Rh Q2 FY2025 Earnings Call

Hello, and thank you for joining us. My name is Tiffany, and I will be your conference operator today. I would like to welcome everyone to the RH second quarter 2025 Earnings Call. I would now like to turn the call over to Allison Malkin from ICR. Please proceed.

Thank you. Good afternoon, everyone. Thank you for joining us for our second quarter fiscal 2025 earnings call. Joining me today are Gary Friedman, Chairman and Chief Executive Officer; and Jack Preston, Chief Financial Officer. Before we start, I would like to remind you of our legal disclaimer that we will make certain statements today that are forward-looking within the meaning of the federal securities laws, including statements about the outlook of our business and other matters referenced in our press release issued today. These forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please refer to our SEC filings as well as our press release issued today for a more detailed description of the risk factors that may affect our results. Please also note that these forward-looking statements reflect our opinions only as of the date of this call, and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Also, during this call, we may discuss non-GAAP financial measures, which suggest our GAAP results to eliminate the impact of certain items. You will find additional information regarding these non-GAAP financial measures and a reconciliation of these non-GAAP to GAAP measures in today's financial results press release. A live broadcast of this call is also available on the Investor Relations section of our website at ir.rh.com. And now I would like to turn the call over to Gary.

Thank you, Allison, and good afternoon, everyone. I'll start with our letter, and then we'll open the call up to questions. To our people, partners, and shareholders, RH continued to generate industry-leading growth in the second quarter as revenue increased 8.4% and demand increased 13.7% despite the polarizing impact of tariff uncertainty and the worst housing market in almost 50 years. On a 2-year basis, revenues increased 12% and demand increased 21%, resulting in significant share gains and strategic separation. As a reminder, we expect the approximate 5.4-point variance between demand and revenues due to tariff disruptions will shift from the second quarter and be realized as revenues over the second half of 2025. Adjusted operating margin of 15.1% and adjusted EBITDA of 20.6% both increased 340 basis points versus last year, including an approximately 170 basis point drag from investments to support our long-term European expansion. Net income increased 79%, and we generated $81 million of free cash flow in the quarter. We continue to be pleased with the second year demand trends at RH England, with gallery demand up 76% in the second quarter and online demand up 34%. Current demand trends indicate that gallery is expected to reach approximately $37 million to $39 million of demand in 2025, its second full fiscal year, with online demand reaching approximately $8 million. To put those results in perspective, if an RH Gallery in the English countryside with an estimated population of 100,000 in a 10-mile radius 2 hours outside of London can generate $46 million of total demand in its second full fiscal year, what can a gallery in the center of Mayfair, the most exclusive shopping district in London, with a population of 9.7 million do in its second full fiscal year? We believe exponentially more. While many questioned the decision to open our first RH Gallery in such a remote location believing it would fail, what they failed to understand is the value of doing something extraordinary that breaks through the clutter and creates the conversation. We've learned during our journey at RH that when we've done extraordinary and remarkable work, we've always figured out a way to monetize it. And we've also learned that it's hard to monetize ordinary and unremarkable. The most important news regarding our European expansion was the September 5 opening of RH Paris, our most innovative and immersive brand experience to date. Located on the Champs-Élysées, just off the Avenue Montaigne, RH Paris stands at the epicenter of fashion and luxury. Pass through the majestic gold leaf gate down a crushed limestone path to a secret garden where ivy-covered walls and sculpted trees frame the 18-foot cast medallion doors marking the entrance. Juxtaposing the entry is a freestanding RH Interior Design Studio. The 2-story glass structure is home to what has become one of the largest residential interior design firms in the world with projects on every major continent. A contemporary inlaid brass and white onyx mosaic frames a 3-dimensional image of Leonardo Da Vinci's the Vitruvian Man and the RH Design Ethos. The image and ethos not only mirror the entrance to RH Paris but are also reflected in every building we inhabit and every house we turn into a home. Step through the threshold and enter the Architecture & Design Bibliothèque. Discover rare books from the foundational masters, Da Vinci, Palladio, Blondel, and Haussmann. Commanding the center of the Bibliothèque is one of the first modern printings, circa 1521 of De Architectura, The Ten Books on Architecture by first-century BC architect Marcus Vitruvius. His description of a man outstretched within a circle and a square inspired Da Vinci's famous drawing, The Vitruvian Man, some 1,500 years after his death. The gallery, spanning 7 levels, is connected by a soaring atrium of floating glass medallion stairs and a glass elevator that magically appears, then disappears from an invisible shaft atop the rooftop garden. A cast bronze caryatid, circa 1870, by renowned French sculptor Louis-Felix Chabaud, whose work is on display at the Louvre, graces the center of the atrium. Beyond their structural role, caryatids symbolize strength, grace, and ingenuity, a harmony between art and engineering. We placed this specific caryatid in the center of the grand atrium as a symbol of not only our desire to connect and create harmony between the architecture, art, history, and hospitality offerings of RH Paris but also our desire to create harmony between RH and the people of Paris. On the lower level, ground, and first floors immerse yourself in artistic installations of furniture, antiques, artifacts, and art in a gallery setting. Each level features full floor exhibits by a singular artist and carefully curated pieces not only chosen to furnish your home but also define it. Dine under a spectacular curved glass and steel structure inspired by the Grand Palais while enjoying a curated menu of American and Mediterranean classics at Le Jardin RH, located on the second-floor terrace. Marvel at the stone mastery as every surface from the bar to the bathrooms is clad in rare white onyx slabs. On the third floor discover The World of RH Bar & Lounge, a physical and digital immersion into the places and spaces that define the RH brand while enjoying lite bites and a craft cocktail by legendary bartender Colin Field. Step into a jewel box of champagne-lacquered walls with a sparkling ceiling of over 7,000 individually hand-blown glass polyhedrons at Le Petit RH. With 30-degree views, including the Eiffel Tower, Grand Palais, and the Louvre, the Le Petit rooftop is one of the most spectacular dining destinations in all of Paris, featuring a creative menu of caviar specialties, small plates, signature salads, and seafood towers. While RH Paris may not sound like a retail store, it's not meant to be. It is an authentic expression of the RH vision and design ethos. It is a global destination designed to manifest dreams, generate desire, and inspire an elevated and elegant way to live. A journalist asked me before opening, 'You're introducing multiple hospitality concepts at RH Paris. Have you considered that Parisians have very strong opinions about their hospitality?' After thinking for a moment, I replied that Parisians have very strong opinions about more than just hospitality. They have strong opinions about art, architecture, antiques, people, politics, fashion, design, food, and wine. Paris is a place where you aim to do your best work. It’s where there’s the most to gain and the most to lose. In Paris, the measure is eternity, and this we understand and have built accordingly. I'm also pleased to report that RH Paris is off to a very strong start. Traffic in the gallery has exceeded RH New York day by day, and in the first 6 days, the design pipeline has been greater than the combined design pipeline of our first 5 European galleries. I wasn't sure what to title the next segment, so I just kept it simple: tariffs, tariffs, and the possibility for more tariffs. Just when you might have thought the tariff conversation was over, a new furniture investigation was announced along with the possibility of additional furniture tariffs on top of existing ones, aiming to return furniture manufacturing back to America. We believe most in our industry hope this investigation highlights the difficulties of that task since current manufacturing of high-quality wood or metal furniture does not exist at scale in America. Establishing that would require years of investments in building facilities and a workforce, which many in this sector cannot afford. Furthermore, we anticipate significant inflation that will likely become evident in the latter half of this year and accelerate into 2026 and beyond. While strong brands like ours might benefit from the dislocation and consolidation that more tariffs may cause in our industry, many smaller companies could struggle under these tariff levels. Moreover, additional tariffs on furniture might lead U.S. manufacturers to shift production to countries nearer to their international clients to avoid freight costs and potential counter tariffs. Our hope is that the investigation will consider the perspectives of various leaders in our industry as we strive for the best outcome for our country. As previously mentioned, we have been shifting sourcing out of China and expect receipts to decline from 16% in the first quarter to 2% in the fourth quarter, with a meaningful portion of the tariff absorbed by our vendor partners. Additionally, we are responding aggressively to the recent 50% tariffs imposed on India, affecting 7% of our business, primarily in hand-knotted rugs. Although the hand-knotted rugs category is highly specialized and not manufactured in America, we have started identifying alternative countries for sourcing. We have also relocated a significant portion of our upholstered furniture production to our own factory in North Carolina, where we have been manufacturing for 10 years and plan to continue doing so. By the end of fiscal 2025, we now project that 52% of our upholstered furniture will be made in the United States, 21% in Italy, and approximately 12% in Mexico. We expect the percentage produced in the United States to continue growing throughout 2026. While uncertainty remains until the tariff investigations conclude, we have demonstrated that we are well positioned to compete favorably in any market conditions. In terms of our outlook, due to the dislocation and continued uncertainty surrounding tariffs, we find it wise to revise our guidance for fiscal 2025 due to subsequent factors: as we negotiate with our manufacturing partners, our updated outlook includes a $30 million cost of additional tariffs, net of mitigations, in the second half. Due to this uncertainty, we have postponed the launch of a new brand extension planned for the second half of 2025 to spring 2026. We've also pushed back the introduction of our Fall Interiors Sourcebook by 8 weeks, as we awaited tariff announcements needed for final pricing. Last year, the entire Fall Interiors Sourcebook was in homes by the first week of August. This year, we expect the entire Fall Interiors Sourcebook to be in homes by the last week of September, with only 28% in homes as of the end of last week. We now anticipate roughly $40 million in revenues will shift from the third quarter into the fourth quarter and first quarter of '26 because of this delay. Our outlook does not account for any new tariffs resulting from the recently announced furniture investigation. For fiscal year 2025, we project revenue growth of 9% to 11%, an adjusted operating margin of 13% to 14%, an adjusted EBITDA margin of 19% to 20%, and free cash flow of $250 million to $300 million. This outlook takes into consideration an approximate negative 200 basis point impact on operating margin from investments and start-up costs related to our international expansion and a 90 basis point impact from tariffs, net of mitigations. For the third quarter of 2025, we anticipate revenue growth of 8% to 10%, an adjusted operating margin of 12% to 13%, an adjusted EBITDA margin of 18% to 19%. This outlook includes an approximate negative 270 basis point impact on operating margin due to investments for international expansion and the opening of RH Paris, along with a 120 basis point impact from tariffs, net of mitigations. Regarding platform expansion, we are committed to creating the most inspiring and immersive physical experiences in our industry and arguably the world. These spaces reflect human design, emphasizing balance, symmetry, and perfect proportions; they blur the boundaries between residential and retail, indoors and outdoors, home and hospitality; they feature garden courtyards, rooftop restaurants, and wine and barista bars; they engage all the senses; and they cannot be replicated online. Our global expansion plans for RH aim to enter new markets locally and transform our North American galleries, representing a multibillion-dollar opportunity. Our platform elevation and expansion plans for the remainder of 2025 include opening 4 additional design galleries in Manhasset, San Diego, Detroit, and Palm Desert. As previously discussed, we anticipate a shift in our business across Europe as we begin opening in key brand-building markets like Paris in 2025, and soon after in London and Milan in the spring of 2026, all featuring dramatic brand-building hospitality experiences. We believe that post-opening, we will have the scale necessary to support essential advertising investments that will accelerate our growth in Europe. If the early performance from RH Paris is any indication, RH Europe and the Middle East may enable us to double the size of RH in the next 5 to 7 years. Looking ahead, we plan to accelerate our expansion strategy, aiming for the opening of 7 to 9 new galleries each year, as well as 2 to 3 design studios, outdoor galleries, or new concept galleries annually to enhance our presence in underpenetrated markets and introduce new markets to the RH brand. Warren Buffett once said, "Every decade or so, dark clouds will fill the economic skies and they will briefly rain gold." Although we expect a riskier business environment due to uncertainties tied to tariffs, market volatility, inflation risks, and growing global tensions, we believe it’s essential to distinguish between the signal and the noise. The fact is we’ve been operating in the worst housing market in nearly 50 years for the past 3 years. For context, in 1978, 4.09 million existing homes were sold in the U.S. when the population was 223 million. In contrast, in 2024, 4.06 million existing homes are expected to be sold with a population of 340 million – that's 50% more people and yet fewer homes sold. It highlights how depressed the housing market has been for the past year to 3 years. Despite this reality, we are performing as if we are in a thriving housing market. We attribute this success to investing with a focused and long-term approach, or what we call being "an inch wide and a mile deep," by elevating and expanding our platform to present the most desired products in the most inspiring environments in the world, paired with bespoke interior design services and beautiful restaurants that foster energy, engagement, and significant awareness of the RH brand. While our business has shown strength, this success stems from action rather than inaction, from innovation as opposed to duplication, from investment rather than divestment, and from aggressively gaining market share during this downturn, positioning us for long-term strategic separation ahead. We are investing in iconic global retail locations that are unlikely to be replicated in our lifetimes. We are building a global hospitality company with multiple concepts across continents. We are developing a comprehensive global bespoke interior design business that handles million-dollar-plus full home installations. We are crafting a global contract and hospitality business featuring our products in some of the finest hotels and residential projects worldwide. Additionally, we are establishing the most desirable and distinguished brand in our industry while projecting an EBITDA margin of around 20%. Just imagine how our margins and cash flow could look in a robust housing market as we begin to reap the benefits of those investments. From the start of the year, we had considerable debt, largely due to our stock repurchases totaling $2.2 billion, but we also began the year with strong business momentum and significant assets. These assets consist of real estate with an estimated equity value of around $500 million, which we plan to monetize opportunistically as market conditions allow, and excess inventory valued at $300 million at cost, which we aim to convert into cash over the next 12 to 18 months while optimizing our assortments following the product transformation. We forecast generating $250 million to $300 million of cash flow in 2025, with plans for substantial and growing cash flow from operations over the next several years if we navigate this aggressive investment phase successfully. We estimate that our adjusted capital expenditures will reduce to a range of $200 million to $250 million in 2026 and $150 million to $200 million in 2027 and beyond. We are confident in our ability to make essential investments to sustain our industry-leading growth while significantly reducing debt and lowering interest expenses. As Warren Buffet stated in his 2016 letter to Berkshire Hathaway shareholders, “Every decade or so, dark clouds will fill the economic skies and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons.” Our debt reflects a washtub bet on ourselves. We have repurchased 60% of our outstanding shares, greatly benefiting our long-term shareholders after Mr. Buffett’s letter was published in 2016 and 2017, and we repurchased 30% of our outstanding shares during this housing downturn in 2022 and 2023. Although our sector has been overshadowed by inflation, interest rates, tariffs, and global politics, those clouds will soon pass, and it will not only be clear skies but also evident that it was a great time to be a shareholder of RH. Thank you all, and now we’ll open the call to questions.

Your first question comes from the line of Simeon Gutman with Morgan Stanley.

So my first question is the free cash flow is starting to sequentially improve, and you generated a decent amount this quarter. If you generate $250 million to $300 million for the full year and presumably even more through '26, is real estate monetization still something you would or even need to pursue?

I’m not sure if it’s something we need to actively seek out. We tend to be opportunistic. We’re primarily developers rather than traditional real estate owners, and we typically hold property for only brief periods. When we were working on deals in Aspen, we noticed that a local developer had an exceptional portfolio of assets, and we saw a chance to invest in that portfolio at what we believed to be an attractive price. Our vision for Aspen is intriguing; it stands out as perhaps the most organized small luxury town in the world. Within a few blocks, there is incredible retail and significant wealth concentrated there. Visitors frequent the shops and restaurants in the area and can easily ski close by at Ajax. As I became more familiar with Aspen, I thought about what we could do in that specific area, which has an impressive population of billionaires. I've never encountered anything quite like it; it surpasses places like Saint-Tropez in terms of wealth and influence. We had the opportunity to construct two brand new buildings located at prime corners in town. Our gallery is situated on Galena, opposite prominent brands like Ralph Lauren and Casa Tua, while our Guesthouse is on East Hyman, close to where a new gondola is being built and in proximity to the upcoming Aman Resorts. These locations are highly trafficked by both pedestrians and drivers. In my view, these are the best buildings to own. As our partner refers to it, this is "forever real estate," guaranteed to appreciate in value. We also have the chance to be landlords to prestigious brands like CHANEL, Gucci, and lululemon. What else could we add to our portfolio?

Golden Goose, Carina Hildebrandt. I mean we got restaurants.

We have Sant Ambroeus and Catch Steak, where we are the landlord, making us a key retail landlord in the core of Aspen. We believed that this would allow us to gain insights into real estate and understand how negotiations work and what is important to others. We aimed to become knowledgeable, and there were opportunities for residential developments along with other projects we've discussed in the past, like the RH Residences at the Boomerang Lodge and our first Bath House & Spa. We thought Aspen would be an excellent location to enhance our brand image and serve as a global advertising platform. Unfortunately, we experienced the fastest rise in interest rates in U.S. history, which is challenging for developers. This increase in capital costs has slowed us down, compounded by the fact that, as our partner puts it, construction in Aspen is more difficult than on the moon. Consequently, we've had to decelerate our efforts, but we're close to opening our mountain house and Guesthouse, which are two key properties in our portfolio. Having been landlords for some time, we've gained valuable insights, and we’re questioning whether it's wise to continue tying up our capital in this way. Given the current cost of capital and construction in Aspen, it doesn’t necessarily look appealing to develop there. While we remain open to opportunities, now isn't the ideal time to sell. If inflation is kept in check and interest rates are lowered, cap rates could become more appealing, potentially leading to offers on a portfolio like ours from those with a long-term investment perspective. However, we are not in a hurry and are willing to be patient. If the right long-term opportunity arises for someone interested in owning real estate like Aspen, it’s a remarkable asset.

And Simeon, I'd just add, when we communicated the value of the real estate, I think you asked if we need to do it. Our intention was never to communicate a need or a plan. It was, as Gary said, opportunistic. It's an opportunity to make sure that folks understand the value of that real estate on our balance sheet, especially as it relates to the debt that we have.

Yes. We have other projects underway, including a $500 million investment. We own locations in England and Detroit, and we are planning to develop RH Shores in New Jersey. Currently, we have a property in Madrid which we love and are looking to monetize; it's on the market now. The property is an incredible old palace, but we feel we don't need two stores in Madrid. We're excited about our work there and will be introducing a small pool concept, Le Petit RH, which doesn't require a large kitchen in Paris. If you missed our recent event, it was one you shouldn't have overlooked. Paris offers a unique experience; it's not just another gallery—it represents a significant change for us, much like The World of RH, Le Petit RH, and Le Jardin RH do. Our hospitality and design efforts are evident, as we established an Architecture & Design library in our second location, the Bibliothèque. We created a library in RH England, preserving a historical library that had existed for 400 years. The ambiance is incredible, and I believe we've elevated the experience significantly. I doubt there's a luxury retailer in that city at the highest end that doesn't recognize we've built the best store in the world. I encourage everyone to visit because it's unlike anything you've ever seen. Considering the traffic, it has perhaps one-third the volume of New York, yet it exceeded New York's traffic every single day since opening. It's outperformed New York today, becoming the highest-volume gallery in our company. The influx of visitors has been extraordinary.

If I can ask a follow-up, I'll be there next week for the Aspen party. My follow-up is perhaps a paraphrase of something you said, Gary. You mentioned that the clouds could be clearing soon. You've navigated through many challenges in the past couple of years regarding rates and housing. Now, your financials show investment in Europe, and you're experiencing growth in revenue and generating cash. It feels like you're on the verge of that growth period you've been working towards for several years. You mentioned soon, and I'm curious if that was a financial forecast or a weather forecast, but it sounds imminent. What is the reasoning that suggests the business is not on the brink of this growth phase?

Yes, I believe the business is prepared to move forward as we are approaching the end of the investment cycle. One challenge we've all faced is the rise in construction costs post-COVID, which have increased by around 100%, and for some in the luxury sector, up to 150%. We have been developing new concepts and discussed our design ecosystem, which includes breaking down larger multi-store boxes to improve capital efficiency and apply our creativity. While it's difficult to predict exactly when we will see the results, there could be an interest rate cut on the horizon. Last year we received one cut, when many expected four or five additional reductions. I personally held off selling my house in Beverly Hills, believing I could secure a better price, but now regret that decision. The housing market in L.A. is currently struggling, and the future remains uncertain. The main concern should be avoiding a repeat of the 1970s economic situation. Looking back at the federal funds rate during that decade, it was one of the toughest periods for the U.S. economy. I recall buying a waterbed at 28% interest when I was 18, and the federal funds rate peaked at 21%. Interest rates seem high now, but if inflation spirals out of control, chaos could ensue. My primary focus is on combating inflation rather than seeking further interest rate cuts. Previous cuts, combined with tariffs, may cause more inflation than anticipated, and the impact on inventories will unfold throughout the year. If additional tariffs are imposed on furniture, that could be detrimental to many in the industry, despite potentially benefiting us in the long run. It's crucial for decision-makers to understand the potential ramifications on a larger scale. A significant portion of hardworking competitors could be wiped out, impacting markets like High Point and Las Vegas. There are very few companies producing wood and metal furniture at scale, and prolonged tariffs could result in severe job losses. I feel administration officials need to grasp the broader economic consequences of these actions. Although I appreciate many positive directions being taken, it’s concerning that no one from the administration is reaching out to me, as the leader of the largest luxury home brand. It's important to voice these concerns as we may be approaching a critical tipping point.

Your next question comes from the line of Steve Forbes with Guggenheim.

Gary, I have a two-part question regarding inventory. First, given the change in the average tariff rate and the excess inventory that you are reducing, could you provide some insights on how much further you can reduce net inventory on the balance sheet? Second, considering your previous comments, how much visibility do you have regarding the planned launch of the new brand extension this spring? Is there still some risk associated with that launch?

I don't see any risk related to the launch of the extension unless we encounter some unreasonable tariffs from this investigation. It would be beneficial for the investigation to involve discussions with industry leaders rather than focusing on just a small part of the business. Our upholstery business will sell more American-made upholstered furniture than nearly any other manufacturer in North Carolina. Many long-established U.S. brands no longer produce wood or metal furniture in America. It's essential to be cautious. We can manufacture upholstered furniture in America competitively due to advantages like special orders and quick turnaround times. However, there is a lack of workforce for producing other types of furniture, and the younger generation is not interested in those jobs. In terms of factory volume, we match the output of some large players in the high-end market, which are often compared to companies like Ashley. Their business model includes about 65% operations in America and 35% offshore manufacturing. I believe the high-end furniture market will take years to recover, which will lead to many closures and job losses that need to be taken into account. Regarding the risk of launching the extension, I believe there is no risk at all. While costs may increase, this will affect everyone equally. We hold significant advantages as we purchase more than anyone else in our market, likely three times more than the nearest competitor at our quality level. Therefore, we have a major advantage. While I wouldn't want to compete against us, I don't feel good about winning this way since it won't be favorable for anyone in the industry. I hope we are past any furniture tariffs, but we must avoid causing major disruptions that could lead to the closure of key furniture stores and long-standing family businesses. The most critical aspect is our inventory reduction and everything else we're managing. And if you're considering our stock, I encourage you to invest regardless. We are positioned to succeed. We've invested billions to create the most powerful and inspiring high-end luxury furniture platform globally, and we excel in sourcing, purchasing leverage, and marketing. If you are a wholesaler and your clients go bankrupt because they can't afford products, what happens then? If tariffs decrease, the furniture business will slow down, which will impact tariff rates. That’s why someone needs to engage with the administration and industries to analyze the numbers. This is a matter of straightforward math. It shouldn't be influenced by emotion but should rely on intellectual and rational data. We have all the figures necessary, and many in the industry are eager to discuss this further.

One important factor to consider is our turnover rate and how it has performed historically. We have managed to achieve inventory turns in the high 2s to low 3s. When reflecting on the $200 million to $300 million inventory reduction mentioned by Gary, it allows us to anticipate where we might stand by the end of the year. We are seeing a trend that suggests our turnover could approach the mid-2s. We believe there is potential for improvement beyond that.

In '18 and '19, we were running like 3, 3.2. Yes.

Yes.

We can operate at a much quicker pace now. You can see the slow returns we are experiencing today due to the significant product transformation. We're purchasing a large amount of inventory, and while some of it is successful, some isn't, which leads to inefficiencies in our recent approach. This effort itself represents a substantial investment, but we're moving past that. We have a completely new concept in the works that I believe is the most significant and least risky brand extension we've ever pursued. Consider how swiftly Modern reached $1 billion—was it in three years? This new idea could potentially be worth $2 billion and could come together quickly. We are confident we will hit the trend spot on. The product we are developing is unique and will be tremendously disruptive and exciting. We are so confident that we will open three galleries to launch this new concept, and we plan to add more if possible. One will be at the Ralph Lauren store in Greenwich, Connecticut, another in an amazing location in West Hollywood, with more details to be announced soon. Additionally, we have our original gallery in San Francisco, situated right in the middle of the Design District, where we relaunched the brand back in 2010.

2009.

And it is going to be an incredible gallery to this new concept. But we've been working on this one for about 4 years. So we'll be ready to go.

And maybe just to confirm as a quick follow-up. So those 3 galleries are launching in conjunction or opening in conjunction with the launch of the brand extension in the spring?

Yes. The locations in Greenwich and San Francisco are confirmed. In West Hollywood, we still need to secure our permits and complete the necessary approvals. We anticipate that will be straightforward. We plan to undertake a two-stage project, starting with a remodel of a location we now own. In Phase 2, once we launch the new concept, we will be constructing an extraordinary restaurant that could be the most beautiful in all of Los Angeles. This will include an exceptional courtyard restaurant that we believe will be outstanding. Adding a restaurant in Los Angeles is significant since we currently lack one in a major market. In Los Angeles, we’re creating an ecosystem. We established our Melrose gallery about 12 years ago, which has an excellent location and a beautiful rooftop. A couple of blocks away, we have a Modern gallery, and we plan to introduce a new concept gallery just a short distance from Melrose. We are also closing a deal for an outdoor gallery on the same street. As a result, L.A. will host a comprehensive RH ecosystem, and I believe our business there could increase by 40% or more, as it represents a substantial market for us.

Your next question comes from the line of Max Rakhlenko with TD Cowen.

Great. So first, just on Europe. It's early, but with improvements in England and the strong start to Paris, can you share what you think those galleries can actually...

Max, we can't hear you quite well. I don't know if you're close enough to the speaker, but it's hard to hear what you're saying.

Speak up, please.

Apologies. But Europe starting to scale. England, that gallery's improving and Paris, obviously off to a strong start. How should we think about the revenues per market or per gallery over the medium term? And then with that, how are you thinking about the four-wall economics in Europe compared to U.S. galleries as we just think about that 200 basis point headwind easing over the medium term?

Yes, we'll keep you updated as things progress in Paris and as we approach our openings in London and Milan. This will happen quickly since we have two more amazing galleries underway, each featuring multiple hospitality concepts. This is how we envisioned our launch process, but to secure Paris and London, we had to prioritize and open other locations first. We faced legal challenges from landlords if we didn't do so. Therefore, we aimed for our initial impression to be inspiring and unforgettable, which is why we opened RH England primarily for discussions rather than commerce. However, looking at the numbers now, it appears promising. We'll have to see how the London opening affects that location; it may actually enhance it rather than compete. The Greater London market is substantial, and the U.K. as a whole has a large market. Our brand awareness is significantly greater in London than in Paris. In Paris, we've found that 50% of the population is aware of the RH brand.

50%.

This was unexpected for us. Many people are aware and eager for us to arrive, and we're in a location that's hard to miss compared to other venues. We're establishing our brand in those areas, including Madrid, which is a highly populated and trendy city, but people there aren't as familiar with a retailer like us. An amusing story involves Jen Kelly, one of our talented curators and designers who has been with us for years. She has a godson finishing his master's degree in New York, and his girlfriend, who is also studying, is from Madrid. They were visiting California when the godson mentioned that his godmother is involved in interior design. The young woman, around 29 years old, excitedly told him that the best home store in the world had just opened in Madrid and everyone is talking about it. Jen, surprised, asked where it was, and after learning the address, she realized, "Oh, I worked on that store! That’s our brand, RH." The young woman had no idea who we were. This highlights that brand awareness in Madrid is still developing, which may take more time, but we remain optimistic. Looking at the four-wall margins, the rents in cities like Madrid and Brussels are manageable, though Munich presents more challenges. We chose not to extend leases there due to uncertainty about potential volumes. However, we have a good idea of what to expect in terms of space, like 14,000 or 20,000 square feet, and we’re considering hospitality options. Initially, we planned to have a restaurant on the top floor in Madrid but hesitated at the last moment. Now, there's a strong desire for it because of the positive feedback about our space, which is a beautiful old palace of about 14,000 square feet. We’re planning to open a restaurant there, similar to Le Petit, with a nice menu that we're sure will be well received. There’s also a long-term opportunity to add a restaurant in Brussels. We're keeping a close eye on how things develop in Germany, as brand awareness there is currently low, and it might take longer to establish ourselves. Our Munich location might not be ideal, but we have options. When projecting the four-wall performance, it looks similar to what we see in the U.S. If Paris performs as we anticipate, it should be great, even with slightly higher operating costs. We have security measures in place that require us to navigate a lengthy path to the entrance, which adds complexity, especially in tough weather. However, we are beginning to see connections and are gathering enough data to observe positive trends. We’re starting to execute effectively now, although there have been challenges around sourcing the right materials and understanding regulations. Currently, I’d rate our execution as a C. How do you all feel about that? Maybe a C plus?

I believe things are beginning to come together. We have sufficient data and are observing how everything is ramping up. We're just starting to put our plans into action. In terms of execution on the backend, dealing with the right products and navigating numerous regulations has been challenging. We've faced questions about which fabrics, foams, and lighting we can utilize. Overall, I'd rate our execution as a C today. What do you all think? C plus?

Our teams would probably say D plus. We had a fantastic series of sessions with them recently. We held another productive meeting. We understand our objectives clearly. We maximized the capacity of both planes, bringing all our merchants along with the leaders from our galleries and our top designers. We paid attention, and we learned. If we can improve our execution from a B plus or C minus to a B, that could mean a significant difference, around 25 points. Achieving an A level execution could result in an even larger impact of about 50 points. We're on the path to get there, although it can be challenging with only a few small stores, as we need to shift people's focus to execute effectively. However, the good news is that Paris has generated tremendous visibility and urgency, which is why we took everyone there for about a week. Many nights, we worked until sunrise. Our teams collaborated closely, bringing this vision to life, and it was an invaluable experience for fostering strong connections between our headquarters and field leaders, enhancing our teamwork.

Got it. That's super helpful. And then in the 10-Q, you discussed how the primary driver of the gross margin increase was due to increased margins in the core brand. Just any more color on what drove that? And then is the takeaway that we should consider is that promotions should continue to normalize ahead and that tariffs are just the major headwind? Or how should we take the learnings as we think about the rest of the year?

Yes, the margin expansion, I mean, it's a reflection of what we were doing last year and the position of the product margin and the activity last year as some of the markdown activity last year. So the year-over-year, we saw margin expansion.

Yes, we faced some challenges due to tariffs, but the impact has been less severe. If tariffs continue to rise in the third and fourth quarters and into next year, we hope there won’t be additional layers added. As mentioned by Darwin, survival depends on adaptability to change. In our industry, we must be innovative and resourceful to navigate whatever comes our way. However, we do expect some gross margin challenges due to tariffs. It's difficult to raise prices quickly, and our manufacturing partners have limited flexibility, which means we need to manage this carefully. The situation is significantly different from what we experienced in China. Unlike China, where factories received government support to cope with tariffs, that assistance is not available in Vietnam or Indonesia. These countries do not have the same level of development or support. Therefore, there will be difficulties ahead, but we will find ways to adapt and move forward.

Your next question comes from the line of Michael Lasser with UBS.

So Gary, the investment community is very focused on the degree to which there's discounting and promotions. In your messaging, the results in the quarter suggest that you've been able to overcome it with your profitability. But with that being said, is it driving incremental sales? And is the thesis that you will be able to pull back on some of this discounting-oriented messaging as the housing market improves and the natural rate of demand simply increases and offset we're seeing done right now?

Sure. To begin with, in the luxury furniture market, everything is on sale. In high-end design showrooms, interior designers and architects are receiving significant discounts, typically around 30% to 40%. Our membership model aims to level the playing field and enhance competitiveness. This is not comparable to brands like CHANEL or Hermes that can afford to discard markdowns due to their high profit margins. The furniture business operates differently from the fashion industry, and misinterpreting this can lead to substantial misunderstandings. Moreover, we are currently experiencing the third consecutive year of a challenging housing market, which I have not encountered in my 38 years in the industry. It's important to factor that in. While some companies may claim they are not engaging in promotions, they are indeed promoting, albeit in a less direct manner. It’s perplexing how some are able to publish statements indicating they aren’t promoting when their promotional efforts are evident in their weekly communications. In the luxury segment of furniture sales, promotions are a significant part of business operations. While other categories may offer different results, our focus is 80% on furniture, which gives us a higher concentration than our competitors. We've decided to step away from holiday-themed sales events like Christmas and Halloween that can dilute the perceived value of furniture. It’s essential to recognize that at the upper echelon of this industry, full-price sales are virtually nonexistent. This is a reality that needs to be accepted. Anyone who believes they can maintain a high ground without promoting in this challenging market is setting themselves up for failure. I would be curious to know who is actually refraining from promotions.

It's hard to name names right now, Gary. But it's a great segue into my second question, which is there is some skepticism around the margin outlook in the back half of the year. You're guiding below what was expected for the third quarter and well above for the fourth quarter. Can you give us more detail on what underlies those margin expectations and build the market confidence that those are realistic?

Jack, do you want to take that?

Well, Michael, we provided guidance for the second half of the year, but we did not provide any quarterly guidance. If you're referring to how the analyst community has interpreted that, I understood you to be asking how it differs from prior guidance. Did I understand your question correctly?

I'm just asking for what drives those or underlies those, Jack. So if you could give us a sense for what you're expecting, is it that tariffs are going to be a headwind in 3Q, but you'll take price by the time you get to 4Q? Let's say, you'll see a significant amount of leverage in the fourth quarter.

I think gross margins will be coming in. Gross margin or operating margin.

Yes, Michael, you're talking about operating income?

Yes, sir.

Okay. Just as a reminder, we experience seasonality in our business regarding advertising expenses and the costs associated with our mailings. That is one factor to consider. We are not focusing on pricing strategies or their timing, as those details are already included in our guidance. However, we won't be discussing that commentary further.

Your next question comes from the line of Steven Zaccone with Citi.

I wanted to discuss the pricing comment and get a better understanding. Gary, you mentioned pricing in the industry due to tariffs. What is your assessment of pricing from an industry perspective? Do you expect it to worsen in the second half of the year with more increases because of the tariffs? Will that be when we reach the peak, or could it extend into 2026?

I pay attention to all the conference calls in our industry, and I feel that no one has truly addressed the tariffs directly. It seems like everyone is avoiding the issue, waiting for someone to present the reality. Perhaps we are the first to do so. I don’t believe anyone is getting better pricing than we are, nor do I think anyone is mitigating more than we are. Our leverage as a single brand is unmatched. I anticipate that everyone will need to raise prices in the second half of the year, leading to significant furniture inflation across the board. I’m not sure how anyone can avoid this unless they are a small business producing all their items domestically. However, even they will face challenges since many components, like fabrics, are sourced from Asia. Additionally, some companies may claim they are manufacturing furniture in America while actually sourcing wood from Asia, only assembling it here and labeling it as assembled in America. This practice could potentially be a trigger for the investigation into tariffs, as there are likely companies attempting to evade them by importing unassembled products from abroad. I think we’ll see new tariffs emerging from these practices. Ultimately, everyone will have to adjust their pricing; it’s unavoidable, as margins will be heavily impacted.

Yes, understood. Regarding the international margin question that Max raised, considering the 200 basis points drag this year, will that improve next year? Or should we expect significant start-up costs from the openings in London and Milan?

We are still facing significant start-up costs. The situation will depend on the ramp-up in Paris, which will influence the ramp-up in London, expected to be considerably higher than in Paris. As for Milan, I’m uncertain where it will land, likely slightly below Paris, but being a larger market, it could perform well. We're launching during Salone, the largest design show globally, attracting around 500,000 attendees to Milan for a week. It's a crucial time for us, and you won't want to miss our next two openings.

Your final question comes from the line of Brian Nagel with Oppenheimer.

I have a couple of questions. First, I want to ensure I fully grasp the dynamics at play. From an inventory growth standpoint, it appears you are managing inventory much more effectively. We've observed a significant moderation in growth during the second quarter. This dynamic seems likely to contribute positively to cash flow. However, I want to confirm my understanding. As you improve inventory management, could tighter inventories in the latter half of the year potentially become a challenge for sales?

Yes. Everything has its value, and it all hinges on the direction of the housing market, potential offsets, and the challenges our new concept may encounter. I believe this new initiative is the most significant we've undertaken and will surpass Modern considerably. It addresses the largest segment of the market. We're launching new galleries, with substantial ones in London and Milan, along with outdoor and conceptual galleries, and new compounds. A lot of time and capital has been invested to prepare the company for the next decade. This is how we approach our next phase. If we succeed, and we're already receiving numerous inquiries about opening locations in Abu Dhabi, Dubai, and potential partnerships, it's clear there is market interest. When a concept like what we are developing in Paris is introduced, it attracts developers and others interested in managing or expanding our brand in the region. We aim to explore flexible investment options, potentially resulting in long-term agreements or pursuing direct sales growth. Our priority is to achieve breakthroughs and become a highly respected global brand during this time, particularly through our efforts in Europe, which will open up various opportunities. Looking to Asia, we’ve been approached about expansion there and in the Middle East for many years, but we wanted to follow a strategic plan. We initially chose to establish a presence in Europe with RH New York for visibility and to cater to European clients. Now, with Paris and London on the way, as well as Milan, we're gaining crucial insights. The brand's appeal is set to grow tremendously. Our work quality is outstanding; I encourage everyone to experience it firsthand. If you want to learn about RH, visit our location in Paris and see what we're doing. It’s poised to be the best work we’ve ever accomplished. Observing how we present ourselves can be enlightening. Those who witnessed The World of RH were amazed by our ability to showcase who we are, our global work presented in an engaging environment that facilitates meetings and casual interactions. Our new locations like RH New York, Boston, and Chicago highlight our achievements through impressive design features and immersive experiences. The crowd during our events has been encouraging, signaling strong interest in our offerings. Everyone who's experienced it is blown away, noting that they underestimated our capabilities. We possess a unique portfolio in architecture, interior, and landscape design, establishing credibility in our interior design sector. We've made significant investments, including creating an exceptional interior design building in Paris, which enhances our position in the industry. We are committed to recruiting the best talent because we see ourselves as more than a retailer; we are pioneering a new approach that, when fully realized, will make perfect sense.

Great. I maybe ask just a quick follow-up and I think maybe for Jack. But just with regard to tariffs. So should we expect that RH is putting in mitigation efforts, particularly price increases as the tariff hit? Or you were able to, in some instances, start adjusting prices before the actual tariff is hitting you?

Turkey is a little wacky. We also did the membership thing.

Yes, I believe it's a combination of factors. We want to be very careful with price increases. As Gary mentioned, while we aim to protect our margins, we also need to consider the revenue of the business and the effects of our decisions. So, we are being strategic and cautious, and we've been implementing this approach since we faced the initial tariffs from China in 2017 or 2018. We will continue to follow this strategy.

That concludes our question-and-answer session. I will now turn the call back over to Gary Friedman for closing remarks.

Thank you all for your interest. These are interesting times for our industry, and even more so for our company. I want to congratulate everyone in our organization; whether you were in Paris or not, your hard work contributed to our success. We've positioned ourselves to launch what we believe is the most exciting immersive retail experience in the world today, and we are incredibly proud of that achievement. I mentioned to the team that we have managed to glimpse the top of the luxury mountain, and now it's our responsibility to establish our presence there. There's still significant work ahead, but the leadership recognizes our potential and the quality of our work, which I believe has garnered their respect and expectations from us. We have a tremendous opportunity to create one of the most admired brands globally, and the momentum we've gained marks a proud moment for our company. I want to express my gratitude to everyone at every level for the effort put forth during these challenging three years. As Warren Buffett said, the clouds will part and the sun will shine again, and we will be ready when it does. Thank you once again for your interest, and thanks to the team for your leadership and dedication to our values. Our time has come.

Ladies and gentlemen, this concludes today's call. Thank you all for joining. You may now disconnect.