Welcome to the Williams-Sonoma, Inc. Second Quarter 2017 (sic) [ 2018 ] Earnings Conference Call. [Operator Instructions] This call is being recorded. I would now like to turn the call over to Beth Potillo-Miller, Senior Vice President of Finance, to discuss non- and GAAP financial measures and forward-looking statements. Please go ahead.

Thank you, Shannon. Good afternoon, everyone. This call should be considered in conjunction with the press release that we issued earlier today. During the first quarter of 2017, we incurred severance-related charges of approximately $6 million or $0.04 per diluted share. These charges were recorded as SG&A expense within the unallocated segment. Also during the first quarter, we incurred tax expense of approximately $1 million or $0.02 per diluted share associated with the adoption of new accounting rules related to stock-based compensation. The remainder of the discussion today will reference full year guidance related to diluted EPS and operating margin on a non-GAAP basis excluding these unusual items. 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. 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 2017 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 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. Thank you.

Good afternoon, and thank you all for joining us today. On the call with me are Julie Whalen, our Chief Financial Officer; and John Strain, our Digital and Chief Technology Officer. Our second quarter results reflect the strength of our brands and our competitive advantages as well as our relentless focus on driving innovation and operational excellence. The acceleration of our revenue growth to 3.7% with comp growth of 2.8% demonstrates the investments and actions we are taking are driving improved top line performance. Our success with our key initiatives is centered upon delivering value, quality and excellent service to meet our customers' changing needs. And we are aggressively building upon these initiatives to further differentiate ourselves and to drive growth. Digital leadership is one of our highest priorities. We are increasing our investments to improve the customer experience and engagement and to drive profitable top line growth. As you're aware, one of our key areas of focus this year is an investment in new customer acquisition through increased digital advertising. Year-to-date, we have significantly increased our digital advertising investment. And as a result, we are seeing strong new customer counts with higher traffic trends and increased orders. And our commitment to increasing our top-of-funnel digital advertising spend has allowed us to reach more customers. We've also experienced strong new customer growth in the key channels of paid search, display and social advertising. In an effort to drive engagement with our customers through relevance across all of our brands, we are expanding our one-to-one personalization efforts. We've experienced an uplift in engagement and higher margins with our new personalization-based e-mails and we are seeing the same results translate to our sites. By the end of the fiscal year, we anticipate tripling the number of personalized impressions delivered on our website,…

Thank you, Laura, and good afternoon, everyone. During the second quarter, our results demonstrated overall sequential improvement from the first quarter and that we are able to once again deliver on all of our financial commitments, including meeting the high end of our EPS guidance range while continuing to invest in our long-term initiatives. On the top line, total revenues for the second quarter increased 3.7% over $1.2 billion, with comp brand revenue growth of 2.8%, a 270 basis point acceleration from the first quarter, further demonstrating the continued progress we are making on our initiatives to drive positive momentum across the business. During the quarter, we saw e-commerce revenue growth reaccelerate to 5.2%, growing to 52.5% of total revenues, an 80 basis point increase over last year and a historical high. With growth primarily at West Elm, Williams-Sonoma, our newer businesses, Rejuvenation and Mark and Graham, and our company-owned international operations, almost all of which had double-digit growth. The retail channel grew 2.1%, driven primarily by strong growth in West Elm and Pottery Barn, reflecting the continued success we are seeing across our various retail initiatives, including our in-home design services and store remodels. The Pottery Barn brand returned to positive growth with a revenue comp of 1.2%, a sequential improvement of 260 basis points from the first quarter. The Pottery Barn Kids comp accelerated 180 basis points during the first quarter and they also saw sequential improvement in their demand comps, which turned positive in the second quarter. In PBteen, we delivered a positive comp of 0.2%, a significant turnaround from the negative 14.3% comp in the first quarter and they also saw a sequentially better demand comp and a positive 1.3% versus a negative 3.7% in the first quarter. Williams-Sonoma, at 1.9%, had its highest second quarter…

. [Operator Instructions] And we first go to Kate McShane with Citi.

With regard to the merchandising changes you've made at the Pottery Barn brand, which sounds like they're very effective. I wondered if you could quantify at all how much of your overall offering in Pottery Barn you've touched and changed with your new merchandising initiative? And by holiday, how much do you think those merchandising changes will touch as a percentage of products sold?

It's an interesting way to look at it. We haven't really measured it that way, Kate. What we've tried to do is really listen to what our customer is asking for, and we have a broad base of customers and we want to make sure we're both delighting our current customers but also attracting new ones. So where we were more specific lately addressing from a percentage basis, a change was in the value offering in the small spaces. And while that's a competitive number, I would tell you that we've just begun in tapping into that market. We're seeing nice response already but we think we have a lot more opportunity in that area without affecting or turning off our current customers either.

We'll go and take our next question from David Magee with SunTrust.

You mentioned both businesses being a big opportunity, and I'm curious as to what you all might be doing differently there to make it maybe more distinctive than your competition.

I think big thing is that we have a wide offer. We have incredible stores and great sales associates in the stores. And we've continued to look at ways to have the channels work together and it's a natural. It's not so much that it's a different execution that we have, I would argue, a better platform to execute it on.

Great. And just one other question, if I could. You mentioned the lower shipping income this quarter. I'm curious, when was the last time that you all sort of correctly reduced that number?

So beginning in Q3 of last year, we started with the Pottery Barn brand. But the other brands all began -- the rest of the Pottery Barn brands began in the first quarter of this year.

Okay. And it's not the Williams-Sonoma?

Williams-Sonoma has always had about 49 ships free.

And they also do have the flat rate that was something to put into place last year as well.

Next question comes from Matt Fassler with Goldman Sachs.

I also want to focus on the shipping piece. Can you describe the elasticity you've seen, the response that you've seen kind of brand by brand as you reduced shipping whether it's having different ticket sizes or different kinds of transactions? And I did note, I think that Pottery Barn was really highlighted from a retail perspective more so than from an e-commerce perspective and I'm wondering how that dovetails with the shipping efforts there.

Sure. It's obviously really competitive to go into many details around the economics of our new shipping model. But I will say that the customer is responding to it, and we keep measuring to make sure that we're getting the return we're looking for. And also looking at the future and saying how can we really increase our average order size, and most importantly, better serve our customers. As you I think all know, the market is filled with lots of different shipping models. Some people put it in the price, some people charge restocking. And what we're trying to do is make it really simple and fair for our customers. And we're not done with -- we're not landed with what the future will hold for our shipping model in terms of specifics because each brand is very different with different AURs, so they are responding slightly differently. And we're going to keep measuring and then changing our model based on what we're seeing.

And the buy channel comment, Matt, I think there's a couple of things you have to think about there. I mean, first of all, we did reaccelerate to 5.2%, and a big piece of that is because Pottery Barn got better from Q1 to Q2. They're obviously not back to where they were so that's a big driver. You can't say that the shipping income then isn't "working" in that channel. And from a retail perspective, a significant piece of what we do is in-home and a lot of that is what we call RTC, Retail to Customer, and a lot of that involves shipping. So the success we're seeing there doesn't mean that the shipping, obviously, is only working or not working in e-commerce. It's also working in retail.

Next question comes from Chris Horvers with JPMorgan.

So I want to follow up on PB. You had a bit of a soft brand relaunch in July, [indiscernible], the aesthetics effort, at least in the merchandising front. Did you actually step up the advertising investment year-over-year? I know you started last year in the fourth quarter about, but did the dollar... [Audio Gap] you're seeing momentum on merchandising and new customer acquisition?

Yes, you bleeped out a little bit but I think I got your question. So yes, we did we relaunch with the fall assortment, more distinct aesthetics, testing new aesthetics, some of which are very successful and we're building on those obviously and then reducing the ones that are less successful. But we're clearly seeing a resurgence in our decorating categories, the things that people come in more frequently to buy, which also happen to be the areas that drive new customer acquisition. So we're very pleased with the effect of the new merchandising strategy on customer acquisition. Also at the same time, we did step up our digital marketing. We reduced some of our catalog marketing, but the total amount of spend was higher than last year.

But does that step up, take another leg up in the back half given where you are?

It depends on the return. We look at it every week. So if we continue to see good returns, we'll fund those brands with the best returns and we reduce those brands that have lesser returns. It's very dynamic. We assume so though. Our plan is now because it's working to keep investing there.

Next question comes from Michael Lasser with UBS.

I wanted to touch a little further on that very topic. Your sales were up about 4%. Your operating income dollars were down about 2%. It seems like some of the investments that you're putting in place are working. So should we expect that operating income dollars are going to continue to hover around this level? Or the year-over-year change in operating income dollars are going to hover around this level as long as you're seeing an effective return on those investments? And I'm talking over the next couple of years.

Well from an operating income/operating margin perspective, obviously, we've guided to be directionally in line with last year for Q3. And obviously, if you kind of do the math, if we're holding on the year, it means we're going to be better in Q4. And part of that is because our expectation is we're going to have higher revenues, which should have a higher flow-through. So we expect that we're going to continue with this accelerated momentum as we move throughout the year. And also as we mentioned earlier, the investments in reduced shipping income and in higher digital advertising we began last year. We had Sonoma Home, but it was a small piece. But in Pottery Barn, we had begun with that in Q3 and Q4. And so that alleviates some of the year-over-year quarterly impact relative to like Q1 and Q2. We're still going to be incremental at the lowest point. We're going to invest if we see the return, but you should see improvement in the op margin as we move throughout the year.

Next question comes from Simeon Gutman with Morgan Stanley.

Back on advertising for a second, you mentioned digital channel is up. Can you -- can we put it all together? Can you talk about advertising dollars in the quarter? What were they? And how it compares versus last year? And any commentary on ROI? I think Laura suggested you're continually monitoring and looking at it, but curious on what you could share on the ROI.

So a couple of things. I'll look at it from a financial perspective, and then I'll turn it over to John to give a little more color. But from a financial perspective, we have said obviously that the biggest driver for our SG&A increase was our digital advertising. And it was obviously even more than that because we offset it with a general expense improvement and so forth. So it is a significant investment. It will come down slightly relative to Q1 and Q2 and Q3 and Q4, but it's still something that we are investing in and has an impact on the total

And it's working, right? We're really excited about the results we're seeing from the digital investments, visits, revenue directly derived from digital marketing channels have improved solidly. And we're going to continue to optimize catalog spend where we can shift dollars into digital channels and numbers reflect actually planned incremental investments there. And specifically, we're seeing strength in non-brand search terms, affiliates, remarketing, social programs, and these are more than offsetting any declines we're seeing in the e-mail. And then just Q2 Pottery Barn alone, we saw year-over-year positive order growth and customer growth. And we're seeing both order frequency and units for order improvement. So in general, these are all indications that the strategy investing in this top-of-funnel digital marketing channel really is working. So we're encouraged by this and some other further top-of-funnel marketing tests that we're doing because we're seeing strong incremental lifts in places like Instagram, Pinterest and the new Google [ POS ] that really are upper funnel. So strategy is working. We plan to continue to optimize spend, take advantage of it.

Next question comes from Peter Benedict with Robert Baird.

I just want to clarify, on the comment on the margins, Julie, I guess, the fourth quarter seems to imply. If you just use the midpoint implies maybe up 50 basis points or so year-over-year. The primary drivers of that, I think you said -- is it that you expect revenues -- revenue growth to accelerate and you'll get leverage off of that? Or are there other dynamics that would drive the inflection in margin -- operating margin in the fourth quarter?

Well, I mean, there's obviously a lot of moving parts. The biggest player is revenue. So I mean if you look at the -- we obviously aren't giving Q4 guidance today, but I know effectively we give implied guidance. And if you look at the high end of the implied guidance, it's 4% growth versus last year so that when you get to the higher level of revenue, it is immediate. It flows right through to the bottom. And so that is the biggest driver of the increase. The second piece is the fact that we are lapping some of that investment in our reduced shipping income and higher digital advertising because we implemented it with Pottery Barn at the back half last year. So those are the 2 big drivers.

Okay. That's great. And just on the occupancy, which grew I think about 2% year-over-year in the second quarter. That's been slowing down. I think it was up around 5% in 2016, what's driving the lower occupancy growth rate? And is that something that we should expect to persist over the balance of this year and into next?

Yes, the occupancy did grow 2.2%. It's one of the lowest in a while. That's correct. I think there's a lot of moving parts in there. You have to remember the depreciation flows through there too. So it's both the fact that we're getting more effective with the renegotiation of our leases, and you're seeing some of that benefit come through. And it's also the fact of the timing of when and what goes into service from a depreciation standpoint. So it has moved around a bit. I'm really pleased to see that occupancy has returned to leverage this quarter for the first time in almost 2 years and I think that also a play in the fact that we have higher revenue, so I expect that to continue.

Next question comes from Dan Binder with Jefferies.

It's Dan Binder. You talked about supply chain savings and we've been hearing about that for probably at least a couple of quarters now. Just curious if you could sort of size that up and give us a sense of how much is still in front of us and where it's coming from.

Yes, we haven't disclosed the amount of the supply chain benefits. What I did say, I mean, effectively with merch margins down because of the ongoing promotional environment, we were able to completely offset that with the ongoing supply chain benefits we had. The lower selling margins were predominantly due to the investment in reduced shipping income, so we are once again pleased to be able to have this benefits continuing to come in to offset that in the merch margin line. We had said I think that we'd gotten pressure before. In Q4 of last year, we had 100 basis point gross margin expansion. We said, "Guys, this isn't going to continue going forward." So we have -- the amount of benefits has come down because part of that was from lapping some of the higher costs in the prior year, but we are at a pretty sizable amount that continues to move forward as we move throughout the year and we don't expect that to change. And we see significant opportunities for ongoing supply chain benefits that we're just getting started with whether it's continuing with reduced returns, damages, replacements, freight, you name it. There's still a lot of opportunities to move that needle.

Next question comes from Brad Thomas with KeyBanc Capital Markets.

A follow-up on the digital advertising as it relates to Amazon. In the last few months, we're seeing more and more home furnishings companies, brands listing their products on Amazon. Maybe, Laura, could you give us an update on what you're hearing from your customer in terms of how much they're looking at Amazon for a purchase like what you offer? And perhaps your willingness to consider selling through them?

Sure. We have really been listening to our customer a lot and what they're telling us is how much they appreciate our stores and the service that we offer is a huge differentiator. And while Amazon does a really -- so many things really well, have you ever tried calling them and asking them if they could please come refurnish your living room? It's a big thing that we do and our customers really love that service. So that is where we're focused. And we may have a lot of initiatives, but they're all centered around our customer and what our customers is looking for. And our service levels cannot be easily replicated and we think it's a huge differentiator. And there's no doubt in my mind that what we're doing at retail and our relentless obsession with customer service is the reason for the success that we're seeing and we're going to continue to focus on that.

We'll take our next question from Brian Nagel with Oppenheimer.

The question I have is if you look at the revenues, clearly revenue really across the business improved in Q2 and Q1. You talked about a number of the internal initiatives. Are you seeing overall improvement in the environment too as you look at your various brands, your overall demand environment?

There's a lot of mixed information. I think you guys quite know better than even we do. But you know there's -- housing metrics, solid unemployment numbers lowest levels in July but there's still a slight pullback in customer sentiments since its peak and retail channels in the mall is down 9. So I mean, there's a lot of mixed news out there. We're, in my mind, or in my perspective, definitely outperforming those numbers. So we've always said that we think there's opportunity for us to do better regardless of the environment and to really focus on what our customer is telling us about whether there's something we're not offering them in product or pricing or service. And as I said in my earlier comments, that is our focus, is just continuing to improve what we're doing, make it better for our customers. I don't think it's necessary, the successes related to any environmental improvement.

And our last question comes from Charles Grom with Gordon Haskett.

As we think about the second half and the improvement you guys saw at PB, you mentioned further acceleration in growth in your prepared remarks, I'm just wondering if that implies better-than-expected rate than you did in the second quarter which I believe was up 1.2%. And then my follow-up is you spoke about shorter delivery times, lower split shipments and reduced damages. Could you quantify that for us to some degree? So we have a sense of the opportunity that lies ahead.

Yes, unfortunately, we don't disclose by brand comps for the future. Obviously, if you'd look at the high end of our range, it assumes that Pottery Barn continues on its trajectory and we have no reason to believe they can't and we have no reason to believe they can return to their historical growth levels. As far as quantifying any of the supply chain benefits, we also don't disclose that except to say if you look back, you've seen they've been significant and they're continuing on that path. Supply chain is one of the biggest expenses we have on our P&L and it's a huge opportunity for us to continue to fine-tune it and get a lot of savings out of it and that's where we're focused on.

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

Yes. So I want to thank you all for joining us. And I'd also like to thank all of our associates, their passion and commitment to outstanding customer service and to driving our strategy is a key component of the success we are seeing and we really want to say thank you to them on this call. Talk to you all next time, and looking forward to continue to report on our business in the future.

And thank you, ladies and gentlemen. That does conclude today's conference. We thank you for your participation. And you may now disconnect.