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

Thank you, Ashley. Good afternoon. This call should be considered in conjunction with the press release that we issued earlier today. Our discussion today will relate to results and guidance based on certain non-GAAP measures, including non-GAAP SG&A, operating income, operating margin, effective tax rate and diluted EPS, which exclude certain items affecting comparability. 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 and third quarters of 2016 and the first quarter of fiscal 2017, we incurred severance-related charges totaling approximately $13 million or $0.09 per diluted share, $1 million or $0.01 per diluted share and $6 million or $0.04 per diluted share, respectively. These charges were reported as SG&A expense within the unallocated segment. During the first quarter of fiscal 2017, 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. 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.

Thanks, Beth. Good afternoon, and thank you all for joining us. With me today is Julie Whalen, our Chief Financial Officer; Felix Carbullido, our Chief Marketing Officer; and Sameer Hassan, our VP of Digital Technology. Our third quarter results demonstrates the effectiveness of our strategic priority to deliver value, quality and excellent customer service. During the quarter, strong execution against our product and digital initiatives drove new customer acquisitions and top line expansion in a competitive and dynamic retail environment. Our investments in digital innovation and cross-brand services as well as continued optimization of our supply chain position us to further differentiate our business and to deliver long-term gains in market share and profitable growth. Before I go and discuss our performance this quarter, I want to take a moment to recognize the strength and compassion of our associates who came together to support each other and their communities in the face of several devastating natural disasters this quarter. From the hurricanes in Texas, Florida and Puerto Rico to the wildfires in California, our associates did a remarkable job providing assistance to those in need during this difficult time, often as they faced disruptions in their own lives. Unfortunately, these natural disasters also impacted our financial results to lost sales of approximately $7 million or 60 basis points of growth. Julie will discuss our financial results in detail, but I wanted to highlight that during the third quarter, we drove net revenue growth of 4.3% and a combined revenue comp of 3.3%, which is inclusive of an estimated 50 basis point negative impact from the hurricane and is an improvement from last year. Also importantly, our demand during the quarter exceeded or was at least equal to net revenues across every one of our brands, most notably in Pottery Barn…

Thank you, Laura, and good afternoon, everyone. Our third quarter results reflect our ability to drive both top line and bottom line growth and to once again deliver on our financial commitments. On the top line, we are pleased to see another quarter of sequential revenue acceleration and a return to market share gains with our home furnishings businesses outperforming the industry during the third quarter. Total revenues for the third quarter increased 4.3% to approximately $1.3 billion, with comp brand revenue growth of 3.3%, which accelerated 50 basis points from the second quarter despite an unfavorable impact from the hurricanes of approximately $7 million in lost sales or 60 basis points of growth. Our top line performance reflects strong growth in both our e-commerce and retail channels. In e-commerce, revenue growth accelerated to 6.4%, and increased 100 basis points year-over-year to a new historical high of 53.1% of total revenues despite lost sales growth in the hurricanes of approximately 30 basis points. This growth was primarily driven by West Elm, Williams-Sonoma, our newer businesses, Rejuvenation and Mark and Graham, and our company-owned international operations, almost all of which had another quarter of double-digit growth. In the retail channel, revenues grew 2.1% despite the lost sales from the hurricanes of approximately 90 basis points and an 8% decline in national mall traffic. Our continued retail growth reflects the ongoing success we are seeing across our various retail initiatives, including our in-home design services and store remodels. We also saw top line improvement across all of our brands. West Elm continued its double-digit revenue growth to 15.4% this quarter, with revenue comps once again accelerating sequentially to 11.5% on top of 12% last year. Williams-Sonoma also saw sequentially improved comps with a revenue comp of 2.3%, which reflects an estimated lost…

[Operator Instructions] We'll take our first question from Kate McShane with Citi.

My first question is just with regards to gross margins, Julie, I know you walked through some of the puts and takes, but could you help us put into buckets how much is from shipping, how much is more from expanding the opening price points, and how much was offset by the supply chain efficiency?

Yes. I'm not going to give you the exact amounts, but I think I can give it to you somewhat in order. If you look at it, the biggest driver of the gross margin decline is slower selling margins because obviously we had another fantastic quarter of occupancy leverage that further leveraged from the second quarter. So if you back that out, the driver is the lower selling margins. The biggest driver is our investment in providing value to our customers through more competitive product pricing and through reduced shipping income. And then as well as the higher shipping costs from higher shipping rates and a move to more furniture this quarter which is more expensive to ship. So when you think about the supply chain benefit, that's another way you could do that answer and you could say that amount of investment that we're making in the product pricing, if you include the occupancy and the supply chain benefit, to completely offset this. And the supply chain benefits are holding to about the same benefit we've seen all year long.

Okay, great. And then an unrelated question, you had mentioned, I think, in your prepared comments about e-commerce operations in Canada. Can you tell us a little bit more about that? What was there before? And how does that change the overall global business?

Yes, sure. We've always had a very successful Canadian retail business. And we put into place Borderfree application to our website, but we didn't have a specific custom-built Canadian website like we do in our other foreign countries that we're doing business in. And we realized that while we had a layer that allowed customers to buy things, it wasn't as relevant as it could be, and also there's nuances with the pricing and matching different promotions that we wanted to get more cleared up and better control the inventory flow to the customers. So it's a better customer experience. We appreciate all Borderfree does for us in getting us into other markets where we have less of an established business. But in Canada, we have such a sizable retail business, it was time to make sure that we had the same consistent online experience that we do in the United States.

We'll take our next question from Chris Horvers from JPMorgan.

Could you explain exactly what demand comp is? I think we're -- there's a bunch of investors that are confused as to what exactly that is. And then as it relates to the fourth quarter, I know you're saying 9% to 9.2% for the year, but it seems like to get in your range, it's pretty tough. Should we think about the gross margin sort of seasonally -- acting seasonally consistent as it does in prior years, where gross margin's up 150, 250 basis points sequentially off the third quarter?

Okay. So first, Chris, this is Julie. For your question regarding demand, demand is where the customer has ordered the goods and wants them. And either we don't have them/from a demand met perspective, we weren't able to deliver them on time to be able to recognize them from a revenue recognition perspective. So it's the true health of the business because customer wants the product, and so that's why we're calling it out. And so it's just the fulfillment side of it that's making it not turn into met, for example.

And let me give you one example. So in Pottery Barn, one of our many strategies is our international drop-ship. In international drop-ship, it's a capital-light strategy and the products is not warehoused in our domestic warehouses. At the same time, the lead time is longer. So as we move more demand to some of those strategies, it doesn't fill in the quarter too well. Just to give you a specific example of why that might happen.

But you don't actually charge -- you don't charge the customer. That's not like a customer deposit. That doesn't show up on the balance sheet.

No. We charge the customer if we have the good and we don't get it delivered, but we don't charge the customer if we don't have the good. So it depends on which is the reason. As far as the operating margin guidance, obviously, we have guided the operating margin directionally to be below last year. Yet the one thing I do want to call out is that this operating margin guidance will still have us maintaining an industry-leading operating margin and operating income with strong operating cash flow. And at the end of the day, we are focused on serving our customer and accelerating our top line growth. We are focused on fulfilling our customers' needs during this holiday season, and our strategy is to drive top line growth through investments in customer service value and new customer acquisition are working. And so this guidance provides us with the necessary flexibility to make the strategic investments to enhance our value proposition and to drive new customer acquisition, both of which has fueled top line expansion and will continue to do so. So we have to continue to invest in those areas that are going to help us stay ahead of the competition and allow us to provide the best customer service to ensure long-term, sustainable, profitable growth for our shareholders. And given our accelerating top line expansion all year, along with our return this quarter to outperforming the home furnishings industry and taking market share, our investment today to drive new customers and the lifetime value that they provide, will not only help to maintain our continued shorter-term sales acceleration, but will also fuel long-term top line performance for our shareholders. As a result, we are aggressively pursuing market share gains by making the necessary investments today while still maintaining industry-leading operating margins and operating income. And we believe this is in the best interest for our shareholders long term.

I think we were going to interpret that as being able to strike that balance, so is it aggressively pursuing share? How do you think about your ability to maintain -- stabilize the operating margin and not have them collapse?

Well, I mean, it's a balance. So I mean, obviously, right what our drive has been, and as you've seen all year along, is to go after the top line and it's working. And we've said all along, we are investing in things that are working, we're going to continue to do that. On the flip side, we've got a lot of opportunities to offset the operating margin pressure. Whether it's continuous benefits we're seeing in the supply chain, there's a lot to go there, as we've talked to you about before. We have opportunities to in-source some of our advertising and technology costs, which will improve operating margin. As we drive that top line, it leverages all the fixed costs, which will improve operating margin, improve profitability in our international operations, helps as well. And so there's a ton of things that we're also working against. We also lap in the fourth quarter the bigger investment for Pottery Barn on both the reduced shipping fees and the investment in digital advertising. We still have the other brands that are still deleveraged there, but it's not as much. And that's a much bigger play in Q4 than Q3 because we started it sort of mid-quarter in Q3. And by that time the goods got delivered, et cetera, it was more of a Q4 play. So that's why we think there's sort of puts and takes on the op margin line.

And we'll take our next question from Michael Fassler with UBS.

So should we think about the difference between brand comp and reported comp, along with the hurricane impact as -- sales you are going to get back in the fourth quarter as inventory is there and you don't face the same disruption that you did earlier in 3Q?

Well, the hurricane, obviously, we don't get back. That's just a function of quantifying the lost sales from the hurricane, but it speaks to the fact that it's not necessarily a downward trend in the customer demand. It's just something that disrupted it. As far as the demand versus met, yes. I mean, obviously, goods come in and then we can fill it, or the goods weren't able to delivered by the end of the quarter and that should come in. And obviously, that's a part of our guidance for the fourth quarter.

And when you -- my second question is when you talk about investment in providing value through competitive product pricing, does that mean you're taking product prices down? Or you're just offering more friends and family sales, more 20% off on certain items? How does it actually unfold?

We're always taking opportunities and making necessary investments to provide more value, whether it's in shipping or opening price points, or even mix of categories. So for example, instead of having only expensive considered purchases like furniture businesses growing, making sure that we're offering customers those things that are easy to purchase with great value every single day. At the same time, as it relates to promotions, we know customers are smart. They're looking for the best value, but they're not looking for it at the expense of quality. And we are consolidating and streamlining our promotions across our brands, and we do not intend to have incremental promotions.

Okay. And just a clarification, what do you expect -- you have an extra week this year. What do you expect the sales and earnings contribution?

We don't have an extra week this year. It's next year for us.

Next year. Got it.

And we'll take our next question from Simeon Gutman with Morgan Stanley.

Julie and Laura, I have a question. It seems like this language around investing in price to create value, I just want to clarify, that does sound like a step-change from the way that we were talking about it just last quarter. Can you talk about what prompted that change, if that is correct? I guess, that will be my first question.

No change.

Okay, so this strategy was contemplated all year long?

Yes. As you may recall, when we laid out our Pottery Barn strategy and we've done all of our customer work, there were some key components to that strategy, including bringing the customer more inspiring decorating ideas, bringing back some of the decorating categories and building them. But also, there was a clear request for more opening price points and better value, similar to the way the Pottery Barn brand was when we started it. And so while a lot of the high-end product sells extremely well, we also didn't want to walk the customer when they're furnishing their first apartment because we know that all customers are not modern and they want different aesthetics, and Pottery Barn should be able to serve those customers like they always did. And by the way, that's the best entry to the brand. So it is the exact same strategy that we laid out. And we are now just further into the year, and we are executing it better than we were in the beginning of the year where we had just laid it out.

Got it. That's helpful. I guess, I was looking at the gross margin, and I thought it looked like it took a little bit of a step change in, I guess, some of the language around it. But I guess, as a follow-up to Chris' question about that trade-off. If we look at the gross profit dollar growth, right, because there, you get the sales and the margin in there. It was decent on an absolute basis, but if you look at it on a multi-year basis, it looked like it slowed a little bit. And so I guess the question is do you have a full understanding of the elasticity here of how much value you put in versus how much sales you get back?

Yes. And real quick, to go back to your other question on gross margin. I think as I was kind of framing up with Kate, at the end of the day, we were providing a competitive product pricing for the customer and the reduced shipping. But I went out of my way to say that obviously the occupancy and the supply chain benefits are offsetting it. So what does that leave? It's the shipping cost. So the big driver that's sort of a little bit unique to this quarter is higher shipping cost than we expected, and that is what's brought it down. And so hopefully, that helps you sort of square root the gross margin. Obviously, we look at the dollars as well as gross profit. I'm happy you said that because I think that's important as well on the bottom line. And so we're obviously square rooting all that as to making that investment into the top line relative to the bottom.

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

This is David Bellinger on for Brian. Just a couple of questions from us. It seems as though sales momentum at Pottery Barn was improving nicely over the past several quarters and then slowed here in Q3. Can you give us some more detail on the step back in trends and help us understand the key drivers there?

Yes. So as I said earlier, our demand comp was actually 2.2%. And that also was affected, unfortunately, by the hurricane. So we continue to see improvement. And the strategies that we're putting in place, particularly in dec-ac, our furniture strategies in small spaces are all working. And so the great news about that is that it's a strategy that builds upon itself into the future, and in particular, for holiday. We're seeing a really nice start to the beginning of the season in Pottery Barn.

Okay. And then just switching gears onto the Outward acquisition and your comments on augmented reality and VR. Are we now seeing some type of shift in the home category and more towards mobile that helped drive the timing of this deal? And can you provide us with more color on how your mobile sales have progressed lately and how that stacks up with others in the space?

I'm going to actually let Sameer and Felix take that question.

Great. Thanks, David. Yes, I mean, this is -- the trend to mobile is one that we've been talking about for some time and that we've definitely seen in retail overall, and in particular, in the home space. And we're really excited about what the acquisition of Outward means for our prospects across the entire digital experience, including mobile. Laura said it well before. 3D imaging is going to significantly transform the way that people shop, especially in the home space. And it's an area where we want to be a leader. To talk a little bit about the partnership first, and I'll address your question about mobile right after that. We've explored partnerships with a number of different companies in the 3D space over the last few years, and we believe Outward is the best. At the heart of their platform is the encoding of a physical product in 3D in a way that isn't purpose-built for a specific use case, but can be leveraged for any number of different use cases. And it's truly different than any other application of 3D that we've seen. It's built for the long term in a space that's changing rapidly. We believe that this focus on future-proofing will serve us well. And the quality of their 3D models is unparalleled. So to talk about mobile, specifically, related to your question, like I said, we've been a partner of Outwards for a few years now, and we've already seen real ROI from their 3D innovations: augmented reality, which is a huge mobile play for us as well as 360 product spin on our websites, including the mobile website. This is driving engagement on mobile, it's driving conversion on mobile, and it's going to be a big part of both our mobile strategy going forward as well our strategy with Outward going forward in terms of developing new 3D innovations that we're going to bring to market. And we're really excited about the prospects of what an even closer alignment with Outward can mean for our prospects of improving our digital experience going forward.

I would say on average on advertising front, we continue to shift funds from desktop to mobile and optimize to across device -- ROI across our brands. We're believers in the power of video across many of the mobile platforms. Laura mentioned our first test into programmatic TV, but we leverage that creative in many of our other videos that we create to advertise across many mobile-centric platforms.

And we have time for one last question from Chuck Grom with Gordon Haskett.

Just on the fourth quarter guidance. Not to beat a dead horse here, but still a little bit be confused on how we should think about the complexion of gross margins in the fourth quarter. Would you expect to get a benefit again from occupancy? And would you think that the total grosses are going to be down commensurate with what they were in the third quarter? Is that how we should be thinking about it?

Yes. I mean, obviously, we don't guide the gross margin at this point, and whatever pressure in that line has been assumed within the op margin guidance. But I think the way to think about it on the upside is that we are going to be lapping, as I said earlier, the Pottery Barn investment and reduced shipping income. And so that should help with the gross margin. We should see occupancy leverage, and so -- and I think the shipping costs should not be as significant given the fact that there's less furniture sales that occur in the fourth quarter for the holiday season. And so you should have some of those benefits that flow through. Of course, we always have our supply chain benefits that are continuing to roll through. And we think there's still opportunity to grow those.

Okay. Okay, that's helpful. And then I guess, when we take a step back and think about a little bit longer term here, your operating margins have obviously been on a little bit of a downward trend over the past few years. And just a backfill to Chris' question earlier, when you think about protecting market share and maintaining margins, do you think that's feasible over the next several years?

Yes, yes. Yes, we do. And just remember, we are running our business for the long term. Customer satisfaction drives all of our decision making, and the current environment has created a lot of disruption, which we believe provides options for us to further drive growth. And so we're focused on making investments to better position our business for growth in the long run. So just not to beat a dead horse, but those are digital advertising, global operations, making opportunistic investments in technology, such as the Outward acquisition, and investing in our people who are, of course, the most important asset in driving our business forward. And as it relates to cost improvements, we also see tremendous opportunity in our supply chain efficiencies. Density in the supply chain drives costs down. Inventory optimization, improved in-stock and reduced overstocks, drive costs down. And we are reducing our ad cost and media buying spend, not by spending less but by spending less on markup, by taking more in-house, so we can expand our reach more efficiently. And last, we're building an engineering-driven technology team that will allow us to more efficiently execute on digital initiatives by reducing the number of contractors. It is all of these opportunities that we believe will set us up and differentiate us from the competition and allow us to drive long-term shareholder growth.

Okay. And if I could just maybe sneak one more in here just to get a little bit of verification here on the demand comp. Obviously, you guys have much better visibility than we do in this sort of new terminology for some of us. Could you maybe help us think about how the comp trended throughout the quarter? And then a lot of retailers that we cover have spoken about a nice pick up here in November. It sounds like that's the case for you guys. I was just wondering if you wanted to help us out a little bit on that front.

Yes. I mean, typically, we don't give color on cadence, but I think it's pretty obvious. Clearly, fortunately, October didn't have the hurricane impact, and so October was obviously probably a stronger month. And then November, with no election distraction that we had last year, should be a stronger month. And we alluded to in the script that we've seen a strong start to the fourth quarter. Hopefully, that gives you some sort of color.

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

Thank you all. I appreciate the questions and the engagement, and I want to wish you all a great thanksgiving. And we look forward to talking to you next time.

And that concludes our conference call for today. We thank you for your participation, and you may now disconnect.