Earnings Call Transcript - WSM Q2 2020

Operator, Operator

Welcome to the Williams-Sonoma, Inc. Second Quarter 2020 Earnings Conference Call. This call is being recorded. I would now like to turn the call over to Elise Wang, Vice President of Investor Relations, to discuss non-GAAP financial measures and forward-looking statements. Please go ahead.

Elise Wang, Vice President of Investor Relations

Thank you. Good afternoon. This call should be considered in conjunction with the press release that we issued earlier today. Unless indicated otherwise, our discussion today will relate to results and guidance based on certain non-GAAP measures. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP financial measures and our explanation of why the non-GAAP financial measures may be useful are discussed in Exhibit 1 of our press release. This call also contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which address the financial condition, results of operations, business initiatives, trends, growth plans and prospects of the company in 2020 and beyond, and are subject to risks and uncertainties that could cause actual results to differ materially from such forward-looking statements. Please refer to the company's current press release and SEC filings, including the most recent 10-K for more information on these risks and uncertainties. The company undertakes no obligation to update or revise any forward-looking statements to reflect events or circumstances that may arise after the date of this call. I will now turn the conference call over to Laura Alber, our President and Chief Executive Officer.

Laura Alber, President and CEO

Thank you, Elise. Good afternoon, everyone, and thank you all for joining us. Also on the call with me today are Julie Whalen, our Chief Financial Officer; Felix Carbullido, our Chief Marketing Officer; and Yasir Anwar, our Chief Technology Officer. As you saw in our press release, we delivered an exceptional second quarter, with net comp growth of 10.5%, operating margin expansions nearly doubled that of last year at 13.1% and record earnings growth of over 100%. E-commerce again drove our results, growing 46% in the quarter and our stores performed better than expected, improving throughout the quarter as we reopened. In a time when home is more important than ever, we have taken this opportunity to push our longer-term plans. We will do this in three different ways: first, we will accelerate digital growth and fundamentally shift the channel mix of our business; second, we're focusing our marketing strategy on content and building customer relationships; and third, we're stepping up our profitability and our longer-term earnings outlook. Our digital-first strategy, our trusted brands, our omnichannel approach and our commitment to sustainability will continue to provide a powerful source of differentiation and a competitive advantage for our business. As always, and especially in challenging times, what makes us proud as a company goes well beyond the products we sell. In the last several months, we've witnessed not only the ongoing impact of the global pandemic, but also heartbreaking reminders of racial injustice in our country. As we continue to support COVID relief efforts in our communities, we are also taking action to help drive positive change and create a more equitable, inclusive future for all. We are committing to multiyear donations to racial justice organizations and increasing black representation internally and deepening our diversity and inclusion efforts. These are extraordinary times that require us to continuously evolve and rethink how we best serve all of our stakeholders. We are rising to the challenge, learning, adapting and leading with our values in everything we do. We know thoughtful actions now will shape the next phase of our growth. We are firmly focused on this opportunity and investing in long-term strategies. Now let's talk about Q2 in more detail. While our net comp was at 10.5%, demand comp was substantially higher. Our e-commerce business grew at a net comp of over 46%, and includes purchases made through our omnichannel services, such as curbside pickup and ship from store. We further optimized our digital experience, adding more inspiring content and enhancing the speed and usability of our e-commerce sites. As it relates to our stores, traffic was down, but conversion was up substantially, and our stores outperformed expectations, improving materially from May to July, with third quarter-to-date demand comp improving to negative high single digits. Another highlight of the quarter was a significant expansion in our margins. In addition to cost savings across the business, we substantially pulled back our promotions and leaned into content-led marketing. Our value equation is driving lasting, authentic connections with our customers and also attracting record-high new customers. Our e-commerce performance this quarter was a powerful example of our brand and digital strategies at work. The key drivers of our growth were innovative, sustainable products, engaging content-rich experience, and technology improvements. Our newly designed single page checkout experience, improved site speed, extensive product information page improvements, and our Outward powered Design Crew Room Planner enhancements all drove strong results. Also this quarter, we continue to optimize our digital spend, high-returning investments, leveraging our in-house media capabilities and a strict test and learn agenda across the portfolio. Our content-rich online experience, coupled with our marketing strategies, drove another quarter of very strong customer growth in the e-commerce channel as well as substantial increase in organic traffic. Now let's talk about our brands. Probably the most impressive was the Williams-Sonoma brand, which delivered a record quarter with a net comp of 29.4%. We maximized the shift to cooking at home during the pandemic and executed on a relevant marketing strategy. Customer growth reached over 15% and we saw an increasing number of new and returning customers turning to us for their cooking and at-home dining needs. Our marketing and relevant content strategies were driven by our food-first approach, highlighting ideas, recipes and culinary skills that revolved around eating well at home. To support the vendor community across the country, we added perishable products from local restaurants and increased our assortment of foods to meet the rising demand from our customers. As we look forward, we are excited about the growing interest in cooking especially for millennials, which will not only benefit our business in the short term, but as more people learn to cook, it will become a lifelong skill that should drive our business over the longer term. To continue our growth trajectory in the Williams-Sonoma brand, we are focused on innovative, exclusive products, further improving our digital experience, driving more awareness and interest in cooking at home and optimizing our channel mix. Our Pottery Barn brand also had a very successful quarter, driving a net comp of 8.1%. Our product line continued to improve, with exciting new aesthetics and high-quality sustainable products at great price points. Businesses that saw a particular strength in the quarter were outdoor furniture, work-from-home solutions and products to update family living spaces. Our growth initiatives, PB Apartment and Marketplace, also grew ahead of expectations and contributed meaningfully to our comp growth. The foundation of our Q2 performance was the tremendous results in our e-commerce channel, which reached over 70% of our sales. We continue to improve our site experience by adding inspiring content that drove strong organic traffic, high average order value, and units per order. Our Pottery Barn children's home furnishings business was also strong in the second quarter, with a net comp of 4.8%. It's clear that customers are responding to our sustainable, high-quality products. Our industry-leading assortment of GREENGUARD certified organic and fair trade products are resonating with customers more than ever, especially in our baby business, which continued to accelerate in Q2 as a key growth category. One area of softness has been our backpack business as most schools are starting the academic year with distance learning. But we are seeing a surge in our study-at-home solutions, especially home study furniture across both Pottery Barn Kids and Teen as we become the destination for study from home for kids of all ages. West Elm continues to deliver very strong net comps year-over-year at 7% and on a two-year basis of 24.5%. This brand continues to have high appeal, particularly in our furniture categories where we saw substantial growth in indoor and outdoor as well as key successes in home office, dining and storage furniture this quarter. We substantially enhanced our digital experience in previously retail dominant categories like upholstery, textiles and decorative accessories, which also contributed to our growth online. Also in the quarter, we expanded our Steelcase partnership for the launch of a new furniture collection, aimed at helping our customers work from home comfortably and productively with products that provide form and function. Cross-brand, our business-to-business division reaccelerated substantially to double-digit growth. As you know, this is a large, highly fragmented industry that we are disrupting. We have invested in a strong sales team and support in our infrastructure to turn this opportunity into a $2 billion business. In the second quarter, as states reopened, we were there for our customers in offering a furniture resource that was immediately available for hotels, restaurants, and corporate public spaces. We also continued to see significantly higher sales growth from our cross-brand loyalty key members compared to nonmembers and more customers shopping across our portfolio of brands to furnish their homes. It goes without saying that none of these results will be possible without our people. Their ongoing resilience and dedication have never been more apparent than during these difficult times. We are proud to continue to invest in our associates through several initiatives announced this quarter, including increasing the minimum wage for hourly associates and further enhancements to our employee policy. Building on our strong culture, especially in time of real adversity is not only the right thing to do, but also creates more loyalty and a better experience for our customers. Looking forward to the second half of the year and beyond, we are confident in our growth trajectory. The strong trends from last quarter are continuing. Our product pipeline is one of the best we've ever seen. Our e-commerce initiatives are driving accelerating KPIs and our inventory position will continuously improve. Longer term, we believe the behavioral changes and industry shifts that have emerged from the pandemic will persist and continue to favor our business. Over the past five months, we have seen an acceleration in online sales and with our powerful digital platform and trusted brands, we are maximizing the shift and driving e-commerce sales to new levels. We expect this trend to continue and are executing to a future where stores will be fewer in number but even better in experience. As a result, we are not only more confident in our long-term financial outlook, but in our potential to further expand our profitability. We're investing in the next phase of our growth and the opportunities that position us for accelerated market share gains. And as we look ahead, we are more optimistic than ever about our future.

Julie Whalen, Chief Financial Officer

Thank you, Laura, and good afternoon, everyone. Our second quarter performance demonstrated our ability to deliver strong top line growth at record profitability levels. Our top line acceleration, combined with strong financial discipline, resulted in the highest operating margin we have seen outside of a holiday fourth quarter and earnings per share of more than double last year. This performance reaffirms the resilience of our digital-first model and the enduring appeal of our innovative and sustainable products. It also speaks to the strength of our team and their agility and strong execution during these challenging times. Before I discuss our financial results in more detail, I wanted to give you an update on our response strategy to the current pandemic. As COVID-19 continues to present ongoing challenges, safety and adaptability remain our guiding principles for how we are operating during this time. This has meant heightened safety measures in all of our supply chain operations in our reopened stores and across our corporate offices. From a financial perspective, given the uncertainties in the macro environment going forward, maintaining strong financial health remains a top priority. As we continue to prepare our business to the various economic scenarios that could unfold in the next 6 to 12 months, we are maintaining tight expense control over all nonessential spend, including the elimination of almost all business travel and other discretionary spend. Advertising investments are limited to those initiatives with the highest returns and our capital expenditures have been prioritized for those initiatives that support our e-commerce growth and further our long-term competitive positioning, including investments in technology and our supply chain operations, while reducing our investments in store remodels and relocations. These actions and our culture of strong financial discipline have allowed us to deliver strong profitability despite the incremental operating costs associated with COVID-19. Our liquidity position remains robust as our strong performance year-to-date has generated over $216 million in operating cash flow and has contributed to bringing our cash balance to almost $950 million. And as mentioned on our last call, we further improved our financial flexibility recently by adding $0.5 billion of liquidity through the extension of our $300 million term loan to January 2022 and the addition of a $200 million, 364-day unsecured revolving credit facility. We believe this level of liquidity puts us in a very strong position to continue supporting our operations while investing in the long-term accelerated growth of our business. Now turning back to our second quarter performance. Net revenues in the second quarter grew 8.8% to $1.491 billion, with a net comp growth of 10.5%, the highest quarterly comp we have seen in the past 10 years. Our demand comp, which includes orders placed but not yet filled in the quarter, was substantially higher at almost 19%. This growth was driven by another quarter of incredibly strong e-commerce growth, which accelerated to a net comp of 46.4% and reached almost 76% of our total revenue in the quarter. By brand, Williams-Sonoma delivered a record net comp of almost 30%, driven by triple-digit growth in its e-commerce business. Pottery Barn accelerated to its highest quarterly net comp in recent years of 8.1% and West Elm grew at a net comp of 7% on top of 17.5% last year. Our Pottery Barn children's home furnishings business drove a net comp of 4.8%, with particular strength in our Teen business. And our emerging brands, Rejuvenation and Mark and Graham, delivered another quarter of double-digit growth. Moving down the income statement, gross margin for the second quarter was 37% compared to 35.4% last year. The 160 basis points of expansion in our gross margin was driven by higher merchandise margins and occupancy leverage. Higher merchandise margins resulted from reduced promotional activity as we continued with our shift to a content-led marketing strategy that focuses on the overall value equation of our high-quality sustainable products. Occupancy leverage was driven by higher sales and an almost 6% or $11 million reduction in year-over-year occupancy costs, which includes the impact of reduced rent and operating costs from fewer stores as well as reductions from COVID-19-related rent abatements. And this resulted in occupancy leverage of 170 basis points at $166 million or 11.2% of revenues this year as compared to $177 million or 12.9% last year. The combined impact of these two drivers was partially offset by higher shipping costs. Shipping costs were up in the quarter as a result of the substantial shift to e-commerce sales in the quarter as well as shipping surcharges from our third-party shippers that went into effect from the last month of the quarter. In addition, we continued to be negatively impacted by incremental China tariffs. SG&A leveraged 460 basis points to 23.9% of net revenues compared to 28.5% of revenues last year. This was primarily driven by significant advertising leverage as we further optimize our digital spend on those initiatives that drove high returns in traffic and conversion employment leverage and other leverage throughout SG&A, primarily from higher top line performance, lower variable store payroll, and strong financial discipline. These results led to our record profitability with operating income growth of 108% to $195 million and operating margin expansion of 620 basis points to 13.1%, the highest operating margin we have seen outside of a holiday fourth quarter. This resulted in diluted earnings per share of $1.80, which was more than double that of last year at $0.87. We are very pleased to be able to achieve these levels of profitability while continuing to pay all our corporate associates and store associates who are working over 12 hours per week as well as absorb the incremental cost to help keep our associates and customers safe during this pandemic, including personal protective equipment, frequent cleaning, testing and COVID bonuses for our supply chain associates. Going forward, even though our profitability is at record high, given the uncertainty in the economic environment due to the COVID pandemic, we will continue to eliminate all nonessential spend to ensure that we can continue to fund the operations of our business and to invest through this crisis and emerge as an even stronger and more resilient business, delivering sustainable, long-term profitable growth. On the balance sheet, as previously mentioned, we ended the quarter with a strong cash balance of almost $950 million compared to $120 million last year. This reflects the strength of our cash balance as we enter 2020, the full drawdown on our $500 million line of credit with the support of our banking partners back in March as well as the resilience of our business during this pandemic, generating positive operating cash flow over $216 million year-to-date. This cash balance has allowed us to not only fund the operations of the business but to also invest over $76 million in capital expenditures in support of our future growth and return over $79 million in the form of continued quarterly dividend payments to our shareholders. And given the strength of our business and our current liquidity levels, we have made the decision to return our capital expenditures to pre-pandemic levels. We are also contemplating reducing the amount outstanding on our $500 million line of credit during the third quarter. Our decision-making process will take into account various factors, including the uncertainty that still remains in the macro environment. Moving down the balance sheet, merchandise inventories were $1.042 billion for a decrease of 12.2% compared to last year. This reflects our efforts to cut and push out our inventory purchases to preserve our liquidity at the beginning of the pandemic and the impact of our subsequent substantial e-commerce outperformance in the past two quarters. We have been working closely with our vendor partners, the majority of whom have returned operating at full capacity, and we expect to see continuous improvement in our inventory position. Turning to our outlook for the second half and our fiscal year guidance. We have made the decision not to provide specific full-year guidance at this time, given the uncertainty in the economic environment due to the COVID pandemic. What we do know now is that our business continues to be very strong in the third quarter. Quarter-to-date sales remain robust across all brands and inventory will continuously improve through the balance of the year. However, as much as we expect to improve our overall profitability on the year and going forward, the Q2 level of SG&A is not sustainable. We have significantly reduced payrolls and ad cost spend as our sales expectations were lower than what we actually delivered this quarter. In terms of margin, we believe they are going to continue to be able to reduce promotions as well as deliver occupancy leverage, but shipping will be a major headwind in the back half. Various surcharges have been announced by third-party shippers on all retailers, and these higher costs will affect us in Q3 and more so in Q4 as a result of peak surcharges during the holiday season. In addition, we also expect to incur incremental costs associated with keeping our people and customers safe during the pandemic. Regardless, we remain confident in our ability to drive higher operating margins on the year compared to last year due to our strong performance to date, including our robust e-commerce performance, which we believe will persist through the balance of the year. With regards to capital allocation, given our business has not only recovered substantially but excelled during this pandemic, we have increased our capital investments in high-returning initiatives that focus on digital to drive our long-term growth. And as it relates to our dividend, we have announced today another quarterly cash dividend of $0.48 per share, which speaks to the confidence we have in our business as well as our commitment to shareholder returns. Looking further ahead, as Laura mentioned, we are even more confident in our long-term financial outlook. The renewed appreciation for the home and at-home experiences, such as cooking and working from home, together with the accelerated shift to online for home furnishings, continue to favor our business on all fronts. We are executing with speed and agility to capture the unprecedented opportunity that lies ahead for our company. Our strong performance through this crisis reinforces the relevance of our design-led, sustainable products, and the power of our digital-first platform. With more consolidation expected in our highly fragmented industry, we are confident that we are one of the very few retailers who are best positioned to outperform and to aggressively take share. As a result, we now believe that with the acceleration of our profitable e-commerce business, becoming a bigger part of our total growth, we can drive operating margin expansion. In summary, this past quarter was another powerful display of our competitive strengths that continue to extend our leadership in the home industry. Our innovative, sustainable products, our multi-brand digital-first model, and our content-rich marketing are the reasons why customers are choosing us over the competition. And this, combined with our long-term growth roadmap and strong execution, gives us the confidence in our ability to maintain this growth and increase profitability in the years ahead. Before I turn the call over for questions, I want to thank our associates for their ongoing dedication, flexibility, and resilience during these challenging times. They are at the core of our company's success and our ability to continue to serve all our stakeholders, our customers, our associates and our shareholders. I would now like to open the call for questions. Thank you.

Operator, Operator

We'll take our first question from Adrienne Yih with Barclays.

Adrienne Yih-Tennant, Analyst

Let me say, it was truly a remarkable quarter. Laura, could you or Julie discuss what contributed to the late quarter demand comparison? Regarding the difference between the 19% and the 10.5%, should we consider that as a tailwind in addition to the momentum from the third quarter? Additionally, are you observing trends beyond major metropolitan suburbs regarding the idea of de-urbanization as a sustainable trend? How do you see that evolving in the future?

Laura Alber, President and CEO

Adrienne, it's Laura. We have experienced very strong demand. When the pandemic began, we significantly reduced our inventories, and our business partners were quick to react to that. As a result, when our demand surpassed the inventory levels, we couldn't meet it in some cases and had to place orders. Furthermore, the demand itself has been limited. One could argue that the demand comparisons would have been even higher if we had sufficient inventory. The inventory levels are one aspect. The second aspect is the mix. Our business is growing significantly across various sectors, but especially in furniture, with a particular emphasis on drop ship furniture. We made a strategic decision to transition much of our Asian upholstery, specifically for West Elm, into our Sutter Street operations. This inventory was previously stored in our distribution center, but now we are making it to order, resulting in a natural delay as we shift towards domestic upholstery. Regarding your second question about demographics, we have Felix here. Felix, would you like to discuss our customers and the trends we're observing across the board?

Felix Carbullido, Chief Marketing Officer

Sure. You got it. In terms of urban and suburban, we haven't seen dramatic shifts, but I think what's noteworthy is the shift into a suddenly younger demographic, with the millennial population getting into household formation. We also are seeing a nice growth in condo and apartment dwellers, where I think we've spent a lot of time and energy focused on the size and scale of our furniture as well as our opening price points. I think that, coupled with the fact that we do offer such a great assortment that is sustainably built is part of the attraction of what millennials are finding. So I think those are two trends that we're starting to see from a demographic perspective.

Operator, Operator

We'll go ahead and take our next question from Peter Benedict with Robert W. Baird.

Peter Benedict, Analyst

Julie, could you provide some insight on the impact of tariffs this quarter? Looking towards the second half of the year, I believe the tariff headwind should even out, but I'd like to confirm that. Additionally, how do the shipping costs compare to the tariff impacts? It seems like the shipping costs have essentially taken the place of the tariff headwind. I know you touched on this in your opening remarks, but could you elaborate a bit more to help us understand it better?

Julie Whalen, Chief Financial Officer

From a China tariff perspective, as we've mentioned previously, the year-over-year impact will lessen as the year progresses. There will still be some impact in the latter half of the year, but it will not be as significant as in the first and second quarters. Shipping charges are substantial, and third-party shippers are implementing surcharges on all retailers, which will be a challenge, particularly in the fourth quarter when peak surcharges occur. While we cannot disclose specific amounts due to confidentiality agreements, these challenges will exert pressure on our gross margins. However, we remain confident in our ability to achieve margin expansion through occupancy leverage, anticipated higher merchandise margins, and improving SG&A leverage.

Operator, Operator

We'll now take the next question from Brian Nagel with Oppenheimer.

Brian Nagel, Analyst

Great quarter, congratulations. So I'll stick to the one question rule. Just maybe to elaborate further, just on the trended business through the quarter. I think, Laura, you had mentioned in your comments about how stores were tracking. I'm looking at just how the business trended through the quarter, both in-store and online, in particular, as the stores open, then maybe if you could elaborate further on just what we're seeing so far into the third quarter.

Laura Alber, President and CEO

Yes. I mean, there's nothing really there that would be interesting, I don't think, to you, even if you saw everything, it's very consistently strong as it is still now. Of course, the stores open and then now we have, I think, 22 currently we shut. So that doesn't help when I read you the comp, and I told you earlier where the comp is right now, that includes that. So we have just rock star store people, who are driving business, not just when the stores are open, but also driving online through design and virtual chats, which is quite amazing. And so they're just so dedicated. We're so proud of them. And that's a big part of, I think these results is what they're doing, and they're training. We kept them all working, and they're so valuable to us because they know how to sell furniture, they know our line of furniture and they're able to do it from home. So it wasn't great that stores we closed. That was hard for everyone, but they're making the most of it. So the big question becomes, I think, as we look in the second half, is what happens. Do more stores shut, do more stores open? And that would be a benefit. I think the stores are really an add to our digital-first strategy. And they certainly bring to life our product and allow you to make even a better decision. So we're very hopeful that they'll stay open, and we'll keep everybody safe as we have been with our appointments and our safety protocol and constant cleaning. So we're very optimistic about the back half. We have a lot of things in our favor. And we feel very lucky at the time where I know it's not the case for everyone, and we're very cognizant of that and empathetic about what's going on in the world and doing our part to use our strength to also make a big difference in the communities and with our employees to drive both safety but also mental health and racial justice. So I know it's a lot of an answer to your one question, but it's important to us, and it's our true north right now, and our values are driving our business, and our business is allowing us to do more for our stakeholders.

Operator, Operator

We'll take our next question from Oliver Wintermantel with Evercore ISI.

Oliver Wintermantel, Analyst

Yes. Laura, you mentioned several times in the prepared remarks, like your digital-first strategy and investments in CapEx more on the e-commerce side and the IT investments. What does that mean for your store base? Is there an underlying message that we might see an accelerated store closures? Or I just want to see, in two years or three years, how would your store base look compared to today?

Laura Alber, President and CEO

We have been investing in e-commerce for many years and have developed a sophisticated platform. I will let Yasir elaborate shortly on the enhancements that are driving performance, but specifically addressing your question about our stores, we view them as an addition to our strategy. We have a significant number of leases up for renewal over the next three years, with more than half coming due. This puts us in a strategic position where we can decide whether to keep, close, renegotiate, or relocate our stores. We are focusing on investing in the stores we operate while closing others to ensure we deliver excellent experiences. The mix will continue to shift as direct-to-consumer growth outpaces store sales, providing us with occupancy leverage. Our landlord partners recognize our strength and value us as a partner, which facilitates our ability to maintain high profitability in our locations. If any terms don't align well, we can seek to re-lease those spaces in the market. The pandemic has highlighted our agility and ability to operate effectively, whether our stores are open or our staff are engaging with customers from home, which has proven to be a significant strength. Now, I would like to turn it over to Yasir to discuss our approach to technology and e-commerce investments.

Yasir Anwar, Chief Technology Officer

Thank you, Laura. I'll connect with the stores first and then discuss e-commerce. As I mentioned, we are committed to providing and investing in great tools for our associates, particularly our designers, who have strong ties to the communities. The design tools and experiences Laura highlighted, including virtual chats and appointments, have empowered our designers and enhanced customer engagement. We have also been investing in creating more omni-channel experiences, such as buy online and pick up in store, shipping from stores, shipping to stores, and curbside pickup, especially to ensure customer safety during COVID. This strategy has proven effective for both our customers and associates. Our e-commerce sector has been a significant part of our business and a major growth driver, and we continue to invest in it. During the pandemic, we took a step back to optimize our tech investments and are now returning to our pre-COVID technology spending levels, particularly in e-commerce. I am proud of my technology team, which has shown great agility and commitment amidst the challenges. Many companies rapidly transformed digitally during the pandemic, and we have done the same, achieving results that would typically take much longer. My teams have developed solutions in a fraction of the time, allowing us to quickly test and respond to customer feedback on our platforms. We are enhancing our website and store experiences and driving our decisions through data, analytics, artificial intelligence, and machine learning. This transformation over the past two years has strengthened our talent and technological capabilities, and we believe we are just at the beginning of what we can achieve, with plans for substantial and lasting growth beyond COVID and into the future.

Operator, Operator

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

Christopher Horvers, Analyst

Great quarter. I have a couple of questions regarding margins. First, in the short term, do you anticipate a decrease in gross margin for the second half while still improving overall operating margin on SG&A? Additionally, concerning SG&A, given some of the events in this quarter, what should we consider the appropriate baseline for our calculations? What would you classify as one-time costs as we plan for the normal seasonality of SG&A expenses?

Julie Whalen, Chief Financial Officer

Chris, this is Julie. I'll take that. From a gross margin perspective, we're really excited about the expansion we experienced this quarter, which is due to higher merchandise margins and occupancy leverage. We believe this trend will continue. While we anticipate increased pressure from shipping costs, we are not specifically forecasting where the gross margin will land, but we are pleased to achieve gross margin expansion despite these shipping challenges. Our SG&A has been leveraged for a while, and we expect that to continue. We are maintaining strong cost controls by eliminating all nonessential spending and being very strategic about our expenses, as we prepare to invest in the business and gain market share moving forward. However, Q2 showed some of the lowest levels we've seen. As we approach the latter half of the year and the peak holiday season, we may need to increase spending on advertising and variable store payroll. Therefore, I wouldn't use our Q2 levels as a basis for future modeling, but we do anticipate SG&A leverage and expect to see operating margin expansion.

Operator, Operator

We'll go ahead and take our next question from Chuck Grom with Gordon Haskett.

Charles Grom, Analyst

Just a couple for me. On the spread again between net comp and demand, can you just help us think about that from a banner perspective? And I guess how that's going to impact third quarter results? Do you expect to recapture that demand comp? And then on the long-term guide, can you provide us some guidepost on where you think operating margins can go to? Or maybe said differently, what you think the flow-through will look like going forward?

Laura Alber, President and CEO

We are not ready to provide the guidance you're looking for. Previously, we mentioned that our operating margin at 8.6% would remain stable while we focused on increasing sales. Now, we are indicating that not only will we drive sales, but we also plan to increase profits beyond the 8.6%. That's all we can share at this moment. Regarding the different brands, the dynamics with furniture result in a wider spread for the furniture brands. Williams-Sonoma has certain aspects to consider, and since furniture represents a smaller portion, the other brands show higher demand compared to their net performance than the Sonoma brand. Now, for the third quarter, what was your question again?

Charles Grom, Analyst

I would like to know what the quarter-to-date account is, but I understand you're not going to provide that information. When do you expect to recapture it? How long does it typically take to achieve that?

Laura Alber, President and CEO

Well, I remember, you ask me where the net comes. I mean it's an interesting question. If demand continues to exceed our expectations, then the inventory constraint will just be kicked down the line because you'll run out faster. So if everything stuck to where we think it's going to be, you'd see recovery in the back half, all the way into next year, by the way. But if we beat the numbers again, then you're going to be hearing me say this next time. The numbers are within what you're seeing us hit now. There is some variation here and there, but there was in the same range of what the comp is that we just share with you for Q2. I hope that helps.

Operator, Operator

We'll go ahead and take our next question from Seth Basham with Wedbush Securities.

Seth Basham, Analyst

Great quarter. My question is around SG&A. Clearly, over time, you're planning to reduce your store footprint, which will produce your occupancy costs, but also take out store labor. As it relates to store labor in the interim, would you plan to reduce that even ahead of store closures because of reduced traffic levels?

Laura Alber, President and CEO

No. In fact, it might be the opposite because things get more complicated. The abating factor is that we can't have that many people in our stores. So even if the demand is there, we can only have so many people. But you should not model that store labor will leverage any further. Holiday will cause us to bring more people in because the sales are higher.

Seth Basham, Analyst

Got it. Okay. That's helpful. And if I could just follow-up, if you don't mind, as it relates to SG&A, thinking about the go-forward run rate. Clearly, we're talking about levels that are higher than the second quarter. Just to reframe the question that others have asked, we're thinking about it on a year-over-year basis, would you expect SG&A to be down year-over-year in the back half of the year?

Laura Alber, President and CEO

SG&A down. We expect SG&A in the back half to be down to last year's SG&A in the back half.

Operator, Operator

We'll go ahead and take our next question from Brad Thomas with KeyBanc Capital Markets. If I could just follow-up, as it relates to SG&A and the go-forward run rate, we're obviously talking about levels that are higher than the second quarter. To reframe the question that others have asked, we're considering it on a year-over-year basis. Would you expect SG&A to decrease year-over-year in the second half of the year? Laura Alber, President and CEO, responded that they expect SG&A in the back half to be lower than last year's SG&A in the same period.

Bradley Thomas, Analyst

Congratulations from me as well. I want to ask about the dynamic of sustainability and pull forward that we're all asking of many home-related companies right now. I've been asked by investors, how many bread makers does the American need to buy? I know the belief that these trends are probably pretty sustainable. But I was hoping you could share some more data on maybe how the customer is shopping you now and what you're seeing in terms of repeat purchases and the ability to cross-pollinate customers across your brands?

Laura Alber, President and CEO

Our cross-brand performance has reached new heights, driven by our key rewards and cross-brand marketing strategies. Initially, we noticed strong sales in specific categories like bread makers and ice cream makers, but now we're seeing broad-based strength. Consumers are increasingly focused on enhancing their home's comfort, and our curated products and trusted brands are highly relevant to them. We're committed to delivering what they expect, backed by our support. This positions us well with a significant competitive advantage that will continue to propel our results.

Operator, Operator

We'll go ahead and take our next question from Michael Lasser with UBS.

Michael Lasser, Analyst

Laura, you probably saw some of your competitors report like 80% growth at Wayfair, Target comping up 30% in the home category. Why do you think in light of those, you might have lost share in the quarter? And also, how much demand comp was realized that was coming out of 1Q into 2Q to contribute to the comp in 2Q?

Laura Alber, President and CEO

I need to revisit that aspect. However, when comparing our profit levels to last year and those of our competitors, we want you to focus on that first. We could increase sales further, but our inventory limitations have held us back. Our priority is to create a great customer experience, minimizing back orders. We understand which items customers are willing to wait for, but excessive back orders lead to dissatisfaction. We are keen on gaining market share. I've mentioned before that it's not an either/or situation for us at Wayfair, especially as the brick-and-mortar landscape evolves and smaller players emerge. A few companies will succeed, and we're among them, given that retail has historically captured 80% of the market, which is changing permanently. Customers will turn to us and other retailers. Our key differentiator is that we offer curated brands, eliminating the need to sift through countless products, ensuring quality and sustainability, and providing fair value, all of which are essential to our customers. We achieve this by designing and producing our own products, enabling us to offer competitive pricing. The thought of their growth being slightly higher doesn't concern me. Regarding demand, let me clarify your question. Are you asking if we fulfilled demand from the previous quarter? We will always fill demand from earlier, but we currently face a greater gap than we can accommodate, resulting in a negative impact on our Q2 net.

Operator, Operator

And we'll go ahead and take our next question from Anthony Chukumba with Loop Capital Markets.

Anthony Chukumba, Analyst

Let me also congratulate you on a strong quarter. My question is about your e-commerce penetration, which appears to be at an all-time high. It seems like that's where the business is evolving. Historically, you've had a roughly equal split between in-store revenues and direct-to-consumer sales. Looking ahead, what do you envision as a sustainable long-term mix? Would it be more like a 60-40 distribution between e-commerce and stores, or perhaps 70-30? How do you view this?

Laura Alber, President and CEO

I think the best way to approach this is to consider how large the overall business could potentially be. Clearly, we are exceeding our targets when it comes to e-commerce as a proportion of our total sales, and that is where the growth will originate. Our results indicate that our digital-first platform has significant capacity to meet our customers' online demand. Additionally, the situation will be influenced by the number of stores we close and how our landlords manage our leases in the future. However, our physical stores remain crucial in helping us stand out to customers, providing an experiential shopping atmosphere and offering the convenience of omnichannel services. This effectiveness brings products closer to our customers, especially as we navigate changes in the market. Currently, we are at 70%. Is there a possibility of going higher? Yes, but we may also see better-than-expected performance from our stores in the latter half of the year.

Operator, Operator

We'll go ahead and take our next question from Cristina Fernández with Telsey Advisory Group.

Cristina Fernandez, Analyst

I'd add my congratulations for the quarter. I wanted to ask about the holiday season. How are you planning it differently this year given the cadence of events and store limits? And do you think merchandise that has worked so far will continue to drive that demand through the holiday season?

Laura Alber, President and CEO

Yes. Thank you for the question. Of course, yes. We always know that getting a running start in the holiday with both customers, new customers, but also products that are selling, makes for a better season and also gives us the ability to get the inventory levels right because we can chase it. So that is all good. In terms of the competitive posture and how we're playing the holiday season, I hesitate to go through that now because it is so competitive. But we're very optimistic and planning for a variety of different outcomes that could occur, as I mentioned earlier, in case we have a second wave of store closures, how will we handle that. And if we continue to beat demand in DTC, how we make sure that we get it to our customers on time.

Operator, Operator

We'll go ahead and take our next question from Bobby Griffin with Raymond James.

Robert Griffin, Analyst

I want to extend my congratulations on a successful quarter. Laura, from a broader perspective, do you believe the pandemic has postponed any new product innovations or developments that the industry normally experiences? Once the industry is able to recover from the current demand and supply chain issues, do you think we will return to our usual product introduction cycle as seen in the past?

Laura Alber, President and CEO

We are not experiencing delays in our product introductions. I can't speak for others, but we are on track. Our teams have been successfully working virtually and approving samples via Zoom, which has been impressive. So, we are not behind. In fact, we might be gaining an advantage over others who are less adaptable.

Operator, Operator

We'll go ahead and take our next question from Marni Shapiro with Retail Tracker.

Marni Shapiro, Analyst

It's really outstanding. Could you provide an update on some of your smaller brands, specifically Mark and Graham and Rejuvenation? Also, could you give us an update on your international businesses? I don't recall hearing about that.

Laura Alber, President and CEO

Yes. Sure. Thank you for that question. So Rejuvenation delivered a very strong quarter, with strong customer engagement, big time increase in traffic. And the stores have shown vast improvement, the AOV is up substantially. And as I said, customer growth, you can imagine with customers spending more time in the home is focused on home projects. We've seen our core categories like lighting, hardware, and kitchen and bath, all drive strong quarter-to-date double-digit comps. And we saw the furniture that was impacted more greatly because of the store closures, rebound later in the quarter. And we remain really focused and bullish on this strategy, accelerating our digital growth, optimizing our marketing strategy, and accelerating our contract trade strategy, which is a big part of this business. Mark and Graham also had a very strong quarter despite the fact that they are not as focused on home, which is quite interesting. And they continue to pivot that merchandising strategy to areas that are the strongest and incremental categories like pet and baby are working. And we're really focused on optimizing the customer site experience there. We're updating it with the new creative overhaul, cleaner personalization experience, et cetera. In terms of global, this is a good one because we did see some weakness in Q2 due to franchise orders being down, but that quickly changed directions. And now we are shaping orders. And just to reiterate, our strategy for global is franchise. It's not company-owned. As it relates to our company-owned though, Australia is doing pretty well. The U.K. is under a little pressure. And we are well positioned to continue to drive e-commerce across our franchises and our company-owned. The thing you didn't ask, which we did mention was B2B, which is quickly becoming a very sizable business for us and one that I think people questioned whether would stay healthy during the pandemic, and we are gaining momentum and confidence in this business with very large companies who are investing with us and our speed to market is a huge competitive advantage here. Our team is very aggressive, out hunting new deals all the time versus just waiting for them to come in, and that's a big change, frankly. And then also, people love that they can shop across brands, with a single person and have us coordinate delivery for them. So it makes it a lot easier versus going through a bunch of different purveyors. So thank you for the question, Marni.

Operator, Operator

That does conclude today's question-and-answer session. I'd like to turn the call back over to Laura Alber for any additional or closing remarks.

Laura Alber, President and CEO

Well, thank you all for joining us today. Thank you for your thoughtful questions. And we look forward to seeing you and talking to you soon at the next quarter earnings results.

Operator, Operator

Once again, that does conclude today's conference. Thank you so much for your participation. You may now disconnect your phone lines.