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Welcome to the Williams-Sonoma Incorporated Second Quarter 2018 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 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 maybe 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 are announcing another quarter of strong results with top line growth at the high-end of guidance, gross margins significantly above last year and a substantial EPS outperformance. Our powerful multi-channel multi-brand platform together with our strong execution of our strategic initiatives and digital leadership, product innovation, retail transformation and operational excellence are having a positive impact on all parts of our business. Given the results in the first half and the momentum of 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 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 continued to gain scale growing double-digits during the quarter.
Now, moving on to some highlights of the progress we have 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 as that of last year with customer spending on average 5x the value of their Key rewards. We will continue to improve the user experience and member benefits to capture the substantial growth opportunity we see in this cross-brand loyalty initiative. In technology, we continue to make strong progress on our integration of Outward, which culminated in the launch of our photorealistic space planning experience, Ensemble, early this month. It’s currently live in all of our West Elm and Pottery Barn stores. We will be making a customer-facing version of the experience available online in September and we will be adding the other brands before peak.
Built off Outward’s proprietary 3D asset platform, Ensemble is the first photorealistic customer-facing space planner in the industry allowing us to create an interactive shopping experience that spans across product discovery, customized product visualization and space planning. Customers will be able to build their own floor plans, browse our product assortments cross-brand and drag-and-drop photorealistic pieces to furnish their homes with more confidence and accuracy. Also in Q2, we significantly improved the digital customer experience through content creation. We updated a shop pass with more engaging content that is inspirational and drives conversion. We materially enhanced our product information pages and are impressed by the results, particularly in the Pottery Barn brand where we introduced editorial content that focuses on product quality and reasons to buy.
We also introduced a multi-image visual layout for shop-by-room pages and revamped the homepage to better communicate the story of the season and breadth of assortment. The West Elm brand also continues to pioneer digital innovations that focus on customer-centric solutions and dynamic personalization. In Q2, we created, deployed and iterated on a new algorithmic recommendation engine for frequently bought together products. This tool is driving increased revenues per visitor and will be rolled out across brands. We also released our guided shopping tool, which leverages our machine learning algorithms and image recognition to create personalized product recommendations based on the customer’s individual style.
In the Williams-Sonoma brand, we are in the process of an overhaul of our Williams-Sonoma home website. Among the enhancements, we redesigned the homepage to better showcase our inspirational lifestyle imagery. We also integrated Outward’s technology to help customers visualize the product alongside other items from our assortment and in different settings. Another major shift across the company is our marketing mix. We are optimizing catalog mailings to focus on higher ROI digital channel to drive more reach more efficiently. Our digital customer growth accelerated double-digits in the quarter, the fastest pace we have seen in over 2 years with new customers up even more. These results demonstrate the success of our digital advertising investments and product innovation strategies over the past year.
We are also becoming more efficient with our advertising spend as the majority of our digital marketing is now managed in-house, helping us drive cost savings and better performance. Looking to the balance of the year, we will continue to partner with large digital players to design and test lifestyle ad units to focus on relevancy and inspiration to drive customer acquisition and strong profitable growth.
We are also gaining strong traction in our strategic priority of retail transformation and excellence by pruning the suite of underperforming stores and selectively investing in new stores, remodels and relocations while elevating the store experience.
Our stores are a key part of our multi-channel strategy as they provide an incomparable experience to our customers to engage with our products in real life. We opened a total of 9 stores this quarter and added 4 more locations of Williams-Sonoma home bringing its total to 69 retail locations. We plan to open another 4 stores in Q3, including a new store in our Rejuvenation brand, which continues to expand in the high-end lighting and hardware market and is on track to becoming a significant multi-channel lifestyle brand. Our new stores are performing better than the fleet generating strong profitability with a payback of just over 1 year.
Our fleet of remodeled and relocated stores, are also outperforming, averaging double-digit growth in annualized sales over the prior stores. Our retail strategies have been particularly successful in Pottery Barn with new remodeled and relocated stores driving above average sales growth and profitability over the prior stores. Given these results, we are planning for 4 more remodels in Q3. In Williams-Sonoma, our remodeled stores are also performing and we have plans for 2 more next quarter. And in West Elm, we opened a new format store in Santa Monica, California that is off to a strong start. This next generation store has an expanded outdoor living area that displays a wide range of outdoor collections and more open space for community engagement.
To further optimize our fleet and expand profitably, we closed 4 underperforming stores as part of our planned store closures for the year. In addition, we have been aggressively pursuing the early closure of the subset of underperforming stores, which we announced at the beginning of the year. In Q2, we successfully terminated the lease for 2 of those stores and we impaired an additional 5 stores. This resulted in non-cash impairment expenses and early lease termination charges. The closures of this entire list of underperforming stores when complete would generate an additional 20 basis points in annual operating margin expansion.
Now, I would like to talk about product innovation, which is another key differentiator for our company. We continue to lead the market this quarter with exclusive design, high impact collaborations and category expansions. In the Pottery Barn brand, we had a strong summer season with new merchandise offerings and we are seeing a strong start to fall. We have also built incremental businesses, including PB Apartment, which continues to grow double-digit and attract new customers. Our Pottery Barn children’s business is also gaining momentum.
We launched the successful cross-brand collaboration between West Elm and Pottery Barn Kids that is driving strong incremental sales as well as new customer growth. And more recently, Pottery Barn Kids unveiled Pottery Barn’s Modern Baby, a high style curated collection with 5 distinctly new design aesthetics to better meet the needs of parents seeking nursery décor that reflects their modern contemporary style. The Pottery Barn Modern Baby collection is also crafted with commitment to safety and quality that we know our customers value. All wooden and upholstered furniture in the collection are GREENGUARD certified and all cotton bedding is 100% organic. The initial customer response has already surpassed our expectations. We have plans to expand both collections over the coming quarters as we see substantial opportunity in the children’s home furnishings market for products that are modern and contemporary in design, but also high-quality and sustainably made.
In West Elm, we launched new products and opening point points and at the same time reduced our inventory and overstocks. Our core furniture business remained strong and growth in our decorating categories continues to accelerate, driving new customer acquisitions as entry points to the brand. We have a compelling pipeline of product assortments in core and new categories for the balance of the year, which should position up well to deliver another strong holiday season.
In our Williams-Sonoma brand, our exclusive products and collaborations, along with our digital marketing efforts are driving strong customer growth in e-commerce, which has accelerated over the past four quarters to double-digits year-to-date. This quarter, our collaboration with Aerin Lauder and Instant Pot were particularly successful. We have also broadened our Williams-Sonoma branded products with further additions to the tools and food businesses. We continue to see this line as a sizable growth opportunity and an important driver of new customer acquisition. In our global business, we are pleased to see another quarter of double-digit growth in our company owned operations. We continue to make strong progress on our Pottery Barn Kids launch in the UK with both the website going live in the shop and shop in the John Lewis Oxford Street flagship launching in Q3. Our franchise partners continue to add locations with 6 locations opened around the world during Q2. Looking ahead, we will continue to focus on operational improvements to drive profitability in all of our businesses and execute on our multi-channel entry into large side markets in Asia and Europe.
And lastly, our commitment to operational excellence, this quarter, we continued to make substantial progress against our inventory initiative. We successfully reduced overstocks and clearance in stores bringing our total inventory growth down to 2.5%, while revenues grew 6.1%. Inventory management remains our single biggest opportunity to reduce cost and improve profitability. Tighter inventory controls allowed us to be more aggressive in reducing our commercial activities. We are driving regular price sales through compelling digital marketing and inspiring store displays and innovative products. This is resulting in higher selling margins. We will continue to focus on managing inventory more effectively in the second half including better in-stocks, more in-time inventory and frequent flow from our overseas vendors and our multiyear transition to one inventory that will substantially improve our DC efficiency.
In addition to inventory management, we drove further cost reductions across the supply chain, including efficiency and improvements in our personalization operations and our domestic upholstery manufacturing facility. We have also reduced our damages by 20% year-to-date. We are encouraged by these results and we have identified further opportunities to drive supply chain innovation and improve customer service. Our focused execution on these opportunities will also enable us to further cut costs.
In summary, these results reflect the powerful advantage of our multi-channel, multi-brand platform along with the important progress that we continue to make on our strategic priorities. The combination of inspiring content, compelling products and lower clearance levels are driving strong sales as well as higher selling margins. Together with our aggressive optimization of the retail fleet and supply chain, we are able to deliver strong top line growth, gross margin expansion and EPS outperformance this quarter. Our strong execution in the first half sets us up to deliver on the important holiday season and long-term future growth. Our cross-brand launches, including Ensemble, our innovative product pipeline, our new and remodeled stores, our improved inventory positions and our supply chain optimization gives us confidence in our performance over the balance of the year and as a result we substantially raised our full year guidance today.
Now, I would like to turn the call over to Julie to discuss our Q2 financial results in detail.
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 benefits 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 longstanding 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 a re-class 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 added 2 comp and our Pottery Barn Kids and Teen business accelerating from the first quarter to a 5.7% comp.
We also saw another quarter of strong revenue comps in West Elm, where comps also accelerated sequentially to 9.5% and total revenues continued to grow double-digits. Our newer businesses, Rejuvenation and Mark and Graham as well as our global company-owned operations, all delivered another quarter of double-digit growth. And in Williams-Sonoma, strength in e-commerce and the continued success from our exclusive collaborations drove a 1.6% comp on top of a 1.9% last year resulting in the strongest second quarter 2-year comp the brand has generated in many years. By channel, revenue growth in both e-commerce and retail continued to accelerate versus last year. E-commerce net revenues grew year-over-year by 8.8% to a record high of 53.8% of total company revenues compared to 52.5% last year. This growth was a significant acceleration of our last year’s growth of 5.2% and represents the highest second quarter e-commerce growth rate we have seen over the past 3 years. We are pleased to see that our investment to drive increasing customer counts and traffic are continuing to fuel our top line momentum.
In our retail channel, net revenues increased 3.1%, with particularly strong results in Pottery Barn and West Elm. This demonstrates the continued success of our high-performing story remodels and relocations as well as the success of our other retail transformation initiatives to further differentiate our customer experience, including the financial benefit we are seeing from our cross-brand design services and our expanding cross brand loyalty program.
Moving down the income statement, gross margin for the second quarter was 36.5% compared to 35.2% last year. This substantial year-over-year improvement of 130 basis points was driven by higher selling margins and occupancy leverage, which includes the overall margin benefit from the re-class of other income into revenues from the implementation of the new revenue recognition standard. Occupancy cost in the quarter totaled $170 million or 13.4% of net revenues as compared to $168 million or 14% of net revenues. Our selling margin improvements resulted from higher merchandise margins across all brands. Our successful merchandise margin expansion this quarter reflects our emphasis on relevancy and inspiration rather than promotions. We have been streamlining our promotions and refining our promotional messaging across all brands and we are pleased to see that we are able to deliver strong top line performance while expanding our selling margins.
SG&A for the second quarter was 29.7% this year versus 28.4% last year. This 130 basis point de-leverage was primarily associated with general expense de-leverage predominantly driven by the re-class of other income into revenues from the implementation of the new revenue recognition standard as well as de-leverage from higher digital advertising and increased hourly wages from the reinvestment of tax savings, which we announced earlier this year. This was partially offset by further catalog advertising optimization.
Operating income continued to grow year-over-year, up 5.8% to more than $86 million and our operating margin for the second quarter was flat to last year at 6.8%. We are pleased that we were able to deliver another quarter of operating income dollar growth that was relatively in line with revenue growth. By channel, the operating margin in the e-commerce channel was 20.6% versus 21.4% last year. This 80 basis point de-leverage was primarily driven by our reinvestment of tax savings into digital advertising and increased hourly wages. This was partially offset by catalog advertising optimization and higher selling margins. The operating margin in the retail channel was 6.6% versus 6.1% in 2017. This 50 basis point leverage was primarily driven by higher selling margins.
Corporate unallocated expenses as a percentage of net revenues were 7.4% in the second quarter of 2018, which was relatively flat to last year. The effective income tax rate in the second quarter was 24.5% compared to 34.8% last year. The lower year-over-year tax rate primarily reflects a reduced federal tax rate associated with the 2017 Tax Cuts and Jobs Act. Second quarter 2018 diluted earnings per share were $0.77 compared to $0.61 last year, representing growth of 26.2% year-over year and a $0.07 outperformance to the high-end of our guidance.
Moving to the balance sheet, cash at the end of the quarter was $175 million versus $103 million last year. In the second quarter, we invested $46 million in the business and returned $173 million to stockholders through share repurchases and dividends, comprising of $137 million in share repurchases and $36 million in dividends. Merchandise inventories at the end of the second quarter were $1.100 billion or 2.5% growth on last year, which was once again significantly lower than our revenue growth. And excluding inventory that is in transit for the fall and holiday season, inventory on hand and available for sale was up only 0.3%. As we said at the beginning of the year, we expect this trend to continue over the balance of the year as we focus on the execution of our inventory optimization initiatives to further bring down our inventory levels while improving the level of in-stock inventory and back order rates and overall customer satisfaction.
Now, I would like to discuss our third quarter and fiscal year 2018 guidance. Given the continued strength across our business and our strong execution year-to-date, we are confident in our outlook for the second half of the year. Therefore, we are pleased to be raising our fiscal 2018 full year guidance for the second time this year with the top and bottom line raise that reflects our full year-to-date beat versus our guidance. We now expect net revenues to grow to a range of $5.565 billion to $5.665 billion from our previous guidance range of $5.495 billion to $5.655 billion. We expect comp growth to be in the range of 3% to 5% compared to 2% to 5% previously and operating margin to be in the range of 8.4% to 9% compared to the previous range of 8.2% to 9%. We are also raising our diluted earnings per share by $0.11 to a range of $4.26 to $4.36 compared to a range of $4.15 to $4.25 previously. All other financial guidance within the press release remains unchanged from the previous guidance.
For the third quarter of 2018, we expect to grow net revenues to a range of $1.355 billion to $1.380 billion with comparable brand revenue growth in the range of 3% to 5%. And we expect diluted earnings per share to be in the range of $0.90 to $0.95. Our guidance does not reflect any potential impact from the reposed China tariffs. We estimate that approximately 15% of our cost of goods sold will be subject to the China tariffs as currently proposed. But given the timing of their potential implementation, we expect there to be minimal financial impact on our fiscal year 2018 results. However, it’s difficult to quantify the certainty of their impact as these tariffs have not been finalized. As we closely follow this topic, we are aggressively working to mitigate the potential impact of these tariffs on our financial results, while maintaining our customer value proposition. We believe we are well-positioned to do so given our vertically integrated multi-country supply chain, where we design and contract manufacture almost all of our products. And finally, from a capital allocation perspective, we remain committed to utilizing our strong operating cash flow to first invest in the business in those areas that will fuel our growth and provide the highest returns and to return excess cash to our shareholders in the form of share repurchases and dividends.
In summary, we are proud of our team and all of the hard work in driving our outperformance in the first half of the year and the broad-based momentum we are seeing in our business. With our top line growth selling margin expansion and our continued occupancy leverage driving improved operating income and EPS outperformance, we are confident that our strategic initiatives are working. And this combined with our long-term growth opportunities and our unique competitive positioning, including our portfolio of strong well-known brands with proprietary products of vertically integrated supply chain that gives us unparalleled flexibility on sourcing and control over quality and cost, a leading multi-channel platform with almost 54% of our business already transacted online, a world class customer service model, a strong balance sheet, operating income and cash flow along with our commitment to operational excellence and a proven track record of strong financial discipline give us the confidence that we will be able to continue the momentum we are seeing in our business and to deliver long-term sustainable growth and financial returns for our shareholders.
I would now like to open up the call for questions. Thank you.
Thank you. [Operator Instructions] We will take our first question from Peter Benedict with Baird.
Hey, guys. Thanks. 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 back it out of the adjusted numbers. I am 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?
Yes. Hi, this is Julie. So we have to remember the biggest component of the piece that we are backing out is associated with the amortization or the accrual of the cost as part of the acquisition. So for example, there is the amortization of the intangible assets and then there is the accrual of the earn-out piece based on a probability of reaching their metrics and so that too us is associated with the transaction and so that is backed out. As far as the actual operations of the business, they are currently in the ramp up stage and so we probably estimate that in a year to 2 years they will be back into our business.
Okay, thanks. Thanks, Julie. 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 you are going to get there and what’s that going to do for you once you achieve that milestone? Thanks.
Sure, Peter. This is Laura. There is a lot of this that is confidential, but let me tell you that what we are putting together first is the furniture aspect of it, because we are 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 are putting that together. The further piece of the CMO business, which is a conveyable mail order business, is to come and we have a lot of factors to consider before we make that decision. We are focused right now on putting the furniture together for the balance of the year.
Okay, great. Thanks so much.
We will move next to Michael Lasser with UBS.
Good evening. Thanks a lot for taking my questions. Can you give us the sense of how the selling margin was at some of the accounting adjustments in the quarter and what have you prospectively assumed for the impact of the accounting adjustments you are guiding in third quarter and what’s implied for the fourth quarter as well? Thanks so much.
We haven’t disclosed per say how it plays out by line except to say that it is the largest component selling margin expansion. It’s the large component out of the 130 basis point expansion on gross margin and then next is occupancy, but the approximate 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 have 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, that’s exactly how it came out this quarter.
Okay. And like you expect that for the next two quarters as well?
Yes.
Got it. And good luck with the rest of the year.
Thank you.
We will move next to Matt Fassler with Goldman Sachs.
Good afternoon, everyone. My first question relates to 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 are seeing, whether it’s the sales volume that’s helping you overcoming any headwinds associated with that?
Hi, Matt. It’s Julie. We still had pressure from shipping costs. I don’t think we should get the wrong impression there. I think the differences that we had, supply chain efficiencies that completely offset it. And so the emphasis in the gross margin and why it expanded was selling margins and occupancy leverage and so we are still feeling pressure as we said, we just lapped the flat rate shipping costs in Q2 with West Elm, we have been now lapping in Q3, the UPS contract, but there is still ongoing cost pressure from a shipping perspective, especially given the mix of what we sell, the more that we sell towards over size for UPS for example or more furniture, there still will continue to be pressure on the shipping line, but what we are pleased about it is that with the supply chain efficiencies that we have been able to generate and the incremental ones we have identified that we are going to be able to offset that.
Got it. And then just by way 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.
Thank you so much.
[Operator Instructions] And we will move next to Steve Forbes with Guggenheim Securities.
Good afternoon. Maybe regarding BOPIS, I know 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 schedule 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 learnings 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.
Thank you.
We will move next to Greg Melich with MoffettNathanson.
I will 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’s important and I assume that, that is China and that’s with the current $200 billion that are proposed?
Yes, associated with China based on the $200 billion, but it’s based on our total direct and indirect estimate as to what is coming from China total company.
Got it. And if it was – could you help us with how much is imported from China if it went from 200 to broader tweet to 500?
We have not analyzed that as to how much would be actually impacted by the goods that we sell from China. So we are kind of backed on that.
Alright. Thanks a lot. Good luck.
Next we will move to Chuck Grom with Gordon Haskett.
Hey, thanks. Good afternoon. Just on the guidance in order the back-end the $0.90 to $0.95, it looks like you are 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 are up a little bit. So I am just wondering what the drivers are for that deceleration and if you could break it out between gross and SG&A that will be very helpful? Thank you.
Sure. The biggest drivers are within SG&A and there is two 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 did not. 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 had the full quarter of the retail last quarter, we had a little bit of distribution center hourly wage impact. This quarter we will 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 will also have that impact of the higher wages. So, it’s 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 in the health of the business.
Okay. So, just as a quick follow-up, obviously there is a little bit of an improvement in the cadence of your merchandise margins, solid margins here in 2Q relative to 1Q, so you would expect that to continue in the third quarter?
Yes. I don’t know if take 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 are working on to drive expanded selling margins should be sustainable.
Okay, thanks. Very helpful.
We will move next to Kate McShane with Citi.
Hi, good afternoon. Thanks for taking my questions. Just I am 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 are going to have less clearance inventory to be able to drive clearance sales. And so we are being very thoughtful in how we set that revenue guidance in light of that, obviously that will help with selling margins and expansion there, but we are being thoughtful about where we set that guidance. Now on the flipside, if you look at the guidance we set on revenue for Q3, it’s relatively in line with where we have been especially at the high-end and on a 2-year basis, it’s accelerating and same thing with the Q4 implied guidance. Q4 last year, you may recall, was one of the highest Q4s we have had in 5 years and it was driven by Williams-Sonoma as a bigger piece of that in Q4 and they had one of the highest Q4s in 8 years. And so it’s just – if you look that on a 2-year basis, we are seeing acceleration.
Thank you
Next we have Simeon Gutman with Morgan Stanley.
Hi, everyone. I have a question on Pottery Barn. The business is stabilizing, improving. I wanted to ask if it’s consistent with what you expected and if you are being purposeful about promotions or discounts and so that you are not overstimulating sales in favor, well you are not pushing it more in sales in favor of 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 to also streamline them, make them clearer and have less of them. And also at the same time, clearance is being reduced. And so absolutely, we are favoring the regular priced 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 are seeing today and what we are seeing today is working. So we are quite optimistic and really proud of the team in all of their hard work and vision.
Thank you.
And next we have Christopher Horvers with JPMorgan.
Thanks. Good evening. One follow-up on the selling margin question, if you look at it, it looked like selling margins were sort of flattish in the back – in the first half of ‘17 and then with the UPS and the 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 are 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, so you have 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 throughout the year, we still have the shipping pressure and we are 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 is my point earlier on the other question that you could 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 the expanded merchandise margins that we should be able to see that continue, so that it comes down to a function of all the other pieces within selling margins to determine where that plays out.
And then – I just had a one quick follow-up, if you think about Sonoma being really important into the fourth quarter as you mentioned. Sonoma did decelerate, was there something on the merchandising side, certain category do you think maybe the way they eclipsed you in the quarter or something like that and what gives you the confidence around the fourth quarter in that brand?
Sure. It’s Laura. We saw in Sonoma in Q2, actually this is one – on a 2-year basis one of the strongest comps we have 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 obviously we didn’t comp those sell-offs of those items last year. So we are very optimistic about the back half. We have some opportunity to get better in stock and some of the runaway products and so we know that, that’s going to happen based on an 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 counts, which we mention 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, do you want to make a few comments about Sonoma in the back half in the market 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, whereas 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 are very excited about what is ahead for Sonoma in the back half.
Thanks very much. Best of luck.
[Operator Instructions] We will move next to Seth Basham with Wedbush.
Thanks a lot and good afternoon. 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?
Well, 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 are doing it more profitably the most and that’s very exciting. We all know that the macro of the consumer is in better shape, but we are also seeing that our strategies are really working and gaining those customers to our brands and as evidenced by what Felix just said about the new customer growth we are bringing them in on the lower ticket and are converting to furniture and we are also improving as we have talked about earlier, our in-stock and reducing our overstocks, which is great. In terms of the shipping fees, I think it’s – we have tested a lot of different things, which is what you might be seeing that there wasn’t any recent change now.
Thank you.
Next we will move to Cristina Fernandez with Telsey Advisory Group.
Hi, good evening. I wanted to ask on real estate, could you update us where you are and your negotiations with landlords as far as the 80 stores you identified earlier this year for potential closure or February lease terms over the next couple of years. And related to the topic with the strong performance you are seeing on the remodels for Pottery Barn adding Williams-Sonoma home to the Williams-Sonoma stores, do you see the potential to accelerate those remodels going forward? Thanks.
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 the population of 250. We have 30 that’s planned for this year and those are on target, those aren’t early lease terminations, which is just regular terminations and then we have made progress as to what Laura alluded to on our prepared remarks on some of the early store closures that we are aggressively going after with the shutdown of two stores and then the impairment of 5 other stores. And so we are pleased with the progress, obviously there is still quite a bit more to do on that, but the good news is we are making progress. As far as the remodels, those are phenomenal and we are moving faster on those as we continue to say that they are doing really well from a profitability standpoint and the top line perspective. So you will continue to see more of those.
And we like to do those when we have to lease so that we have the longest life possible on the store.
And we have time for one last question and that will be from Jonathan Matuszewski with Jefferies.
Thanks for taking my questions. The spend in The Key rewards 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 in the program? Thanks.
Sure. This is Felix. Well, I am 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 that they are 3x more likely to shop across our family of brands. We think there is a material opportunity in terms of customer shopping across our 7 brands, especially during holiday. So, we know that they shop more brands and they spend more than our average non-member. 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 as they start to shop for the holidays.
Great. Thank you.
That concludes our question-and-answer session for today. I will 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 has 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.