Williams-Sonoma, Inc.
Q3 2017 Earnings Call Transcript

Published: 17 Nov 2017

[Operator:]

Welcome to the Williams-Sonoma, Inc., Third Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session after the presentation. 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.

[Beth Potillo-Miller:]

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 recorded as SG&A expenses in the unallocated segment. During the first quarter 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.

[Laura J. Alber:]

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 SVP of Digital Technology. Our third quarter results demonstrate the effectiveness of our strategic priorities to deliver value, quality and excellent customer service. During the quarter, strong execution against our product and digital initiatives drove new customer acquisition 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 on to 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 life. Unfortunately, these natural disasters also impacted our financial results with 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 and Pottery Barn Teen which is a strong indication of the health of our business. Our strategic areas of focus on innovation and operational excellence are underpinned by our continued vision to create a high touch customer service platform that is transformational for the home furnishings industry. For more than 60 years, we've been leaders in customer experience which began in our first Williams-Sonoma store with our founder, Chuck Williams, who served every customer with passion and care. And since then his attention to the customer has become deeply embedded in our culture and a part of who we are today, a multichannel, multi-brand retailer that continues to deliver superior customer service and high-quality differentiated products. Our high touch customer service platform is comprised of several key components. We have a multichannel model with an experiential retail base that gives our customers the ability to touch and see our products, together with the convenience of our established content-rich e-commerce presence. We have a multi-brand portfolio that offers our customers proprietary high-quality merchandise which addresses a range of demographics, lifestyles, aesthetics and customer life journey. We have a comprehensive database of approximately 60 million households across our brands, which enables us to deliver personalized relevant messaging to our customers. We have a vertically integrated supply chain with direct sourcing and regionalized distribution centers to ensure that every piece of furniture is of the highest quality and delivered to our customers in a superior manner. We believe the combination of all these elements establishes a truly differentiated platform that is a core competitive advantage against mass retailers. And in this quarter, we continue to make progress in further enhancing and leveraging this platform to drive growth across our business. In digital advertising, we are committed to increasing our brand awareness and expanding our market reach. In Q3, we launched our first sizable test of addressable TV with West Elm's House Proud TV commercial, which combines the targeting and measurability of our traditional direct marketing with a compelling storytelling strength of video. We filed this commercial with distribution across digital, print, social and targeted television. We also partnered with Facebook on their launch of Collection ads which brings to life our catalog on social media. Meanwhile, our content-rich personalized email campaigns continue to drive improvement in customer engagement metrics and overall sales. As we have discussed before, our internally-designed and developed e-commerce platform gives us a distinct advantage to react quickly to changing customer behaviors and deliver impactful digital improvements with a fast time-to-market. In the quarter, we continued to innovate by making improvements in our ability to deliver rich, engaging product storytelling to our customers. Our redesigned product page experience integrates this content in a way that allows us to better tell the story of our products and differentiate ourselves in the market. We'll be testing this new experience in Q4 and we'll be iteratively rolling it out through the quarter and next year. Digital leadership remains one of our most important priorities, as we firmly believe technology enhances the customer experience. Therefore, it is with great excitement that we're announcing the acquisition of Outward, Inc. Together with the Outward team, we will drive further digital innovation to create highly engaging experiences that will revolutionize the industry. We believe the quality and scalability of Outward's 3D models are unparalleled, and that we'll be able to transform the way people shop for home furnishings across the industry and in our brands. We'll also drive efficiencies and cost savings in the way that we capture and create 3D models and utilize them in a more extensive and seamless way across various digital channels. One such application is the augmented reality room planning tool that we'll be launching on the Apple iOS. The Pottery Barn 3D Room View app offers an intuitive user interface experience, and is the only AR technology on the market that offers clear the room functionality using advanced techniques to dynamically clear the existing contents of your room. The Pottery Barn 3D Room View will also become a critical tool for our Design Crew, an exciting addition to our growing set of custom digital and retail services such as the West Elm Pinterest Style Finder tool. Another significant component of our platform is our proprietary delivery network of four regional distribution centers and 43 furniture hubs which allows us to deliver furniture quickly and damage free. The most important driver of our supply chain operations is customer service, and our initiatives there are targeted to significantly improve the delivery experience which will set us even further ahead of the competition. Year-to-date, our supply-chain efforts are yielding results. We continue to receive very high ratings from our customers on some of the most critical customer touch points. In Q3, we expanded the reach of our customer satisfaction surveys to include third-party delivery providers, such that we're now able to obtain feedback for every piece of furniture delivered. We also increased our points of interaction with the customer during the delivery process, including the implementation of a text message notification 30 minutes prior to delivery to enable better tracking on delivery day. Our customers are receiving their orders more quickly, while returns and replacements are declining. In our distribution centers, technology is further improving our order consolidation and decreasing the total number of packages per order. As we enter the holidays, we are well prepared with these process improvements and employee training in our DCs to further streamline and fast-track order fulfillment for this peak season. Our vertically integrated supply chain digital leadership and e-commerce platform together are highly leverageable and create a unique platform that supports one of our key competitive advantages

[Julie P. Whalen:]

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 gain 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 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 from 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 improvements 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 sales impact of 60 basis points from the hurricanes. Across the Pottery Barn brand, their combined comp accelerated both year-over-year and sequentially from the second quarter. And while their net comp only accelerated 10 basis points, their demand comp accelerated 2.3%, and both reflect an approximately 50 basis point negative impact from the hurricanes. In Pottery Barn, we saw improved active, new and reactivated customer accounts, which, if you adjust for the impact of the hurricanes, helped to drive another quarter of positive revenue comp and a sequentially accelerated demand comp of 2.2%. In our Kids and Teen brands, inclusive of the lost sales impact from the hurricanes, we saw a positive comp of 0.1% in Pottery Barn Kids, which was a significant improvement from last quarter's negative 3.9%. And in Pottery Barn Teen, we saw positive net comp of 3% and a demand comp of 9%, both of which significantly accelerated from the second quarter and year-over-year. And in our newer businesses, Rejuvenation and Mark and Graham, as well as our company-owned international businesses, we delivered another quarter of double-digit growth. This broad-based improvement in our top-line speaks to the strength of the initiatives that we are driving across all of our brands. It is clear that our focus on customer service, product innovation and value is working. Moving down the income statement, gross margin for the third quarter was 35.9% versus 36.8% last year. Occupancy costs of $171 million versus $168 million last year leveraged 30 basis points during the third quarter. The 90 basis points of gross margin deleverage was primarily driven by lower selling margins. We made a strategic decision to provide more value to our customers. As such, we have been implementing more competitive product pricing and shipping fees, which we indicated we've been investing in all year, and our customers are responding favorably, evidenced by the accelerated growth we have seen this year across all of our brands. We also incurred higher year-over-year shipping costs. Ensuring a superior customer delivery experience is a key focus for us, and these costs reflect our desire to ensure timely and damage free deliveries. This combined with higher shipping rates and higher customer demand for furniture, which is more expensive to ship, were the primary drivers for the increased shipping costs. These increased costs, however, were partially offset by our supply chain fulfillment related benefits that we continue to see. SG&A for the third quarter was 27.4% of net revenues in 2017 versus 27.9% in 2016. The 50 basis points of leverage was primarily driven by lower employment expenses, which was partially offset by higher digital advertising costs from our investment in new customer acquisition. Operating margin for the third quarter was 8.5% versus 8.9% last year. Our operating income of almost $111 million, reflecting the lost sales impact from the hurricanes, was comparable to last year. And if you take into consideration the earnings impact of the lost sales from the hurricanes, our operating income growth was relatively in line with our sales growth. By segment, the operating margin in the e-commerce channel was 20.7% versus 23.1% in 2016. The deleverage in operating margin was primarily driven by lower selling margins from our strategic decision to provide value to our customers through competitive pricing and reduced shipping fees, as well as higher shipping cost to ensure a superior customer delivery experience. We also incurred higher digital advertising costs to support our investment in new customer acquisition. The operating margin in the retail channel was 7% versus 7.9% in 2016. This decrease in operating margin was primarily driven by higher employment expenses as we continue to make the necessary investments in order to deliver an elevated customer experience in our stores and to support our new stores across the West Elm, Pottery Barn and Rejuvenation brands. The retail operating margin also reflects an approximately 20 basis point impact in lost sales from the hurricane. Corporate unallocated expenses as a percentage of net revenues were 5.8% in the third quarter compared to 6.9% in 2016, due to lower employment expenses. The overall leverage of corporate expense is resulting from higher year-over-year revenue, as well as lower technology infrastructure investment. The effective income tax rate in the third quarter was 35.3% versus 36.6% last year. The year-over-year tax rate improvement was primarily driven by the overall mix and level of earnings, as well as the incremental benefits we continue to see from the improved profitability across our international operations, which are taxed at a lower rate. We are pleased that we have seen improved profitability across our international operations all year and that these profits have driven a corresponding reduction in our corporate tax rate. Our third quarter diluted earnings per share grew to $0.84, which includes an estimated $0.02 negative impact associated with the lost sales from the hurricanes. On the balance sheet, we ended the quarter with a cash balance of $91 million versus $75 million last year. And we had $170 million outstanding under our revolving credit facility at the end of the quarter. As a reminder, given the seasonality of our business, our cash levels reach their lowest point at this time of the year as we fund our business ahead of the holiday season. During the third quarter, we invested an additional $53 million in our business and returned $95 million to stockholders through share repurchases and dividends. As a result, by the end of the third quarter, we had invested approximately $136 million in the business, paid approximately $102 million in dividends, and bought back over $154 million in our stock, leaving approximately $256 million remaining under our current share repurchase authorization. Merchandise inventories at $1.177 billion increased 10.6% compared to last year. A large portion of this inventory growth, however, was associated with inventory that is in transit. Our inventory on hand and available for sale grew 6.7%. The biggest drivers of our inventory growth are higher growth brands, particularly West Elm and Rejuvenation. Excluding the inventory associated with those brands that are experiencing double-digit sales growth, inventory on hand and available for sale grew 4.2%. This inventory growth sets us up well for the holiday season, and we still expect inventory growth at the end of the year to be relatively in line with our sales growth. I would now like to discuss our fourth quarter and fiscal year 2017 guidance. For the fourth quarter of 2017, we expect to grow net revenues to a range of $1,610 million to $1,675 million, with comparable brand revenue growth now in the range of 2% to 6%. We expect our fourth quarter operating margin to be below last year, and we expect diluted earnings per share to be in the range of $1.49 to $1.64. This fourth quarter guidance will have us delivering at the high end of our ranges, revenues and EPS growth of 6%, despite investments in our business to drive future growth. For the full year, we are raising our revenue guidance. We now expect to grow revenues to a range of $5,225 million to $5,290 million with comp brand revenue growth in the range of 2% to 4%. We expect our operating margin to be 9% to 9.2% and our tax rate to improve to a range of 35% to 36%. Our diluted earnings per share are expected to be in the range of $3.45 to $3.60. All other financial guidance within the press release remains unchanged from the previous guidance. Our strategies to drive top-line growth through investments in customer service, value and new customer acquisition are working. And we are focused on fulfilling our customers' needs during this holiday season by leveraging the power of our multi-brand, multichannel model to offer high quality superior products with excellent customer service. Our guidance provides us with the flexibility to make the necessary strategic investments to enhance our value proposition and drive new customer acquisition and long term top-line expansion. At the same time, we remain firmly committed to delivering sustainable earnings growth and maximizing returns for our shareholders. From a capital allocation perspective, we remain focused on a balanced capital allocation strategy. We plan to utilize our strong annual operating cash flow to, first and foremost, invest in the business in those areas that will fuel our growth and provide the highest returns. We plan to utilize our excess cash flow to return capital to our shareholders in the form of share repurchases and dividends. With regards to our investment in Outward that we announced earlier today, we'll be funding this $112 million, all-cash transaction through our existing cash balances and our current revolving credit facility. In an effort to further optimize our capital structure, we are also currently seeking term-loan funding of approximately $300 million in conjunction with the renewal and extension of our current revolver. This additional liquidity will allow us to reduce our seasonal reliance on our revolver and to provide additional financial flexibility. In summary, as we head into the fourth quarter, we are confident that our strategic focus on digital leadership, product innovation, a high-touch customer service experience, and operational excellence, together with our proven track record of strong financial discipline, will allow us to continue the momentum we are seeing in our business and to deliver long-term value for our shareholders. I would now like to wish you all happy holidays, and I will now open up the call for questions. Thank you.

[Operator:]

And we'll take our first question from Kate McShane with Citi. Please go ahead.

[Kate McShane:]

Hi. Thank you for taking my question. 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 is offset by the supply chain efficiency?

[Julie P. Whalen:]

Yes. I'm not going to give you the exact amount, 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 lower 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, there's another way you could do that answer and you could say that the amount of investment that we're making in the product pricing, if you include the occupancy and the supply chain benefits, it completely offsets this, and the supply chain benefits are holding to about the same benefit we've seen all year long.

[Kate McShane:]

Okay. Great. Thank you. 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?

[Laura J. Alber:]

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 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 and 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.

[Kate McShane:]

Thank you.

[Operator:]

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

[Christopher Horvers:]

Thanks. Good evening. Could you explain exactly what demand comp is? I think 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 seeing 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 acting seasonally consistent as it does in prior years, where gross margin is up 150 basis points, 200 basis points sequentially off the third quarter?

[Julie P. Whalen:]

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 in that perspective, we weren't able to deliver them in time to be able to recognize them from a revenue-recognition perspective. So it's the true health of the business, because the customer wants the product. 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 net, for example.

[Laura J. Alber:]

And let me give you one example. So in Pottery Barn, one of our many strategies is our international drop ship, and international drop ship it's capital light strategy, and the product 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, if you will, just to give you a specific example of why that might happen.

[Christopher Horvers:]

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

[Julie P. Whalen:]

No. We charge the customer if we have the goods and we don't get it delivered, but we don't charge the customer if we don't have the goods. So it depends on which is the reason.

[Christopher Horvers:]

Understood

[Julie P. Whalen:]

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. 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 strategies 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 have 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 investments 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.

[Christopher Horvers:]

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 stabilize the operating margin and not have them collapse?

[Julie P. Whalen:]

Well, it's a balance. So obviously right now what our drive has been, and as you've seen all year long, is to go out for the top line, and it's working. And we've said all along if we are investing in things that are working we're going to continue to do that. On the flipside, we've got a lot of opportunities to offset the operating margin pressure, whether it is continuous benefits we're seeing from 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 of the fixed costs which will improve operating margin. Improved profitability in our international operations helps as well. 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 the 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 lines.

[Christopher Horvers:]

Thank you.

[Operator:]

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

[Michael Louis Lasser:]

Good evening. Thanks a lot for taking my question. So should we think about the difference between brand comp and reported comp along with the hurricane impact as sales you're going to get back in the fourth quarter as inventory is there and you don't face the same disruption that you did early in 3Q?

[Julie P. Whalen:]

Well, the hurricanes obviously we don't get back. That's just a function of quantifying the lost sales from the hurricanes, but it speaks to the fact that it's not necessarily a downward trend in the customer demand. It's, there's something that disrupted it. As far as the demand versus net, yes, obviously, goods come in and then we can fill it, or the goods weren't able to be 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.

[Michael Louis Lasser:]

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

[Laura J. Alber:]

We're always seeking 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 business is growing, making sure that we're offering customers those things that are easy to purchase and are of 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.

[Michael Louis Lasser:]

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

[Julie P. Whalen:]

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

[Michael Louis Lasser:]

Next year. Got it.

[Julie P. Whalen:]

Yeah.

[Michael Louis Lasser:]

Thank you very much.

[Julie P. Whalen:]

Yes. Thanks.

[Operator:]

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

[Simeon Ari Gutman:]

Thanks. Good afternoon. 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, 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? And I guess that'll be my first question.

[Laura J. Alber:]

No change.

[Simeon Ari Gutman:]

Okay. So this strategy was contemplated all year long?

[Laura J. Alber:]

Yes.

[Simeon Ari Gutman:]

Okay. And then back to...

[Laura J. Alber:]

Just 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 don't want to lock 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.

[Simeon Ari Gutman:]

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, and I guess some of the language around it. But I guess as a follow-up to Chris' question about the 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?

[Julie P. Whalen:]

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 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 costs 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.

[Simeon Ari Gutman:]

Okay. Thanks, Julie.

[Operator:]

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

[David Bellinger:]

Hi. Good evening. This is David Bellinger on for Brian.

[Laura J. Alber:]

Hi.

[David Bellinger:]

Just a couple 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?

[Laura J. Alber:]

Yes. So, as I said earlier, our demand comp was actually 2.2%. And that also was affected, unfortunately, by the hurricanes. So we continue to see improvement. And the strategies that we're putting in place, particularly in Decac, (52

[David Bellinger:]

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

[Laura J. Alber:]

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

[Sameer Hassan:]

Great. Thanks, David. Yes. I mean, 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 this is 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 and it's 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 model is unparalleled. To talk about mobile specifically, related to your question, like I said, we've been a partner of Outward 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 as our strategy with Outward going forward in terms of developing new 3-D innovation that we're going to bring to the 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.

[Felix J. Carbullido:]

I would say on an 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 step into programmatic TV, but we leverage that creative in many of our other videos that we create to advertise across many mobile-centric platforms.

[David Bellinger:]

Thanks for all the color. Really appreciate it.

[Laura J. Alber:]

Thank you for the questions.

[Operator:]

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

[Chuck Grom:]

Hey. Thanks. Just on the fourth quarter guidance. Not to beat the dead horse here, but still a little bit 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?

[Julie P. Whalen:]

Yes. I mean, obviously, we don't guide the gross margin at this point in 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 reduce shipping income, and so that should help with the gross margin. We should see occupancy leverage. 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.

[Chuck Grom:]

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 to backfill on to Chris's question earlier, when you think about protecting market share and maintaining margins, do you think that's feasible over the next several years?

[Laura J. Alber:]

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 opportunity 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 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 these opportunities that we believe will set us up and differentiate us from the competition and allow us to drive long-term shareholder growth.

[Chuck Grom:]

Okay. Thanks. And if I could just maybe sneak one more in here just to get a little bit verification here on the demand comp. Obviously, you guys have much better visibility than we do in the 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. Just wondering if you wanted to help us out a little bit on that front.

[Julie P. Whalen:]

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, 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.

[Chuck Grom:]

That's great. Thank you.

[Operator:]

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.

[Laura J. Alber:]

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

[Operator:]

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