strategy to enhance the retail experience. Our stores are one of our most powerful marketing tools and one of our most important competitive advantages. The ability to physically experience our products allows our customers to know and trust our brands and make better shopping decisions. Importantly, our largest source of new customers comes from our stores. Our store is an important driver to sales across both the retail and e-commerce channels. Therefore, we know that our stores need to be in relevant locations and need to provide our customers with great shopping experiences. As retail traffic has declined and customer shopping patterns continue to shift, we are focusing on enhancing the retail experience. And as a result, we are selectively investing in transformative store remodels to make our stores more of a destination and to drive profitable results. In Pottery Barn, we have just opened 2 fully remodeled stores, 1 in South Coast Plaza in Costa Mesa and 1 in Corte Madera, California. The results from these store openings have been quite positive. We also recently opened 2 mini remodeled stores, which are also very successful. In addition to substantially higher comps, we're very encouraged to see growth in the e-commerce sales in the surrounding areas as well. While early, we will continue to monitor results, and we plan to test 4 mini remodels in the back half of this year. And as always, we are very diligent in our real estate investments, and will use the results of these tests in planning our strategy for additional remodels next year. In Williams-Sonoma, we're also experiencing great results with our new store formats. In the second quarter, we opened 2 stores, 1 new store in Minnetonka, Minnesota and a fully remodeled store in San Diego, California. During the third quarter, we'll be opening 4 new stores, all of which have Williams-Sonoma Home collections. In addition, we're also actively reviewing our fleet, looking at store locations that are underperforming, that are undesirable due the mall deterioration, excessive rent escalations or other market conditions, and we are potentially repositioning them. We see great opportunity to optimize our retail fleet. We are aggressively pursuing all avenues. Now I'd like to highlight the key results within our brand portfolio, beginning with the Pottery Barn brand. Pottery Barn comp brand revenues declined 4.8% in the second quarter. Product categories that performed well in the quarter included upholstered and outdoor furniture where our new product introductions were well received. Underperforming categories were fashion bedding and indoor pillows. Our business was also negatively impacted by softness we saw on decorative accessories and tabletops. In addition, Pottery Barn, as our largest brand and with the widest customer base, is most impacted by a softening environment and declining mall traffic. To maintain our growth and leadership position as consumer spending habits change, it is critical to strengthen our approach to acquiring new customers. We're going after this aggressively, and we are seeing improved trends in customer acquisitions. We have initiatives to support this focus, including providing more exciting, accessible products in easy-entry categories, digital and marketing innovation and making improvements in our stores. We're in the midst of transforming our marketing mix to focus on new customer acquisition, refining our catalog pages and circulation and investing in the most efficient e-marketing tactics. We are increasingly developing content and creative assets to engage and convert customer on new platforms, including Instagram, Pinterest, Facebook and YouTube. In addition, we have several other key opportunities that we are focused on that provide a clear path to growth, these opportunities on the categories of brand aesthetic and product development, our value proposition and the retail experience. We have been conducting extensive brand and customer research both internally and with an external third party. Although not yet finalized, this work has validated our aesthetic direction and strategies. Our sales in new product information -- introduction, further confirm we are on the right path. In July, we launched our new fall product collections and Healthy Home initiative with increased assortments of responsibly sourced products, including organic textiles, reclaimed wood furniture and recycled glass lighting and accents. We supported and augmented these launches with content marketing, decorating tips and ideas. Resulting demand for our new products in upholstery, bedroom, dining and home office has been strong. One of the key differentiators of our upholstery is that the majority of it is manufactured by skilled craftspeople in United States in our own North Carolina factory. The in-sourcing of our upholstery manufacturing allows us to ensure a consistent high level of quality from raw material selection to construction. And looking towards the balance of the year, we've been extremely aggressive about ensuring the product that we have on order in Pottery Barn is consistent with what our customer is looking for from us. In fact, we have more bestsellers in our new fall furniture assortments than last year, and we are aggressively chasing reorders. In Pottery Barn, value is the foundation of all of our product strategies, and it is driven by both price and by differentiation in products and services. We are focusing on -- our offerings in accessible product categories that are important for customer acquisition and inspire our customers to convert. Additionally, we're adding more opening price points across all categories, including in furniture, making more products affordable to a broader base of consumers. Our direct sourcing advantage allows us to work with our vendors and designers to get more value to our customers. And when it comes to price and shipping, we know our customers are very savvy, and they look at the total cost. We have a great opportunity in messaging our quality, value and differentiation to the customer and are making improvements in our communication and marketing to highlight our unique products and services. In retail, we are focused on customer experience and store design. We are offering differentiated services, the hallmark of which is our free in-home design service. And as we discussed before, we're also rolling out our successful to our models of the future. Moving to Pottery Barn Kids. Second quarter comp brand revenues were up slightly to last year. Strength in our furniture and back-to-school businesses was offset by softness in the textiles category. Growth in our furniture business was driven by innovation in nursery and bedroom. Customers are responding to our new collection with rich complex finishes and functional design. During the quarter, we launched our biggest ever back-to-school collection featuring high-quality personalized gear and new solutions for eco-friendly, waste-free lunch storage. Looking ahead, we are focused on driving growth in the PB Kids brand through several key initiatives. We are committed to quality. Pottery Barn Kids stands for timeless design and superior quality at a compelling value. Our commitment to quality ensures that our furniture is crafted of high-grade materials and is tested to rigorous safety standards. We pride ourselves in furniture that is built to be passed down to generations, and we will demonstrate in our marketing how favorably our standards compare to many competitors that take shortcuts with low-grade materials and poor construction. We'll also continue to grow our commitment to building a healthy home and appeal to increased customer demand for product that is good for children and good for the planet. We're aggressively expanding our offering of organic bedding and GREENGUARD-certified furniture. And beginning later this year, we'll deepen our support of the vendor community by being the first children's home furnishings retailer to launch Fair-Trade-Certified products. We celebrate the memories and milestones of childhood. We are encouraged by the strong initial response to our new Halloween collection, and we will continue to delight our customers as we celebrate the holidays with new seasonal decor and high-quality gifts that inspire imaginative play. We're placing a heightened focus on gift giving year round, highlighting our proprietary personalized gifts for babies and kids. Moving to PBteen. In the second quarter, comp brand revenues declined 5.2%. Sales in the textile category were especially challenging, and in-stock levels in other areas of the business hampered results. To address these inventory issues, we brought in new leadership in inventory management, and we expect to be in stock by the end of the year. During the quarter, we did see favorable results from our expanded back-to-school focus. Innovation in the gear category and evolution of our dorm assortment coupled with robust marketing support produced growth. Product collaborations continue to be an important strategy, and we're seeing exceptional response to our latest Emily & Meritt collection. Through the balance of the year and 2017, we're committed to growing the business through the following 3 strategies: We're focused on product innovation across our core categories. In addition to our core textile and furniture businesses, we are focused on providing inspirational decorative solutions across the life stages of teens, including tweens, teen and dorm. As customers' need to change across life stages, it is our objective to offer product with great teen function, providing new reasons to purchase. We're also committed to increasing our value proposition, and we are broadening our opening price point offerings. We believe that this will be an important strategy for new customer growth and retention, and we are encouraged by the improvement that we saw in new customer growth in the second quarter. We're also deepening our brand awareness efforts, leveraging other internal brands to promote the PBteen brand and focusing our marketing strategies to communicate our brand values and improved customer acquisition. In PBteen, we market to parents, teens and young adults. While we leverage our existing marketing strategies for the parent, there are a number of digital-only tactics we use to capture the increasing purchase influence of the youth audience, including Facebook, Instagram, YouTube and Snapchat. Stores have also been an important part of customer growth and awareness, and we have expanded the brand's retail footprint and are testing new store concepts with innovative store design, merchandising and collaboration shop in shops. We recently opened 2 new stores in Jacksonville, Florida and San Diego. The San Diego location is our largest store in United States, and we'll offer fun, creative ways for our customers to design their ultimate bedroom, study space, lounge and dorm room. In summary, across the Pottery Barn brands, we are confident in our long-term strategies for growth. Through the remainder of this year and into 2017, we have a road map of exciting product introductions, market collaborations and new store tests every single quarter, and we will leave no stones unturned. Moving on to Williams-Sonoma. In the second quarter, Williams-Sonoma comp brand revenues were flat. We saw gains in cookware, particularly our Williams-Sonoma-branded products as well as strong growth in Williams-Sonoma Home. These strengths, however, were offset by softness in food, electrics and cook tools. During the second quarter, we also made progress in the execution of our growth strategies in Williams-Sonoma, including delivering the best product at the best value, growing Williams-Sonoma Home, increasing our online business, enhancing the retail experience and aggressively acquiring new customers. From a product perspective, we continue to increase our offering of Williams-Sonoma-branded product, including the introductions of our exclusive professional copper cookware and our own high-quality affordable glassware collection. We're expanding our Open Kitchen line with new products and affordable electrics and bakeware. We continue to see growth in exclusive products from our strategic vendors, and we'll be launching new products through the remainder of the year. In May, we launched a new partnership with Fortnum & Mason, one of England's oldest and most iconic retailers, offering a curated collection of more than 35 items, including Fortnum & Mason's signature artisanal teas, preserves, biscuits and hampers. This exclusive partnership is Fortnum & Mason's first foray into the United States with a national retailer. Williams-Sonoma Home delivered strong growth in the quarter online and especially at retail. We added Williams-Sonoma Home products to 6 stores during the quarter, and we'll add it to another 4 in Q3 for a total of 30 installations. Our e-commerce business in Williams-Sonoma has been the principal driver of brand growth. We continue to see additional opportunities to drive the growth of our online business by directing more of our marketing spend to digital, strengthening our content messaging, improving on-site conversion, optimizing our mobile experience and expanding our DTC advantaged product offerings. From a marketing perspective, we remain focused on customer acquisition. Our registry program is growing double digit as these are multipronged approach in product marketing and customer outreach. We're also engaging with existing and potential new customers in multiple venues. For the second year in a row, Williams-Sonoma presented the Culinary Stage at BottleRock, Napa Valley, where chefs and celebrities entertained the audiences with culinary-themed performance, including a drum set constructed of cookware. And we recently announced a 9-city Culinary Mystery Tour with Christopher Kimball, founder of Milk Street Kitchen. The show will include tastings for the audience, cooking and live science demonstrations and offers an evening for guests to share their cooking challenges and memories with Mr. Kimball. At retail, we continue to focus on the customer experience, our new store management tools and reengineered processes. And as I mentioned earlier, our new store models are working, and we'll be rolling them out in the future. Finally, we're happy to announce Williams-Sonoma's fifth annual fundraising campaign benefiting the No Kid Hungry program, a national film profit organization working to end childhood hunger in the United States. Over the past 5 years, Williams-Sonoma has helped raised $1.7 million to support No Kid Hungry, which equates to 17 million meals served to children in need across the nation. This year, we hope to raise $1.5 million through our fundraising efforts, which will include customer donations both in-store, online, store events, corporate fundraising and limited-edition products such as the incredibly popular celebrity-designed spatulas where 40% -- 30% of the proceeds benefit No Kid Hungry. Moving to West Elm. For the second quarter, West Elm comp brand revenues increased by 15.8% over last year's 15.7%, another quarter of double-digit growth. All major product categories posted significant gains, particularly in our core furniture business. Results were driven by new introductions across our indoor furniture category as well as overall strength in our outdoor furniture. In the second quarter, West Elm opened 2 new stores in the United States, 1 in Boise, Idaho and the other in San Antonio, Texas. Each site was carefully selected in areas where West Elm can play a contributing role to urban renewal and redevelopment. Like each of our stores, these new locations include a rich assortment of local products from area makers and designers. We have plans for 5 new stores in the months of August and September, most notably the move of West Elm's first store on Front & Main to the home of the brand's new headquarters across the street in the historic Empire Stores building in Brooklyn. This location marks West Elm's 100th store, a fitting milestone for the neighborhood the brand has called home since its inception in 2002. In July, West Elm announced a new partnership with a sleep company, Casper. West Elm is Casper's exclusive retail store partner with dedicated sleep areas in each of its locations. This relationship is off to a strong start in the first 2 months. In the commercial furniture industry, West Elm Workspace marked the end of its first year in June with a strong showing at NeoCon, the industry's leading trade show. West Elm Workspace filed its inaugural campaign where it won the prestigious Best of NeoCon Award with recognition from both Metropolis Magazine and Interior Design at this year's show. West Elm Workspace is poised for a second strong year as it continues to build momentum in the office furniture market. Whether at home or at work, West Elm continues to have a meaningful impact on its customers' everyday lives. We have a number of exciting initiatives on our road map that we believe will grow West Elm to be our largest brand over time, and we look forward to updating on the progress throughout the remainder of the year. In our global business and our newer businesses, Rejuvenation and Mark and Graham, we also continue to see strong growth. During the second quarter, our global business delivered strong results, growing revenues 20% by executing on our key growth and profit improvement strategies. Sustained focus on operational excellence along with the growth in our company-owned retail and e-commerce operations in Australia and the U.K. has resulted in further cost structure leverage and improved profitability in each of these markets. In the quarter, our franchise growth was fueled by the opening of 7 stores in Mexico, which solidified our presence in the country. Planned new stores in the Mexico and the Middle East in the second half of the year will help maintain our growth across multiple geographies. We continue to actively engage with top retailers in key markets and plan to announce new partnerships later this year. Additionally, our U.K.-based John Lewis partnership is executing as planned with the opening of 3 new stores in the second quarter, and we are on track now to be in a total of net 9 retail locations by the end of this year. Our Rejuvenation brand continued its strong double-digit growth in the second quarter, driven by expansion into new categories of the home as we broaden our offerings around our core high-quality foundational lighting and hardware. During the quarter, we launched our first bedroom collection with a comprehensive product line, including lighting, furniture, beddings and rugs across multiple aesthetics, including our fast growing Northwest Modern line. We also launched into the home office space with strong results across multiple categories. Our new Chicago store in Lincoln Park is set to open in November, and we're excited to directly connect with the customers we've built up over 40 years in that market. We're focused on our domestic sourcing strategy and continue to forge partnerships around the U.S. with companies with a heritage of craftsmanship. We believe our opportunity across all of our categories is to provide the core functional and timeless elements of our customer's home, whether in lighting, hardware or furniture. Now I'd like to talk about Mark and Graham. Mark and Graham's growth in the second quarter was driven by classic personal accessories and gifts at affordable prices. Revenue was also driven by new key categories, including picnic, travel solutions, golf solutions, games and flags. Mark and Graham continues to help customers celebrate milestones throughout the year. We experienced success in key item Father's Day gifting by offering a marketing campaign that was heartfelt and relatable. Year-to-date, our success has been driven by continuing to focus on classic and preppy affordable key items that are innovative and unique. Looking ahead, we believe that offering affordable, customizable luxury across diverse product categories will continue to drive the growth of this brand. Together, these 2 businesses, Rejuvenation and Mark and Graham, grew 32% in the second quarter, and we see substantial opportunity for future growth. In summary, we remain intently focused on strengthening and growing our brands, further differentiating our product offerings, accessing new markets, driving continuous improvement in our supply chain and improving our service levels. We continue to see confirmation that the major initiatives positioning us for long-term success are working. We expect softening retail traffic to be an ongoing challenge, so we'll continue to drive growth in our e-commerce channel where we already have competitive advantages that we will continue to optimize. We have the infrastructure, strategies and team in place to succeed and are confident in the long-term prospects of our company. I look forward to updating you next quarter on our progress. I will now turn the call over to Julie to discuss our Q2 results in more detail and the guidance for the remainder of the year.

Thank you, Laura, and good afternoon, everyone. Before I walk you through the second quarter financial results in more detail, I would like to begin with a few second quarter financial and operational highlights. We are particularly pleased with the progress we have made on our long-term initiatives and the impact of these initiatives on our financial statements. First, our focus and disciplined execution against our long-term growth initiatives are driving quarter-after-quarter top and bottom line growth. West Elm, which we believe will be our largest brand over time, delivered their 26th consecutive quarter of double-digit profitable growth with comparable brand revenue growth of 15.8% on top of 15.7% last year. Our newer businesses, Rejuvenation and Mark and Graham combined, had another quarter of double-digit growth approximately 32%. In our global business, we also saw improved profitability and another quarter of double-digit revenue growth of approximately 20%, taking our global revenues to $80 million for the second quarter. Second, we have made progress on our operational initiatives. Our direct sourcing advantage continues to drive material cost reductions, allowing us to provide value to our customers and still maintain merchandise margins that are only slightly down to last year. Our focus on our supply chain initiatives has generated reduced shipping and fulfillment-related costs, resulting in improved selling margins. And our inventory initiatives have already allowed us to reduce our inventory levels and to reduce costs from our distribution network. Finally, we are a company with a culture of strong financial discipline. We continue to leverage our SG&A with strong cost control, particularly across employment and general expenses. We maintain a strong balance sheet, which in turn have allowed us to continue to invest in our business for future growth and to provide returns to our shareholders in the form of dividends and share repurchases. Now I would like to discuss in more detail our second quarter results. For the second quarter, net revenues increased 2.8% to $1,159,000,000 with comparable brand revenues increasing 0.6% on top of 6.3% last year. The strength in West Elm and our newer businesses was partially offset primarily by the 4.8% decline we saw in the Pottery Barn brand. The strong growth in our global business and our newer non-comp West Elm stores drove total revenue growth to exceed our comparable brand revenue growth by 220 basis points. Net revenues in our e-commerce channel grew 5.2% to $600 million or 51.7% of total company net revenues, 110 basis point increase over last year. This e-commerce growth was driven by the continued strength in West Elm as well as in Williams-Sonoma, whose strategy to aggressively pursue strong e-commerce growth is clearly working. Our retail channel net revenues increased 0.4% to $559 million in the second quarter. Strong growth in West Elm as well as growth in our global business was partially offset by the general weakness we saw across our U.S. retail store base primarily from an overall decline in nationwide mall traffic. Gross margin for the second quarter was 35.4% versus 36.1% last year. The 70 basis points of gross margin deleverage was largely driven by occupancy deleverage of 40 basis points. Occupancy costs were $165 million in the second quarter of 2016 as compared to $156 million in the second quarter of 2015. The remaining 30 basis points of deleverage was primarily due to higher franchise and wholesale revenues, which are dilutive to gross margin but accretive to the operating margin. Excluding the impact of the higher franchise and wholesale revenues, our selling margins were essentially flat. This is a testament to all of the positive financial contributions, our efforts in our supply chain and inventory initiatives are providing. SG&A for the second quarter was 28.2% of net revenues in 2016 versus 28.7% in 2015. The 50 basis point improvement primarily resulted from employment leverage and lower overall general expenses from strong financial discipline. The improvement in our employment cost was primarily a result of the corporate reorganization that we implemented during the first quarter. Operating margin for the second quarter was 7.2% versus 7.4% in the second quarter of 2015. By channel, the operating margin in the e-commerce channel was 22.1% versus 21.5% in 2015. The 60 basis point improvement in operating margin was driven by higher gross margins primarily due to improved year-over-year shipping and fulfillment-related costs as a result of our focus on all of our supply chain and inventory initiatives. This was partially offset by an increase in SG&A, driven by higher advertising costs from incremental e-marketing investments as a result of our increased focus on new customer acquisition. The operating margin in the retail channel was 5.9% versus 7.3% in 2015. This decline in operating margin primarily resulted from lower gross margins from lower selling margins and occupancy deleverage from lower overall retail revenue growth. The selling margins were particularly impacted by our decision to more aggressively liquidate less productive SKUs and aged inventory to our retail outlets as part of our supply chain and inventory initiatives. Selling margins were also impacted by higher franchise revenues. The gross margin decline was partially offset by SG&A leverage primarily from lower employment costs; from strong financial discipline as well as cost leverage throughout SG&A from higher franchise revenues. Corporate unallocated expenses as a percentage of net revenues were 7.1% in the second quarter, flat to 2015. As a result, second quarter 2016 diluted earnings per share was $0.58 versus $0.58 last year, which included an approximate $0.03 benefit from a reduced tax rate. On the balance sheet, we ended the quarter with a cash balance of $111 million after investing an additional $50 million in our business during the quarter and returning $69 million to stockholders through share repurchases and dividends. Merchandise inventories at $963 million decreased 6.6% compared to Q2 2015. This is the first year-over-year decrease we have had since the recessionary time period and reflects our commitment to drive inventory levels below sales growth. Our inventory initiatives are driving substantially reduced inventory levels as well as improved efficiencies in our supply chain. I would now like to discuss our third quarter and fiscal year 2016 guidance. Our guidance reflects our best estimate at this time as to the possible outcomes for the back half of the year. As we have said, we are seeing a softening retail environment. As a result, we have revised our guidance for the remainder of the year to reflect this change in trend. For the third quarter of 2016, we expect to grow net revenues to a range of $1,235,000,000 to $1,285,000,000 with comparable brand revenue growth in the range of 0 to 4%. We expect our third quarter operating margin to be relatively in line with last year, and we expect diluted earnings per share to be in the range of $0.75 to $0.80. For the full year, we are reducing our revenue growth by 100 basis points and our earnings per share by $0.10 on the high end of the range. As a result, we now expect to grow net revenues 2% to 5% to a range of $5,075,000,000 to $5,225,000,000 with comparable brand revenue growth in the range of 1% to 4%. We now expect operating margin to be 9.4% to 9.8%, and our diluted earnings per share are expected to be in the range of $3.35 to $3.55. All other financial guidance within the press release remains unchanged from the previous guidance. From a capital allocation perspective, there are no changes to our plan. Given our strong balance sheet and operating cash flow, we intend to continue to make the necessary investments across our business of approximately $200 million to $220 million in capital expenditures to strengthen our competitive advantages and to support our long-term growth initiatives. And we also intend to continue to return capital to our shareholders in the form of share repurchases and dividends. In summary, we are pleased that we were able to deliver upon our second quarter financial commitments despite a challenging retail environment. We believe that our competitive advantages are driving our success. Having a portfolio of strong brands, a balanced multi-channel model, a continuous focus on operational improvement and a tenured executive team as well as a culture of strong financial discipline, and with these competitive advantages and the ongoing success of our strategic initiatives, we are confident that we will be able to drive sustainable, long-term profitable growth. I would now like to open up the call for questions. Thank you.

[Operator Instructions] And we'll move to our first question. This will be from Daniel Hofkin with William Blair & Company.

Just wondering, you cited obviously the softer retail environment. Wondering how -- kind of what gives you confidence that, that's the main factor versus -- and I'm am thinking particularly about Pottery Barn here, versus internal merchandising or execution or, let's say, competitive factors. And then just a related question. How should we think about your outlook for the rest of this year in the context of your 3-year plan issued earlier this year?

Thanks, Daniel. It's mixed out there. We know mall traffic's down. Certain categories are more challenged than others. On the flip side, housing metrics appear to be strong, and we also are seeing growth in some of our smaller businesses. Our approach has always been the same. We're going to focus on things we can control, and we would prefer to be self-critical. The things we can control are our product, our value prop and our service. We're executing on our growth strategies and against our operating initiatives to drive improvements across the company, and we believe that these priorities, along with the combination of our portfolio of strong brands and our multi-channel model, will leave us well positioned amongst the competition regardless of what's going on in the external world.

And Dan, this is Julie. Regarding the outlook -- 3-year outlook. Our 3-year outlook still remains unchanged with mid- to high single-digit revenue growth and low double-digit to mid-teens EPS growth. Obviously, in the short term for 2016, our earnings growth is guided to obviously be below that outlook, and that is both due to the revised guidance on the year resulting from the softening retail environment, but it was also due to the investments we spoke to you about last time that we're making in our supply chain and inventory. But we are confident longer term, first, by the fact that West Elm is definitely clearly on their path to $2 billion with another quarter of double-digit growth. The scaling of our global businesses that I spoke to, the improvement in our newer businesses and their continued growth and all of these supply chain and inventory initiatives that we said we were doing, we're working on for a while and clearly, now they're showing that we are executing upon them and getting the benefits from them, when all of those come together plus all the strategic initiatives that Laura mentioned on the Pottery Barn brand, we are absolutely confident in our ability to grow in the longer term.

This time we'll take a question from Peter Benedict from Robert Baird.

Julie, in your remarks, you kind of mentioned the gap between revenue growth in CBR in 2Q, 220 basis points. Just curious -- and that's the way it's been for the last several quarters. What would affect that going forward? Why wouldn't that gap continue as we look out to the back half of this year?

I mean it could. In our full year guidance we do show that. We do have the revenue growth 100 basis points above the comp growth. Obviously, it just depends on the mix of revenues in any given quarter, but we've certainly reflected that in our full year. We don't -- have no belief, to answer your question, that West Elm is slowing down anytime soon, nor our global operations. So with those 2 being the big drivers of the non-comp growth, that is -- we still think that's going to continue.

At this time, we'll move to Matt Fassler with Goldman Sachs.

I want to ask one question about the guidance. You spoke about the retail environment eroding, presumably, over the course of the quarter and since you last spoke to us in May. The midpoint of your comp brand guidance for the third quarter is actually a bit better than the number that you put up for Q3. So is that a function of the environment stabilizing? Is it a function of other steps you're taking? Particularly I'd ask on the promotional front to try to shore up that revenue because even though there's some deterioration, I guess, it doesn't seem like you're modeling a much softer outcome for Q3 than you saw in Q2.

Yes. I mean, our guidance obviously, as I said, reflects our best estimate at this time, as the possible range of outcomes for the back half and for Q3. Obviously, the higher end of our range does assume improvement, and depending on the ongoing success of our growth initiatives in all the areas that we're focused on that Laura went through in detail, at the Pottery Barn brand, those should drive improvements. Obviously, we've got a range. We still have a softening retail environment. We don't know if that's 2 weeks or 2 months or what have you, so that is why we have a range of 0 to 4%. But on the upper end of that range, we do expect improvement.

And then just by way of very quick follow-up. Would you say, if you think about underlying demand, that you can detect within the e-commerce channel versus underlying demand, that you can track at retail particularly as it relates to traffic? Would you say that this is more of a footfall issue in brick-and-mortar stores or more of a consumer issue, broadly speaking?

I would say that it's both. In retail, there's reported reduced traffic from all the counter aggregate data you see. And then the customer's just more careful right now. And I'm not an economist, so I'm not going to go through all the reasons that can be. But our focus is on giving them incredible service and great value and innovative products. And we are testing a lot of things in both channels, and we have a lot of things that are working that we're building on. As I said earlier, particularly in Pottery Barn, we are very aggressively ordering what's working and canceling what's not and that it's really good to have new bestsellers that are really, really strong that you can build on even though you also are seeing some softness in other categories. So a little bit -- a little bit more color. And we're working across all of our channels, which do affect each other quite a lot to increase conversion and drive traffic and over the long haul, really build a much stronger, more loyal customer base. So we have a lot of initiatives. I went through them in probably too much detail in my script that are all focused on customer acquisition and driving traffic and conversion in both of our channels.

We'll move now to David Magee with SunTrust.

Can you give us what -- sort of an early read on what you see with the success of the seasonal merchandise thus far? Just maybe an early read on what you have for seasonal, for the fall.

Sure, great question. It's early, and we love the seasonal holidays. They provide the customer a great reason to buy new things and decorate their homes. And I know, for me, it gives me a lot of pleasure to put up those Halloween decorations every year for the kids, and our customer's telling us the same thing. Despite what I said about the caution, we're delighted to see strong results to Halloween so far. I mean, it's really early, so I hesitate to even tell you that, but it is true. And we have incredible costumes in kids and some wonderful entertaining stories in both Williams-Sonoma and Pottery Barn and so far, so good. And following that, of course, we don't know about Christmas yet. We did see a nice back to school with kids. I mentioned that earlier. And also in teen despite the softness in other categories, the seasonal merchandise has been selling. And this is important because not only is it important for sales, obviously, in the short term, those are the categories that bring the new customers in. So you want to make sure that you're getting customers in with those things because then they're more likely to buy a sofa from you or a rug in a different life stage or when they move than they would have they'd never experienced the brand.

We'll move now to Chris Horvers with JPMorgan.

So I wanted to ask a couple questions on gross margin. Can you quantify how much the inventory clearance impacted enterprise-level gross margins? And do you expect any remnant markdown pressure in the third quarter? And then I have one follow-up.

It predominately hit the retail operating margin the most. As we've said, that we did most of the clearance through our outlook stores, which hit the retail operating margin. So you can look at the delta on the retail operating margin and come to some conclusions. We haven't disclosed the exact amount, but it was material to that margin. As far as of the guidance, I think, sure, could we still have some pressure from some of our inventory initiatives? Sure. But I think the bigger story to take away from, what I'm really pleased to be able to say is if you look at our gross margin, if you look at it sequentially, it has improved from Q4 to Q1 to Q2, and we've gone from basically holding our merch margins flat to slightly down and our selling margins, taking out global, are flat. And I think it's been a long time since I have said that. So clearly, everything we are doing from a supply chain perspective is allowing us that -- trust me, we are still promotional, so -- but we're able to be able to offset that unlike other retailers because of all these initiatives we've been tirelessly working on. It is finally coming to fruition. So I think that's the great story about the gross margin going forward.

That's a perfect segue to my follow-up question. So you previously had talked about improved gross margin performance in the back half. Obviously, lower comp, you have occupancy deleverage. But can you update us on your thoughts on selling margins? Will you promote more to drive the business? Will that be -- can you offset that? And then the impact of shipping and fulfillment costs, obviously, a lot of pressure from out-of-market shipping and returns of damages last year in the back half. Do we get those back now that inventories are cleaning up?

So we're seeing all of that even today. We're getting a lot of benefits from the fulfillment-related costs that are improving as we speak. I don't expect that to change, so we should see that. To your point about occupancy, it depends on the top line, right? Occupancy, depending on where the revenues come in, can deleverage and that would affect total gross margin. Often depends on the mix of revenues from a global perspective, if you got higher franchise, all of that. So it's hard to say exactly where clearly, we don't guide it, where the margin's going to come out. But what I did say is that the op margin we expect for Q3 to be relatively in line with last year, so hopefully, that gives you some indication that we're not feeling that the gross margin's going to be changing.

We'll move now to Greg Melich with Evercore ISI.

I guess, I want to switch gears a little bit. If we think about the overall sales growth, the comp -- brand comp of 0.6%. And I think, Laura, in your comments, you mentioned more opening price point items being added at Pottery Barn, and I think PBteen. Could you help give us some examples on the quarter, the second quarter, as to whether ticket was actually up or down and if this is meant to help improve conversion and sort of gets to a price point that's more affordable for the consumer? Or what's really driving that decision?

Customers are savvy. As I said earlier, they know a value when they see one, including if it's a higher price point type of item. So a sofa that's a great value may be a lot more money than a candle. The truth of the matter though is that the candle, a lot more people can afford. So as I said earlier, we have to make sure that we are not just driving our furniture business but bringing in really innovative decorating and entertaining ideas into all of our brands. It's a very competitive area, so I hesitate to go through specific examples because, as you know, the competition is listening very carefully to our strategies. So I'm sorry not to give you more detail. I'll just say that there's no tricking those customers. They know a good price when they see them, and we are looking at our pricing both versus the competition but also where we cannot just stay status quo but where we can really win. And because we have better quality and they know it and we also offer a lot of service, I believe as we continue to give them innovation and that combination, we will outpace our competition.

That's helpful. And Julie, just to follow up the gross margin question from before. I think last year, did you, sort of, mention something like 50 or 60 bps of headwind on supply chain and related to the West Coast ports and some of that? And how should we think about cycling that in terms of the second quarter and then the back half guidance?

I don't recall that I exactly gave the amount. Probably what I did was alluded to more the fact that if the gross margin was down, it was predominantly associated with the supply chain challenges that we were -- were occurring. So we are seeing a lot of that return and come back to us as we should expect, but I think the bigger story for -- it's going to -- it's a ship you're turning around, so it takes a while. But we've seen all of it start to come back first quarter, second quarter, and it's gaining momentum. But I think the bigger story there that we have to take away is that we are now seeing opportunity to get back to even better than we've been before. And so that's what we're focused on. So we've got improvements from last year, but as we move forward, as we move through the end of the year, into subsequent years, we've got to improve it even beyond that. So that's the exciting part.

We'll move along to Michael Lasser with UBS.

Could you frame the margin benefit that you're seeing from all the supply chain initiatives that you've been putting in place? Also, how long can that last? And how are you thinking about, from a strategic perspective, letting those margin benefits fall to the bottom line versus reinvest them back in the promotions to drive the business?

Yes. We haven't disclosed it, and there's different kinds of margin benefits we're getting. So from specifically from the merch margin line item, it's a lot of the sourcing benefits that we've been talking about for years. I know I've gotten the question a lot that is it going to end next quarter. Well, no, it keeps going on. So first, we started with just the reductions in actual cost vis-a-vis versus the third party and that's still continuing. But now we're moving into that second phase where we've got our employees out there, and they're actually make a difference on the raw material and the negotiation of prices. And so that's one piece of it. The other piece of it is all the supply chain initiatives that we're working that were challenges last year. So get some improvement from that but then also to move ahead from it. So I think the way I would think about it is it's the fact that we are almost -- effectively, it's only slightly down in merch margins and flat on selling margins if you take out the global impact. We were less promotional. So if you look at other retailers and see how promotional they were, you might be able to get some idea of how much benefit we are getting. And would we ever have let it drop down? I mean, of course, but at this point, we see the opportunity to continue to be aggressive and competitive and move forward.

We'll now move to Dan Binder with Jefferies.

Just 2 items. I was wondering if, first, you can discuss a little bit more color on the cadence of the quarter from a sales perspective. And then secondly, on the promotional environment, I'm just curious with the change in the comp momentum, what you're seeing customers -- what have they stopped responding to versus maybe what they were responding to before.

On the cadence of the comps, Julie, you want to answer that?

Yes. We usually don't comment on the cadence of the comps. But as far -- I mean, I can comment, Laura can comment, but on the promotional environment and what we thought was different at least from my perspective, from a financial perspective, if you look at many retailers, we are not alone in this situation. If you look at Q1 versus Q2, it was much more broad based. You saw deceleration from Q1 to Q2. It was much more across categories that we've seen before. So I think that's where you start to step back and say, hmm, this is something a little more than we've got the wrong product category in a particular brand.

We have time for one more question. This will be from Simeon Gutman with Morgan Stanley.

I'll make it 2 parts just to get it all in. Just a follow-up on gross margin, Julie. You talked about, a few minutes ago on a response, how you think you can get back to -- or maybe better than some of, I don't know exactly what your words, but to some levels that you were before. In that context, can you talk about do you feel like the gross margins are bottoming cyclically, temporary and you should be able to move on from here? And then my follow-up question, to sneak it in, it looks like the first, I guess, through third quarter margins are roughly flattish. And so doesn't the full year guide imply that margins are going to be down in the fourth quarter? And why is that the case?

What -- for your second question, are you talking about operating margins? Are you talking about gross margins?

Operating.

Okay. So as far as gross margins, I mean, there are so many moving parts in there. That's why it's so hard for us to answer that. I mean, clearly, I am confident our supply chain and inventory initiatives, both sourcing and comping the supply chain challenges we have last year, so I'm confident in that piece of it and that piece moving forward. Obviously, it depends on the promotional environment. It depends on the mix of revenues that we have, how much is global. It depends on the level of revenue to determine where does occupancy play out. And so I can't give you a specific answer to that, but I think the fact that we've seen Q4 to Q1 to Q2, we've seen improvement and we are seeing the success of our supply chain initiatives roll through, I feel really good about the gross margin. From an op margin perspective, really, that is a revenue play. It really depends on -- obviously, we said, for Q3, we're going to be relatively in line with last year, so it was a Q4 conversation, one of our biggest quarters and where the revenue lands. At the high end of our range, we're flat to last year, and so -- and it's a range. So we could be a different level on the revenue, different level on the op margin relative to our guidance, but it does assume that we've got continued improvement in our supply chain.

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

Well, thank you all for joining us, and we look forward to catching up with you again next quarter.

Thank you. And again, that does conclude your conference for today. We thank you for your participation. You may now disconnect.