Earnings Call Transcript - RH Q2 2020

Operator, Operator

Ladies and gentlemen, thank you for standing by, and welcome to the RH Second Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation there will be a question-and-answer session. Please be advised that this conference is being recorded. I would now like to hand the conference over to Ms. Allison Malkin. Thank you. Please go ahead.

Allison Malkin, Senior Managing Director

Thank you. Good afternoon, everyone. Thank you for joining us for our second quarter 2020 Q&A conference 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 our outlook for 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 adjust 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. With that, I'll turn the call over to the operator to begin our Q&A session. Operator, we are ready for questions.

Operator, Operator

Your first question comes from the line of Steven Forbes with Guggenheim Securities. You may now ask your question.

Steven Forbes, Analyst

Good evening. So, Gary, you spoke in the letter about the expectation for revenue growth to lag demand by, I think it was 5% to 10% in the third quarter. So, I want to start there just as we contextualize the build for the back half here given the current trends. So I don’t know if you can talk about how much of the closure between this expectation and the 16% 2Q spread is due to demand being fulfilled versus sort of a more natural closure in the spread between demand comp and revenue comp. Because I think you did mention that you expect to fulfill the majority of that demand over the next three quarters. So, any sort of color that could help us walk or build that out over the three quarters would be helpful.

Gary Friedman, Chairman and CEO

Sure. Thanks for the question, Steve, and I’ll try to add some color and maybe Jack can fill in some pieces. But if you kind of start back when we spoke to you last quarter, we expected revenue to lag demand comps by about 10 to 12 points, and what happened recently is that the gap got bigger. It got to 16 points in the second half of the quarter; our demand really accelerated and ran away from our trends and our inventory flow. It built up a much bigger gap. As you think about the demand build month-over-month as we laid out in the letter, it’s hard to plan for something like that. It started with a big picture and said the pandemic hit in mid-March, and our revenues dropped by just about 40 points. In a three-month period, a little over three months, our demand went from down 40 to up 40, right? Roughly, just directionally. So it’s an 80-point swing, and we responded very quickly to the downturn. Based on our analysis, we didn’t know how long our galleries were going to be closed and what the impact was going to be, but we wanted to react quickly. We were able to cut receipts and push out inventory. Then, as demand builds, we thought it looked good coming back from down 40 to down 20 to down 10 to up 7, and then it just took off. So, if you start there, we are behind. You compound that with the fact that the pandemic hit everybody. It hit every country in the world. It hit every one of our manufacturing partners across the globe. They had dislocations, whether it’s block face workers or shutdowns, so on and so forth, whether it’s in North America, Asia, Europe, or South America. I would say we have relatively good visibility if things don’t change drastically from here. I am not sure if demand will continue to grow month-over-month. I don’t think so, but I don’t know that it won’t. We are off to a pretty good start in the first two weeks of September. What’s different about September year-over-year is that last year, we had a higher mix of clearance inventory that we wanted to get rid of. Last Labor Day, we ran a Labor Day sale with clearance inventory and liquidated goods, and that gave us a lift. But if you just think about the first two weeks, what will happen in the next several weeks, I'm not sure. It’s funny; I’ve never spent too much time looking at our business day-to-day. But it changed so dramatically, and we are learning. So, as we look at the second half, our expectation is that we look at expected inventory flow, we should start to catch up and close the gap.

Steven Forbes, Analyst

Go ahead, Jack.

Jack Preston, CFO

No, no, I think that was great.

Steven Forbes, Analyst

Yes. Well, maybe one for you or either Jack or Gary. If I think about 2Q gross margins, right, this was clearly a focal point for us and investors heading into the quarter, and as we think about raising the long-term guidance here, right, the 25% EBIT margins from 20% versus the 22%, you delivered. What’s the right gross margin profile for this business? I mean, is there still a lot of opportunity as we think about whether it’s delivery, damages, or diverse engineering, the whole supply chain, where is the right margin profile for that long-term target as it stands today?

Gary Friedman, Chairman and CEO

I don’t know if we caught the right margin profile. We think about what’s possible. And I don’t think there is an analyst on the street that has a 20% operating margin in the next five years. When you say what’s right, there is a path to 20%. How quickly is it going to unfold? A lot of it comes down to the desirability of your product when it relates to margins. We are seeing now as we have transitioned and transitioned from a single-source rug relationship to a direct sourcing model in rugs. We got a very different business, and it’s a different margin profile that is lifting the business. We’ve talked to you guys about annualizing the accelerated clearance of products through our outlet division. A year ago that dragged margins; that’s now washed through, and we are seeing more normalized margins there. If you think about the 21.8% or the 47.5% we hit in margins, we did that thinking about it from a gross margin or operating margin perspective in flat revenues. When I wrote in the letter that we expect to reach 20% operating margins in 2020 with 5% revenue growth, I was trying to give you a floor for this year. I don’t think there is any way we will go under 5% revenue growth. But I don’t know, all the stores shutting down again. Who knows what can happen with this pandemic? It seems like things are kind of getting better, not worse.

Steven Forbes, Analyst

Thank you, guys.

Operator, Operator

Your next question comes from the line of Curtis Nagle with Bank of America. You may now ask your question.

Curtis Nagle, Analyst

Good afternoon, guys. Thanks very much for taking the questions. Just a quick one on, Gary, in the letter you cited evidence of some of your clients moving out of urban centers, buying second or maybe even third homes. Hard to imagine a company that’s probably better positioned for that maybe over the next few years. I guess, could you extrapolate a little more in terms of how much demand that’s driving, maybe hard to know, but how sustainable that growth could be?

Gary Friedman, Chairman and CEO

Yes. We try to articulate it in the letter. Your guess is as good as ours, but we like the data we see. I think that because this pandemic is lasting as long as it has, I asked my doctor a few weeks ago how long do you think we are going to be wearing masks, and he said at least two more years. I said really? Two more years? He said yes, you’ve got to think about the math. It’s going to take. When he said 270 million people that have the antibodies or the vaccines to get to herd immunity. Most likely, the vaccine is not going to come until the spring of 2021. It’s going to take at least 18 months to move really fast to get 270 people to herd immunity. So, he said we’ve got a new behavior shift that he thinks is going to last for a while. I don’t think any of us could conceptualize that early on, and now it starts to make sense. The data and the shifts, I think, I’m surprised how quickly people responded to this pandemic from the activity in the home market, how quickly people moved to buy second homes to get out of cities and so forth. Not all out of the city, just getting second homes to have somewhere to go. Many of them still have their city home. And then people that are moving to suburbs, in fact, there are new suburbs forming. I mean, I was talking to some people that there’s a whole new view of how they think about suburbs in Silicon Valley. So many of the people are learning they can work remote more. So they are moving, buying homes in places like Palm Desert now, which is turning from a retirement community to a suburb for many people, right. Younger people move where they can get a bigger home, have more space. There’s a perception that there is less crowd, more safety, and so forth. Who knows when we are all going to travel again. That’s our biggest question on international. We can’t go to Europe unless we want to quarantine for two weeks. So, is this going to completely snap back? Are there going to be some permanent changes in behavior? If you think about the home buying cycle and home furnishing cycle, it’s not short. And I do think we are well positioned for it because of our assortment and our unique interior design ability where we can just come in and do someone’s telling; we are doing more full projects than ever before. People are looking for solutions that save some time, and we can do that. So, like I said in the letter, I think we are going to have a higher water level through 2021, but I don’t know. I’ve never seen anything like this. Maybe the air comes out of the balloon sooner, or maybe it’s a permanent shift. When you get people thinking about something, this could create a whole new market for the home. I mean, just think about this: how many people are not going out to dinner today, or limited amounts of people going out to dinner. I read some stats that OpenTable reservations are down by 50%. I’m going out to dinner 80% less than it was. We are going to people’s homes for dinner, people we know well. When there’s a shift like this, people go to other people’s homes, and they look at someone else’s home, and they go, ‘Oh, their home is much nicer than our home.’ Honey, we’ve got to redo our home. You get, the interesting thing about humans, right, we kind of compare and contrast ourselves all the time: what we wear, what we drive, where we live, the size of our home, all these little things. What we go; where we go on vacation. Oh, I went to Pepperdine. Oh, yes, we went to Pepperdine too. All that going to stuff that humans do. I think that focus on the home, and this amount of time people are spending on the home that could become a permanent shift. But, like I said in the letter, I don’t know how to plan for that stuff. We don’t want to take too much risk because we aren’t sure. We are going to invest very thoughtfully. We will continue to let cost chase demand versus demand chasing cost. We don’t want to build a big cost structure based on 40% demand comps and have it go to 10% and go.

Curtis Nagle, Analyst

Got it. No, understood and thoughtful answer. Thank you. Just a quick one in terms of the capital structure. So, you paid down the converts. You guys, I don’t know, I think are wanting at 1.3 leverage, something like that. How do we think about that going forward? Do you remain underleveraged? What does the capital structure look like in the explosion in margins?

Gary Friedman, Chairman and CEO

Yes, we are going to generate a lot of cash. So, the capital structure is going to look really good, and as we said in the letter, we’ll remain opportunistic as it relates to sources and uses of capital. There is always going to be some kind of opportunities and dislocations in markets like this, whether they are short-term or more medium-term. We like to maintain optionality. So, we will see. Again, we’ll see how long these rates last. Our model just from an investment perspective, even though we are doing Europe, we’ve got surprisingly first several galleries that are not going to be capital-intensive but one. Just central one, where we are screening together four buildings and making them into one, and that will be a bit more of a capital investment kind of like New York. But Paris, RH England is not as heavy capital investment. The following two galleries we’ve got signed are not going to be capital-intensive, so we’ll see. You should see us start to ramp up more prototypes, and we’ve got that model fine-tuned. We’ll have less capital investment. If you think about the last couple of years, we have had some heavy capital-intensive stores. We had RH New York; we had the development of first new prototypes. Those because we were working on them for a long time, making a lot of changes just like developing a new iPhone or something, right? That store is really like an R&D project. There was a lot of capital there. Or in San Francisco, a lot of capital, our first guesthouse in New York, again it’s like an R&D project; that’s a lot of capital. You roll through that, and we don’t have as many galleries that are capital-intensive galleries. And then as we said in the letter, our performance is going to drive a new credit profile on our company, which is going to make us a more valuable development partner for any developer. That’s like, they’ll get a better cap rate on our rents and our credits than they will on other tenants. So that tends to allow us to get more TI, lower rents, so on and so forth. And it really helps us in our home development deals because we can, we should be able to get better cap rates. No different than we sold Minneapolis in the middle of the pandemic. That’s crazy. First, with the other people walking away, we walked away and said, hey, I mean, this is temporal. We are okay. Then they came back and we closed at a 5.5 cap. Initially when we talked about that several years ago, we were going to put out $1.8 million rent on it and sell it for $33 million. We decided to put $1.4 million rent on it and sell it for $25.6 million. But the fact is we got a 5.5 cap, and that was before we leapfrogged to 20% or 20% plus operating margins. The cash flow profile and the return on capital profile that you are going to see, I think there’s a chance we’ll exceed 50% return on invested capital this year. That was a long-term target. I didn’t update that long-term target because I was like you start this silly math when we are going to have like 75% return on invested capital. But it’s going to be a good model as we flip over and don’t have as many capital-intensive projects. Even if you think about our second guesthouse that we are building in Austin, that’s a joint venture development and it’s a very capital-light guesthouse. We are able to kind of do a deal like that because we were already in construction and have the designs and plans for the first one. So the development partner was like, got it; that looks amazing. Okay, I’ll cut this kind of deal. Our first one in New York, people thought we were nuts. What are you guys going to do? People still think we are nuts. I think until they see it and they’ll get it. We like the capital profile of the business. We like the new cash flow model, return on invested capital, capital requirements of the business. I think it looks good. I honestly would have never imagined it would look this good. I mean, in my early days here, a lot of people sit around the table here the whole time. Just like we’re like, okay if we can get to a billion dollars to make 8%, if we can get there, we’ll have made it. If you would have told me hey, we would build that leading luxury design platform in the world and we’d be at 20% plus operating margins and a cash flow profile model like we are building the galleries that we are building. We are not building cheap little retail stores. We are developing buildings. These are like, look great 50 years from now. So, it’s remarkable. When we say inside our company, the thing that I’ve learned in my career is that you can always monetize extraordinary, remarkable, amazing work. It’s hard to monetize ordinary and unremarkable work. The thing we’ve learned is that if we focus on doing extraordinary, remarkable, amazing work, we can always create a model and a business around that.

Curtis Nagle, Analyst

Thanks very much, guys. Appreciate it.

Operator, Operator

Your next question comes from the line of Chuck Grom with Gordon Haskett. You may now ask your question.

Chuck Grom, Analyst

Hey, thanks. I was just curious when you talk about sustaining that 20% operating margin goal, which is impressive. Just wanting if you can contextualize that for us longer term in light of that you go down the path of building out RH residence and obviously you are going down the path of RH guesthouses. Just how do we think about the margin structure over time as you continue down those avenues? Or do you view those channels as accretive, dilutive? Do you think you can sustain the operating margin structure?

Gary Friedman, Chairman and CEO

Yes. I think we think about it from a couple of perspectives. One is, we think that they will elevate and render the RH brand more valuable. So how do you build those high-end luxury brands? I tell the team, all the great brands were born at the top of the luxury mountain, LVMH, Gucci, and Canoe just to name luxury brands that come to mind. They have always been luxury brands. We didn’t start anywhere close to a luxury brand. We had Oxydol laundry detergent on the cover of our catalog, right? So we have to scale this luxury now. You have to do things that create a consideration of the brand that elevate the brand in the right consumers’ mind. Whether it’s doing an extraordinary experience at a guesthouse that’s going to create a new market for customers seeking privacy and luxury, or having RH3, a luxury yacht that you can charter in the Mediterranean and Caribbean, I mean not a lot of people can use that. But I guarantee when we do the portal of RH, and you see it on our website, you will see our guesthouses and the other things we are doing. We don’t have a marketing department in our company because we say marketing is a lot of times putting lipstick on the pig. People try to take an ordinary thing and dress it up and make look better than it is. It’s not what we say; it’s what we do that defines us. We build our brand through our work. We don’t really run many ads. We might take a few ads here or there in home magazines like Digest but really it’s mostly our work. Our galleries are our work, the extraordinary experiences in our stores are our work, and our web portal will be another version of our work. We think the guesthouse and residences, if done really well, knows they’ll elevate the brand and help us climb the luxury mountain. If we build extraordinary projects, I believe we’ve learned that if we do remarkable work, we can figure out how to monetize it and build the business model. Even though we haven't opened a guesthouse, a few people in the hospitality world that I’ve shown it to have said, oh my god, do you know how much you can get for those rooms? If they are half right, we are going to do really well. But they are not just kind of a new business thinking independently; you have to think about them together and how they elevate and render the brand more valuable. It’s just like the mistake department stores made, if you visited Stanley Markets in the beginning of markets and tell you the restaurants were never supposed to be the leading profit driver in the company. The restaurants were supposed to get the high-end female consumers to come to the store more often and walk through the shoe department and buy really expensive shoes and other things. If you look at things in isolation, you can make a mistake and not see the bigger picture. No difference than quite frankly it blows my mind how many retailers right now are talking about closing stores and just having a website. I guarantee, if people start closing stores, their website traffic is going to plummet. They will find out the cost of acquiring customers through digital marketing is very expensive. The cost of marketing an invisible store online. Good luck with that. All the digital native brands are opening stores. So, the other elements, guesthouses, residences, other things you’ll hear about that will test and incubate; they are going to create a big conversation around our brand. They will be extraordinary pieces of work in their industries. They will elevate our brand and render us more valuable. So we are going to find they will become real businesses in and of themselves, and if they are right, the ecosystem gets bigger. If not, we have a handful of them and they are tremendous examples of our work and elevate our brand. But I think long-term we are going to try and find now that we have worked on them longer, we are going to find that they are businesses and we won’t do anything that’s going to destroy value here, right? We don’t want to all of a sudden try to build an 8% operating margin business when we got a 20% to 25% operating margin business. We’ll drag the whole thing down and destroy value. The idea is can we build things in an integrated way that lifts the whole margin profile of the business? We’ll test these and try them; we’ll learn more. But I know one thing for sure. They will elevate the RH brand. They will create a conversation at the highest end of the market, and that’s what’s really hard to do. No one has ever climbed the luxury mountain before starting where we did. I can’t name one brand. Most brands go down. This requires a different kind of effort. You are not going to do it just running some ads in magazines. Our work has to define us here. It’s the only way we’ll earn the respect of the consumers of the very best brands in the world.

Chuck Grom, Analyst

That’s helpful. And just as a follow-up, just thinking about the factors that have driven the demand improvement over the past several months, probably – but just curious if you can give us a sense of how much of that’s coming from some of the deurbanization movement versus the shifts in the second home markets versus just the overall housing market and how better the last buck will be just the pandemic and people just being more hunkered down. I’m just wondering if you can think about the different drivers of the recent strength.

Gary Friedman, Chairman and CEO

Yes. I think it’s all those things together. I mean again, we were running at 8% before this pandemic. We went down 40, and now we are up 44, something in the core business or something, but 47 in August and up 44 for month-to-date in September. There is a big shift here. The question is, how much of it is systemic and how much of it is temporal? The key is I think you’ve got to play it with the expectation that it could be temporal; otherwise, you can kind of goof up your model. We are okay not trying to optimize everything in this market. This thing is temporal. You can like, change your model and try to run after every sale and optimize it. You can put your head down in the weeds and maybe you’ll crank out another 3% to 5% of sales, but all of a sudden you focus on the little rocks, and you screw up your model and then when the air comes out of the balloon, you’re like, oh now what? You got to disarchitect your business and stop your cost structure. We are okay; we are not chasing any sales. We didn’t put one thing on promotions. We are letting demand get away. We know we are losing demand with the backorder race we are running. You are right there. So, that’s okay. This is, I don’t want to be famous for like, hey they did really great during that pandemic, didn’t they? Did you, do you remember them like, oh my god, they had the best numbers during the pandemic. What happened to them? Oh yes, long-term they kind of screwed up their model. We look at this as this is some kind of a temporal advance that may have systemic long-term benefit to the home. We hope it does, but if it doesn’t, it’s okay. We are looking at our model long-term. I love the fact that hey our revenue is flat this quarter, thank god. I don’t have resilient questions from everybody like, where was the margin? How much was this? What’s the leverage there? Revenue is flat and we have 21.8% operating margin. That’s with a 40 basis point drag in the pandemic that’s a 90 basis point drag from water works. It’s got an 80 basis point drag or something like that, hospitality confirmed startup mode. We’ve got another drag from some kind of one-time investments we are making. So, we can take those pieces; that helps us see yes, 25 down that road. So stay down that road. Don’t get lost in the little rocks of the pandemic. Ride this wave the best we can, but I don’t think the business stays up 40%. It might stay here for a couple of years. Maybe there is a new water line, I don’t know. I guess this is hard to say. It hasn’t been that long. I mean, I’ve never seen anything like it. I don’t want to overreact to it and goof up the last decade of work. So, we are taking a very long-term view here. We are not running around with our heads down trying to manage the business from week-to-week. We are not pulling any levers. There are no promotions going on here. Just trying to build the best brand of its kind in the world.

Chuck Grom, Analyst

Great. Good luck. Thank you.

Gary Friedman, Chairman and CEO

Thank you.

Operator, Operator

Your next question comes from the line of Brad Thomas with KeyBanc Capital Markets. You may now ask your question.

Brad Thomas, Analyst

Hi. Thanks for taking my question. Congrats on all the momentum in the business and the bright outlook here. My question was if you could share any color on how to think about some of the expenses and SG&A in the back half of this year. On the one hand, I would presume there are perhaps more sales coming from e-commerce or web orders than in the stores, and that may benefit cost. You are also not mailing the source book, so on the other hand, of course, knock on wood. The sales book is pretty good. How should we think about expenses for the balance of the year?

Gary Friedman, Chairman and CEO

Yes. We will obviously have some savings in ad cost. We are not going to try to chase and optimize revenue over the short-term here. We think we’ve got enough, and we are already chasing it from a supply point of view. It’s not like we aren’t mailing the book and doing nothing. We are not mailing the book and we are going to invest our time and energy and resources and make investments in other areas that we think will have a real long-term benefit to the business versus mailing into doing a lot of work and maybe that gets a little extra bump or no bump. Mailing into it just not having the goods or the customer already optimized. By the way, the other thing that we want to learn is, I don’t maybe the books aren’t as productive anymore, as we think. Let’s take this time and test our way kind of add it back into it, and we’ll get some fresh data that says maybe when we launch the portal and because we are building all these new big stores, we can mail fewer books. So, there is lots of motivation about testing and learning for the long-term. But we are making a lot of investments in long-term growth. Making a lot of investments internationally, making a lot of investments to elevate and expand the product. You’ve probably read, if you haven’t read, we made a small acquisition of a business that we disclosed. We are not saying much about it for competitive reasons, but we think it’s going to elevate us. The talent in the acquisition is going to continue to help drive our product capabilities. That’s what we are focused on, and we want to do our best work at introducing the brand internationally in Europe because that opens a whole door. If we start to demonstrate that this brand can work without a long ramp-up, if our brand can be introduced internationally and actually ramp anywhere near a market, a normal market that we haven’t been in—say like Canada where we opened galleries—just means that we can lay the tracks to the brand being $20 billion globally without really anything else working. Again, I kind of think about it if we can prove ourselves internationally and we can over several years, ramp up in England and France, and throughout Europe and Spain, and other places like Germany and so forth, that probably is a really good indicator of what’s going to happen as we move across to Asia, Australia, and South America and other parts of the world. The world is what we feel is good about; our timing is that the world is exponentially getting smaller. The visualization that happens on the internet through all the platforms; social media; and all the various interest; and everything else—the world is getting smaller. The world is adopting the same pace and style and so forth. I think that really, all of this is going to benefit great global brands. So, we are investing in all those things, and despite the investments, again, we think we’ll do well from a profitability and margin performance perspective.

Jack Preston, CFO

And Brad, it’s Jack. I’ll just add quickly. Gary was talking about with—if we think about the 20% model, at the floor, it implies sort of 5% revenue creep. You can do the math also on what that implies for H2 op income, and that’s 22.2% with 700 basis points, right? Again, that’s just the implied math of the forward guidance. We are not telling you how that’s split between gross margin and SG&A—obviously we are not guiding—but naturally, as you alluded to, the sourcebooks that benefit would naturally I’m going to see inside come more in Q3 than it would in Q4, given that’s when the mailing would occur.

Gary Friedman, Chairman and CEO

That’s a good point.

Adrienne Yih, Analyst

Great. Thank you. Great content and color. Gary, as you were talking about sort of brand building, when you look at many brands, global brands, they have a line that’s called demand creation. When you think about your catalogs as being sort of 3.5% to 4% to sales, you only have the luxury of having another 600 basis points or so in all of these different areas like RH3 and guesthouse and hospitality, right, to build that. My question is, is that the right way to think about it? How much could you bring that demand creation up to as a percent of sales? Because now you have the luxury of this extra margin? To your point on the catalogs, could the catalogs ever turn from content-only product-only and be a physical manifestation of sort of the world of RH and sort of the Lifestyle Content Magazine?

Gary Friedman, Chairman and CEO

Yes, you got some work here. Our whole leadership team is in the room by the way. Yes, it was like, yes, okay, you think like we think. So, yes, it’s correct on all of it.

Jack Preston, CFO

We have given it, but we don’t.

Gary Friedman, Chairman and CEO

Yes. Yes. Just a big part of our business. But we are not giving it just for competitive reasons right now. And then like, whereas color is probably, ask me that question next quarter. We have a series of off-sites and time we are spending just to evaluate all of our key value driving strategies and initiatives. We have a pretty long list of opportunities, and it’s how many can we do at one time. How do we sequence them? What’s the emotional strategic and financial value of each one of them, and that’s how we kind of allocate our time and human capital and financial capital. So, we are excited. I mean, I actually—it’s kind of a gift to say like, you know what this, don’t mail the book right now. Don’t do all that work unless you make everybody stop. We are taking all our talent in this organization to really see the board. Really put things in the right order and focus on the next few big rocks that can change everything again. I really believe that if we use our time wisely over the next six months, we can really step change the core business with regard to comparable sales point of view. You really need to get all the leadership to focus. It’s got to take everybody together. We’ve got so many things to work on, so many opportunities. We’ve also brought in a lot of new talent, and we have a lot more capacity to do more. But it takes everybody together and to focus to move the big rocks. Otherwise, people are working really hard in the little rocks and they have to kind of range in organizing things, and at the end it doesn’t really move the needle that much. In the short time, we started to focus on a couple of categories, I think if you were sitting here with kind of our senior leaders or product, I think everybody’s eyes are wide open and we think there are a lot of opportunities here.

Adrienne Yih, Analyst

Thanks so much. Congrats to the whole leadership team. I mean what you are creating is really remarkable. I had to say that.

Gary Friedman, Chairman and CEO

Thank you.

Michael Lasser, Analyst

Good evening. Thanks a lot for taking my question. It's two quick ones and maybe for Jack. Number one, can you provide an explicit breakdown of where the gross margin expansion came from in the second quarter? And then I have a quick follow-up.

Jack Preston, CFO

Well beyond what Gary already mentioned in the letter, we did talk about 490 basis points of product margin, and so the rest would be shipping and occupancy expenses which we got a little leverage on each of those. We are not going to go into much more detail than that.

Michael Lasser, Analyst

Did that just come from fewer promotions and discounting that occurred in the second quarter?

Jack Preston, CFO

Yes, partly that; I mean, but partly higher quality product that commands higher margins and all the things that we’ve talked about, and the cycling of the outlet, definitely the cycling of the rug transition.

Gary Friedman, Chairman and CEO

Those two were about a little over a third of it, right? A little less than half. The rest is just higher margins across the business, right, across all the categories.

Michael Lasser, Analyst

That’s helpful. And my follow-up is, you are on the path to 20—mid-20s margin over time. Is there an area where you would take—your margin would take a step back if you accelerated some of these investments? Or do you think from here you can continue to see margin expansion year-over-year even while you do make these investments?

Gary Friedman, Chairman and CEO

We think we can do it even while we are making those investments, because we keep doing it while we are making—we’ve making investments, and I think the key is, maybe there is a time we say, look, we’ve got so many really good ideas now. We are going to invest even more, and we are going to have a flat year. We might have a year that’s a little down, I don’t know, it may be. We’ll tell you when we get there. I mean, we will make really good long-term decisions. We are not going to all of a sudden become a company that gets to the 20% operating margin and starts managing quarter-by-quarter and go into the downward spiral that a lot of companies do because they start protecting their brand instead of building their brand. They really smart and inventive and innovative while they are building their brand and then they build something that’s valuable and then they start to protect, and everybody start playing defense instead of offense. That’s when you just go into the death curve. We are going to, if it’s right for us to run flat margins or slightly down margins to make an investment to leapfrog the company by hundreds of basis points, of course, we’ll do that. I’m not trying to get out of this company or sell this company. None of us are. This is our life. It’s not just our job. We are going to make decisions like we own 100% of the company. We are not going to suddenly play small ball and try to play quarter-by-quarter, year by year predictable margin improvement; we could have by the way not let the things swing shot to 2020. I’d say it like oh, let’s spend a bunch more money here so we grow 100 basis points a year, 150 basis points a year? Let’s do something big.

Michael Lasser, Analyst

Understood. Thank you very much.

Gary Friedman, Chairman and CEO

Yes.

Cristina Fernandez, Analyst

Yes. Hi, good afternoon. I wanted to ask about the demand trends you are seeing. It seems like it’s a very good opportunity to attract new customers to RH. Can you talk about whether you are seeing an increase in your customers or is a lot of the demand coming from existing members or reactivated customers that perhaps shopped before but not recently?

Gary Friedman, Chairman and CEO

Yes, and we said the numbers would indicate we are seeing a lot of new customers. This is an acceleration in new customers. This acceleration in existing customers, but you can’t run up 40 demand 47 demand without new customers. People are buying second homes, and hopefully this means it again, it sets a new level of importance on the home possibly indefinitely.

Cristina Fernandez, Analyst

That’s helpful. And then my follow-up, can you talk about the performance of the two new stores that you opened this quarter? And then on your letter, you mentioned you couldn’t provide opening guidance for galleries given all the changes, but maybe an update on what’s going on there and when do you think you could resume some of the store openings in 2021?

Gary Friedman, Chairman and CEO

Yes, we show and rendered our—we are really happy with both. They are performing extraordinarily well. Marine is not performing as well as Charlotte because the restaurants we opened have been closed for about a month and a half, two months, something like that. It’s really great for everybody that’s—we haven’t opened for our associates, so we are feeding our people, which keeps our team engaged. But our customers can’t, and that drives a lot of extra traffic and extra revenues. But despite that, Marine is really performing well. Charlotte is kind of off the hook, right? Like what we are finding in some of these; I don’t know if you take Charlotte is a secondary market. Yes, I mean some of these markets like Charlotte and Columbus are extraordinary lifts. I mean lifts like way better than we expected, and I think that we are even more differentiated and unique in markets like that because even the great brands, if you look at the luxury brands, my sense is they probably under-invest in those call it markets because they don’t understand them. There’s a lot of wealth in many of the markets, and my sense is that brands tend to under-invest. We couldn’t be happier with how the new galleries are performing. As far as this guidance for 2021, we will open new galleries. Things are moving around. We’ve had some of the developers—they froze their capital outlets for a few months. We’ve lost time; it’s hard to get things into local municipalities and get approvals right now. Doing Zoom meetings and we are trying to get RH Morristown approved in New Jersey, which is a 5.5-acre stake with a historic home and we are developing multiple buildings and gardens and food and beverage offerings. It would be extraordinary galleries. It’s hard to—without physical meetings and town meetings, trying to do stuff on Zoom has taken forever. We’ve got a bit of a slowdown on things, but we will have new galleries in 2021. I think it’s too hard to commit to a number because some things are going to get kicked into 2022, and things that were 2022 are going to probably get kicked into 2023. Everything is kind of backed up.

Operator, Operator

Your next question comes from the line of Oliver Chen with Cowen and Company. You may now ask your question.

Oliver Chen, Analyst

Hey guys. Thanks a lot. It’s Max on for Oliver. Can you provide any updates on timing in Europe? Where are you in the process of just planning where the DCs are going to be and then the new gallery openings? It seems like maybe it’s also been pushed out a little bit. Any color there would be great. And then we have a follow-up.

Gary Friedman, Chairman and CEO

Yes, nothing has pushed out in Europe right now. The initial gallery that we plan to open, RH England, we tentatively plan to launch in early summer 2021. That’s anticipating we can travel over there soon. The team is identifying distribution and logistics solutions and where we are going to be, and whether the DC is going to be in Belgium or the Netherlands or the UK. We have optionality, and your team has done a good job of creating the options and doing the math and thinking about it short-term and long-term as we think about the investments, and we’ve got ramp up being able to place orders by April or May so we can open in June is kind of our target. We might be able to open as early as May, but I think it’s going to be more like June. A lot of it is going to depend on the virus and what travel looks like and what local restrictions look like, as far as gatherings and shopping and are we going to have a second wave of viruses or is there going to be a slowdown shutdown? We just don’t know. We said tentatively 2021 that’s when we are going to open that first gallery. We are targeting 2022; we would have Paris ready to go and maybe another one. My sense is Central London is a more complex job that might take longer. It might be 2023, but we’ll see. It all depends, getting the approvals right now and things like that are the difficult thing, and understanding timing on construction.

Oliver Chen, Analyst

Got it. That’s very helpful. And then, on the new opening pipeline, obviously no guidance; we just discussed that, but can you remind us how many of those galleries are planned to be capital light? And then, with that in mind, just any sort of framework we should think about longer-term CapEx, where it could be versus the last several years?

Gary Friedman, Chairman and CEO

I don’t know for one. I think you are going to see more capital light than less capital light. We don’t have that many bespoke projects on the dock right now. New Jersey is basically capital light. It’s a development deal. So we—New Jersey, yes we are finding.

Jack Preston, CFO

New Jersey is a development deal where we are going to be doing a sale leaseback.

Gary Friedman, Chairman and CEO

Yes. We’ll do a sale leaseback. We’ll get 100% of our capital back out of New Jersey. I think about those as capital light, and we have a little bit of capital we are putting upfront, taking construction loans, and we’ll get all our capital back immediately after we sell it. But I’m just trying to think—most of our big capital jobs, I mean, the one on the horizon I’m thinking about is London. Depending on what we do in Orange County, that will probably be a little heavy—more capital-heavy because it’s going to be a new gallery. Miami could be if we have an opportunity to do a deal we’ve been trying to do for seven or eight years. The performance is going to drive a new credit profile on our company, which is going to make it more valuable development partner for any developer. That’s like, they’ll get better cap rate on our rents and our credits than they will on other tenants. That tends to allow us to get more TI, lower rents, so on and so forth.

Oliver Chen, Analyst

Got it. Thank you so much.

Operator, Operator

Your last question comes from the line of Tami Zakaria with JPMorgan. You may now ask your question.

Tami Zakaria, Analyst

Hi. Thank you so much for taking my question. I have two quick modeling ones. So you mentioned COVID-19 related costs were about 40 basis points of drag in the second quarter. Any guidance on what we should expect for the rest of the year related to that? And then could you remind us how much was the annualized savings from the headcount reduction you did back in April?

Jack Preston, CFO

Hey, Tami, I’ll take that. Look, from a COVID perspective, clearly with the reopening activity in Q2, there is probably the bigger hit is going to be then with the 40 basis points, and so as I think about the rest of the year, it’s some amount less than that. As far as the headcount savings, as Gary talked about, we went from demand being down 40 to demand being up 40, an eight-point swing in our business, so in some ways those savings are sort of minus in Q1 and some in Q2. But we are in investment mode given the trajectory of the business.

Tami Zakaria, Analyst

Got it. That’s super helpful. And then lastly, another quick one regarding the World of RH, when do you expect that to be up and running?

Gary Friedman, Chairman and CEO

I think it’s probably more like spring of 2021, somewhere around there.

Tami Zakaria, Analyst

Got it. Great. Thank you so much.

Gary Friedman, Chairman and CEO

Thank you.

Operator, Operator

Your last question comes from the line of Seth Basham with Redbush Securities. You may now ask your question.

Seth Basham, Analyst

Hi. Good evening. It’s Seth Basham with Redbush. My question is really around the sequencing of all these investments that you are paying—

Gary Friedman, Chairman and CEO

You got a really bad connection. Yes. You’ve got a really bad connection. We can’t understand you on this end.

Jack Preston, CFO

Are you talking about the sequencing of the investments we are making?

Seth Basham, Analyst

Yes.

Jack Preston, CFO

So, how we manage execution risk with the investments we are making?

Gary Friedman, Chairman and CEO

Yes, again, we spend a lot of time deeply thinking about where we allocate our human and financial capital and we think about investing in things that have much greater asymmetrical risk to the upside. So I don’t see any elevated risk level in the investments we are making. The investments we are making, especially in international expansion. But, we think we’ve got that appropriately handicapped, and we are moving at a good pace that’s going to allow us to kind of learn, adapt, and overcome. So, I don’t—the level of capital that we are putting into the European expansion is, if you would have asked me three years ago, I would have said we’re probably going to be putting in two or three times more capital than we are.

Seth Basham, Analyst

Thank you.

Operator, Operator

I will now hand the call back to Gary Friedman, Chairman and CEO for any closing remarks.

Gary Friedman, Chairman and CEO

Great. Well, thank you everyone for your time and interest in the organization. I do want to thank our people and partners of RH in the U.S. and all around the world, just your extraordinary efforts to improvise through this period and adapt and overcome the challenges and bring our brand to life in new and innovative ways. I believe it’s been extraordinary to watch and it’s made us all proud. The next ten years for this organization, the opportunities ahead of us are just extraordinary. If anybody takes a look at what we did in the last 20 years, with no capital and basically trying to dig ourselves out of the grave, you think about what this organization is going to do with the knowledge we’ve acquired, the capital structure we have, the experience and passion we have, and the love we have for what we do. We couldn’t be more excited about what’s next. Thank you everyone. We appreciate your leadership and we appreciate your partnership.

Operator, Operator

Thank you, ladies and gentlemen for joining RH Second Quarter 2020 Earnings Conference Call. Have a great day. You may now disconnect.