Signet Jewelers Limited Management Discusses Q1 2014 Results - Earnings Call Transcript

| About: Signet Jewelers (SIG)

Signet Jewelers Limited (NYSE:SIG)

Q1 2014 Earnings Call

May 23, 2013 8:30 am ET

Executives

James Grant

Michael W. Barnes - Chief Executive Officer and Director

Ronald W. Ristau - Chief Financial Officer, Principal Accounting Officer and Member of Disclosure Control Committee

Analysts

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

Oliver Chen - Citigroup Inc, Research Division

Rick B. Patel - Stephens Inc., Research Division

Anthony C. Lebiedzinski - Sidoti & Company, LLC

William R. Armstrong - CL King & Associates, Inc., Research Division

Irwin Bernard Boruchow - Sterne Agee & Leach Inc., Research Division

Jeffrey S. Stein - Northcoast Research

David Wu - Telsey Advisory Group LLC

Warwick Okines - Deutsche Bank AG, Research Division

Operator

Welcome to the Signet Jewelers First Quarter Fiscal 2014 Results Conference Call. My name is Larissa, and I'll be operator for today's call. [Operator Instructions] I'll now turn the call over to Mr. James Grant, Vice President of Investor Relations. Sir, you may begin.

James Grant

Good morning, and welcome to our first quarter fiscal 2014 earnings call. On our call today are Mike Barnes, CEO; and Ron Ristau, CFO. The presentation deck we will be referencing is available from the financial section of our website, www.signetjewelers.com.

During today's presentation, we will, in places, discuss Signet's business outlook and make certain forward-looking statements. Any statements that are not historical facts are subject to a number of risks and uncertainties, and actual results may differ materially. We urge you to read the risk factors, cautionary language and other disclosures in the annual report on Form 10-K that was filed with the SEC on March 28, 2013. We also draw your attention to Slide #2 in today's presentation.

I will now turn the call over to Mike.

Michael W. Barnes

Thanks, James, and good morning, everyone. We're very pleased with our outstanding first quarter results. We delivered a strong financial performance in the first quarter, driven by the excellent execution of our strategies, which led the sales growth and expense leverage. Our comps at Signet increased by 6.4%. The U.S. division comps grew 8.1% on top of the 1.2% increase last year. And then the U.K. comps declined by 2.3%. We also had tremendous continued momentum within our consolidated eCommerce space, as we grew by 40.7%. Of significance, as of 2012, Signet is now the #3 largest eCommerce retailer in the jewelry category. That is up from 2009 when we stood at #11. It's a great performance for our eCom team. Altogether, this led to operating income of $142.8 million, 10.4%. And diluted earnings per share were a record $1.13, up $0.17 or 17.7%.

So let's begin by taking a look at the U.S. division performance. In the U.S., total sales were $858.6 million, up $107.1 million or 14.3%. Our sales growth was driven by broad-based strength across all merchandise categories in both Kay and Jared, as well as the Ultra acquisition. Kay and Jared experienced increases in transaction counts, and Kay in particular, increased in average transaction value. U.S. same-store sales increased by 8.1% in the first quarter. Kay comps increased 10.2%, while Jared increased by 6%. The success in both concepts was driven, in part, by a successful Valentine's Day period, but also by broad-based strength across all merchandise categories through most of the quarter, particularly in bridal and a strong lead into Mother's Day.

And then in the U.S., as I mentioned earlier, eCommerce performed strongly with sales up $8.3 million to $25.6 million, an increase of 48% for the U.S. division. The U.S. division also delivered operating profit growth of 11% with a 17.8% operating margin. Excluding the dilutive effect of the Ultra acquisition, operating income increased 13.7% and operating margin was 19%, up 70 basis points, a record level for the first quarter. It was another great quarter for the U.S. team members.

The drivers of our performance were our sustainable competitive strengths. In particular, our great customer experience, our investment marketing and broad customer acceptance of our powerful merchandise offerings. The customer experience is central to our success and we remain focused on training and development of our store teams, including the best use of in-store sales enhancing technology. Branded, differentiated and exclusive merchandise continue to perform very well, virtually, across the board. Our marketing investment for Valentines and Mother's Day again proved very effective, with increased impressions helping us drive strong sales performances and building the value of the brand equity of both our store concepts and our merchandise collections. We also saw success selling across channels. As I mentioned, U.S. eCommerce sales were up 48%. This was driven, in part, by 18 million visitors to our sites and over 1/3 of those were through mobile devices.

Now I'll turn the U.K. Total sales in the quarter were $135 million, down $13.5 million or 9.1%. Comp sales decreased 2.3% compared to an increase of 1.2% in the first quarter last year. The total sales decline was due to a same-store sales decrease, primarily in H.Samuel, the impact of closed stores and currency fluctuations. In Ernest Jones, the number of transactions increased and we experienced strength in the bridal business and watches, excluding Rolex, which is being offered in pure stores in the U.K. In H.Samuel, the number of transactions declined, resulting in lower sales across most merchandise categories.

eCommerce sales were $5.5 million, which was up $0.7 million or 14.6%, a nice double-digit gain. Our U.K. websites attracted 7.7 million visitors in the quarter and 42% of those were through mobile devices. Operating loss was $4.1 million, an increase of $1.1 million from the last year, primarily due to lower sales that's partially offset by cost reductions. I would like to thank our U.K. team members for their strong efforts in what continues to be a very challenging market.

We are well positioned to achieve our fiscal 2014 financial objectives. This is due to our excellent first quarter results in both top and bottom line, strong Mother's Day results, as we have moved into the second quarter, and our consistent ability to execute initiatives by focusing on our competitive strengths, which are our people. It always starts with them. Our brands and the overall strength of our merchandise offerings, our sector leading advertising, the strength of our real estate portfolio, our supply chain leadership, particularly in the U.S. our in-house customer finance programs, and finally, our strong financial position.

And now I'll turn the call over to Ron for a little more color.

Ronald W. Ristau

Thanks, Mike, and good morning, everyone. I'll start by explaining sales in more detail. For the quarter total sales for Signet increased 10.4% to $993.6 million compared to $900 million last year. Same-store sales increased 6.4% compared to 1.2% growth last year. In the U.S., total sales increased 14.3% or $107.1 million to $858.6 million, which included the same-store sales increase of 8.1% that Mike discussed. Our non-same-store sales were up 6.2%, with non-comp stores generating an increase of 1.6% and Ultra adding 4.6%.

The U.S. sales increases, again, were driven by broad-based strength across all merchandise categories in both Kay and Jared, as well as the Ultra acquisition. Kay and Jared experienced increases in transaction counts of 6.6% and 10.3%, respectively. In addition, Kay increased average transaction value by 4.9%.

In the U.K., total sales decreased 9.1% or $13.5 million to $135 million, while comp store sales decreased 2.3%. The total sales decline was due to a same-store sales decrease of $3.1 million, primarily in H.Samuel, the impact of closed stores of $4.8 million and currency fluctuations of $5.6 million, which were unfavorable. Signet eCommerce sales were $31 million, up $9 million or 40.7%, continuing their strong trend, as Mike referenced.

Now let's take a look at the components of operating income. Our gross margin was $382.8 million, an increase of $29.1 million. The gross margin rate was 38.5%, down 80 basis points. The inclusion of the results for Ultra increased gross margin dollars by $8.8 million, however, reduced the consolidated gross margin rate by 50 basis points and the U.S. gross margin rate by 60 basis points. The Ultra gross margin is lower than the core U.S. business due to lower store productivity and the impact of the integration. Ultra gross margins are expected to improve as the Ultra integration and conversion to Kay outlets is completed.

The remaining 30 basis point reduction in the consolidated gross margin was attributed to the following changes in the U.S. and the U.K. businesses. Our gross margin dollars in the U.S., excluding Ultra, increased $24.1 million, reflecting higher sales, partially offset by a gross margin rate decrease of 70 basis points. The gross merchandise margin was impacted by merchandise mix, new bridal and Jared test programs, which were designed to further increase our competitive positioning in the bridal category and the impact of the Mother's Day sales shifts.

Gross margin in the U.K. decreased $3.8 million, primarily reflecting the impact of decreased sales and currency fluctuations. Currency translation costs were $1.5 million of the $3.8 million decline. The gross margin rate declined 20 basis points, as increased gross merchandise margins were offset by deleveraging of expenses on lower sales.

Our selling, general and administrative expenses were $287 million, and as a percentage of sales decreased 50 basis points to 28.9%. This was primarily due to leverage on advertising and store staff costs. I will discuss this in more detail in a moment. Other operating income was $47 million or 4.8% of sales, compared to $40.2 million or 4.5% of sales last year. This increase was primarily due to higher interest earned from higher outstanding receivable balances.

So our consolidated operating income in the first quarter increased $13.4 million to $142.8 million, representing 14.4% of sales, which was flat to prior year. However, excluding Ultra, our consolidated operating margin would have been 15.3%, up 90 basis points over the prior year. The U.S. division's operating income, including Ultra, was $152.8 million or 17.8% of sales compared to $137.7 million or 18.3% of sales in the first quarter of fiscal 2013. When we exclude Ultra, the U.S. division's operating income was $156.6 million, or 19% of sales, up 70 basis points. The operating loss for the U.K. division was $4.1 million, an increase of $1.1 million. Our consolidated operating income increase led to fully diluted earnings per share of $1.13, up 17.7%. If we were to exclude Ultra, fully diluted earnings per share were $1.16 up 20.8%. Under this scenario, it was a very strong performance.

Now some additional detail on SG&A expenses. Again, the SG&A expenses are $287 million compared to $264 million in the first quarter of fiscal 2013, up $22.5 million. And as a percentage of sales, they decreased by 50 points to 28.9%. SG&A spending was well controlled, and leverage was realized on both advertising and store expenses, particularly in the U.S. SG&A expenses in the U.K. were reduced by $2.7 million, reflecting the impact of cost reductions and currency fluctuations, while they did deleverage slightly on lower sales. The inclusion of the results for Ultra increased SG&A in this quarter by $12.6 million and increased the consolidated SG&A rate by 30 basis points. We expect a reduction in Ultra SG&A going forward as the integration is completed. If we exclude Ultra, the rate was 28.6%, an improvement of 80 basis points. So SG&A spending was well controlled in the quarter.

Turning to our share authorization, of course, we continuously look at a variety of ways to deliver shareholder returns. Beyond reinvesting in our operations, we have taken a shareholder-friendly view towards our use of cash. In the first quarter, we completed the $350 million share repurchase program by purchasing approximately 749,000 shares of Signet stock at an average price of $66.92. Over the life of the program, which launched in the fourth quarter of fiscal 2012, we have repurchased 7.4 million shares at an average cost of $47.10. We ended the quarter with cash of $263.7 million, and we remain committed to ending the fiscal year with cash on hand equal to 7% to 9% of our annual sales. We will continue to review with our board future options for the creation of shareholder value.

Net inventories ended the quarter at $1,426 million, an increase of $91.4 million or 6.8% from a year ago. Again, this increase is primarily due to a $49.8 million increase in inventory for Ultra, $31.5 million of diamond inventory associated with our strategic sourcing initiative, expansion of our bridal programs and new store growth. Partially offsetting these increases were management actions to improve churn. Excluding Ultra, our inventory increased only 3.1% and was very well controlled. We continue to believe our inventory remains the best controlled in the specialty jewelry industry.

Our credit portfolio also continued to perform strongly. Accounts receivable were $1,157.5 million, up 12.9% due to higher credit sales driven principally by an increase in our bridal business. Credit participation as a percentage of U.S. sales, excluding sales from Ultra, which doesn't provide credit currently, was 57.7%. This compares to 55.8% in the first quarter of last year and 56.9% for the full fiscal 2013. The increase, again, was primarily driven by higher bridal sales. Our average monthly collection rate was 13.4% compared to 13.8% last year and net bad debt expense, which was $21.3 million, represented 2.5% as a percentage of U.S. sales, flat to prior year. Finally, our other operating income increased primarily due to higher interest income from higher outstanding receivables balances.

Now turning to our second quarter guidance. As we referenced in the 8-K we filed back in January 15 of 2013, the company continues to expect the shift of the Mother's Day sales this year, partially into the first quarter, to impact our second quarter sales and earnings performance. In addition, integration costs and the seasonality of the company's newly acquired Ultra Stores are expected to be dilutive to the second quarter EPS. The company continues to expect the integration of Ultra Store systems and the conversion to Kay outlets to occur as planned in the second quarter, and Ultra to contribute positively to performance by the fourth quarter of the year. As such, for the second quarter of fiscal 2014, the company currently expects same store sales to increase in the low- to mid-single digit range. Earnings per share is expected to be in the range of $0.79 to $0.84, which includes a $0.06 per share negative impact from the Ultra acquisition referenced above. The Ultra loss expectation is approximately $0.03 greater than originally anticipated due to a potential decrease in sales short term, as we complete key steps in the transition this quarter.

EPS, excluding Ultra, are in the range of $0.85 to $0.90. I'd like to please note that the majority of the $0.09 loss that we are expecting for both the first and second quarter combined of Ultra, is attributed to nonrecurring cost for duplicative overhead, severances and unnecessary office space, and will not repeat next year or into the second half of this year.

For the full fiscal 2014 year, the company continues to expect capital expenditures in the range of $180 million to $195 million, which includes costs related to the opening of now 70 to 80 new Kay and Jared stores, up from our previous expectations of 65 to 75 store remodels, digital and information technology infrastructure and Ultra capital spending, which we now expect will range at approximately $14 million, representing a reduction from our previous expectation of $18 million.

Thank you. And I will now turn the call back to Mike.

Michael W. Barnes

Thanks, Ron. In conclusion, I'd like to once again thank the Signet team worldwide for their contributions to a very successful quarter. We would now be pleased to take any questions that you have.

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from Jennifer Davis from Lazard Capital Markets.

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

A couple of clarifications. First of all, Ron, how should we think about the other operating income going forward, should we kind of think of it as 4.5% to 5% of sales in general or...

Ronald W. Ristau

Yes. It's not going to move that much, Jennifer, I think you should think about it in the range of last year. This quarter was a couple of basis points up, but I don't think the range is going to move substantially.

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

Okay. But we should think about it as in terms of percent of sales rather than a fixed dollar amount?

Ronald W. Ristau

It does fluctuate by quarter somewhat, but I would follow the actual results from last year as a guide.

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

Okay. And then sorry if I missed this. What was the -- how come the Ultra acquisition is going to be about $0.03 -- how come the impact will be about $0.03 greater than originally anticipated? Did you say that was because...

Ronald W. Ristau

Sure. I'm sorry, that's a great question, thanks. It really relates to when we originally -- we were originally expecting it to be about $0.03 in each quarter. We're now come to realize or anticipating in our second quarter guidance is that we're going to be completing the majority of the transition of the systems and inventory cutovers in the second quarter, as we've always indicated. And we think there could be a little more of a disruptive effect on sales as that happens. And also, I believe that we could have -- we should have done a little bit better job in anticipating the Mother's Day shift in Ultra, which was as strong for them as it was for us, and our original budgets that we worked on with them didn't really include that.

Michael W. Barnes

Yes. But one thing I would add, Jennifer, this is Mike, is that it's an exciting opportunity for us because we've been waiting a long time now to get this transition completed, and we're expecting to have it done in the second quarter. And once we get the majority of these stores switched to Kay nameplate and are able to leverage the great equity that we have in Kay, it's going to be a big opportunity for us going forward. So we're very excited. We've been waiting for this moment and we're glad it's almost upon us.

Ronald W. Ristau

Yes. And the one last thing I would add to that, Jennifer, is that of the $0.09 that were -- the $0.03 from the first quarter and $0.06 in the second quarter we're anticipating, the majority of that, close to $0.08 of it is related to nonrecurring cost, again, on duplicate overheads, severances and accruals for unnecessary office space that we will be incurring in the -- particularly, in the second quarter. And these costs, for sure, will not be repeating in the second half of the year or in the next year. So that's a good strong help to us.

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

Yes. Right. And absolutely, Mike, I'm -- we're really excited about the opportunity with Ultra as well, so -- or I should say Kay outlets now. One last question on, well, actually 2. On Mother's Day, what was the impact with the shift, I think that I kind of mismodeled a little bit maybe.

Ronald W. Ristau

Well, there was no effect -- once again, there is no effect on comps. The comps were directly shifted, but the dollar sales move was -- it ranges between $32 million and $35 million is our best estimate.

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

Okay. All right. And then bridal, it sounds like it's increased as a percent of sales, could you talk a little bit about that? And how do margins on bridal compared to the rest of the assortment, are they a little bit lower or are they about the same?

Michael W. Barnes

Well, I'll start off and let Ron finish up with margins. On the sales, we had a very strong quarter for bridal and that's a very important. Because what we saw in this quarter, it was not just driven by the big holiday events, the Valentine's and the lead into Mother's Day. We had a great continuity business throughout the quarter, and bridal was really big part of that. We continued with our usual strong promotions. We also, because we're so focused on bridal, we tested some new promotions that were related specifically to bridal in both the mall and in the Jared stores. And we had really great results from that. So we think there's a lot of opportunity for us to continue driving the bridal. Ron, do you want to talk about the margins, any other points on that?

Ronald W. Ristau

Yes. Our bridal margins are a touch lower than the overall company, just a touch because of the fact that there's a lot of -- there's new stones involved in that, and new stones tend to be one of our lower margin businesses. It's not really that -- it's not all that different.

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

Great. Okay. And then, theoretically, you will get greater, I guess, rents and fixed cost leverage on the sales?

Ronald W. Ristau

Absolutely. I mean, driving bridal sales is a very important part of our business, representing more than 50% of our sales and is something we continue to stay focused on, because we believe it's a natural intersection of all of our competitive strengths. Our great store experiences, the credit offerings that we have and the quality of our merchandise, all combine for a great bridal experience and is something that we are best at. So it's a very good thing for us.

Operator

The next question comes from Oliver Chen from Citigroup.

Oliver Chen - Citigroup Inc, Research Division

What are you thoughts on how we should think about modeling the gross margin going forward in terms of the puts and takes and what can happen there over time? Also, if you could update us on the commodity cost environment and if you're seeing the flexibility there with respect to what you're seeing in how you may be able to adjust your attitude in retail?

Ronald W. Ristau

Well, I'll take the first question. I think that from an overall perspective, we still try to work on maintaining our margins. We can't be specific going into the third and fourth quarter of the year, but we think those margins will be good. When you think about commodities and what's happening at commodities, first thing I'd like to point out is we are on an average cost FICO basis, which takes commodity fluctuations into our P&L at different rates than some of our competitors. Currently, when we look about -- 55% of our cost of goods is diamonds and about 17% is gold. So right now, we really continue to see some upward pressure on diamond prices for our quality goods, although prices are really generally more stable on a relative basis in the near term. Long term, we really believe that this direction is up because global demand is flat and demand is pretty strong still. The recent gold price declines, if they hold, should be somewhat helpful to us in the second half. However, we did do some gold settings, I would point out, and we did have some unfavorable gold hedge positions that we found necessary to close with the reduction in gold prices. However, there's always -- there's a lot of multiple factors including pricing decisions, content, how we run our promotional programs, which will reflect in our overall margins. So our outlook is good, but we really have to figure out how long this will all last and who ultimately wins the battle on gold commodity pricing. But it will be helpful, eventually, to us if it holds.

Oliver Chen - Citigroup Inc, Research Division

Okay. And regarding your comp guidance, should we anticipate that the same kind of run rates may continue between U.S. versus U.K.? And if -- and on your low- to mid-single digit, is that traffic and conversion led? If you could just give us parameters from which we should think about your forecast, that would be helpful.

Ronald W. Ristau

Well, if you think about our -- if you ask me -- let me try to understand the question though, how we comp forecast going forward will be reflected in transactions and pricing?

Oliver Chen - Citigroup Inc, Research Division

In terms of the comp leverage...

Ronald W. Ristau

I think, if you take a look at the U.S. division you'll see that there was a healthy mix of transaction growth and there was also some price increase, particularly at Kay on average, which went through, why we think that we would expect both transactions and price to drive in the United States as we go forward. In the U.K., we are seeing some traffic declines. We are seeing that particularly at our H.Samuel brand. We hope that we can arrest some of those as we move into the second half of the year, but we are fighting traffic declines in the U.K. So I would, if I had to bet right now, I would say that there'll be some degree of transactional decline in the U.K. going forward. That's probably the best way I can answer that question. I mean, the U.S. is a great healthy mix, the U.K. is really driven by transactional decline more than anything else.

Operator

The next question comes from Rick Patel from Stephens.

Rick B. Patel - Stephens Inc., Research Division

Just a question on the conversion of Ultra Stores to Kay outlets. When this occurs, are you going to reprice all the merchandise in the stores virtually overnight or are you going to replace and reprice the Ultra product as it's sold through? And as a follow up, when do you expect the pressure on gross margins to wane from selling Ultra products, will it be in the third quarter once the conversions are done?

Michael W. Barnes

On the products, I would tell you that we have been working on starting to move products into Ultra as we could even before the full transition, and we'll continue to do that. Clearly, as we change the nameplates on the majority of the stores to Kay, they're going to look like Kay stores going forward. But having said that, because the outlet channel is a separate channel for us to sell into, we believe that there's ways for us to optimize that channel. In the past, our Kay outlet stores have been pretty much the same as our Kay mall stores in terms all the merchandise offerings. We think that there's going to be an opportunity for us to do some more made for product that is more targeted towards the outlet store customer, including the great tourist opportunity that exists out there in the outlet store channel of distribution. So it will be a little bit of a different mix to optimize it on a go-forward basis, but that's a work in progress. Initially, it's going to be switched over and become a Kay store just as quickly as possible. And the pricing will be exactly the same as it is in Kay.

Rick B. Patel - Stephens Inc., Research Division

And can you talk about the merchandise mix in the U.K.? Have you began to edit the assortment there as part of your strategic plan in the region? And if so, perhaps highlight what you've learned from doing that?

Michael W. Barnes

Yes. On the U.K., as Ron mentioned earlier, it continues to be a very challenging market for us. And as we have laid out the initiatives that we believe are going to help us turn that market around, merchandise is one of the first ones. I mean, we're still very, very focused on that. We are even beginning some new initiatives on how to focus even harder on the merchandise mix and possibly gain some more leverage with more of the products that we have here. If we look at the U.K. market, some of the things that have been successful have been some of the branded merchandise that we've had in there, but it's a lower part of the mix than it is in the U.K -- or I'm sorry, in the U.S. And we see more focus in that direction, more focus on new products. We have to be careful with pricing. We talked about the weakness that we saw in H.Samuel, in particular. Part of that was price increases for H.Samuel didn't stick as well as we had hoped that they would. And so we've got to stay very focused. I've seen -- I saw a recent article from the British Retail Consortium talking about the consumer continues to look for value in the marketplace. So we're very focused on the merchandise offerings, we're focused on branding, we're focused on new product and we're looking at how we can be more innovative going forward and think a little bit more outside the box to really drive some more change into that marketplace in our stores.

Operator

Next question comes from Anthony Lebiedzinski from Sidoti & Company.

Anthony C. Lebiedzinski - Sidoti & Company, LLC

In the past, you guys have been more upbeat about the regional malls in the U.K. versus the high street locations, is that still the case?

Michael W. Barnes

Well, those are still the best performing that we have. I have seen some traffic statistics. Ron was talking about traffic being down across the -- it's kind of down across-the-board in the U.K. The last stats that I saw, the High Street and the malls were down as well. But we continue to perform certainly better in the malls than we are on the everyday high streets. And we think that, that is going to continue to be the direction for the U.K. market, that these big regional malls will continue to be the biggest part of our business on a go-forward basis, notwithstanding London, which of course, is always going to be strong with all the tourist activity going on there. But I think that the traffic itself was down in the malls, as well as on the High streets, but it still is the better performing part of our portfolio there.

Ronald W. Ristau

Yes. Definitely the stronger part.

Anthony C. Lebiedzinski - Sidoti & Company, LLC

Okay. So can you give us a sense as to what percentage of your stores in the U.K. are in the High Street locations versus regional malls? And also, as you look to optimize your store base, maybe you could give us a sense of how do you think that's going to be in 2 to 3 years from now?

Ronald W. Ristau

Yes. I mean, I believe that the mix now is around 60%-40%, 40% regional malls, 60% High Street. But I'm going to double check that number for you, okay. As we go forward, we'll have a much higher -- it should help with the shift that we would end up with 60s -- 65%, 70% of sales in regional malls.

Michael W. Barnes

Yes. The difference, it depends on how you ask the question. In terms of number of stores, there are fewer regional malls, but they drive a disproportionate part of the business for us. So in terms of sales, while it's fairly, even last time I looked, and we'll check those numbers, I think it will become a bigger part of the business going forward in the malls.

Ronald W. Ristau

I will get those exact numbers and dollars for you and give you a call back.

Anthony C. Lebiedzinski - Sidoti & Company, LLC

Okay. Sure. Not a problem. And also, in terms of your store growth expectations now, you did accelerate the -- or you're looking to open more stores than previously, is it more Kay and then Jared? Could you give us a sense to where the increase is coming from and can you also talk about the trends that you're seeing in real estate costs?

Ronald W. Ristau

Well, it is more Kay than Jared, obviously, because it takes a long time to open up a Jared store. There's a couple more Jared stores in there. I believe, we're up to about 13 Jared stores for the year and the residual is Kay. And that Kay is primarily in the off-mall area. We're seeing lots of opportunities, so we're being a little more aggressive as we've said we always would be if the opportunities present themselves. In real estate cost, real estate costs remain as a constant challenge for us. We work very hand-in-hand with our landlord partners and we've been reasonably successful at working continually beneficial deals. But the real estate costs for good real estate have never really changed. They've always been very competitive and we're always after the best space, so there's really no new news. I wouldn't say that the pressure is more or less, it's always been fairly consistent for us.

Michael W. Barnes

We don't compromise on the real estate that we go forward just to open new stores. So that's what's exciting about this, this increase in new store openings, is the fact that the team is doing a great job out there finding the best possible real estate because, again, it's just something we will not compromise on and the cost is what it is.

Anthony C. Lebiedzinski - Sidoti & Company, LLC

So you haven't changed your objective of your 20% IRR rate?

Ronald W. Ristau

No. No, not at all.

Michael W. Barnes

Absolutely not.

Ronald W. Ristau

No, no, no.

Anthony C. Lebiedzinski - Sidoti & Company, LLC

Got it. Okay. And lastly, when you look at your cash -- free cash flow generation capabilities, you've exhausted your share buyback program going forward. Can you give us any sense as to how the board is thinking between dividends and share purchases?

Michael W. Barnes

Well, that's an ongoing conversation that we have with the board, and we will continue that conversation. What we have done is we've made a commitment as to what we think our capital structure and our balance sheet should look like. And we continue to feel like having approximately 7% to 9% of annual sales in cash. It's a good flexible number for us. And beyond that, we want to invest back in the business, number one, that's the best return we can get for our shareholders. But we'll have ongoing conversations with the board regarding other opportunities to return value to shareholders, such as the continuing dividend and potential share buybacks in the future. And we'll update you as appropriate how those conversations continue.

Operator

The next question comes from Bill Armstrong from CL King & Associates.

William R. Armstrong - CL King & Associates, Inc., Research Division

Ultra gross margins are expected to improve from current levels. Do you think they can get all the way up to the overall company average in the high-30s or is the outlet sector just structurally a little bit lower?

Ronald W. Ristau

Well, I think they can get substantially closer. I think the outlet does tend to be a touch lower than the overall mall, but this will be still a smaller percentage of our business. So I think it will go up substantially from what it is today and we'll approach closer to the levels. But obviously, because the product mix is a little different, it won't get all the way to the same level. It's just a different -- it's a different gross margin model. Of course and we have other costs that are lower. And in particular, one of the things I think we're very pleased with and -- we really are going to have a very -- the SG&A structure of the outlet operations is something I would urge you to think more about, too, is that -- because once we integrate, we will need very little additional incremental SG&A other than our store operations people to run the business. And that's a big part of the savings as we move into the third and fourth quarter of the year.

William R. Armstrong - CL King & Associates, Inc., Research Division

In terms of SG&A leverage, you mean?

Ronald W. Ristau

Yes.

William R. Armstrong - CL King & Associates, Inc., Research Division

Got it. How about in the eCommerce, that's obviously a growing piece of your business. Are the gross margins in eCommerce similar to margins at retail?

Ronald W. Ristau

Yes.

Michael W. Barnes

Yes. The merchandise margins would be the same because our pricing is the same online as it is in store.

Ronald W. Ristau

And the pricing is -- I'm sorry, the overall operating margins are as good as our best stores or sometimes even better.

William R. Armstrong - CL King & Associates, Inc., Research Division

Got it. Okay. And then just lastly, just to clarify a comment, I think, Ron made earlier on price increases at Kay. Were those increases taken during the first quarter or were they taken last year?

Ronald W. Ristau

Well, what I said was that, if you take a look at the charts we're providing on average price and transaction cost, Kay average price went up, which is partially pricing and partially mix adjustments. So I want to be clear about that. The pricing -- we did take price increases on our normal cadence in the March and before Mother's Day timeframe, so we did do that. We don't disclose how much in total, but they were a little less than we have in previous years.

Operator

The next question comes Ike Boruchow from Sterne Agee.

Irwin Bernard Boruchow - Sterne Agee & Leach Inc., Research Division

Mike, sometimes -- if you can help us out, this would be the overall consumer environment right now, it was a great U.S. comp for you in Q1. Could you maybe give us some color on what you're seeing in the environment thus far quarter to date?

Michael W. Barnes

Yes. I mean, the environment, we've -- I've talked about this a lot in the last couple of weeks even. The best way I can characterize it, and this is just one man's opinion, is that it feels like a more stable environment than I would have spoke to 12 months ago at this same time. A lot of the noise that was going on out there kind of subdued itself a little bit with fiscal cliffs and the rising payroll taxes and late tax returns. We heard a lot of that noise, especially at the beginning of the first quarter in early February. And it's somewhat subsided. Who knows what the macro environment is going to bring to spook or support the purchasers at retail tomorrow, I have no idea, I don't have that crystal ball. But I would characterize it, just in general, as being a more stable environment than I have seen in the past, and we'll see where it goes from here. That's in U.S. market. In the U.K., it's still an extremely volatile environment with a lot of continued bargain-hunting going on. And I was just reading U.K. unemployment, it went up more than it's gone up in a long time. I mean, it's a tale of 2 different markets, really. But the U.S. driving the majority of our business has been much more stable, we had a great first quarter, we had a good beginning of the second quarter through Mother's Day. And as we've said, we believe we're really well positioned to make all of our objectives for the year. So we continue to be excited about the opportunities we have in front of us and we're going to just keep driving the successful business model we have.

Irwin Bernard Boruchow - Sterne Agee & Leach Inc., Research Division

Okay. Great. And I guess, Ron, the company's historically broken out their merchandise margin changes in both the U.S. and the U.K. when you guys report your quarters, is there any way you can help us out there just so we can have it updated in our models? And maybe, I know you've even asked a few times, but maybe any color on how you expect the U.S. merchandise margin to progress throughout the year given some of the puts and takes that you called out?

Ronald W. Ristau

Well, I would say is that the gross merchandise margin followed in the U.S. the gross margin, so if the overall excluding Ultra margins in the U.S. were down about 70 bps, the gross merchandise margins were down similar type numbers. So explaining one explains the other, if you will. In the U.K., our merchandise, gross merchandise margins are actually up about 100 bps, but that was offset by deleverage on the lower sales on some of the real estate and other costs. So they only netted up about 20 basis points, I believe. When you think about go-forward, I believe that it depends upon the mix of what happens with gold and commodities and our stance promotionally. We did see, of course, in the first quarter that some of these very successful bridal promotions did have an impact on our gross merchandise margin, but were very, very profitable for the overall business. So I would say, in general, you should expect them to be a little better than they were this quarter. And you should start to see the dilutive effect of Ultra start to diminish. At what rate, I can't really predict for you. But as we convert the model in the second half of the year, you would expect or I would expect that the margins would get closer to those experienced by our core business. If that's helpful.

Irwin Bernard Boruchow - Sterne Agee & Leach Inc., Research Division

Okay. No, very helpful. And then just one quick last one. Ron, you talked about a $0.09 impact from Ultra integration in the first half of the year. Did I hear you correctly saying that there shouldn't be any real drag as a we get into Q3 and Q4. I know we'd lapped the acquisition, but is that..

Ronald W. Ristau

What I don't think is -- what will happen is a lot of the SG&A overhead cost will diminish after the second quarter as the impact of integrating the business more fully to our Akron operation occurs. I continue to believe that the third quarter is a -- still a little bit of risk for us, some degree of dilution. And then we expect it to turn positive in the fourth quarter. And the only reason I hedged in the third quarter is the fact that, we believe, a good couple of months of learning with all the new systems and the training that has to go on in the field sales force, so it's a bit of a -- a bit difficult to predict how long that training will need to take root, you understand?

Irwin Bernard Boruchow - Sterne Agee & Leach Inc., Research Division

Yes.

Ronald W. Ristau

So the systems and everything converts during the kind of the end of the second quarter. We give ourselves a couple months to work out all the operational issues, if there are any, right. And then we believe that in the fourth quarter, we start to become accretive. But the overhead costs will start to diminish as we move into the third and fourth quarter for sure.

Operator

And the next question comes from Jeff Stein from Northcoast Research.

Jeffrey S. Stein - Northcoast Research

Ron, question on -- I was looking at this footnote number 11 on hedging, and wondering if you could just try to explain the impact that your hedging losses have had. It looks like, if I'm reading this correctly, you had a negative $17.5 million impact in Q1 versus $12.9 million in Q2, and how your open contracts could potentially affect Q2 through Q4?

Ronald W. Ristau

Well, first, let me explain that what you're looking at there is balance sheet-related items, not P&L items. But what ended up happening with the -- it was the largest move in gold in 38 years that we can trace, so we had open hedging positions. And we took the decision, as allowed by accounting rules, to close those hedges in essentially on a stock loss basis. And then, of course, we'll move forward with the reset pricing levels. So we've made a lot of money in hedging over the years. As this pricing reset occurred, it was, of course, unfavorable to us. That will flow into the P&L, Jeff, over the life of our inventory turns. So it takes about 12 to 16 months for those to flow-through. But on the plus side, remember we're buying the underlying commodities. So we're getting tremendous benefit by buying gold at spot as we go along. In fact, we're doing much better than our hedging positions, of course, would have allowed us to do. So that was a business decision. Nobody likes to take losses, but we've figured it was the lesser of 2 evils, if you will. And as we go forward, we're approaching the gold market with caution. And we will gradually seek to reestablish our hedging positions as the market becomes a little more predictable.

Jeffrey S. Stein - Northcoast Research

So Ron, based upon the losses that you took and the lower spot prices that you're paying right now, presuming that prices were to remain flat, and we don't know where they're going to be, but if they remained flat, net-net, are you in a plus position or a minus position for the rest of the year?

Ronald W. Ristau

Net-net, we would be in a plus position. Because the value of the buying at spot far outweighs the loss that you incur in the close of the hedge positions.

Jeffrey S. Stein - Northcoast Research

Got it. Okay. That's great. And with regard to your credit business, can you talk a little bit about the mix of interest-free versus your traditional monthly payment, revolving payment?

Ronald W. Ristau

It's been relative stable, Jeff. It has -- we got a shift on that which started to occur in the first quarter of last year. And of course, we talked about it last year because it was resetting those other income ratios throughout the year. But right now, we're seeing stable. It really hasn't changed much from the third to fourth quarter of last year, it's been relatively stable. So the incremental income this year is really more driven by higher outstanding balances as opposed to a shift in the mix of programs.

Operator

The next question comes from David Wu from Telsey Advisory Group.

David Wu - Telsey Advisory Group LLC

First, the gross margin contraction, obviously, a bit surprising, even if you exclude the impact from Ultra. And I want to know if you could break out the impact between the unfavorable merch mix shift and the Mother's Day sales shift? I understand that bridal is a lower gross margin category, but I want to know if you adjusted pricing at all to be more competitive there? And if you could provide more color on the Jared test programs? And also is it fair to assume that mix should remain a headwind in the second quarter?

Ronald W. Ristau

Let me answer that a couple of different ways. Mike do you want to take...

Michael W. Barnes

Yes. Well, I'll take the last part of that first, Dave, this is Mike. On the Jared test programs, basically, what we talked about is that we did do some test, promotional programs, especially as it was related to bridal, but we're really not going to go into detail for competitive reasons on that. We felt like we saw a lot of good success and a lot of opportunity for us to continue to tweak our business, our promotions, our merchandise and everything going forward, quite frankly. And that's what we do, we continue to evolve and grow as this industry changes and find better and better ways to compete effectively and gain market share. But all I could tell you is that we were very pleased with both the merchandise that we've tested and some of the new promotions that we're not comped that we tested. And we think we got a big opportunity going forward. And I'll let Ron take the gross margin.

Ronald W. Ristau

What I basically say in the gross margin, excluding the impact of Ultra, the 70 bps adjustment that we realized, that is primarily caused by the impact of these programs. And not so much unfavorable mix, but we've decided, we made the decision to get to somewhat improve some of our programs and offerings and see how they would work in the market. And they worked fantastic, as evidenced by the strong, strong comp that we experienced during the quarter. We did have to give up some margin on that and we believe that was a good trade-off. We continue to believe that all those programs have fantastically high return on investment. And the part of Mother's Day was really in the neighborhood of 10 bps to 15 bps of the 70 bps, so the majority of what was really these programs that we were running in Jared and the bridal programs that we were initiating.

David Wu - Telsey Advisory Group LLC

So theoretically then, as you continue to test these programs, that should remain a headwind then in terms of the second quarter on the gross margin in the U.S.?

Ronald W. Ristau

No. These are programs that we flex in and out of, okay. Some of them, depending upon what we do, I don't think you should assume that we will just be running all these programs there. Like anything, they are programs that we put in, at times of the year, we think are effective. Some of the Jared programs that we ran could have some more longevity in the system, but they have lesser impact. And we get tremendous -- you saw the Jared comp really start to get very strong. So all of these things, we believe, as business people, were very favorable trade-offs for us to make for the long-term health of the business.

David Wu - Telsey Advisory Group LLC

Great. And the U.K., gross merchandise margin, up 100 basis points, obviously, a vast improvement from the prior quarter. Can you talk about the main drivers there and comment on promotional levels, and should we expect a more sort of moderate decline in the U.K. gross merchandise margin going forward assuming that the comp maintains a similar pace?

Ronald W. Ristau

Well, some of it is mix. And the basis of the fact that as Rolex becomes a lower percentage of the risk, the merchandise margins, of course, will improve. So some of it is mix, some of it was the impact of pricing. As Mike indicated, we're not totally enthralled with the benefits of pricing that we received in the first quarter. So what I would say is, Mike correct me if you disagree, but the jury's out a little bit on whether or not we'll continue to realize incremental gross merchandise margin in the U.K. We may choose to do it a little differently as we go forward.

Ronald W. Ristau

Yes. I think that we're going to have to really focus on pricing in the U.K. market, and it's something that we've got to really watch very closely. The prices didn't stick in H.Samuel as well as we had hoped that they would. There's just a lot of pressure in that market in that regard, and so we've got to make sure that we remain competitive and that we're kind leading the charge over there. So we're going to be looking at a lot of different opportunities and different ways to move forward. So that's something that we'll just have to watch and see. But I wouldn't expect to see anything in particular change for us regarding the margins there.

David Wu - Telsey Advisory Group LLC

And is credit as instrumental in driving the sales performance in the U.K. as it is in the U.S., and could there be an opportunity to potentially introduce a similar type of in-house credit program into the U.K.?

Michael W. Barnes

We use a third-party provider in the U.K., and it's a very, very low percentage of our business, in the single digits, I believe.

Ronald W. Ristau

It's very low, yes.

Michael W. Barnes

And it's just a different type of customer profile over there. I think that they're much more inclined to use their bank cards for those type of purchases, whether it's to gain miles. But certainly, some of the big, big retailers have private label, I guess. But there's not -- it's not near the successful impact that it is in the United States, it's just a different customer profile. And it wouldn't be large enough for us to even consider going in-house with just by the fact that it's such a low part of the mix, even in the third-party credit that we do offer.

Ronald W. Ristau

We don't have a term for [indiscernible].

David Wu - Telsey Advisory Group LLC

Great. And on the second quarter guidance, will the $0.06 negative impact from the Ultra acquisition, will that come more from the gross margin versus SG&A? So similar to what we saw in the first quarter?

Ronald W. Ristau

More from SG&A.

David Wu - Telsey Advisory Group LLC

More from SG&A, okay.

Ronald W. Ristau

That's why I make the point that when you look across the 2 quarters and I look into the components of it, I say there's a couple of things. Number one, I've got lower productivity stores in general than I have in my main Kay operation. But I also have costs that will -- we were not able to take out of the system until we make the transition. We were making the transition more in the -- by the end of the second quarter. So therefore, some of our costs and then some of our onetime costs that involve severance and excess real estate and things like that, once we're through all that, then I believe that the cost structure will get better. And we know because I can control that virtually 100%, we just know that's going to happen.

David Wu - Telsey Advisory Group LLC

Great. And then just lastly, the higher ticket that you saw in the U.S., was that tied mainly to particular strength out of bridal or did you also benefit from a higher ticket in fashion jewelry?

Ronald W. Ristau

I would say in Kay, a little bit more as of -- because of bridal. A little bit because of the stronger bridal business, which carries a little bit higher ticket.

David Wu - Telsey Advisory Group LLC

Great. But on the fashion jewelry side, how did ticket trends perform?

Ronald W. Ristau

That's a little -- I don't want to give -- I would say nothing -- they didn't move much at all. They didn't really move much on average for us.

Michael W. Barnes

We had strong fashion trends throughout the quarter as well, I think that's important to point out. And again, some of the branded merchandise, Le Vian did very well for us in bridal, as Ron mentioned. Certainly that helped the ticket price because we had, again, strong brand bridal with Leo and Tolkowsky and Neil Lane. Neil Lane fashion did well on the fashion side. So that's really what's driving it. And we're seeing a lot of strength out of all of those great brands that we have. And we're very pleased with the partnerships and the opportunity going forward to continue driving that.

Operator

The last question comes from Warwick Okines from Deutsche Bank.

Warwick Okines - Deutsche Bank AG, Research Division

Actually, just following on from the last one. Could you say what the mix was at branded and exclusive in the U.S. in the quarter, please?

Ronald W. Ristau

We don't generally disclose it in the quarters. We tend to do it on an annual basis because it tends to fluctuate on the quarters. But it was positive, significantly positive as a penetration in the first quarter. So those products, as well as our non-branded and our more fashion products. So across-the-board, branded, non-branded, bridal, everything worked well for us in the U.S. in the merchandise offerings in the first quarter.

Michael W. Barnes

Very broad based.

Warwick Okines - Deutsche Bank AG, Research Division

Right, right. I guess, I was trying to -- I mean, you talked to the full year last year, I think, 27.4%. I was just trying to work out whether that was that kind of underrepresents the progress you've made in the last few quarters?

Ronald W. Ristau

Well, I would say that our -- if you look -- what I'm basically telling is that our penetration, relative to the penetration a year ago, in the first quarter was up in branded and exclusive. Does that makes sense, yes?

Warwick Okines - Deutsche Bank AG, Research Division

Yes. Okay.

Ronald W. Ristau

So we're on trend to keep improving, but we have to see how the rest of the year develops.

Warwick Okines - Deutsche Bank AG, Research Division

Okay. And finally, could you ask -- could you tell us whether at the AGM you'll be seeking further authorization to repurchase shares?

Michael W. Barnes

Yes. We mentioned earlier that's -- our capital structure and our balance sheet are going to be ongoing conversations with the board. We've made a commitment, again, to keep approximately 7% to 9% of cash, we think is appropriate to keep on the balance sheet. Beyond that, we want to invest in our business first. And then we'll have ongoing discussions with the board about how best to return other value to the shareholders beyond anything that we are investing in the business. So I would just say, again, stay tuned. As we have further discussions with the board, we'll see what decisions are made. We were very pleased with the buyback that we concluded, and it was very successful in our opinion. We're very pleased with the dividend that we have and will continue having those discussions with the board, and we will update you as appropriate --

Operator

And we have no further questions at this. I'll now turn the call back to Mr. Barnes.

Michael W. Barnes

Thank you very much, appreciate that. And thank you, all, for taking part in this call. We really appreciate your time this morning, spending it with us. Our next scheduled call is going to be on August 29, and we'll review our second quarter results at that time. So thanks again and goodbye. Have a great day.

Ronald W. Ristau

Thank you.

Operator

Thank you, ladies and gentlemen. This concludes this conference. Thank you for participating, you may now disconnect.

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