Earnings Call Transcript - WSM Q3 2020

Operator, Operator

Ladies and gentlemen, welcome to the Williams-Sonoma, Inc. Third 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

Thanks, Elise. Good afternoon, everyone. 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, Chief Technology Officer. On today's call, I want to talk to you about our outstanding third quarter results and more importantly, our company's distinctive positioning and long-term growth prospects. In the third quarter, sales, again, outperformed expectations with demand comp up nearly 31% compared to a net comp of 24%, driven by strength across all of our brands. E-commerce accelerated sequentially to a record net comp of over 49%, and we were pleased to see our store performance improved throughout the quarter to a net negative 11% comp. Even more encouraging is the retail demand comp at negative 4%. And we delivered these sales more profitably with operating margins reaching record levels, expanding to 15.7% versus last year's 7.6%. All of our brands outperformed. Pottery Barn delivered a net comp of 24.1%, driven by double-digit comps in all divisions. Growth initiatives, including PB Apartment and Marketplace, continue to build momentum, growing more than 100% again this quarter to reach nearly $200 million in sales year-to-date. Our Pottery Barn Kids and Teen business grew at a net comp of 23.8% with accelerated growth in all areas. We also saw a longer tail in our back-to-school business, with our Gear and study-at-home solutions delivering a strong finish to the season. The Williams-Sonoma brand delivered another record quarter with a net comp of 30.4%. This is a business that has always had a smaller online percentage compared to our other brands, and this represents a big opportunity. Our initiatives in e-commerce and our real estate optimization strategies are driving our channel mix shift. We're also pleased to see our stores performing better than expected in the Williams-Sonoma brand. And finally, in our West Elm brand, we saw a significant pickup in net comp in Q3 to 21.8%, driven by strong growth in all major categories as well as the traditional retail-dominant categories of textiles and decorative accessories. As we enter the fourth quarter, holiday is off to a strong start across all of our brands. We are seeing earlier sales in holiday products than in years prior, and our teams are prepared and ready to meet this demand by moving up launch dates and marketing for our holiday merchandise. Our supply chain team is also working diligently to meet this elevated demand. Despite industry-wide capacity and shipping constraints due to COVID-19, our teams are leveraging our scale and unique business model to do everything we can to ensure the best customer experience this holiday. Our global sourcing team has been partnering with our vendors to expand capacity, leveraging our in-country presence and long-standing vendor relationships. Our transportation team worked quickly and aggressively early this year to further diversify our carrier network, and we believe we have successfully secured parcel shipping capacity for the elevated volumes we expect to drive this holiday. We will also be maximizing our omni-channel capabilities such as ship from store and buy online, pick up in store to supplement our supply chain fulfillment capacity. We expect our omni services to fulfill up to 20% of our expected total DTC volume this holiday. These results demonstrate our company's ability to deliver long-term profitable growth post-pandemic. Our company's mission is to enhance the quality of people's lives at home. We have built our business with this mission at the forefront, investing in areas that matter most to our customers. These include high-quality, well-designed, sustainable products at a great value because of our scale and vertical supply chain; inspiring marketing; and the convenience of our high-touch digital-first omnichannel experience. And this, combined with our loved brands that serve a wide range of customers across aesthetics and price points, is our distinctive positioning and our competitive advantage. No one else in the market is doing what we are doing. Our mission also extends to how we take care of our employees, our vendor partners, our customers, and our shareholders. At Williams-Sonoma, Inc., and across our brands, we are good by design from managing resources responsibly, caring for our people, and leading with our values. In a year marked by social, environmental, and health crises on a scale not previously seen in our lifetime, these values are more important than ever. And we are proud to be leaders in our industry through our financial performance, our impactful ESG programs, and how we have taken care of our people while increasing returns to our shareholders. As we look at our business today, there are three key accomplishments that we believe will deliver significant growth for the future. First, we've been acquiring new customers in our digital channels at a rate of over 30% year-to-date, a significant acceleration compared to previous years. While we have seen this in the past, it generally foreshadows strong business in the future. This is particularly notable as stores have historically been the key driver of new customer growth. This overall increase, despite less store traffic, shows the effectiveness of our current digital marketing strategy in acquiring new customers. Second, and even more encouraging, is that we are attracting these customers while deliberately shifting away from promotions towards marketing that has inspiring content and is brand building. This should mean that we have higher retention of these customers post-pandemic. And finally, all of our brands are resonating with younger generations. Over the last three years, this cohort has driven the majority of our new customer growth. And year-to-date, millennials represent nearly 50% of our sales from new customers. This, of course, has not been a coincidence as our value proposition and competitive strengths are highly appealing to younger generations who have a strong affinity for design, engaging content, and accessible sustainably made products. In addition to these three internal positive indicators, industry trends also support our longer-term growth. These industry trends include the rapid shift to e-commerce, further industry consolidation, the generational shift to a younger customer, the importance of sustainability and consumer purchasing decisions, and the increase in remote work and population mobility. We believe that we are one of the few retailers best positioned to take market share in the years to come. Not only is our value proposition relevant and compelling, our multiyear growth strategies and investments are working. We will continue to prioritize e-commerce growth and push the natural shift in our channel mix. We will also expand into product whitespace and aggressively support the growth of new businesses and opportunities within our brands and cross-brand. For example, our business-to-business opportunity. We believe that Williams-Sonoma, Inc. business-to-business will be our next $1 billion business within the next five years. The B2B market is large and highly fragmented with a market size of $80 billion in the U.S. alone. Our competitive advantage is that we have eight unique brands, in-house product development capabilities, and a sustainable supply chain, which allows us to simplify the customer experience for our B2B customers. Since the launch of this business in 2019, we have gained traction in all areas with average order size and repeat purchases both growing double digits, and major project wins in residential, commercial, education, healthcare, and hospitality verticals. Our number of contract accounts is up 50% versus last year. We are aggressively pursuing this growth opportunity and are on track to drive over $300 million in sales this year, which represents strong double-digit growth compared to last year. Another key growth driver that we believe is underappreciated is our global opportunity. Our expansion to date has proven that we can grow profitably with low capital investment, further supporting the viability of profitable growth in this business for us, and the estimated $450 billion global home furnishings market. To reiterate, our strategy for expansion is through a franchise model, and we look forward to growing our presence in our current markets and our launch in India next year. In summary, our vision is to own the home. And with our distinctive positioning, we will only become more relevant. We have brands that serve a wide range of customers across aesthetics and price points. And unlike our competitors with undifferentiated marketplace models, we have always been different. We design the vast majority of our products. And for those that we carry from third-party vendors, we ensure that they are high-quality, sustainable, and the best value in the market. We offer service that is high-touch, both in person and virtually because of our impactful stores and associates and our sophisticated e-commerce platform. And most importantly, the shift to e-commerce favors our business and provides a long runway to gain market share. We have the strategies, the team, and the world-class platform to successfully execute on our growth opportunities. And we are confident that we will continue to drive accelerating sales growth with increasing profitability and evolve into an even more attractive business for our stakeholders during and post-pandemic. Before I turn the call over to Julie, I want to thank our team. We have been operating in this challenging environment for more than eight months now, and our team has been an unwavering source of energy, creativity, and determination. We are deeply appreciative of their remarkable performance. And with that, I'd like to pass the call over to Julie to discuss our financial results for Q3 and our outlook for Q4 and beyond.

Julie Whalen, Chief Financial Officer

Thank you, Laura, and good afternoon, everyone. We are pleased to report another quarter of record growth and profitability. It is clear our mission and value proposition are increasingly more relevant, and our growth strategies are continuing to gain traction. This, combined with our world-class platform that we have been investing in over time, the agility and strong execution from our team, and a culture of strong financial discipline has enabled us to capture market share and expand profitably. We are so proud that our ongoing financial strength has allowed us to continue to take care of our stakeholders, our associates, our customers, our communities, and our shareholders during this unprecedented time. Turning to the third quarter financial results. Net revenues grew 22.4% year-over-year to $1.765 billion, with net comp growth accelerating to 24.4%. This strong performance was driven by all of our brands and at a higher margin than we have seen as we have been materially shifting away from promotions. Our demand comp, which includes orders placed but not yet filled in the quarter, was again higher at almost 31% as sales continue to outpace our expectations. Our accelerated growth was driven by a 49.3% comp in e-commerce and a material improvement in our retail revenues. All brands sequentially improved to strong double digits this quarter. Williams-Sonoma delivered another record net comp of 30.4%. Pottery Barn accelerated to a net comp of 24.1%, the Pottery Barn Kids and Teens business grew at a net comp of 23.8%. West Elm delivered a comp of 21.8% on top of 14.1% last year. And our emerging brands, Rejuvenation and Mark and Graham, delivered another quarter of strong double-digit growth. Moving down the income statement. Gross margin expanded by 400 basis points to 40% in the third quarter. This was driven by higher merchandise margins and occupancy leverage. Higher merchandise margins resulted from reduced promotional activity as we continue to shift to a content-led marketing strategy that focuses on the overall value creation of our high-quality, sustainable products. Occupancy leverage was driven by higher sales and an almost 3% or $5 million reduction in year-over-year occupancy costs, which includes the impact of reduced rent and operating costs from fewer stores. This resulted in occupancy leverage of approximately 250 basis points at $174 million or 9.9% of revenues this year as compared to $179 million or 12.4% last year. This occupancy leverage, combined with our merchandise margin expansion, was partially offset by higher shipping costs year-over-year, driven by the substantial shift to e-commerce sales in the quarter as well as shipping surcharges from our third-party shippers. We were pleased to see that even with these higher shipping costs, our selling margins, which include our merchandise margins and shipping, expanded by 150 basis points. This, plus our occupancy leverage, allowed us to deliver our highest ever third quarter gross margin rate. SG&A leveraged 410 basis points to 24.3% of net revenues compared to 28.4% of net revenues last year. This was primarily driven by significant advertising leverage as we further optimized our digital spend on those initiatives that drove high returns in traffic and conversion, employment leverage, and other leverage throughout SG&A from higher top line performance, lower variable store payroll, and ongoing strong financial discipline. These results led to another quarter of record profitability with operating income growth of 152% to $277 million and operating margin expansion of 810 basis points to 15.7%. This resulted in diluted earnings per share of $2.56, which grew 151% or more than double that of last year at $1.02. We are proud to achieve these levels of profitability while continuing to take care of our associates with heightened safety protocols, such as personal protective equipment, frequent cleaning, and COVID testing as well as higher employment costs from providing pandemic bonuses for our store associates and increased hourly wages for our distribution center associates. On the balance sheet, we ended the quarter with a strong cash balance of $773 million compared to $155 million last year. This reflects the strength of our cash balance as we entered 2020 as well as the resilience of our business during this pandemic, generating positive operating cash flow of almost $727 million year-to-date. Our strong liquidity position allowed us to fund the operations of the business to invest nearly $125 million in capital expenditures in support of our future growth and to return nearly $117 million in the form of continued quarterly dividend payments to our shareholders. Additionally, this quarter, as previously announced, we also repaid in full our short-term borrowings under our $500 million revolver, reinstated our share repurchase program, repurchasing $109 million this quarter alone, and we also committed to a quarterly dividend increase of 10% effective with our next dividend payment in the fourth quarter. These decisions reflect our confidence in the long-term growth and profitability trajectory of our business and our commitment to maximizing returns for our shareholders. Moving down the balance sheet. Merchandise inventories were $1.125 billion for a decrease of 10.6% year-over-year versus a 12.2% decline in the second quarter. As Laura said, we have been working closely with our vendor partners to manage through the COVID disruptions and to expand capacity. But given the ongoing elevated demand and our high back orders, we do not expect to be fully back in stock until the second quarter of next year. What this means is that we have 700 basis points of demand sales from Q3 that we expect to fill in future quarters when the inventory is available and delivered to the customer. We are pleased that our customers have continued to want their orders delivered even if they have slight delays. Turning to our outlook for the rest of the fiscal year. It is clear from the latest surge in COVID infection rates across the country and globally that there is still, unfortunately, significant uncertainty related to this pandemic. As a result, we will not be providing specific sales and earnings guidance for fiscal 2020. But directionally, I can tell you our business continues to be strong across all brands three weeks into the fourth quarter. The momentum in our business is continuing. From a gross margin perspective, with lower levels of planned promotions, we expect merchandise margins to continue to expand year-over-year. We also expect occupancy leverage to continue, driven by the cost savings from the leases that we have already renegotiated year-to-date as well as the closure of unprofitable stores and final rent abatement negotiations. This will be partially offset by higher shipping costs that will continue to be a headwind in Q4 given the anticipated elevated levels of e-commerce sales and peak surcharges that will come into effect during the holiday peak selling season. In terms of SG&A, we expect to incur incremental costs associated with keeping our people and customers safe during the pandemic as well as additional supply chain employment costs. At the same time, we will continue to exercise strong cost discipline in all areas of nonessential spending to ensure that we can remain resilient during this period of uncertainty. As a result, on the year, we remain confident in our ability to drive substantial operating margin expansion versus last year due to our strong performance to date and the likely continuation of robust e-commerce trends through the balance of the year. With regards to capital allocation, in addition to the increased quarterly dividend and reinstated share buyback program, we have increased our capital investments in high-returning initiatives that focus on digital to drive our long-term growth. We expect our total CapEx this year to be back relatively in line with historical levels. As far as our longer-term outlook, we remain confident in our ability to drive strong top-line results while continuing to deliver operating margin expansion. It was clear pre-pandemic that our strategies for growth were working with accelerated comps through 2019 and an almost 10% comp heading into March before the pandemic accelerated. These successful growth strategies, combined with our strong new customer count and growing loyalty customer base, the fundamental shift of business online as well as our leadership in sustainability, which has become increasingly more important to the consumer, reinforces our ability to continue to drive strong top-line growth post-pandemic, and we expect to deliver this growth with further operating margin expansion. As you know, we have a highly profitable e-commerce business with an operating margin that, over the last 10 years alone, has averaged over 21%. Unlike many retailers who are still in the process of scaling their online business, we have already made the significant investments in our e-commerce platform over many years, which enables us to drive significant leverage throughout as we further scale our e-commerce business. This is a significant competitive advantage that speaks to the earnings power of our digital-first model. As we continue to prioritize e-commerce growth and structurally shift the channel mix of our business, we will drive material occupancy leverage as we renegotiate more favorable leases and close unprofitable stores. We have half of our leases coming up for renewal in the next three years, and we'll be looking at each lease and keep only those stores where the economics of the deal make sense and where they are brand enhancing. Our plan, currently, is to close approximately 40 stores this year. Stores continue to be a competitive advantage as people like to see merchandise in person. However, we are anticipating a future with fewer, better, more profitable stores. We are also planning for merchandise margin expansion by not only continuing to deliver more relevant content-led marketing but by also building more value into our product line, which will enable us to be less promotional. Our strong product line and loved brands give us pricing power that others don't have because their products are undifferentiated. This is very important as we expect costs globally to increase over the next several years. Another important driver of long-term operating margin expansion is SG&A leverage. And while there may be some increases in some lines, our shift to digital gives us confidence that we will be able to leverage throughout SG&A and deliver operating margin expansion post-pandemic. In summary, our third quarter results continue to demonstrate the power of our distinctive position and driving strong profitable growth. Customers come to us for our in-house design products that are high-quality, sustainably made, and have the best value in the market. They come to us for our brands that serve a wide range of aesthetics and price points. They come to us for our inspiring content that is engaging and speaks to their needs. And they come to us for the convenience that we offer with our omnichannel model. These competitive advantages, combined with our long-term growth strategies and proven execution, give us the confidence that we'll continue to drive long-term strong sales and earnings growth and further returns for our shareholders, both this year and post-pandemic. And now I would also like to thank our associates. Without their unwavering commitment to all our stakeholders, none of this would be possible. I would now like to open the call for questions. Thank you.

Operator, Operator

And first, we'll go to Oliver Wintermantel from Evercore ISI.

Oliver Wintermantel, Analyst

Congratulations on this performance this quarter, again. I had a question, Julie, you mentioned shipping costs are staying high because of the shift to e-commerce, but then also for the rates of shippers. Do you expect that to actually increase in the fourth quarter versus the third quarter? And how do you plan to offset that?

Julie Whalen, Chief Financial Officer

We do because there's peak surcharges that come in during the holiday selling season. But what I will say is that our supply team has done an unbelievable job of coming up with alternative carriers that we can use to help take care of the capacity constraints we have as well as the higher prices. So it won't be a full offset, but they certainly are doing everything they can to help mitigate it. And then, of course, along with the merchandise margin expansion, the occupancy leverage, we should still see gross margin expansion regardless of the shipping costs.

Oliver Wintermantel, Analyst

Got it. Regarding that, could you provide an update on what portion of your COGS is coming from Asia and how much is produced in the U.S.?

Julie Whalen, Chief Financial Officer

I don't think we've ever disclosed that. I think what we've said in the past is that we've been moving goods out of China to other locations, other Southeast Asian locations. And so our goal was to get the amount that we had produced in China down by about 50% by the end of this year, and we're still on target to do that.

Operator, Operator

Next up is Kate McShane, Goldman Sachs.

Katharine McShane, Analyst

A big question last quarter was the difference between the demand comp and the comp that you reported. And just what the demand comp would look like over time? Or what it could contribute to comp over time? So now that we are a quarter in here, I wondered if there was a way to quantify what the gap or what the demand comp, what part of it was made up during the third quarter? Was it a big contributor to the acceleration in the comp that you saw from Q2 to Q3? And if not, just what was the unlock for the meaningful acceleration in your comp in Q3 versus Q2?

Julie Whalen, Chief Financial Officer

The comparison is fueled by strong performance across all brands. Our products are selling well, and we're seeing excellent performance overall. Looking back at the last quarter, there was an 800 basis point difference between demand and net sales. This quarter, it dropped to 700. As we receive more products and continue to improve our top-line performance, we expect to make considerable gains each quarter. The teams have been actively partnering with our vendors, and we have strong relationships that help us restock quickly. However, due to the high demand from our customers, restocking will take a bit longer than anticipated, likely extending into the second quarter of next year. Thankfully, our customers have been understanding about these delays. The positive takeaway is that we anticipate the gap between demand and net sales will close in upcoming quarters.

Katharine McShane, Analyst

My follow-up question to that is, is there a potential for furniture mix to be higher in Q4? Just again, with some of these delays in the order as things get pulled or pushed back, could you see more furniture mix in Q4? And would that be any kind of headwind in addition to maybe the higher surcharges you would see in the fourth quarter?

Laura Alber, President and CEO

It's not a challenge. Typically, when we discuss demand comparison in Q4, the non-furniture category, as a percentage of our total, increases slightly due to more gifting and the additional presence of Williams-Sonoma. However, it’s true that we have a lot of new furniture arriving, and we are optimistic about being able to utilize much of it. Therefore, it should not be a challenge. Furniture is a highly profitable and excellent business for us, and we are excited to serve our customers and provide them with products, regardless of the quarter.

Operator, Operator

We'll go next to Chuck Grom from Gordon Haskett.

Charles Grom, Analyst

Great quarter here. My question is on the margins and the outlook and the opportunity. You've got really three big buckets: reduced promotions, lower occupancy dollars, and more efficient ad spend. So when you think ahead, and this isn't really about the fourth quarter but really more in the next couple of years. How would you rank those opportunities? What has you most excited? What categories do you think you have the most visibility on?

Julie Whalen, Chief Financial Officer

I believe the excitement stems from a comprehensive shift towards online business, which is a trend seen throughout the industry. As we transition to e-commerce and welcome more new customers in this space, we anticipate significant growth in our e-commerce segment. Historically, our operating margins have averaged above 21% over the past decade, which indicates strong potential for margin expansion moving forward. Additionally, we are optimistic about our merchandise margins and our ability to reduce promotions through a content-driven marketing strategy. This trend is expected to persist. We're also working on achieving better occupancy costs through renegotiated leases that are due for renewal in the next three years. We plan to close any unprofitable stores while retaining the successful ones, ensuring they meet our higher profitability standards. As we shift further towards e-commerce, we expect our SG&A expenses to scale effectively. Overall, we see significant opportunities for profitable growth, driven by our commitment to e-commerce, which we believe is a lasting change.

Charles Grom, Analyst

That's helpful. I have a quick follow-up. One of the concerns about the story is the sustainability of some of the trends we're seeing today. I'm curious how you would rank them in terms of their staying power over the next couple of years, particularly the trends driving the strong demand.

Laura Alber, President and CEO

I want to remind everyone that before the pandemic, we were achieving close to a 10% comparable store sales growth. We saw great opportunities in our business and are very optimistic about our future prospects. We have clearly benefited from the stay-at-home trend, but even before the pandemic, larger trends were favorable for us, particularly with the shift away from brick-and-mortar retail. Historically, 80% of sales were made in retail stores, but we recognized that this was changing. As consumers increasingly turn to online shopping and younger demographics gain more purchasing power, we anticipated that we would capture significant market share. Our unique positioning gives us a competitive advantage. While there are many online retailers, we cater to a diverse range of customers in terms of aesthetics and pricing. Our consumers love our brands, and we create our own products. This distinguishes us from many other large companies, which will also succeed, but customers will choose us for our unique, accessible, and sustainable in-house designs that can't be found elsewhere. This alignment with consumer values is compelling for both current and future customers. We are confident about attracting consumers to shop with us. From a financial perspective, we have highlighted the parts of our business that are not only reliable but also promising. We have invested heavily in e-commerce, allowing our platform to handle significantly more volume without requiring substantial additional investments, unlike other retailers that only recently began investing. We envision ourselves as a digital-first company with outstanding physical stores, becoming more profitable than ever. We anticipate that e-commerce will comprise around 70% of our business, which is a significant milestone for our company's financial profile. These are the aspects that excite me.

Operator, Operator

Next from Morgan Stanley is Simeon Gutman.

Simeon Gutman, Analyst

It was a strong quarter. Laura, let’s break this down into two parts. First, you mentioned acquiring customers, which is likely to benefit you in the future. Can you share what insights you're gaining from an operational standpoint, such as inventory management, markdown management, or product movement that will enhance your position post-pandemic? Julie, you brought up the difference between demand and actual comps, which narrowed by one point. Should we interpret this as a non-issue, or does it indicate that the supply chain is improving or that demand is gradually slowing?

Laura Alber, President and CEO

What was the last thing you said? Demand has slowed, or what did you say?

Simeon Gutman, Analyst

So with the spread between the actual comp and the demand comp. If it narrowed by one point, it could just be a non-event. But let's say, if we see that narrow by a few points going forward, can you attribute it more to the supply chain catching up to the demand? Or does that mean the demand slows a little?

Laura Alber, President and CEO

Okay, I understand you now. Thank you. Difficult times often make you stronger, and it's essential to evaluate what to invest in. We have been focusing on the areas that are most important to our customers and recognizing the value of our workforce. When you support your employees, they can achieve remarkable things for you. This principle has been reinforced for us, and we decided early on to continue paying our employees rather than furloughing them. That decision had a profound impact on our store associates. When you visit our stores now, the experience is noticeably different compared to many other places in the malls, thanks to the strong relationships we’ve built and the mutual support we offer one another. Regarding inventory management, it’s hard to anticipate what would happen when all this began. I’m really impressed with how flexible the team has been in sourcing products and getting us back in stock. Currently, we aim to provide customers with the best possible delivery date from the start. This way, they understand the initial delay, which helps avoid repeated postponements. Knowing I’m waiting for a specific timeframe for a sofa feels much different than having that timeframe pushed back repeatedly. We're trying to incorporate those potential delays into our quoted times now. I'll address the last question first. The net comp is something we've always monitored, but we've never encountered such a significant gap between them. This occurred due to store closures and a significant spike in low inventory. Typically, that happens the first time, and then we catch up. As we increase sales, this gap may persist for a while as we work on rebuilding our inventory to ensure better stock levels. While demand may reduce the net coming in, this situation will ultimately benefit our P&L in the future, even though we would prefer to have the products in stock for our customers. We're focused on getting our inventory back to where it needs to be, which will open up more sales opportunities down the line since the net will align with the previously high demand. Thank you for the questions.

Operator, Operator

Next up is Brian Nagel, Oppenheimer.

Brian Nagel, Analyst

First off, congrats on a really nice quarter. Nice work. So the question I want to ask, look, with regard to the gross margin expansion, you talked about the shift in marketing to more of a content strategy away from promotions. So I mean just a couple of questions within that. One is, is there a way to kind of size the benefit of that to margins here in the quarter? And then more strategically, clearly here, while demand was accelerating pre-pandemic, demand has turned even better here for the Williams-Sonoma family of companies through the crisis. Are you confident that the strategy of this content-driven strategy will yield the same type of results as demand trends potentially normalize back to what they may have been pre-pandemic?

Laura Alber, President and CEO

I have Felix on the phone. Let me begin with the question and then I'll hand it over to Felix. If anything, we've learned the importance of being adaptable to our current circumstances. When something like this pandemic occurs, we explore new approaches, and we realized that people need relevant and inspiring content. While we all spend so much time looking at screens, it's far more engaging to discover new things to cook at home with family rather than just hearing about a new discount. Therefore, we are constantly testing different ideas. We might discover something even better next year. We use our various brands to experiment and implement new strategies without taking significant risks. While we have reduced our promotions, we have also focused heavily on enhancing our value. If you revisit previous scripts, you'll notice I frequently mention everyday value as a fundamental aspect of our strategy, such as the entry price point in Pottery Barn. Our Pottery Barn apartment strategy specifically aims to attract new customers. Additionally, West Elm is a brand that continues to grow, and we will keep prioritizing value. It's not about raising prices; it's about reducing promotions and minimizing markdown inventory. We have significantly decreased markdowns compared to where they stood a year ago.

Julie Whalen, Chief Financial Officer

It's down 37%.

Laura Alber, President and CEO

Our clearance inventory.

Felix Carbullido, Chief Marketing Officer

Yes, I think that's a great question. A couple of points when we look at the business include the effectiveness of our content-led messaging. We are seeing growth in our active 12-month customers, including those who haven’t made a purchase in over a year but have now returned. Additionally, we are experiencing continued double-digit growth in new customers, which is a positive sign across all three customer groups. Looking at future growth, the trends among new customers are very promising, with record-high retention rates and increased cross-brand purchasing. We see these as strong indicators of their long-term value. These are some key points that demonstrate how well our message is resonating.

Operator, Operator

Our next question is Brad Thomas, KeyBanc Capital Markets.

Bradley Thomas, Analyst

I want to extend my congratulations on the impressive results. I would like to discuss margins, as it appears there are structural changes contributing to the record highs in margins, along with several drivers for the future. Let's also consider some potential challenges, such as the record low clearance activity, rising costs of raw materials, transportation, and labor. It would be helpful to understand how we can incorporate these factors as we refine our models for 2021.

Julie Whalen, Chief Financial Officer

Yes, we still expect to maintain strong gross margins despite the challenges you mentioned. The team has been proactive in addressing these issues and assessing potential costs. Our ability to design and engineer our product allows us to set a price that can handle the challenges related to raw materials and transportation. We anticipate transportation will remain a challenge, but our supply chain team has effectively navigated these hurdles by quickly finding alternative carriers. We are managing this situation to reduce costs moving forward. Additionally, the shift to e-commerce provides significant advantages, and the improvements in merchandise margins and occupancy leverage will help drive substantial operating margin expansion in the future.

Operator, Operator

Adrienne Yih from Barclays is up next.

Adrienne Yih-Tennant, Analyst

I want to extend my congratulations. Laura, great job on the promotions and the content-led marketing; it's really showing results. I wanted to ask you about the significant question for next year: how do we compare our performance? Much of this is driven by new customers, new product lines, or existing customers purchasing more products. I was particularly intrigued by your comment on B2B. Can you share the size of that segment now? What metrics can you provide? Also, I apologize if I'm not fully informed, but is it a wholesale transaction or a discounted retail price? Please share some insights and how you see this evolving over time. Additionally, Julie, regarding the long-term target of mid- to high-single-digit growth in revenue, how should we relate that to earnings per share? Lastly, with 70% of sales coming from e-commerce and stores reopening next year, should we consider that penetration rate of 70% will remain? The return on invested capital when shifting to e-commerce certainly enhances cash flow, and I completely agree with that.

Laura Alber, President and CEO

Great. Thank you for the question on B2B. So we decided for the first time to give you guys the number. So I think you probably might have missed it in the script, we're going to be over $300 million this year. And so it's been sizable. And we really are continuing to see even stronger strength. We passed our first $100 million milestone in a single quarter for the first time. And our growth was really driven by, in B2B, our internal program improvements and execution on our key strategies with a continued push to diversify our business pipeline across various industry verticals. And we're acquiring new customers. Average order size is improving at double-digit rates, and we're also seeing consistent build in sales volume each month. In terms of strategic initiatives, we're aggressively expanding our contract deployment. So really converting our products to be contract grade. And to build brand awareness, we have transitioned to a virtual digital marketing and engagement platform. And for example, this is fun, we partnered with Interior Design Magazine this quarter to take part in a series of live interviews as well as an Instagram takeover featuring all of our brands. We're also expanding our B2B offering with Contract in virtual events such as cooking classes, which have been sell-out for us. We are charging for these virtual events, which present an interesting business opportunity that we are seriously considering for the future. The industry continues to display positive signs of recovery, and we are observing the Marriott pipeline continuing. The hotel occupancy rates are rebounding from the lows experienced in the industry, and renovations that were heavily impacted by COVID are now progressing again. We are seeing strong internal indicators suggesting that the pipeline will only grow stronger, and we have established a foundation to manage these large orders. It depends on various factors such as discounts on retail and the size of the orders. Typically, customers need to approach multiple suppliers to furnish hotels or projects, but they can come to us for a complete solution. We also offer made-to-size and made-to-order products, which many others cannot provide.

Julie Whalen, Chief Financial Officer

Regarding the long-term target, from a mathematical standpoint, if you consider where it might land, we are definitely leaning towards the higher end in terms of revenue. When you take into account the potential for operating margin expansion, especially with the shift to e-commerce, merchandise margin growth, and ongoing occupancy leverage, it all suggests strong growth in EPS. While it's not a straightforward answer, calculating these factors should lead you to the EPS figures. Ultimately, there are no current indications that operating margin and EPS will diverge significantly.

Operator, Operator

We'll go next to Anthony Chukumba from Loop Capital Markets.

Anthony Chukumba, Analyst

I just had a quick question. So Julie, you mentioned fourth quarter surcharges for deliveries. I know that's a seasonal thing, but I want to make sure I understand. Are you seeing higher surcharges than usual in the fourth quarter, or are you just noting that there are these surcharges to be aware of regarding shipping costs?

Julie Whalen, Chief Financial Officer

Yes, it will definitely be higher. As people may have noticed from the EPS release last quarter, all retailers are passing along costs, so we're not the only ones. However, our exceptional supply chain team has acted quickly and aggressively, which reflects our company culture. We took immediate action to mitigate these costs as much as possible, both in terms of capacity and pricing. While there will still be some incremental costs or surcharges, we believe we will be in a much better position compared to others.

Laura Alber, President and CEO

And UPS is a great partner of ours, and they've been a good partner. But the truth is there's a lot more cost with COVID in the supply chain.

Operator, Operator

Our next question is Steven Forbes, Guggenheim Securities.

Steven Forbes, Analyst

I wanted to follow-up on the customer cohorts, right, and maybe specifically focus on the active 12-month customer base. I'm really just curious if you can expand on how that cohort has engaged with the portfolio of brands during 2020, right, maybe relative to '19? Any context there? And whether you have seen any change in behavior, right? Whether it's opting out or any sort of behavioral change, right, as the business has migrated more towards this content-led and less promotional activity, right? As we think about your conviction behind ongoing growth and market share gains.

Laura Alber, President and CEO

I'm going to let Felix take that.

Felix Carbullido, Chief Marketing Officer

Thank you for the question. I'll begin by noting that we have reached a record high in the number of active customers, driven by both our existing customer base and an influx of new customers, particularly in the D2C channel. This indicates that our messaging is resonating well. Our email metrics, such as engagement and open rates, along with our social media engagement, are at record highs. In terms of customer demographics, we are seeing a significant increase in millennials within our customer base, which is promising given that this is a large generation. This trend bodes well for us in 2021 as these customers move into household formation. Additionally, the majority of our new customers are now part of The Key, our cross-brand loyalty program, which has demonstrated higher repeat and retention rates compared to non-Key members. Overall, this positions our active customer base well for growth in the coming year. Did that answer your question?

Steven Forbes, Analyst

Yes, it did. I don't think we've had an update on The Key members for some time, and since you mentioned it, can you provide that information today as well?

Felix Carbullido, Chief Marketing Officer

Sure. Yes, we have over 11 million members, and as I mentioned, most of our new customers are now enrolled. The Key, which is our loyalty program, as you know, it's a very cost-efficient way for us to drive incremental sales. And I'm proud to say that year-to-date, we now have more cross-brand customers than we ever had in our company. So that we know is an incremental opportunity for all of us and clearly, much more efficient way to drive sales with existing customers than acquiring new ones. So again, gives us confidence in advertising efficiency going forward.

Operator, Operator

Our next question is Marni Shapiro, Retail Tracker.

Marni Shapiro, Analyst

Congratulations. So I'm going to move on past COVID. I'm tired of talking about it in the post-COVID world. Laura, you've talked a lot about your point of differentiation and your brands and everything that you guys do internally. You've also, for quite some time now, focused your company on sustainability and organic products. And things that I think millennials and Gen Z are very interested in. So can you think, in 2021 as everybody has discovered that home is a great business, how do you think about marketing sustainability and this part of the business to keep your positioning and kind of even better position you guys for the future?

Laura Alber, President and CEO

Thank you for the question. Sustainability is crucial for us, and we plan to continue pursuing strategic and significant sustainability programs that are important to our business and our customers. We aim to lead in ethical production, worker well-being, and expand our environmental commitments. We released our report in October, and for next year, we will focus on climate and energy. We intend to build on this year's Scope 3 footprint and CDP disclosure to establish a science-based target for reduction. In terms of responsibly sourced materials and finishes, we will maintain our leadership in Cottonwood and GreenGuard and broaden our commitments to lower-impact alternatives such as recycled polyester. Regarding waste and circularity, we will leverage our scale and successful circular pilots. Across all these ESG areas, we will continue to disclose, measure, and track our progress. For example, in our corporate responsibility report this year, we publicly committed to diversity and inclusion through our equity action plan and shared our first data on gender and ethnicity representation. We are dedicated to our principle of good by design, with our pillars being people, planet, and purpose.

Operator, Operator

Next up is Seth Basham, Wedbush.

Seth Basham, Analyst

Congrats as well. My question is really a clarifying one. Julie, I think you mentioned that you expect operating margin expansion post-pandemic. Should we take that to mean after we get a virus, you still expect operating margins to rise from whatever trailing 12-month level they're at for the next 12 months? And after we get a vaccine, I should say?

Julie Whalen, Chief Financial Officer

Yes. We do expect ongoing operating margin expansion because our expectation is that the top line is going to continue to thrive, especially in e-commerce, as I mentioned. And all the things that we're doing from a margin expansion perspective and occupancy leverage, all of that will continue. We do expect it to expand above where we're landing on this year.

Seth Basham, Analyst

Fantastic. And then secondly, as we just think about some of the shipping dynamics one more time, what are you doing in terms of shipping fees that you're charging customers to mitigate some of the higher costs that you're incurring?

Laura Alber, President and CEO

We haven't changed our model. It's the same shipping model that we have.

Operator, Operator

Ladies and gentlemen, that is all the time we have for questions today. I'd like to hand the conference back to Laura for any additional or closing remarks.

Laura Alber, President and CEO

Sure. Thank you all for joining us today, and I really, sincerely wish you a wonderful and safe Thanksgiving with your friends or probably just your family, but maybe your friends, if I assume. So we'll be talking to you soon and look forward to it.

Operator, Operator

Once again, everyone, that does conclude today's conference. Thank you all for your participation. You may now disconnect.