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RH RH

Participants
Allison Malkin ICR, IR
Gary Friedman Chairman and CEO
Jack Preston Chief Financial Officer
Adrienne Yih Barclays
Max Rakhlenko Cowen and Company
Steven Forbes Guggenheim Securities
Chuck Grom Gordon Haskett
Michael Lasser UBS
Curtis Nagle Bank of America
Brad Thomas KeyBanc
Tami Zakaria JPMorgan
Seth Basham Wedbush Securities
Call transcript
Operator

Ladies and gentlemen, thank you for standing by. And welcome to the RH Third Quarter 2020 Q&A Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] As a reminder, today’s call is being recorded. I would now like to turn the call over to your host, Ms. Allison Malkin of ICR.

Gary Friedman

Allison, are you on mute? Sorry.

I think we are ready to go right into Q&A.

Allison Malkin

Oh! No. It’s okay. I will start. Thank you. Good afternoon, everyone. Thank you for joining us for our third quarter fiscal 2020 Q&A conference call.

Joining me today are Gary Friedman, Chairman and CEO; and Jack Preston, CFO.

Before we start, I would like to remind you of our legal disclaimer that we will make certain statements today that are forward-looking within the meaning of the, excuse me, federal securities laws, including statements about the outlook for our business and other matters referenced in our press release issued today. These forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please refer to our SEC filings, as well as our press release issued today, for a more detailed description of the risk factors that may affect our results. Please also note that these forward-looking statements reflect our opinions only as of the date of this call and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Also during this call, we may discuss non-GAAP financial measures, which adjust our GAAP results to eliminate the impact of certain items.

You will find additional information regarding these non-GAAP financial measures and a reconciliation of this non-GAAP to GAAP measures in today’s financial results released. A live broadcast of this call is also available on the Investor Relations section of our website at ir.rh.com. With that, I will turn the call over to the operator to begin our Q&A session. Operator, we are ready for questions.

Operator

Thank you. [Operator Instructions] Our first question comes from Adrienne Yih of Barclays.

Your line is open.

Adrienne Yih

Great. Thank you very much. Good afternoon. And I just have to say, wow. I mean, this is a really remarkable performance.

So congratulations to everybody at RH. Gary, I guess, my first question for you is, in the past you have mentioned two macro drivers that benefit the company. One, being kind of high-end housing growth and the second being robust stock market returns to where the market that we have both. And based on the historical perspective, how long have the -- what’s been the lag in terms of the effect, and obviously, we are seeing it sort of immediate today. But what’s been the duration of the positive impact to your business from that? And then my second question is, the sales galleries in Europe, what size will they be and how should we think about, I guess, the annual sales contribution of each of those? Thank you very much and congratulations.

Gary Friedman

Thank you. Thank you. It’s hard to be specific on duration.

I think it depends on severity of correction in any of the markets. Particularly we have seen, as you know, with sharp stock market moves sometimes will pause consumers at the high end.

So it’s hard for us to kind of give you a number or range there. But I’d say, there’s nothing different than how you might assume the consumers would behave depending on the severity of the changes in a marketplace. I would say, we see a very healthy home market, right? And I have been asked recently about Keith, how do you feel about the cities you have galleries in that are consumers or moving out of some of the key dense cities based on the pandemic and there a boom in the suburban housing market in the second home housing market.

We are generally -- I would just say, we are generally indifferent, because people moving and buying homes is just a good thing, right? We have galleries in every major market.

So that will all kind of balance itself out and our key market galleries like New York tend to draw from the broader suburbs and everywhere, because it’s where our best assortment is. But this -- the uptick in the housing market and how long that will last? Again, we don’t have a crystal ball. There’s usually a longer tail there, because as anybody on the phone knows, if you have bought a new house or moved into a new house and it triggers a lot of spending on the home and it’s not an easy job.

Adrienne Yih

Yeah.

Gary Friedman

It takes a long time.

So we think that the tail from just the housing market move looks pretty good. It’s hard to say today what’s going to happen with the stock market and how the market is going to read what happens next in the pandemic. It’s hard for us to understand how the market will cycle through the stay-at-home stocks, as they call them versus others. And we just -- we try not to get too focused on those things we can’t control. But as you think about the galleries in Europe and how you should think about that the sales contribution. We think it’s very different obviously from the perspective of work.

If you think about the U.S., when we opened a new gallery almost all of them are replacing an existing gallery.

So there’s something very good about that and there is -- yet from the perspective that there’s little risk and we have a lot of history. We know we have a gallery that’s doing $18 million and we open a new gallery that has hospitality generally in the first 12 months to 36 months. It will double to $36 million and we have a point of reference in each of those markets. But when you think about opening it internationally, we are not replacing any stores.

So you have a bit of an unknown on that end. But -- and that can be a negative, because there’s more guesswork and there’s less data to use. Again, we are relatively very accurate on understanding what’s going to happen with our expansion in the U.S. and even where we have hit new markets so we opened in the U.S. we are relatively accurate in predicting the performance.

So we had less data internationally. We don’t know exactly what the reaction will be. But and so that’s a negative. I’d say on the positive the way to think about it is, you are not opening a market, you are opening a country, right? And so I think about it from the perspective of the U.K., just if you start there. California today, call it, directionally a $500 million market for the business without all the gallery conversions. Longer term, probably a $700 million-plus market for RH, probably, as we continue to expand the assortments and become a more disruptive, dominant brand, help California long term, maybe it’s close to $1 billion, $800 million, but easy to see $700 million as you think about transforming California. Well, take the U.K., a 68 million people, right, versus California with 39 people -- 39 million people.

You have got similar demographics, similar wealth populations, and so on and so forth, little change in the density.

So you open a gallery in England, London, or whatnot and we have got kind of a unique strategy there.

We are opening a really terrific gallery from an image and impact and kind of conversation point of view, RH England, which is this magnificent estate on 73 acres in Oxfordshire. It’s five minutes from the Soho Farmhouse. It’s been called the coolest house in Great Britain. And -- but it’s kind of out from the population. It will create a lot of awareness of the brand and just because of the footprint and the uniqueness of the gallery and it’s got a great size of -- I think of 50 something thousand square feet there and the three buildings. And then you have a very different one in central London in Mayfair, right, where we are right in the heart of it and we are framed by Savile Row and Burlington Gardens and we are block off New Bond Street and the flagship Ralph Lauren and the big project that LVMH is doing. And no one’s going to -- and all the wealthy people, no one will miss us there.

I think everybody will hear about us in Oxfordshire. How many people will go? Not sure. But the way to think about it is not just as you are always you are opening up the entire direct market, right? And we have always been a brand. We used to refer to our self as a direct centric brand.

If you think about and it’s funny because I just wrote about physical first strength. And at some -- and it’s that -- and certain people think, oh, he doesn’t believe in the Internet, because he’s building these big stores, these big galleries. But the way we got to even be where we are today is we did that through the direct business, right? When we started here, where these little stores and we had a little assortment and there’s no way you could show our assortment in the 6,000 of selling or 7,000 square feet of selling. We had the average galleries and we had a strategy that we used to talk about kind of first leg as a public company and didn’t talk about it so much when we reentered the public market. But we still talk about direct center growth. What we meant by that is we said, we were going to size the assortments to the potential of the market, not limit them to decide to the store. And use the stores and the website to reach a much broader market. And by doing that, we were able to grow the company, a company that was on the edge of bankruptcy in a very capital efficient way. And that is going to kind of play through when you think about moving into new countries, right? Here we started with 106 stores and we kind of right sized it down that we think kind of it was 60, 70, whatever it will end up being as we optimize the footprint. I don’t know if we have to have as many galleries in Europe, right, with because the Internet continues to be a better and better tool to shop or to convert, right? And so if you are well positioned you may not need as many physical stores. It’s just that today we know what the physical stores do. We know we can double the business in every market and from retail point of view.

So when you open up a gallery or two in England again and greater the U.K., we open up a gallery in Paris, right? You are going to open up all of France and greater parts of Europe.

We are going to open up your business to all the travelers.

And so we are not sure exactly how to think about that until we until we have a couple. But I’d say the asymmetrical risk to the upside from how we think about our business, because we have been a company that had yeah before we are transforming our galleries when our galleries were undersized.

We have 50% of our business was direct to customer, omnichannel, digital first, whatever you want to call it. We just call it online or on our website it’s where it’s transacted.

And so we believe opening up markets is -- opening up countries is a big deal, a really big deal. And that I think gives us asymmetrical risk to the upside, downside of maybe not having as much specific data, right? Like it would be like that’s being the brand start today where kind of the awareness we have today and opening up California with a magnificent store in LA, right, at an incredible gallery, I don’t know, call it in the Napa Valley or somewhere that people visit vacation and go to for weekends.

So what does that do? We think it’s some kind of a really good outcome would be our best use today.

Adrienne Yih

That’s very helpful. Thank you very much.

Gary Friedman

Yeah.

Operator

Thank you. [Operator Instructions] Our next question comes from Max Rakhlenko of Cowen and Company.

Your line is open.

Max Rakhlenko

Hey, guys. Thanks a lot for taking my question and congrats on the nice quarter.

So it’s really good to see that your cancel rates are below last year. Do you think that that could remain the case over the coming or could there be some risk as supply will trail demand for a bit longer than you previously anticipated? And then just separately, how are you guys thinking about cash allocation priorities at this point? Your free cash flow is starting to ramp and with fewer major capital heavy projects, as well as debt maturities, do you think we could see accelerated share repurchase, special dividends M&A? Just want to hear your thoughts on that? Thank you.

Gary Friedman

Yeah. The cancel rates have been down for several quarters now.

So the trend would indicate that there’s not a risk, right? That the -- and I think there’s not a risk because, one, because I don’t think we have a lot of direct competition at our -- where we are in the market.

We are one of the few people that stock higher end luxury home furnishings. In most places, it’s a much longer wait time custom, etcetera, etcetera. And I think that the consumer needs the product and I just don’t think anybody else is in stock, right? I mean, we are running the highest back orders in the history of the company since I have been here 20 years now.

So I have never seen this kind of phenomenon, right? I have never seen back orders at all-time highs and cancel rates at almost all-time lows, right? So, one, is that tells you the consumer probably doesn’t have a lot of other choices, what choices they perceive they have, also don’t have product to ship right away. And they really need the product, so they are, in many cases, forced to wait, right? So you kind of go, God, if I don’t order it now, how long might I wait, right? How many more weeks might the delay be? So the numbers would tell you over the last few quarters that there doesn’t look like a risk. That doesn’t mean things won’t change. I just don’t see any reason for them to change.

So our degree of confidence of converting the orders to revenues is very, very high, right? We have a lot of data now and very, very consistent back orders trends lower not higher, back orders have been below a year ago and they were low -- and that’s why back orders, excuse me, cancel rates below a year ago and they are below a year ago last year. And as backorders have increased every quarter, right? Because you can’t, when else are obviously started trending up, we weren’t buying for us, while we have cancelled orders so when they started trending up 20%, we are buying for 20%. Also they went up 30% and then you -- they are buying for 30% and then go 40%, like, God, way and buy for 40%.

Let me ask wait a few more weeks and then you go, okay, it looks like a trend that you buy 40%.

So we have on a compounded basis and then they went up to 47%, right? So we kind of got behind, right? So as we thought we would start catching up, we also -- we actually fell behind because the demand continued to accelerate and you would have thought that cancel rates would be impacted. But for the reasons I stated I believe that they are haven’t been impacted and now I kind of have a more firm view that I don’t believe they will be. It doesn’t mean we won’t be wrong about that but that’s our view today. And as we think about cash allocation priorities, look, we are in a world where things are changing daily, right? Again, we are -- we just went into the State of California shelter-in-place orders, right? Retail is operating at 20% capacity. The malls and shopping centers have less traffic than they have had in the last few months. We just saw the most severe drop off of the Black Friday to Cyber Monday selling seasons that we have ever seen. And in discussing with other retailers and leaders in the business, people saw a massive fall off during that period, like, we are sitting here going, oh, like, we just orders is the tailwind over and it just seemed that based on the fact that that the virus was spiking, people decided not to go out and shop and all of a sudden, once we get past Cyber Monday, our business started to ramp back up.

So when you are in that kind of a business situation with so many unknowns that we are in, whether you have a headwind or tailwind, it doesn’t -- for me it doesn’t really matter. I mean we have more optionality with the tailwind. And I -- do I feel better being on this side of the table than maybe apparel people or other people had their business or restaurants and other people had their business devastated? Yeah, of course choose the side we are on. But it doesn’t mean you should adjust anything long-term. It means you should just kind of do your best day-to-day, week-to-week, month-to-month as new data comes in to make really good decisions for what you know and don’t lose sight of your long-term vision and strategies that will create -- that you believe will create significant shareholder value long-term. And I think we have proven based on big decisions we have made and from moving from a promotional model to a membership. Again when I talked about having much too help for heavily cause and staying true to that and transforming our whole way of doing business. That was a long-term view and we didn’t let short-term noise distract us. We redesigned and re-architected the entire operating platform of the company and a lot of short-term noise as we were doing that. We stayed focused on where -- how we could create long-term value and that’s hasn’t changed. And that’s why I wrote one of my longer shareholder letters here, try to give you as much detail as we could how -- as transparent as we can how we are seeing the business, but things are changing all the time.

So to kind of have a strong view about what you are going to do from a capital allocation point of view, buybacks or M&A or other things, like, we are always going to be opportunistic. But I -- it’s just hard to kind of commit to too many things today. I mean, we were pretty certain we were going to open RH England and all of a sudden travel shuts down in the U.K. and we can’t go unless we quarantined for two weeks. And you can’t send your leadership team and other people to go quarantine in a hotel for two weeks, to work two days and come back.

And so we just decided, like, yeah, it’s not a good time. We had to make a decision to commit to distribution infrastructure and other investments and people and so on and so forth. And we said, like, look, it’s important that we take a long-term view here. The long-term view is like everybody will still be there if we wait to ‘22.

We will be more prepared.

We will do a better job.

We will have more visibility.

We will understand what this looks like on the other side of the pandemic.

So, right now, I’d just say, too many moving parts to be committed to kind of any kind of specific activity. If the right thing comes along that had asymmetrical risk to the upside that there’s real opportunity, we will do those things. And we have made some small acquisitions, I think, you will read about in our filings, they are not really material. But we are taking opportunities to do things that will elevate the brand and invest in the brand and we will continue to do things like that. Where we going to make significant share buybacks with all the uncertainty? I don’t think so. Not right now.

I think let’s let things pass and just no different than look I think we are very smart at not raising debt right away and we -- when also this pandemic hit and our business went down, our business moved 50 points, right? Everybody is like you don’t have enough cash. It’s what -- this look like and we researched it. We created a lot of optionality. We had a lot of choices to raise capital. The interest rates would have been really high. It would have been very expensive money and it might have bought us some optionality. But you just don’t need to take risk without having real clear visibility. I mean some people thought we took a big risk buying back almost 60% of the company at $1.2 billion. We didn’t see this risky, right? Because we understood what was going to happen. We understood we were going to -- we architect the supply chain. It takes $400 million to $500 million out of inventory. We knew what would happen. We had really good assumptions. I’d say we knew, like, really good assumptions. We knew our business really well and we made some moves that to other people, looked risky, to us had more asymmetrical risk to the upside.

And so, right now, I think, it’s just -- we are in a really uncertain time. We gave you as much forward-looking information as we could, tried to -- I kind of look at this as it’s -- look at this over a two-year period, right? Fiscal ‘21 is a, excuse me, fiscal ‘20 is a down first half, up second half. Fiscal ‘21 is just the opposite. I’d look at the two years together and say, what kind of company do you think you have when you balance it all out? We think this is a company on its way to being one of the great companies and that’s what we are focused on.

So that’s how I’d characterize our frame of mind today.

Max Rakhlenko

Got it. Thanks a lot, Gary, and happy holidays to everyone.

Gary Friedman

Thank you. Happy holidays to you.

Operator

Thank you.

Our next question comes from Steven Forbes of Guggenheim Securities.

Your line is open.

Steven Forbes

Good afternoon. Hey, Gary. Maybe to start, on the last call, you talked a lot about the reallocation of human and financial capital, right? And I wonder if you can provide more context around the potential benefits here, right, as you digest those moves and is the launch of RH Contemporary, right, and RH Color like a result of these efforts or how do you sort of speak to the potential benefits, right, of that strategic change and not dropping the sourcebook in the fall?

Gary Friedman

Sure. Well, not dropping the sourcebook in the fall was a decision based on the fact that inventory was chasing demand massively and we were only going to create a greater pressure and possibly not satisfied, just have customers frustrated with ads and so on and so forth.

So we give up topline in by not mailing a book? Sure, we did. If we were to mail the books, would there have been incremental toplines? There would have. Would there been higher backorders? There would have. Would there have been more frustrated customers in wait times? There would have.

And so we thought the right long-term move was not to try to chase this kind of optimize the business in this time of the pandemic, like, how to shift our human capital and focus on the longer term.

And so we reallocated our time and energy towards other things contemporary being one of them. We held back newness, right, that would have been generating demand today. I feel really good that demand in the core businesses bounce back to what is up 39, right? Up 39 with no books, right, with no newness.

So we are up against last year’s book.

We are up against last year’s newness and we are still up 39.

And so could we been 48 or 52? I don’t know, maybe. But our business would have been messier. And it’s never good to kind of create a messy business. I mean, I have run those before. This company has run in a messy way before in a chaotic way. It’s no different than -- it’s pretty clear if you just look at the emails you receive in your inbox is that there is a period where very few people were promoting.

Now it looks like a period of a lot of promotions.

And so my sense is there’s a lot of people in the retail business that are trying to fuel the fire with increased promotions.

I think that’s a -- I think that’s not a good long-term view, because then you are up against all that next year when you have got a cycle of these difficult comparisons, I look at next -- I look ahead next year and I feel really good.

We have got a cycle demand up 40. Maybe this fourth quarter will be less than that because we didn’t mail the books and we don’t have the newness. But next year we are going to have a lot of newness and we are going to have really thoughtful, constructed and architected assortments, and we will even be more strategic and we will be able to make investments in other elements of our business that will elevate the brand.

And so we feel very good next year -- about next year unless something big happens. Thus, we have a stock market crash and the bottom falls out of the home business. But, for the most part, I’d like next year is shaping up because of the decisions we have made.

I think we are very excited.

I think there’s tremendous new products in the pipeline, almost too much.

We have to make sure we have been disciplined about our investments from an inventory point of view and our risk, our newness, but it’s a lot of great newness. And I think RH could temporary is going to open up an entirely another new layer of the market, right, that for us. It’s going to bridge the gap between the kind of class -- updated classics of interiors and the more harder edge modern and fill in with some aesthetics that we just hadn’t pursued before in a very RH way, right, through our own unique point of view and I think it’s going to be really exciting to the consumer. And we have got some tremendous new talent from a design and artisan point of view coming onto the platform. I don’t know if anybody’s picked up the new Architectural Digest. But you will read a two page article about Alison Berger coming under our platform with some incredible new lighting designs. And Alison is known as one of the great lighting designers and glass designers in the world today. I mean, yeah, she sold exclusively on Holly Hunt’s platform, which Holly Hunt had been known as the best high-end interior design showroom in the United States. And you have someone like Alison come over to our platform kind of fix things again, right? And -- but it just about the product and the people joining the platform and the people joining the cause. There’s just a lot of momentum in our brand today. From a human capital point of view, both inside and outside RH that are going to contribute to RH. From design, manufacturing, business intellect and merchandising capability and so on so forth.

So I guess the way to think about it is there’s got to be a balancing, right, kind of not mailing the books and not having any newness and then cycling around next year. And not just mailing the books, but mailing more books, right, and with more unit because you are going to have contemporary and you are going to have this kind of upward momentum.

Now what will happen to the markets? Do we think some air is going to come out of the demand? Do we think this -- you can’t -- it would be foolish to think like this thing last for a real long time not at this level. Like, we think it’s -- you are going to cycle it. It’s going to normalize. There’s going to still be momentum in the home business from our point of view because of the long tail and that happens when people buy homes and move. But the long-term, if you just think about the moves we are making strategically, those are not temporal. The pandemic is temporal, right? The moves we are making are systemic and strategic and they are going to last a long time.

So that’s what we are focused on.

One of the moves we are making, the investments we are making that are going to elevate the RH brand and render our brand more valuable in the marketplace, more desirable, more unique, more authentic. And that are going to have a lasting value, because it’s -- look, our stock went up $120 or $130 in the last 30 days or something like that. Like I -- the stock is going to move around.

You are going to have like the short-term stuff is, you get to focus on that and you start kind of managing your business, right? And manager generally arrange and organize the status quo and try to protect the present.

We are builders here. We don’t have anybody with a title of Manager in this company. We only have leaders. And leaders are taking people somewhere they have never been, doing things they have never done, right? And they are building things and they are building value, and that’s the culture of our company.

If you walked in our Center of Innovation, you’d walk through a portal that says, RH, the home of the extraordinary, the remarkable and the amazing, right, because that’s how we think, right? What are we focused on that’s extraordinary, remarkable and amazing? That’s the kind of work -- that’s kind of focus you have to have to build one of the most admired brands in the world and that’s our DNA. That’s our focus.

So all the other stuff is kind of noise and distractions.

The important things are the big moves and the big investments that are going to continue to change everything for a very long time.

Steven Forbes

And then maybe just a quick follow-up for Jack. I don’t know if you can sort of speak to what’s the right level of expenses as we look out to 2021 or if you just want to sort of based on the third quarter here and maybe help us conceptualize what some of the transitory factors were, right, like the removal of the sales structure and so forth as we think about our 2021 models?

Jack Preston

We don’t give guidance. We gave you our outlook and I think it reflects our confidence in the business and the sort of operating structure. And look, some of the things I look to continue to strengthen in gross margin and product margin, like that is a strong part of the story. And when we look out and our confidence to reach the 25% margin in our outlook -- our longer term outlook, I mean, that -- those are the strong elements of the story.

As far as like specific elements in 2021, we are not in a position to provide at this time. I will look at Gary if there’s anything else.

Gary Friedman

No. I mean, what we believe we are going to have a double-digit revenue growth and expanding operating margins.

We will know more each week, each month as the pandemic kind of plays out here and the world returns to some kind of a more normalized environment for people, how people are going to behave and what’s going to happen. But -- we are not going to get out over our SKUs from a cost point of view, right? And if we had -- you can’t tell, so we are in kind of a temporal environment.

You have got to be smart about that.

So that’s why we feel confident that the margins will continue to expand because we have got a good handle on expenses and we have a good line of sight into the product pipeline and what we believe can be the margin structure from a product point of view, which is the key lever. And expenses, we were pretty disciplined around here from an investment point of view. It’s a -- we tend to have a culture that doesn’t spend money.

We have a culture that invests money based on what we think the return with that investment, what kind of return will that generate.

So, as long as we keep that discipline and we don’t become complacent or arrogant, based on business trends that are happening today. We keep our edge.

We continue to be unsatisfied, serious, critical, always unfinished, always on the move and we will continue to do great work.

So I don’t think there’s any other people that are giving you much more data than we are giving you today.

So I think our -- the shareholder letter has a lot in it.

Steven Forbes

Thank you both. Happy holidays.

Gary Friedman

Happy holidays, Steve.

Operator

Thank you.

Our next question comes from Chuck Grom of Gordon Haskett.

Your line is open.

Chuck Grom

Hey. Thanks. Good evening. Can you guys put into some context how big of an opportunity the outdoor furniture market could be for you guys? And then, for Jack, just trying to understand the connection between deferred revenue and customer deposits in your balance sheet there, I believe over 60% year-over-year and then your demand comp, which is lower than that.

Just wondering if you could connect those two dots for us?

Gary Friedman

Yeah.

I think, look, outdoor, I’d say, outdoor business is a lot like the general RH business.

I think when you build a brand like ours you in many ways are creating a market. And yeah, you are inspiring people to purchase and invest versus other purchases and investments they may have made based on what they see. And no different than Apple created a new market, they didn’t look the cellphone market, and say, how big -- I mean, Apple create an entirely new market around smartphones and the iPhone. Nobody thought it would sell in China. It became the bestselling phone in China. When you create a really good product and not just a single product, I am talking about a full integrated branded proposition.

You have an opportunity to create a new market, right? To disproportionately expand a market because you are putting something out there that wasn’t there before, right? And I think that’s happening in many places, right? And look at a lot of brands that are creating new markets.

So in outdoor, it’s much of the same.

If you just stood back and said, where do you go buy outdoor furniture? There’s not a lot of consumer facing outdoor furniture stores, right? They are kind of out off the beaten trail kind of in weird places.

You can come up with the names you have driven by them before. But if you said it’s the high-end outdoor furniture, where do you go? Where do you even see it? Where do you even get inspired to buy it? It’s -- no one really presents it, because it tends to be more seasonal in nature as far as the peaks of the business. I used to joke around and tell people is what -- you might remember that this was called Smith & Hawken, right? And they opened like 50 stores and then almost went bankrupt. And they took another go at it. And I’d say why didn’t Smith & Hawken’s make any money? And I say, jeez, well, I don’t know, I said. Well, for the most part they had to pay rent, right? And they paid ground for rent for a very seasonal business. And if you look at our strategy and what we have done with rooftops and terraces and things like that, we -- in our new galleries we present somewhere between 20 and 30 outdoor collections depending on the outdoor garden space and the rooftop space. Nobody faces the customer like that in the outdoor furniture business. Because we are facing the customer like that in this current environment, we are creating a new market. And we are creating a new market in the outdoor furniture at a very high return on invested capital.

So we really liked that business and say, well, why can’t other people do that. Well, other people don’t build galleries as big as we do.

So their rooftops could never be as big, right? They don’t control the real estate like we do and they don’t -- it’s very hard to emulate what we are doing, right, and that’s -- and why the physical nature of our business is so important, right? Like, I would say, the -- a website is an invisible store, right? You don’t see it.

You don’t pass it.

You have to be prompted to go to it. And this physical stores, people drive by they see -- if you are in the right locations, you are in the -- you are going to be constantly visible and you can present products and categories in ways that you can’t online. Where the online -- and online, this is very democratic, right? We -- everybody has the same size screen, again, probably, some store can look as big as RH online. And I don’t want to say Holly’s home stores. Nobody named Holly. It’s just refers to a higher end local furniture, specialty store that someone’s running. And -- but those kind of businesses can’t do what we do and that’s why we are so disruptive.

So when you are disrupted like that, you are taking share. But even most -- more importantly than taking share, you are creating a new market and that’s how we think about it. And then, Jack, maybe you can comment on if you …

Jack Preston

Yeah.

Gary Friedman

…deposits and revenue.

Jack Preston

Yeah. I mean, obviously, with the strength of the business and the high demand and the supply chain constraints we talked about, those are the two items -- two key items that you are going to see that grow with customer deposits and sort of deferred -- the special order business that we have that grows those customer deposits. And then as the business grows, naturally you are going to have a growth in the deferred revenue balance.

You are looking year-over-year. I would have you look sort of sequentially sort of where Q2 to Q3 grew as well. That’s a -- that was like an 18% sequential build.

So I think you are going to look at both, don’t get me wrong. But I think as far as impact from walking down from demand down to revenue growth, you kind of want to look at that sequential build.

So, like I said, that was an 18% growth and very much expected relative to the trajectory of the business.

Chuck Grom

That’s a good color. I will look at it sequentially then. And then just my follow-up would be just wondering if you guys and it’s probably a little bit more art than science. But just any sense for how much of your revenue growth is coming from consumers who are actually buying second homes and/or people who are shifting out of cities into larger suburban homes?

Jack Preston

We have looked at the data Chuck. Look the data is what exactly we would expect that that suburban homes are -- have high growth rates, second home markets have the highest growth rates. And then you have as Gary talked about an exodus out of cities.

So -- but again we are in all these markets and our customers whether they have a primary home in an urban market and happen to be moving out there. It’s all at the end f the day good for our business.

We haven’t gone into much more detail. But I think the trends, like I said, that hierarchy of second home having strongest growth suburban very strong growth and urban being the weakest of the three. Again, it’s kind of a firm grasp of the obvious as we say sometimes. But I am not sure, Gary you got anything else there?

Gary Friedman

No. No. I mean, look our business has always been our biggest part of our business is a suburban market business, right? It is where more large homes are, where those large homes have more bedrooms, more living space, outdoor furniture space, so on and so forth. And no surprise it’s the largest part of our business.

And so the suburban market which is significantly large part of our business is -- has tailwind and as people move into it. That’s good for us. But its’ again -- it’s we know all the data we have got -- we look at it. I don’t know if any of it tells us to do anything differently or expect anything differently. There’s not like markets we go, oh, My God, they are buying homes there and they don’t know about us or let’s rush to open a gallery or stuff like that. I mean, some place you go, okay, we have been looking in Palm Desert in Southern California for years and it’s on fire. And the staff who is our Chief Gallery Officer went to see his grandparents over Thanksgiving. And he said we really, really need a gallery there and I felt yeah, it’s on the list.

You feel strongly about it, go find a location and we will get it then quickly. I mean -- but it’s not like -- it’s not like oh my God. That’s going to change so much. It’s just probably a little mark. But we are really well-positioned in North America to capitalize based on any way it shifts within the market. We just like that the market is up, right? We are well-positioned to capitalize. No matter where they are moving in North America.

I think the only places like we were not represented in Montreal and we are not represented in Hawaii. I am trying to think.

So there’s a couple of places like that.

Jack Preston

Naples?

Gary Friedman

Yeah. Yeah. Yeah. We -- yeah.

We are not in Naples.

Jack Preston

Yeah.

Gary Friedman

We plan to be in Naples, but we do great business in Naples even though we are not there.

Chuck Grom

Got it. Thanks very much.

Operator

Thank you.

Our next question comes from Michael Lasser of UBS.

Your line is open.

Michael Lasser

Good evening. Thanks a lot for taking my question. Gary, can you give us a flavor of the customer behavior that you are experiencing that drive this strong demand growth? How much is coming from new customers versus repeat customers and how much is coming from larger basket? Are you seeing a trend of customers who are more often buying furniture more than one room in their house and that where you are seeing a strong demand growth?

Gary Friedman

Our interior design business keeps growing and has been growing and so you’d thinking a big move like this. It’s kind of everything’s lifted here. If something shifted, we had outdoor was off the charts in the beginning because a lot of people I think realize you are not going to travel for the summer and spend a lot more time at home. But the consumer behavior is -- it hasn’t -- it’s no different than what you’d expect with demand like this. It’s a -- new customers to higher spend from existing customers, and so on and so forth. The metrics don’t make us think about doing anything meaningfully differently than what we are doing.

So --yeah, yeah, so, we -- our business is -- has been growing if you think about size of basket and so on and so forth. It’s -- because we have moved the business from a -- from just conceptualizing selling product to or creating product and conceptualizing and selling spaces. And the efforts behind building an entire interior design platform on a national scale, if you go into our new galleries and you see the dedicated office space for our interior designers and the design affiliates and the meeting rooms and the space we have designed, it will tell you that that obviously is something we are investing into.

So -- and we think that’s going to be create strategic separation for a long time to come. All these investments we will continue to create strategic separation and render our brand more valuable long-term and so that’s what we feel best about. Look at all these pieces and say, what will this look like over the next decade, which I tried to give people a view at and told you what’s sitting behind me. I am looking, yeah, no one’s changed the whiteboard, so same whiteboard. That’s how we think about the business. Like I have always said, when people ask -- have asked me in the past, can I buy your stock? And I always say, ask the same question and say, are you an investor? Are you a trader? If you are a trader and you are focused on short-term episodic swings in the stock market or quarter-to-quarter kind of things, like don’t buy our stock. It’s going to be a volatile stock, because we are building something people haven’t seen before. It’s going to be misunderstood. It’s going to get overvalued and undervalued and you are going to not sleep a lot at nights. But if you are an investor and you take a long-term view, I mean, it’s one of the best places to put capital. I said that 10 years ago and I said that five years ago. And if you look at our performance, we -- we are -- you’d say, hey, boy, I wish I just hung on to RH stock. If I look at -- you look at our biggest shareholder today is Fidelity and the team of Fidelity who’s been there the whole time has held their stock. They have held 15% of our stock. At one point, it went up to almost 30% because we bought back at the company and they had a restriction. They couldn’t hold that much, but they would have liked to. But that team has not sold their stock at all since the IPO. And I think they feel pretty good that they invested in a stock in the -- when we went public at $24 a share and we will continue to invest in that looks like a good investment, even though it’s went crazily up and down, right? And one of the biggest shareholders in the company and like people asked me on days when the stock does really well, the stock does really bad. It’s like, look, I don’t think about that.

If you think about this is a long-term investment. This is a great place to invest. And I think the character in the makeup of our shareholder base would tell you the same thing.

So…

Michael Lasser

Yes.

Gary Friedman

Yeah.

Michael Lasser

My follow-up question are these periods of disruption are always an opportune time to learn how to operate differently, given the extremes on the cost side in the third quarter and recognizing that some of the SG&A decline was from mainly in the sourcebook. Is RH now able to operate its model less cost intensively with a lower amount of labor so we shouldn’t necessarily expect the same amount of labor expense moving forward and how would you think about reinvesting some of that back in the business?

Gary Friedman

Well, the --look, the models are going to continue to evolve, right? When -- look, if you just take a simple move in our model and say, hey, we went from a legacy gallery to design gallery. And that design gallery will essentially double the business, right, over in one year to three years.

So we are not going to mail any more sourcebooks into that market. We generally don’t. We maybe do a little splash, because we are opening a new gallery so people are aware of it. But our ad cost at a -- at that level, right, the leverage is massively. And I think people sometimes miss that in a model like ours, right, because they see this big gallery and they go, oh, it must cost a lot of money. It’s much more expensive and they don’t think about the dynamics of what happens, because no one -- like no one’s ever taken a really productive kind of a legacy store like we have. And then been able to just change the footprint and basically double their business. I have never seen it before. Consistently, across the entire country, we can do that.

And so, when you think about ad cost, that gives you big leverage. When you have a temporal situation like this with the pandemic and you make a decision to not mail a book, are there things we can learn there? Yeah, but it’s really -- it’s a little tricky, like, as we go to reinvest and mail the books, we mail as much as last year. We do e-mail more. Do we mail less? Do we -- what do we test? I mean, we are going to look at a lot of data.

We are going to run the models.

We are always looking for opportunities to be more efficient to optimize.

You also don’t want to under invest in the business certain times.

So -- but our model -- again, all the way through, you think about doubling your revenue at retail which is the biggest part of our business in a market and what that does to the cost structure at corporate? What that does to cost structure against all the other operating areas, our distribution centers and so on and so forth? You are going to have leverage. When you think about kind of climbing the luxury mountain as we are and taking quality up and desirability up and prices up, that’s going to give you leverage, right? And then you think about just kind of being consistently unsatisfied with whatever today’s performance is which is our culture you are always looking at how to do things better.

And so we are going to have the cost structure and where we have got all kinds of initiatives going, all kinds of investments we are making that we think will have really good returns that will make the model more efficient, more profitable.

So whether it’s labor savings, it’s not so much labor savings, it’s leverage on -- in the business and strategies that we are doing that are making the business just more profitable, right? So -- and we have a lot of things happening that we believe will do that and our history, right, over the last several years. I mean, I remember when we said we were going kind of be 10% operating margin, everybody was like, oh, you can’t be 10% operating margin.

So like I just want to say and then we hit 11.4%, right? And look, I remember reading reports on the company 11.4% no one is, like, it’s higher than whoever and it’s unsustainable, right? They only have half the revenues of this other company that their high was 10% or whatnot and 11.4% is unsustainable and then we hit 14.1% operating margin and it’s like everybody was like it’s unsustainable.

Now we are going to be at 21% and 21% on call it 7% revenue growth, like really the way to stand back and think about the pandemic is like smoosh the year altogether.

We are only going to have revenues up 7% and operating margins are going to be 21%. Does it really matter how those revenues came over the course of the year or does it matter that on 7% revenue growth they hit 21%.

So I don’t know if we didn’t have a pandemic, would we have hit 20% or we would have hit 22%? It’s not like the pandemic from a revenue point of view has enabled our operating margin this year. It really hasn’t. If anything it’s deleveraged our operating margin this year. It made us less efficient when you look at how things are happening. Like think about this.

We are generating like roughly $80 million to a $100 million of future revenue. We spent all the money engaging like all the customers, helping all the customers, doing all the design work and we are getting no revenues this year, that $80 million to $100 million. Put that $80 million to $100 million in your model this year and what would the operating margin for RH be? Because there wouldn’t really be much more cost, right? Like most of the cost is already behind us. We would had shipping and stuff like that. But you look at the flow through on that, you go operating margins would be higher than 21%, right? Like that’s what I focus on. Wait a minute. I am 7% operating margin. They hit 21%, right? I mean, they were -- we thought they were high at 14% and we thought they were really high at 11%, yeah. And then it starts to help you think about like, oh, where are they going next? Like we -- when we said we had a clear line of sight at 2020, it just came sooner than you expected, right? We say we have a clear line of sight at 25%.

We have a clear line of sight. We think it’s over the next several years, all depends what’s going to happen. If -- look, if we don’t go into a recession, if we go into a recession, we will stop right there. It will be reset. It will take a little longer. But if we don’t and if the economy continues to just perform, like if we just grow it 8% to 12% a year, we are going to do pretty good. If we accelerate, like we think next year it’s going to be double digits, right? So that’s 10% or over.

And so we wouldn’t tell you double digits if we didn’t really think it looked pretty certain, even like not expecting the trends in the second half of next year, we think when we anniversary those numbers, it’s not going to look like this. But we can look ahead and say, here’s all the things we are doing that will create upside.

Here’s what’s going to cycle forward.

Here’s the pluses and minuses. I mean, if you just take the lost revenues in our New York restaurant and add those back, it’s not a little, like that was -- it’s a very high-volume restaurant. And once the vaccines get out to there, people are going to start going back to restaurants. By the way, if you think about all the traffic we lost in restaurants, you think we run the restaurants just for the restaurant business? Of course, not. All that traffic drives business in our galleries to our brand.

And so when you go, oh, the restaurant business, I don’t know, the last few months were down like 70%, right, to our plan. When that comes back, there’s going to be a whole lot of people in RH Galleries, a whole lot of people discovering a lot of new products, a whole lot of people hopefully be inspired by our environment and there’s going to be kind of tailwinds here. But the real point is don’t get lost in the pandemic, right? Like, it’s a crazy year, right, down in the first quarter, stores closed. Stores closed part of the second quarter. Things all of a sudden swing back. I kind of watch it all way go. Revenues up 7%, looks like, okay, we are a little behind our 8% to 12% growth, but operating margins are going to be 21%. I really like this model. This is a really good model. I wouldn’t bet against this team.

We have done what we said we were going to do very consistently and we have exceeded people’s expectations massively over the last few years since we have transformed the entire company on so many levels and now we have got kind of a brand with no peer. And we have a DNA that’s just massively unsatisfied. We get super excited for like a few minutes and then we are really intense around here about like what’s next and making things great.

So I just -- I like the path we are on. And as a big shareholder here, I really like the next 10 years and I wouldn’t have told you that if it really wasn’t on the whiteboard behind me. My team’s all not even smiling, right? We look at this.

We are big thinkers. We look at a long-term view. I know you have a lot of customers that are real short-term focused. That’s okay. Like, don’t buy our stock. Like, if they want it -- if they want to own one stock with a long-term view, it’s a good place.

Michael Lasser

That’s very helpful. Thank you very much and have a nice holiday.

Gary Friedman

Thank you.

Operator

Thank you.

Our next question comes from Chris, excuse me, Curtis Nagle of Bank of America.

Your line is open.

Curtis Nagle

Hi. Good evening. Thanks very much.

So, yeah, I want to turn I guess for the RH contemporary line. Maybe just get a little more detail in terms of the vision and strategy. Gary, you described it as bridging between the interior and modern lines in the ladder. I am guessing there’s -- I guess, what I’d say is, an extremely strong chance, you wouldn’t rule it out if you thought it would cannibalize existing business.

So, yeah, I just kind of curious what gives the confidence you think that this is going to be a good incremental business about how it’s out of the other lines. Yeah, how should we think about it?

Gary Friedman

I think about it is we are excited about it and you ought to be excited about it. Because we are not excited about things that we don’t want to buy and that we -- I mean we are -- we might be too excited about it, right? If anything last night late as selling area like, okay.

So let’s make sure we are looking at the whole Board here, because it is really exciting. There’s a lot of really new product and so we just think it’s going to open the aperture of the brand. And yeah, we are really excited about how our teams can do everything at once and we keep kicking the can down the road at color. We got -- I think we are starting to zero in on RH color. It’s a tough one, right? We are a neutral space brand.

We are kind of famous for our look in point of view.

In fact, we are so famous for it, that people that like color kind of hate our brand almost like it offends them that there’s not a lot of color in our age. But that’s okay. We tell people that, look, there’s not a lot of color in humans, right? We are also some form of a neutral color from light to dark, right? And that’s why neutrals is the biggest part of the market, because most great design is a reflection of human design. That’s why it’s familiar and comfortable with it and that’s why you go, ah, because it’s a reflection of self. But we do think that there’s a market for color. It’s not the biggest part of the market. But that will open up the aperture that we are in.

So just no different than beach house and ski house opened up our brand. People talk like relatively small introductions, writing small books, but a big conversation. I can’t tell you how many people have said, oh, I have got your ski house book. It can’t wait.

We are doing it. We got your test book and so forth, so a lot of these things too. Again, we say internally if you want to be part of the conversation you have to create the conversation, right? And contemporary is going to create another conversation. Color is going to create another conversation.

You just have to do these things really, really well. But you should be really excited about it because we are really excited about it. And it’s -- what exactly does it look like, I mean, I can’t say that. It’s their remarks. It’s going to look very new and fresh. But again, we like to say the things that really do well are fresh yet familiar, right? So you can’t do things that are too far out there. Those are interesting but generally not relevant to your business and don’t sell well. But we think it looks very fresh. There’s a familiarity to it and there’s kind of really great historic design references that make it familiar.

So when we get things that are fresh and familiar they are usually really good.

Curtis Nagle

Go it. Excited to see it when you release it.

Just as a quick follow up.

Going back to Europe, I don’t know in theory. Do you think that the -- I know there are a lot of moving pieces here and its super early. But do you think that perhaps the profit contribution could be higher than the U.S. at some point in time, when do you get a little bit scale, given the comments you made about perhaps having a less dense category strategy [ph] and the additional international exposure you guys are probably going to see from being in these major capital cities?

Gary Friedman

Yeah. All our research and due diligence would say the potential is for higher margins than the U.S. And a lot of brands as you know have higher margins and higher profitability outside the U.S. than they do inside the U.S. And that’s because you are getting a lot of leverage off your cost structure, right, if you set it up well if you are not overly redundant. And for us, right, we don’t have to set up any kind of redundant buying organizations or inventory organizations or things like that. I mean think about it. We don’t have any cash and carry, what is our cash and carry business these days?

Jack Preston

Less than a 1%.

Gary Friedman

I’d say, 1%.

Jack Preston

Yeah.

You are right.

Gary Friedman

It’s almost zero…

Jack Preston

It’s a zero…

Gary Friedman

Almost, right, like…

Jack Preston

Yeah.

Gary Friedman

We don’t really sell anything. It used to be like a percent or 2% and now it’s almost zero. We just -- yeah, we have gotten rid of the holiday stuff. We got rid of the ornaments and everything.

So, yeah, every once in a while, someone buys some towels or something like it and walks out with them.

For the most part, we don’t really inventory anything in our stores.

So our model has -- is very simplistic versus other models, like, someone’s saying to me, like, oh, well, Home Depot or Target or other people didn’t do so well over in Europe or other -- yeah. Well, one, those are kind stores, not brands, right? They are stores selling other people’s brands. Most high-end luxury brands work really well globally, right? And if you are the best in your kind of category and we believe we are, then those brands do -- they usually do exponentially better than others.

And so -- and then -- and it seemed very strategic, I actually liked that we gave ourselves a little bit more time on Europe, because we had more time to think about things like this Curtis, the margin structure, how we think about it, the pricing. All the different nuances and really, really think deeply about these moves that we are going to make in positioning the business correctly, because everything we have looked at and read and looked at points of references would say, we should have higher profit margins in Europe.

Now there’s going to be some short-term, some expense yet minor expense deleverage as you ramp up the infrastructure. But that might take care of itself relatively quickly because of the broad based market you are going to address by opening and just -- by opening it just in the U.K., in London and England and Paris, and a couple of these galleries, even looking at Munich and Dusseldorf or Madrid and Brussels and once just with that little footprint.

You are going to get a massive audience, right, because of the Internet and because the online component of the business. And by positioning ourselves in these kind of extraordinary locations and stores and environments that we are looking at, it’s going to be a great new learning. I mean, I really -- as much I really didn’t want to delay it, it was just the right business decision to do it, because we are so anxious to learn. But I think what you are saying is directionally right.

I think it should be based on other points of reference more profitable or at least as profitable as our U.S. business. But it should create leverage, right? So the net-net effect should be overall RH margins going up.

Curtis Nagle

Got it. Thanks very much for the thought and happy holidays.

Gary Friedman

Thank you. Happy holidays to you.

Jack Preston

Operator?

Allison Malkin

Ally?

Jack Preston

Operator?

Gary Friedman

We have got our last question or is the operator…

Jack Preston

We saw three…

Allison Malkin

No. There…

Gary Friedman

Three more.

Allison Malkin

There’s two more.

Gary Friedman

Two more? Okay.

Jack Preston

Two more.

Gary Friedman

We lost our operator?

Operator

Brad Thomas, your line is open.

Brad Thomas

Hi, Gary and Jack. Can you hear me?

Gary Friedman

We can hear you.

Jack Preston

Hi, Brad.

Brad Thomas

Great. Hey. It’s Brad Thomas with KeyBanc. Thanks for making time for my question here.

Just hopefully a quick one just on how to think about 4Q? I know there’s not specific guidance. But if you go back the last four years the fourth quarter has been your highest order for operating margin of any quarter and so just trying to understand some of the seasonal dynamics. Gary, I think you also reference that if sales for the full year come in growing about 7% that that might get you to 21% operating margin, which maybe pushes that 4Q operating margin closer to 20%.

Just trying to understand if there’s any puts or takes that we should be aware of to make this 4Q different than what we have seen the last few years seasonally?

Gary Friedman

Yeah. Well, I mean, Jack can give you some highlights.

Jack Preston

Yeah.

Gary Friedman

But one of the big ones is, Q3 has helped by not mailing a book. Hard to say exactly how much because we would have got more revenue.

We expect revenues to slow a bit based on the fact that we don’t have the books and so you don’t have the ramp of the books and we are at record kind of out of stocks and things like that.

So we are taking a conservative view and I think in the fourth quarter as we should. But -- I think the landscaping is a little hard to look at historically, because there has been so much change, change in demand trends, change in margins, you have things cycling through like when -- when the outlet business, how the outlet business cycles in and out and how the rug business cycles quarter-to-quarter, puts and takes that may have distorted past orders in past times.

So -- and then we have things like -- we generally have a much bigger bonus accrual in Q4 and other things like that where we are having really good years and that can distort things.

So, yeah, I don’t Jack if you want to?

Jack Preston

Yeah. One thing I will add, as you think about the 21% in 2020 and as we talked about that as sort of floor number, that 7% growth rate.

So that it does imply about 20% growth for revenue, as Gary mentioned, that is a slight deceleration from the 25 points in Q3. And then margin wise, to get the year at to ‘21, obviously that implies just shy of ‘21 for Q4, and I think, Gary spoke to that.

You can’t look at the same sequential trends because Q3 has the advertising benefit.

And so, I was going to make similar comments on the cycling, right? So like the rug business, we had talked about it as a sort of -- when you think about when we started clearing that out and put the new product on. The biggest benefits are going to be through this quarter.

We will still get some benefit in Q4 and then once you come into next year. That will be fully cycled. And our outlet will have a different dynamic. But directionally I think those are some of the pieces.

Brad Thomas

That’s really helpful color. Thank you. If I could squeeze in one more housekeeping just around the merchandising newness for next year, any more color on maybe the magnitude. What percentage of products you may refresh or maybe new in 2021 and how that compares to what you normally change out or would like to normally change out?

Jack Preston

I will just say year-over-year it will be a -- it will be a meaningful increase year-over-year.

Brad Thomas

Thank you so much. Hope you all have a great holiday.

Gary Friedman

Great. Thank you, Brad.

Jack Preston

Thanks, Brad.

Gary Friedman

Happy holidays to you.

Operator

Thank you.

Our next question comes from Tami Zakaria of JPMorgan.

Your line is open.

Tami Zakaria

Hi. Thank you so much for taking my question. I just have one longer term question.

I think in your press release you spoke of 10% to 15% annual sales growth potential in the future with mid-20s operating margins.

So what’s really driving that optimism of 10% to 15% versus 8% to 12% that you have been speaking out prior to this trend? Do you need all the new businesses to come to life, like, the Yard and RH Residences business to come to life to get there or can you get to that 10% to 15% with the existing home furnishings business alone?

Gary Friedman

Yeah.

First, let me kind of characterize that, what -- I gave you kind of our internal view of what’s possible, right? Not necessarily our guidance and we are obviously going to always have a view internally of what can happen. I’d start with you, if you just kind of thought about -- if you take the belief that, hey, RH is building one of the dominant -- one of the kind of premier luxury brands in its space in the world and if it performs like other luxury brands and you think about the -- just the market at a global level, it would imply that 25% of our business should be kind of in the U.S./North America and 75% of our business should be outside of the U.S. And we believe we can be $5 billion to $6 billion long term in North America. That would imply that we would be a $20 billion to $24 billion global brand as architected today. The yacht is a brand elevating conversation, right? There’s -- some people that are spending money like everybody else on digital marketing, doing things that nobody talks about. We mentioned a yacht and a lot of people are talking about it, right? And when you see it on our website in the world of RH where 30-odd million people will see it every year, it’s going to be a pretty cool thing and a pretty big conversation for a pretty minor investment, right? And so it’s not it’s not about how many people are going to be on the yacht. It’s about how many people are going to appreciate the design, the creativity, the taste and style of the yacht and how many people are going to be aware of it and talk about that yacht, right? And so, yeah, the yacht is not a big growth story, the yacht conversation, right? The ads probably say we do want to be part of the conversation.

You got to create the conversation.

You want to climb the luxury mountain and you want people at the highest end of -- at this top of the mountain to talk about you, do things that they are interested in. Do -- be places where they spend their time.

If you are in something in hospitality whether it’s a yacht or a guest house, do something that forces the very highest people at taste level of wealth influence force them to tip their hat that you did such great work that you earn their respect that think you create a forced reconsideration of your brand, right? So -- but the growth like if you just said, hey, we are going to get to the number is like $7.4 billion to $11.5 billion?

Jack Preston

$11.5 billion. Yeah. $7.4 billion to $11.5 billion

Gary Friedman

$7.4 billion to $11.5 billion is like maybe half way to our global potential.

So it’s -- for us to have a goal of saying, hey, can we grow this thing at 10% to 15%? We could. We could maybe grow faster. It depends on how much risk. It depends on how quickly you can go without putting risk into the work, right? I mean we are -- furniture of this quality has never been made in these quantities.

So we have to build this supply chain and the platform to be able to do this, right? But -- I mean the thing that gives me confidence about that is it from where -- we have been to where we -- to where we are.

We have learned that supply chases demand.

If you create demand, people will figure out how to supply that demand, because there’s opportunities for people to benefit economically, right? And so we believe we will create a market at the higher end. We think that market is a potential for probably $20 billion to $25 billion globally and 10% to 15% annual sales growth could be possible. I wouldn’t plug it into your models. But if you wanted to look at an upside model of what might potentially could be if we start opening countries and opening countries is exponentially more valuable opening stores in North America that could accelerate our growth rate, right? We have people knocking down the door here, trying to partner with us with our brand, wanting to partner with us in China, partner with us in the Middle East, partner with us in Europe, partner with us in South America, partner with us in Mexico. Like, there is not -- I don’t think there’s a country unrepresented as far as people like knocking on our door wanting to take our brand globally. We could go faster. It might mean less control and we believe brands with more control will become more valuable.

If you look at history and you look at all the great brands, they are all buying back their business from partners, because they believe they can run the business better and there’s greater returns.

So we are going to learn from that history.

We are going to probably go slower and with more control. And we are going to try to retain as much control of our brand as we possibly can. I mean, today, we have 100% control of our brand. Nobody presents our products but us. Nobody sells our products but us. Nobody uses our brand or our marks but us. And we think that’s going to be more and more important in a world of marketplaces and kind of what it called message, right, like this.

I think any of these brands -- I mean, you look to the right model, look at what Macy’s [ph] is doing, look at what Chanel’s doing, look at what the LVMH brands are doing, look at the people that didn’t put their brands out in marketplaces that were very discerning about what they have done that the investments that they have made. They have taken -- you look at the great brands, they have taken more and more control of their distribution.

You look at the brands that didn’t make those investments and what happened to them and I don’t have to name them but you know who they are. I mean they are -- the value has been significantly diminished, because there’s brands that had too much of their distribution was controlled by department stores. Department store is a decaying platform. Imagine if you were -- you built a great brand and your distribution platform was predominantly department stores and you don’t have control of your distribution channel. I mean, I think what [inaudible] and Channel teams and other people who have invested over the past 10 years to 15 years to take control of their distribution that’s why there’s a brands they are today. Good news is we are not in any department stores.

We are not in any -- nobody’s got any control this brand but us and so we love that positioning and we think it may mean we go slower with higher quality and that’s okay, that’s okay.

We are -- the world is only going to get smaller. It’s not going to get bigger, right? The Internet and communications and technology is bringing the world together. English is going to become the language and it’s so much different and every decade it’s exponentially easier to operate internationally.

So and that just is going to grow faster.

So -- and I just think that, if you were, I would say, 10% to 15%, it’s -- probably people on the long side of this business that have that model probably. Should it be a secret that choose the RH team thinks that they might be able to grow this to 10% to 15%. We think we can probably do that. Is that what we are going to guide you? No. Not until we are more confident. There may be a time we are sitting here and that becomes the guidance. There may be a point that we are sitting here in a few years after we have got more data and proof-of-concept globally, that the number could be 15% to 20%. I don’t know. It’s not unreasonable if you think that the size of the market for logistic core business. Everything else is gravy.

So I think we are -- the yacht business is going to be meaningful from a taste and style and image in conversation point of view, yes.

For revenue point of view, no.

We will do revenues, but I think we have got, like, we have multiple charters lined up. It’s like we -- and we unfortunately had to cancel seven charters on the boat this past summer because of the pandemic. But there’s a lot of demand for a boat. But that’s irrelevant from a revenue point of view. Do I think things like guest houses could be meaningful long-term. They might be.

I think the work is that good.

I think what it’s evolved into is something extraordinary beyond what my initial vision or expectation support were. And I think it’s become that because we control everything. Not some third-party. It’s not Marriott using our brand.

You have a bunch of bureaucrats with no taste kind of screwing up your brand. It’s not some other little hotel company that’s just doing a revenue share thing with you.

We have total control of this thing. Do I think RH Residencies could be a big idea? I really do. I am fascinated with it. I am fascinated with selling spaces, because when I go on Zillow and I go on Redfin and I look at the level of taste, the design, I see crappy architecture,. I see non-existent interior design and I am like, man, people with a lot of money don’t have the ability or access to make their home look, amazing. Like, why doesn’t everybody have an incredible inspiring home, especially if you can afford it? Why? Because it’s really hard to do and there’s no way to do it. And by the way, why wouldn’t you buy homes that are fully furnished, that are perfect. That you just like you buy and just give me the key and you move in, enough to spend a year or two years or three years or four years or five years or never get your home. Most people just never finish it. Like so -- like Eri said to me a long time ago, like, hey, they don’t sell you are a car without an interior.

You don’t sit there and trying to figure out the interior of your car. Yeah, you get to pick your color.

You want tanned.

You want black.

You want -- so I just think I am fascinated with the fact that there’s so little great architecture, such little great design. I mean start in any market you want. Like you want to go to marine right now, I think the most expensive house is $43 million.

Just click down and tell me what you think of the architecture, the landscape architecture, the interior design, the furnishings, the taste, the style. It could be massive. It could be massive.

You said like, hey, was there an acquisition we make some day? I don’t know. Maybe we buy one of the big home builders and we infuse them with great taste and I am not saying we are going to do that. But if you want to think big, I mean, there’s -- like I think we can create an entirely new market for residences whether they are condominiums or homes or single homes and communities and things like that, and you will hear more about this.

We are pursuing opportunities in spaces and place is part of our strategy. And you will hear about our first tests of Orange residences and --but whether it’s home, condominiums, whether it’s luxury rentals huge opportunity. The market’s full of crap out there like it’s massive opportunity.

Tami Zakaria

Got it. Got it. That’s very helpful as always. Thanks, Gary.

Gary Friedman

Thank you. Happy holidays.

Tami Zakaria

You too.

Operator

Thank you.

Our final question comes from the Seth Basham of Wedbush Securities.

Your line is open.

Seth Basham

Hi. Good evening, Seth Basham here. Thanks for taking my question.

The first question is just around understanding product margin in the quarter.

Now product margin expansion certainly drove the majority to gross margin expansion. But could you help us understand how much of the revenue mix shift away from hospitality and outlet helped increase gross margins in the third quarter?

Gary Friedman

From a product margin point of view our hospitality margin is like quite good.

You obviously have a higher mix of employment. But we are also operating the restaurants at very low levels of productivity and we are keeping people employed, right? So we actually got a pretty big drag from the restaurant…

Jack Preston

Overall to the business.

Gary Friedman

Overall…

Jack Preston

Slight -- a slight lift in the margin to -- very slight.

Gary Friedman

Very slight.

Jack Preston

In the sales margin?

Gary Friedman

There’s not enough sales.

Jack Preston

Yeah. There’s not enough sales to make a…

Gary Friedman

Yeah. Yeah.

Jack Preston

… big impact.

Gary Friedman

Yeah. Yeah.

So…

Jack Preston

Yeah. But…

Gary Friedman

Yeah. And then the outlet, yeah, we have kind of given you directionally that’s year-over-year that’s been a big driver because we redesigned and re-conceptualized the whole reverse logistics business.

Jack Preston

Yeah. Yes.

So, of that 530 basis points of product margin, essentially half are in our core business, with some of that still related to the rug cycling as we talked about. And then half is from outlet. And that -- those are the big pieces of the factors.

Gary Friedman

Yeah. But inside the core business I think every category has got positive product margins, right?

Jack Preston

That’s correct.

Gary Friedman

Yeah.

Seth Basham

Very helpful. Thanks. And then…

Gary Friedman

Yeah.

Seth Basham

…one item that -- one area that we haven’t really discussed much on this call is the interior design architecture and landscape architecture opportunity. Could you just give us an update on your rollout plan associated with that business?

Gary Friedman

Well, interior design is out there, right. It’s a -- I think today we must be the biggest residential interior design firm in North America, if you look at the work that we do and the projects that we do. And architecture -- and landscape architecture, we will begin to test that. I gave you a bigger vision for that, how it’s going to be within the world of our age. But we were going to move more quickly.

We have pushed some of the plans out a bit because of the pandemic. But we are looking at testing our first kind of freestanding architecture interior design, the landscape, architecture, studio in a design district that will support many of our galleries in a market.

So we will -- the way to think about it is where you see today if you have been into one of our new galleries.

One of our prototypes where kind of the back part through -- if you look through the staircase is big glass wall with desks and it’s right next to our design affiliate.

We are all -- our interior designers have their offices and that says right now RH interior design. Long-term, we believe it will say, long -- RH architecture, interior design and landscape architecture. And I think about that the galleries because they are a manifestation of great architecture, great interior design and great landscape architecture.

We will have the only consumer-facing business of its kind like that. Most architects don’t have an office that anybody sees and most architects’ offices aren’t in great architecture necessarily. Landscape architects, like where do you find one, like, interior designers, again, not a consumer-facing business.

So inside these big magnificent galleries that are an example of all those disciplines, it only makes sense that people would go, oh. I can’t tell you how many times people are in our galleries that ask us who the architect is. How many people ask us out, who did the landscape architecture? Who did the landscaping here? They obviously know we did the interior design.

So we think there’s an opportunity to continue to elevate and amplify the core business by expanding our services business, which is a very capital-light business if you think about it, right? It’s not a lot of capital to make the investment to act -- add those services and those services don’t face the consumer in a very compelling way.

So -- and there are things that we already do really well, right? We now do almost all of our architecture internally, right, very little externally.

We have a great internal architecture team. We do all of our landscape architecture internally. We do all of our interior design internally.

And so their competencies of our company and it’s just building out the teams kind of market-by-market, right? And just as we did with interior design, I see it no differently than interior design. It will take us several years to kind of do it and we will learn and we will roll it out. But we have set up kind of the galleries, the new galleries to accept those businesses.

Now we may need support offices behind the scenes.

We will interface with the customer there.

We will catch them there.

We will consult with them.

We will make the initial connection. But we probably will need some office space to support those businesses but that office space can be anywhere, right? It’s not high cost real estate.

You are not paying premium retail real estate for the back-of-house office. We do all of our meetings in the galleries, but we might have to house more team members doing the production work on the architecture or the landscape architecture and things like that.

So we think it’s very logical for us to pursue the services side of the business and we think we are really well-positioned to capitalize on it and we have the competence, right? It is what we do.

Seth Basham

That’s helpful.

Just to clarify Gary, I know you don’t charge for the in your design services now unless I am mistaken. But do you plan to charge for those in the future and I presume that you plan to charge for the architecture and landscape architecture design services?

Gary Friedman

Yeah. Yeah.

For sure the architecture and landscape architecture design services, how we think about the interior design piece work, we are still noodling with that. We believe at some point, we will probably charge to that. But we may not need to. I am not, I am not sure honestly. I mean I go back and forth on that one all the time, like, so more to come, but we will develop there more. But I think as we test this and kind of get our arms around it and we are going to -- we will probably start it here locally. I guess, I could say, we are thinking of doing right. Yeah, I mean, we could -- I reserve the right to change our mind, I think, I am assuming. But we -- our plans for opening a beautiful new gallery in San Francisco at the historic Bethlehem Steel Building, it’s really spectacular when everybody can travel again and come up to San Francisco.

Let us know we will get you a seat at the restaurant spectacular restaurant. It will be the first restaurant with our -- we are actually testing our new guesthouse concept and menu there. It will be kind of a dual restaurant.

We will have a live fire cooking component to it. That’s really great. But we are in this spectacular gallery in San Francisco, rooftop park, views of the bay and the city and so on and so forth. And we have this is -- as you know if you have been in San Francisco, we -- one of the great learnings for us is when we took this amazing little building in the heart of The Design District that was the Ed Hardy Antique Gallery and he built this charming palladium building. And we went into this center of the design district and said we got to put our brand among the very best. Remember the headline in the local San Francisco paper was There Goes the Neighborhood Change Store Going into the Design District, right? So we did pretty good work. We opened a beautiful gallery there.

I think we see the people’s expectations and it became really fantastic for bid we -- that gallery is like $20 million.

Jack Preston

Correct.

Gary Friedman

Yeah.

Something like that. In 4,500 square feet.

Jack Preston

Right.

Gary Friedman

Incredibly, it was one of our best real estate moves ever. We bought a little building I think for $3.5 million. But we have this charming building with a beautiful garden courtyard and we have learned so much being in that building and we could sell the building for $10 million or something. And we are thinking -- we are right in the center the design district. Why don’t we take that building and turn it into the first kind of freestanding RH architecture interior design and landscape architecture studio, right? And right in the heart of the design district, face the customer there in the heart of the design district and then face the customer in our galleries and use this as our first ecosystem for the services platform right here in our backyard. We can go there. We can listen and learn, very visible, use it as a lab and we think that will really accelerate our learnings.

So that’s what we will do with it. Exactly when we start? Not sure yet.

We have got a lot of big rock for moving in different parts of the business right now. And just want to make sure we do this one well. And we have a team in place that can really positioned this well and make a great first impression as we entered the services business. But that’s what you can expect from us.

I think we will -- now that I have said it, what I like is that we are committed to it, right? It kind of -- we have been talking about it but now, we are committed.

So it will happen. But if it works, I think, it just opens up another aperture business for us, right? If all of a sudden we become the architect for people’s homes, you are just going to sell them a lot more furniture and lighting and accessories and blubs [ph] and bath hardware and all the things we sell.

Seth Basham

I get it. Very exciting. Thank you very much and happy holidays.

Gary Friedman

Thank you.

Jack Preston

Thanks, Seth.

Operator

Thank you. I am showing no further questions. I’d like to turn the call back over to management for any closing remarks.

Gary Friedman

Great. Well, thank you, everyone. I want to especially thank our people and our partners around the world who have worked so hard through these challenging times to continue to elevate our brand and bring our vision to life each and every day. And also our thoughts and prayers go out to everyone who’s suffering through this pandemic, especially of people who have been infected by this virus and have family members and loved ones impacted. And thanks to all the people on the frontlines that are just working to keep us safe and get us through this. And this is -- it’s been a -- just a very mixed feelings, right, from our company, you -- again, when there’s so many people suffering and your business is doing well and you are getting the tailwind, it’s hard to really feel that good when other people are having the opposite experience.

So we just hope that we get through this very soon, that the world will continue to evolve and improve and we will be here for the long-term. But we want to thank everyone for their hard work, their leadership, their imagination and their perspiration in bringing this to life. And all our frontline teams that is in our galleries, it’s in our call centers, it’s in our distribution centers and delivering our products into our customer’s homes. They have had to walk a fine line, right, and being on the frontlines, and especially want to thank those teams who have represented our company and our brand so well through these challenging times.

So we wish everyone a wonderful holiday and a safe holiday and here’s to getting to the other side of this and back to bright and sunny days for everyone on this planet. Thank you.

Operator

Thank you. Ladies and gentlemen, this does conclude today’s conference. Thank you all for participating.

You may have a great day.

You may all disconnect.