Welcome to the Williams-Sonoma, Inc. Second Quarter 2018 Earnings Conference Call. [Operator Instructions] This call is being recorded. I would now like to turn the call over to Elise Wang, Vice President of Investor Relations, to discuss non-GAAP financial measures and forward-looking statements. Please go ahead, ma'am.

Thank you. 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. 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 Exhibit 1 of 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 conditions, results of operations, business initiatives, trends, guidance, growth plans and prospects of the company in 2018 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, and good afternoon, everyone. On the call with me are Julie Whalen, our Chief Financial Officer; Felix Carbullido, our Chief Marketing Officer; and Yasir Anwar, our Chief Technology Officer. Today, we're announcing another quarter of strong results with top line growth at the high end of guidance, gross margin significantly above last year and a substantial EPS outperformance. Our powerful multichannel, multibrand platform, together with our strong execution of our strategic initiatives in digital leaderships, product innovation, retail transformation and operational excellence, are having a positive impact on all parts of our business. Given the results from the first half and the momentum our initiatives are creating, we are raising our full year guidance for net revenues, comp revenue growth, operating margins and EPS. Let's discuss in more detail our second quarter results. Net revenues and comp growth for the second quarter were towards the high end of our guidance at $1.274 billion and 4.6%. Growth was broad-based across all of our brands, with the Pottery Barn brands comps continuing to improve year-over-year. West Elm delivered another quarter of double-digit growth and a sequential acceleration in comp growth to 9.5%. Williams-Sonoma also had a solid quarter with a comp growth of 1.6%. Our emerging brands, Rejuvenation and Mark and Graham, continue to gain scale, growing double digits during the quarter. Now moving on to some highlights of the progress we've made against our strategic priorities. First, digital leadership. We are unlocking the power of our cross-brand platform through cross-brand initiatives and technology. This quarter, our cross-brand loyalty program, The Key, continued to gain momentum. Since we re-platformed this program in Q1, enrollments have been tracking at 4x the pace of that of last year, with customers spending on average 5x the value of their Key rewards. We will…

Thank you, Laura, and good afternoon, everyone. We are excited to report another strong quarter with top line results at the high end of our guidance, selling margin expansion and occupancy leverage, driving increased operating income and flat year-over-year operating margins, resulting in EPS exceeding our expectations. This performance reflects the success of our strategic initiatives and the benefit they continue to drive across our business, including strong profitable growth in all of our brands, e-commerce revenues outpacing to another historical high and inventory growth substantially below revenue growth. These results also demonstrate our long-standing commitment to financial discipline and to generating consistent returns for our shareholders. Before I review our performance in more detail, I would like to remind everyone that our second quarter 2018 results include the financial impact from the implementation of a new accounting standard associated with revenue recognition. The primary impact is associated with the reclass of other income from SG&A into net revenues, which resulted in an approximate 100 basis point improvement to revenue and a 60 basis point swing in margin improvement from SG&A into gross margin. The remaining impact is primarily associated with the timing of our revenue recognition for certain merchandise shipped to our customers, which is dependent upon our performance during the last week of the quarter. Now I would like to review our second quarter results in more detail. Net revenues in the second quarter were $1.274 billion for a year-over-year growth of 6.1%, and comparable brand revenue growth was 4.6%, an increase of 180 basis points over last year. Growth was broad-based, with all brands delivering another quarter of positive comps. Comp growth for the Pottery Barn brands, on a combined basis, accelerated more than 300 basis points year-over-year, which includes Pottery Barn at a 2 comp and…

[Operator Instructions] We'll take our first question from Peter Benedict with Baird.

So I guess my first question is just around Outward, and you brought it up a few times in the script. And it sounds like it's playing a nice role in the business, but you bracket out of the adjusted numbers. I'm just -- can you remind us what the thought process is there? And is there a plan to kind of put them -- put that business back into the numbers at some point down the road?

This is Julie. So what you have to remember is the biggest component of the piece that we are backing out is associated with the amortization or the accrual of the costs as part of the acquisition. So for example, there's the amortization of the intangible assets and then there is the accrual of the earnout piece based on our probability of reaching their metrics. And so that, to us, is associated with the transaction and so that is backed out. As far as the actual operations of the business, they're currently in the ramp-up stage, and so we probably estimate that in a year to 2 years, they'll be back into our business.

Okay. And then my other question was just around the one inventory view. Can you give us a little more color on your progress there? And when are you going to get there? And what that's going to do for you once you achieve that milestone?

Sure, Peter, this is Laura. There's a lot of this that is confidential, but let me tell you that what we're putting together. First is the furniture aspect of it because we're shipping that directly to the customer, anyway. They don't pick it up in the stores. And that really allows us to optimize the inventory, be better in stock but also not have the excess in individual channels because currently, we hold it both separately electronically but also physically, so we're putting that together. The further piece of the CMO business, which is the conveyable mail order business, is to common. We have a lot of factors to consider before we make that decision. We're focused right now on putting the furniture together for the balance of the year.

We'll move next to Michael Lasser with UBS.

Can you give us a sense of how the selling margin was ex some of the accounting adjustments in the quarter? And what have you prospectively assumed for the impact of the accounting adjustment in your guidance in the third quarter and what's implied for the fourth quarter as well?

We haven't disclosed per se how it plays out by line except to say that it is the largest component -- selling margin expansion is the largest component out of the 130 basis point expansion on gross margin and then next is occupancy. But the proximate 60 basis points that we said was associated with the largest piece of the accounting change, is exactly what we estimate will continue in the guidance. We've been saying it's going to be about 60 to 70 basis points of shift between gross margin, SG&A, and about 50 to 100 basis points on the revenue line, and that's exactly how it came out this quarter.

Okay. And do you expect that for the next 2 quarters as well?

Yes.

We'll move next to Matt Fassler with Goldman Sachs.

My first question relates to shipping costs, shipping expenses. We didn't hear a lot about that today which, I guess, is good news. If you could talk about why that seems to have faded as a challenge, whether it's the environment, whether it's efficiencies that you're seeing, whether it's the sales volume that's helping you overcome any headwinds associated with that.

Matt, it's Julie. We still had pressure from shipping costs. I don't think we should give the wrong impression there. I think the difference is that we had supply chain efficiencies that completely offset it, and so the emphasis in the gross margin on why it expanded was selling margins and occupancy leverage. And so we're still feeling pressure. As we said, we just lapped the flat rate shipping costs in Q2 with West Elm. We've been now lapping in Q3 the UPS contract, but there's still ongoing cost pressure from a shipping perspective, especially given the mix of what we sell. The more that we sell towards oversized for UPS, for example, or more furniture, there still will continue to be pressure on the shipping line. But what we're pleased about is that with the supply chain efficiencies that we've been able to generate and the incremental ones we've identified that we are going to be able to offset that.

Got you. And then just a very quick follow-up. You gave a very crisp explanation of the impact of the accounting change on gross margin this quarter. I think it was 60 basis points to gross margin. Given that there was so much disclosure in Q1 and you changed that a bit, can you just give us the equivalent number in Q1? Was it also 60 basis points or was it a different number?

I think it was around 70 basis points, but we can circle back with that.

[Operator Instructions] And we'll move next to Steve Forbes with Guggenheim Securities.

Maybe regarding BOPIS. I think we talked about this last quarter, but can you discuss how that offering performed during the second quarter within the Williams-Sonoma brand and then maybe just update us on the scheduled rollout to the other brands within the portfolio?

Yes, sure. It's working well in both Williams-Sonoma and in PBK and driving footsteps and also customer experience because it's very convenient. They really like it, the feedback is great. We wanted to leverage our learning from Williams-Sonoma and PK before we scale to Pottery Barn and West Elm to make sure that we -- that our customers receive the best experience possible. And currently, the West Elm rollout is planned for October, well ahead of the peak season.

We'll move next to Greg Melich with MoffettNathanson.

I'll keep it with one. You mentioned, Julie, at the end about tariffs and sourcing and your flexibility there. That 15% of COGS, is that direct or indirect that you're importing? I assume that, that is China and that's what the current $200 billion that are proposed?

Yes, associated with China is based on the $200 billion, but it's based on our total direct and indirect estimate as to what is coming from China, to total company.

Got it. And if it was -- could you help us with how much is imported from China if it went from $200 billion to that -- the broader tweet of 500?

We have not analyzed that as to how much will be actually impacted by the goods that we sell from China. So I'll get back to you on that.

Next we'll move to Chuck Grom with Gordon Haskett.

Just on the guidance, in order to back in the $0.90 to $0.95, looks like you're expecting about 100 basis points of operating margin compression on a similar compare to a year ago. And obviously, in the second quarter, you were roughly flat. First quarter, you were up a little bit. So I'm just wondering what the drivers are for that deceleration. And if you could break it out between gross and SG&A, that would be very helpful.

Sure. The biggest drivers are within SG&A and there's 2 things that are driving it: one, last year at this time in Q3, we had lower incentive compensation expense associated with performance-based compensation that we didn't earn. And so this year, we have -- given our outperformance year-to-date, we have higher incentive compensation that's running through. The other piece is the incremental reinvestment of our tax savings that's coming into Q3 associated with our hourly wages and in digital advertising. The hourly wages, we have had a full quarter of the retail. Last quarter, we had a little bit of distribution center hourly wage impact. This quarter, we'll have in Q3, a full quarter of the distribution center impact, plus you have to realize as we start to hire seasonal hires for both retail and distribution, they are typically hourly, and so they'll also have that impact of the higher wages, and so it is purely a function of our reinvestment and the prior year lower compensation expense. I wouldn't read anything else into it. We still have the same expectations from a selling margin and gross margin perspective, and the health of the business.

Okay. So I guess, just as a quick follow-up, obviously, there's a little bit improvement in the cadence of your merchandise margins, selling margins here in 2Q relative to 1Q, so you'd expect that to continue in the third quarter?

Yes, I don't know if I'd peg it exactly to the cadence delta between Q1 and Q2 and assume that cadence goes forward. But we feel very comfortable that the initiatives that we're working on to drive expanded selling margins should be sustainable.

We move next to Kate McShane with Citi.

Just when looking at your guidance today, what do we need to see to get to the high end of the top line? I ask because it looks like the beat in the first half is the driver of the increased guidance. And it seems like from an execution standpoint and a macro standpoint, demand is accelerating. So could you maybe walk us through what could -- what scenario gets us to the higher end of your top line guide?

Are you talking about the revenue side?

Yes.

Well, I think the one thing you have to keep in mind is as we bring down our inventory levels especially towards the back half of the year, we're going to have less clearance inventory to be able to drive clearance sales. And so we're being very thoughtful in how we set that revenue guidance in light of that. Now obviously, that will help with selling margins and expansion there, but we're being thoughtful about where we set that guidance. Now on the flip side, if you look at the guidance we set on revenue for Q3, it's relatively in line with where we've been, especially at the high end. And on a 2-year basis, it's accelerating and same thing with the Q4 implied guidance. We have -- Q4 last year, you may recall, was one of the highest Q4s we've had in 5 years and was driven by Williams-Sonoma had the biggest piece of that in Q4, and they had one of the highest Q4s in 8 years. And so just if you look on a 2-year basis, we are seeing acceleration.

Next we have Simeon Gutman with Morgan Stanley.

I have a question on Pottery Barn. The business is stabilizing and improving. I wanted to ask if it's consistent with what you expected. And if you're being purposeful about promotions or discounts in it so that you're not overstimulating sales in favor -- well, you're not pushing it more in sales and favor profit.

Yes, absolutely. Pottery Barn is really -- the team has done so much good work, both in product but also in the presentation of the product, both in-store and online. As I mentioned, our new Pottery Barn stores are performing better than we expected. Our online experience has dramatically changed, and it's allowing us to reduce the amount of overall promotions but also streamline them, make them clear and have less of them and also at the same time, clearance is being reduced. And so absolutely, we are favoring the regular price sales, the higher-margin sales versus competing just on price. And right now, I believe strongly that the Pottery Barn momentum is going to continue because the product, the strategies going forward are all incremental to what we're seeing today and what we're seeing today is working. So we're quite optimistic and really proud of the team and all of their hard work and vision.

And next we have Christopher Horvers with JPMorgan.

So I wanted to follow up on the selling margin question. If you look at it, it looks like selling margins were sort of flattish in the back -- in the first half of '17 and then with the EPS and finishing the roll at a flat rate, they looked like they were down over 100 basis points in the back half of '17. So was it all the UPS in the rollout of the flat rate? And as you think about an environment where it looks like you're optimizing your promotional posture, it looked like free ship days were down year-over-year, why shouldn't we assume that those selling margins, which were up in the second quarter, see a substantial step-up in the back half?

Well, so the biggest driver before, going back to 2017, was both shipping and merchandise margins. And so as we move through the year, we still have the shipping pressure and we're starting to see the merchandise margins, as you can tell from Q1 to Q2, a substantial change in expansion. But I wouldn't assume that, that same acceleration to that degree, which was my point earlier on the other question, that you can assume that cadence as we move throughout the year. But we are very optimistic about where we landed on Q2 and our ability to drive the top line and expanded merchandise margins that we should be able to see that continue. So then it comes down to a function of all the other pieces within selling margins to determine where that plays out.

Understood. And then I just have one quick follow-up. If you think about Sonoma being really important in the fourth quarter, as you mentioned, Sonoma did decelerate. Was there something on the merchandising side, a certain category? Do you think maybe in a way they eclipsed you in the second quarter or something like that? And what gives you the confidence around the fourth quarter on that brand?

Sure. It's Laura. We saw in Sonoma in Q2, actually, on a 2-year basis, one of the strongest comps we've seen. And summer season is the one that's most different because of the outdoor cooking element. A full 100 basis points of the comp was that last year we did some Williams-Sonoma Home sell-off that we did not anniversary this year, and that resulted in higher margins in our Williams-Sonoma Home business, which was a great thing, but we obviously didn't comp those sell-off of those items last year. So we're very optimistic about the back half. We have some opportunity to get better in stock in some of the runaway products, and so we know that, that's going to happen based on our inventory flow. We had some out of stocks in some key areas this quarter in Sonoma, which should not continue. And the other thing that gives me a lot of confidence is the customer count, which we mentioned is always an indicator of what's to come. And the customer counts are very strong, and our digital marketing efforts are really driving that business. Felix, you want to make a few comments about Sonoma in the back half in the margin strategy?

Sure. As Laura mentioned, we have not seen this momentum for a few years in terms of heading into the back half in Sonoma. Our customer counts are up double digits, especially in the direct channel. Or as Laura said, we see continued growth there. So our marketing mix as well is geared more than ever as we head into third and fourth quarter towards where we see our greatest source of acquisition, which is more digital than ever. So we're very excited about what is ahead for Sonoma in the back half.

[Operator Instructions] We'll move next to Seth Basham with Wedbush.

My question is on the furniture category broadly. How did that outperform this quarter relative to recent quarters? And on a related note, I believe you guys increased flat rate delivery fees for furniture earlier this year. What kind of elasticity did you see with that move?

We haven't broken out furniture. I will say that based on looking at the numbers that are published industry-wide, we are gaining share and we're doing it more profitably than most. And that's very exciting. We all know that the macro, the consumer's been in better shape but we are also seeing that our strategies are really working and gaining those customers to our brands, and that's evidenced by what Felix just said about the new customer growth. We're bringing them in on the lower ticket and they're converting to furniture. And we're also improving as we talked about earlier, our in-stock and reducing our overstocks, which is great. In terms of the shipping fees, I think we tested a lot of different things, which is what you might be seeing but there wasn't any recent change, though.

Next we'll move to Cristina Fernández with Telsey Advisory Group.

I wanted to ask on real estate. Could you update us where you are in your negotiations with landlords as far as the 80 stores you identified earlier this year for potential closure or favorable lease terms over the next couple of years? And related to the topic, with the strong performance you are seeing under remodels for Pottery Barn, adding Williams-Sonoma Home to the Williams-Sonoma stores, do you see the potential to accelerate those remodels going forward?

So first of all, I think you mentioned 80 stores. 80 stores was the number we gave associated with store closures or potential store closures over the next 3 years based on a population of 250. We have 30 that's planned for this year and those are on target. Those aren't early lease terminations, they're just regular terminations. And then we made progress, as what Laura alluded to in her prepared remarks, on some of the early store closures that we're aggressively going after, with the shutdown of 2 stores and then the impairment of 5 other stores. And so we're pleased with the progress. Obviously, there's still quite a bit more to do on that, but good news is that we're making progress. As far as the remodels, those are phenomenal and we are moving faster on those as we continue to see that they are doing really well from a profitability standpoint and a top line perspective. So you'll continue to see more of those.

So we like to do those when we re-up the lease, so that we have the longest life possible on these stores.

And we have time for one last question and that will be from Jonathan Matuszewski with Jefferies.

The spend in The Key reward members is really impressive. Anything you can share there regarding the profile of this customer group? Is the greater spend driven by frequency of visit or higher ticket or both? And any updates on how many members are enrolled within the program?

Sure. Thanks. This is Felix. Well, I'm excited for that question. We don't disclose the number of members as of yet. We believe The Key is a competitive advantage from a program structure perspective. But what I can share with you is they are 3x more likely to shop across our family of brands. We think there's a material opportunity in terms of customers shopping across our 7 brands, especially during holiday. So we know that they shop more brands and they spend more than our average nonmember. So this is a very healthy customer during these stages of The Key. And we know that for fourth quarter, we see a tremendous opportunity to get them shopping across our brands and as they start to shop for the holidays.

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

Yes. I want to thank you all for joining us. Thank you for your support and a big thank you to our team who's worked so hard to produce these results and who will continue to. Look forward to talking to you next time.

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