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Signet Jewelers Limited (NYSE:SIG)

Q2 2014 Earnings Call

August 29, 2013 8:30 am ET

Executives

James M. Grant - Vice President of Investor Relations

Michael W. Barnes - Chief Executive Officer and Director

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

Analysts

Rick B. Patel - Stephens Inc., Research Division

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

Jeffrey S. Stein - Northcoast Research

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

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Brian J. Tunick - JP Morgan Chase & Co, Research Division

Oliver Chen - Citigroup Inc, Research Division

Operator

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

James M. Grant

Good morning, and welcome to our second 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 second quarter and first half results. And now we're focused, really, on our second half of the year, particularly our important fourth quarter holiday selling season.

For the first 3 weeks of the third quarter, we've had a positive start in both the U.S. and the U.K., which is a nice trend reversal in the U.K. Keep in mind, though, that we're only 3 weeks into the quarter and we have seen a lot of noise out there in both the macro retail environment and obviously, the geopolitical scene. But we do have some major events beginning soon, in fact, this weekend, we have a major event and continuing into later September and October. And we remain well prepared for the second half, especially with Q4. I'll discuss some of our strategies for holiday in just a couple of minutes.

Turning back to the second quarter. We delivered a solid financial performance in Q2, driven by the excellent execution of our strategies, which led to sales growth and earnings growth, excluding our acquisition late last year. Our second quarter comps at Signet increased by 3.6%. The U.S. division comps grew at a 4.9% rate on top of 8.2% last year, while the U.K. comps declined by 2.4%.

We also had tremendous continued momentum within our consolidated eCommerce space as we grew by 28.9%. This all led to operating income of $105.5 million and diluted earnings per share of $0.84, were at the high end of our guidance. Excluding Ultra, our diluted earnings per share were $0.90.

Let's begin by taking a look at the U.S. division performance. The U.S. total sales were at $741.1 million, and that was up $39.2 million or 5.6%. The U.S. same-store sales increased by 4.9% in the second quarter. Kay comps increased a strong 5.8%, while Jared increased at 5.5%. The success in both concepts was driven by particular strength in bridal, color diamonds and watches. Within these categories, our branded merchandise continue to do very well. Kay and Jared experienced increases in both transaction counts and also, average transaction value. So it was a nice mix in the increase.

And in the U.S., eCommerce performed very strongly with sales up $6.7 million to $25.3 million, which was an increase of 36%. The U.S. division operating profit declined by 4.9% with a 15% operating margin. But excluding the dilutive effect of the Ultra acquisition, operating income was $119.3 million and operating margin was 16.8%, up 10 basis points. It was another great quarter for the U.S. team numbers.

Now let's take a look at what's really driving the business. 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, especially our exclusive and differentiated brands. The customer experience is really central to our success and we remain focused on the training and the development of our store teams, including the best use of in-store sales enhancing technology. Branded, differentiated and exclusive merchandise continue to perform well, particularly among some of the brands you see here listed on Slide 5 like Neil Lane, Tolkowsky, Le Vian, Open Hearts by Jane Seymour, et cetera. We also saw success across selling channels. As I mentioned, in the U.S., eCommerce sales were up 36%. This was driven in part by 14 million visitors to our sites. And the amazing thing is, over 40% of those came in through mobile devices.

Now I'd like to talk a little bit more about our outlook business. As most of you know, Ultra was purchased to build out an outlook strategy. Outlooks are seeing stronger customer traffic and development trends than any other retail selling channel at this time. By the end of this year, we expect to be operating approximately 120 Kay outlets and 39 Ultra Stores. Operationally, our strategy is working well and we're on plan. We have converted to Kay the nearly 70 stores we set out to convert from Ultra. Our field teams are up and running and they're in training as we speak. The IT has been integrated, including our in-house credit program. Credit penetration and our converted outlets is approximately 40% and growing. Now that's up from the low 20% as a stand-alone Ultra Stores before the acquisition.

We're also transitioning the merchandise mix to leverage the Kay brands, and we're creating made-for-outlet product to further differentiate from the Kay mall stores and also to meet the demands of the bargain-seeking outlet customer. From a financial perspective, we're on plan as well. The first half EPS dilution was $0.09, as was forecast, the third quarter dilution should be relatively minimal. And then in Q4, we continue to expect to be accretive. So overall, we're very pleased with the initial performance of this strategy and the acquisition, and we expect to see continued improvements over time from where we are today.

Now I'll turn to the U.K. Total sales in the second quarter were $139.1 million, down $12.9 million or 8.5%. Comp sales decreased by 2.4% compared to an increase of 2.1% in the second quarter last year. The total sales decline of 8.5% was due primarily to 3 things: The impact of closed stores was $5.6 million; the same-store sales decrease, $3.4 million; and currency fluctuation that hit us for $3.9 million. In Earnest Jones, which reported a negative 2.4% comp, the number of transactions increased driven primarily by strength in the branded bridal and watches, excluding Rolex, and average transaction value was lower. And that's primarily due to the impact from Rolex being offered in fewer stores compared to the prior year. In H.Samuel, which also reported a negative 2.4% comp, the number of transactions declined. That was due to lower traffic and store closures. This resulted in lower sales across many merchandise categories, but was partially offset by strength in branded bridal products. Sales in both of the businesses were impacted by lower B transactions.

eCommerce sales were $5.9 million, which was up $0.3 million or 5.4%. Our U.K. websites attracted 7 million visitors in the quarter. And unbelievably, 45% of those came in through mobile devices. The operating loss was $0.8 million, an increase of $0.5 million from last year, and that's primarily due to lower sales partially offset by cost reductions. I'd like to thank our U.K. team members for their continuing efforts to improve the business there.

So how do we win back the back half of the year? While we remain confident in our ability to deliver outstanding product ranges that meet our customers' desires and we've tested a lot of new programs with great results. We have exciting new products that will roll out in the second half including our exclusive differentiated brands, some of which you see pictures here on Slide 8. In bridal, we're line extending Leo Artisan, and we're also extending the very successful Neil Lane Bridal line. We will also expand colored diamonds, which have been really hot in the past year, and this includes the Artistry brand at Kay and Vivid brand at Jared. In Le Vian, another hot fashion brand for us, we'll roll out proven styles and new colors supported by special events. The Open Hearts new Wave Collection is producing great results, and we're expanding this brand as we did The Family Collection last year. The initial tests indicate Wave is another big winner for the brand. We'll speak more about our merchandise initiatives at our Investor Day conference on October 8, and I hope you can all make it there.

We'll continue to build upon our digital ecosystem as well, launching a new eCommerce website kayoutlet.com in September to support our outlet strategy, as well as enhanced Kay and Jared mobile websites. These initiatives, together with the variety of other new and exciting product offerings, will, we believe, produce an exciting and successful holiday season. Our team of merchants have done a great job and they're continuing to stay at the forefront of new products and trends.

We also have new and memorable ad campaigns ready to launch for the holiday season. We're increasing our advertising investment and we'll have a greater number of television impressions over the holiday compared to last year, as well as a much higher digital media profile. Plus our enthusiastic and our well-trained sales teams are primed and ready to support the merchandise initiatives. With all of this in place, we believe we're well positioned for the back half of the year and as I mentioned, especially the holiday selling season.

And now I'll turn the call over to Ron for 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 3.1% to -- or I'm sorry, $880.2 million compared to $853.9 million last year. Our same-store sales increased 3.6% compared to 7.1% growth last year. In the U.S., the total sales increased 5.6% or $39.2 million to $741.1 million, which included a same-store sales increase of 4.9%, as Mike discussed.

Our non-same-store sales were up 0.7%, which includes a 4.2 % increase for Ultra, and a 3.5% decrease for the U.S., excluding Ultra. This is caused by the timing shift due to the 53rd week in the calendar last year. The reported number in the second quarter of last year includes a $32.2 million benefit from the calendar shift of a Mother's Day promotion. The U.S. sales increases were driven by particular strength in bridal colored diamonds and watches and both Kay and Jared experienced increases in transaction counts of 2.2% and 1.4%, respectively. In addition, Kay increased average transaction value by 4.7% and Jared by 3%

In the U.K., total sales decreased 8.5% or $12.9 million to $139.1 million, while comp store sales decreased 2.4%. The total sales decline primarily due to the same-store sales decline of $3.4 million or 2.4%, the impact of closed stores of $5.6 million or 3.7% and currency fluctuations of $3.9 million or 2.4%, which were unfavorable.

The U.K. merchants showed particular strength in branded bridal and watches, excluding Rolex. In our H.Samuel brand, transaction counts declined by 5.4%, but increased in average transaction value by 1.4%. And Ernest Jones experienced an increase in transaction count of 2.2%, while average transaction value decreased by 8.9%, primarily due to the Rolex impact. Signet eCommerce sales were $31.2 million, up $7 million or 28.9% continuing on their strong trend.

Now let's take a look at the components of operating income. Our gross margin was $309.7 million, a decrease of $1.5 million. The gross margin rate was 35.2%, down 120 basis points in the quarter. The inclusion of the results for Ultra increased gross margin dollars by $5.7 million. However, it reduced the consolidated gross margin rate by 50 basis points and the U.S. gross margin rate by 70 points. The Ultra gross margin is lower than the core U.S. business due to lower store -- Ultra Store productivity and the impact of Ultra integration expenses.

Gross margin dollars in the U.S. increased by $1.3 million compared to the second quarter of fiscal 2013, reflecting higher sales offset by a gross margin decline of 180 basis points. Let's get into that. The lower U.S. gross margin was primarily attributed to the following components: Gross merchandise margin decreased by 50 basis points, which was entirely attributed to Ultra, the core business ran even to last year; and store occupancy and operating expenses deleveraged by 70 points, of which 40 basis points was due to Ultra and the remaining 30 basis point change was a result of the impact of the year-on-year calendar shift and an increase in the number of store openings. The U.S. net bad debt ratio increased to 4.9% of sales compared to 4.5% of sales in the prior year second quarter. The increase in the ratio was primarily due to growth in the outstanding receivable balance. I will explain further in a moment.

In the U.K., gross margin dollars decreased $2.8 million, primarily reflecting the impact of decreased sales and currency fluctuations, offset by gross margin rate increase of 40 basis points. Currency translation costs were $1.1 million of the decrease in gross margin. The gross margin rate increase was primarily driven by the sales mix.

Our selling, general and administrative expenses were $250.5 million, and as a percentage of sales increased 40 basis points to $28.5 million. With the inclusion of the results of Ultra, increased SG&A by $13.5 million, and increased the consolidated SG&A rate by 70 basis points if we exclude Ultra to the SG&A leverage. And I will discuss this in more detail on the next slide.

Our other operating income was $46.3 million or 5.3% of sales compared to $40 million or 4.7% of sales last year. The increase was primarily due to higher interest earned on the higher outstanding receivable balance. So our consolidated operating income in the second quarter was $105.5 million representing 12% of sales. This was 100 basis points lower than last year, and is primarily due to Ultra. As we exclude Ultra, our consolidated operating margin was 13.3%, up 30 basis points over the prior year.

In the U.S. division including Ultra, our operating income was $115 million -- $111.5 million or 15% of sales compared to $117.3 million or 16.7% of sales in the second quarter of fiscal 2013. When we exclude Ultra, the U.S. divisions operating income was $119.3 million or 16.8% of sales, up 10 basis points. The operating loss for the U.K. division was $0.8 million, an increase of $0.5 million. And therefore, our consolidated operating income led to fully diluted earnings per share of $0.84. And if we were to exclude Ultra, the fully diluted earnings per share were $0.90, up $0.05 or 5%.

Now some additional detail on SG&A expense. Our SG&A remains well controlled. As I mentioned, SG&A expenses were $250.5 million compared to $240.3 million in the second quarter of last year, up $10.2 million, and as a percentage of sales they increased by 40 basis points to 28.5%. This is primarily caused by Ultra, which added $13.5 million to our expenses driven by the operations and onetime acquisition cost. When we exclude the impact of Ultra sales and expense, the SG&A expenses decreased $3.3 million and leveraged by 30 basis points to 27.8% of sales, primarily as we leveraged the U.S. expenses. SG&A expenses in the U.K. declined $2.9 million reflecting the impact of our cost reductions and the currency fluctuation impact, and this represented a slight deleverage due to the lower sales.

Turning to our share buyback program. Of course, we continue to look at the variety of ways to deliver shareholder returns. Beyond reinvesting in our operation, we've taken a shareholder friendly view towards the use of our cash. In the second quarter, we authorized a $350 million share repurchase program, of which $325 million remains. In the quarter, we repurchased approximately 375,000 shares of Signet stock at an average price of $66.74 per share. We ended the quarter with cash of $212.9 million, positioning our company well for the holiday season.

Our net inventories ended the quarter at $1,417,700,000, an increase of $104.9 million or 8% for a year ago. But let's look at the reasons for this: The increase is primarily due to a $41.7 million increase in inventory for Ultra, and a $32.3 million increase in diamond inventory associated with our rough diamond initiative. Excluding these items, our core inventory increased by 2.4%. Our inventory is well positioned for the holiday season and we expect, by year end, to be closer to prior year end inventory levels as the inventory impact of Ultra and of rough diamond initiative will be less significant on a year-over-year comparative basis.

Now let's turn to credit, which remains an important component of our business. Our accounts receivable increased to $1,152,100,000 up 11.6% for the quarter. In the quarter, credit penetration, excluding Ultra, was 60.4% compared to 59.4% last year, attributed to increases in our bridal and branded product sales. It should be noted that our credit offerings were rolled out to Ultra stores in late June, and we have seen an initial strong response, as Mike discussed. However, as a group, it is currently less than our historical base, which is why our credit penetration with Ultra is 59.1% versus 59.4% last year. We believe credit usage in these stores will continue to grow as we are in the early units. The average monthly collection rate this quarter was 11.9% compared to 11.1% last year, as customers continue to opt for our regular credit terms, which required lower monthly payments as opposed to the 12-month interest rate program.

In the quarter, our bad net -- our bad debt expense increased to $36.5 million in the second quarter, an increase of $4.9 million driven primarily by growth in the receivable balance, which accounts for approximately 75% of this interest. The remaining increase is attributed to a variety of factors including slightly lower collection efficiency. As an example, the training and hiring of new staff that handle our volume increase has had a slight impact. And changes in the credit mix, for example, our regular credit terms, which carried longer repayment terms versus the 12-month interest free, is experiencing a slightly higher expense. We continue to believe the portfolio is performing well.

Offsetting the bad debt expense was an increase in other operating income, which is primarily interest income on the higher outstanding receivables and the shift away from the interest-free programs. The income on the portfolio was $46.3 million or 5.3% of sales in the second quarter, an increase of $6.3 million. Now the net impact of these 2 items, the bad debt expense and the other operating income, was income of $9.8 million in the second quarter as compared to $8.4 million in the prior year, representing an increase of $1.4 million. As we look forward, we believe the third quarter will be impacted in a similar fashion, with bad debt increasing versus last year's percentage of sales by 34 basis points, and other operating income increasing 34 basis points, with the 2 largely offset. This, will again, will be primarily driven by growth in the receivable balance. In the year -- year-to-date, we see a similar trend of increased bad debt, offset by increased other operating income, with a net impact benefit of $5.3 million.

Now let's turn to our third quarter guidance. For the third quarter of Fiscal 2014, the company currently expects same-store sales to increase in the low-single-digit range. As a result, earnings per share are expected to be in the range of $0.37 to $0.43, based on an estimated $80.5 million weighted average common shares outstanding. In the second quarter, we completed key introductions for the integration of Ultra as planned. And in the third quarter, we expect Ultra dilution to range from 0 to negative $0.02. For the full fiscal year, we anticipate having a range of approximately $80.4 million to $80.8 million weighted common shares outstanding. For the full year, the company expects capital expenditures in the range of $180 million to $195 million, which includes cost related to the opening of 75 to 85 new Kay stores, and several stores in the U.K., our store remodels, digital and information technology infrastructure buildouts and outlet store channel integration.

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'd now be pleased to take any questions that you might have.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Rick Patel from Stephens.

Rick B. Patel - Stephens Inc., Research Division

Can you help us think about what happened to Ultra's gross margin on a sequential basis, just comparing the first quarter to the second? On the surface, it looks like things got a little worst, but we're just trying to understand if it has to do with product, pricing or if it's just a transitional thing that you're going through right now?

Ronald W. Ristau

Well, Rick, you mean the operating margin in Ultra?

Rick B. Patel - Stephens Inc., Research Division

Gross margin.

Ronald W. Ristau

The operating margin in Ultra was affected in the second quarter by onetime exit costs. So therefore, the loss was about $0.06 in the quarter as we had previously indicated. And as we said, the entire loss in Ultra, about $0.09 in the first half of the year, a lot of that is related to transitional and onetime costs. So as we move forward we don't, of course, next year believe that, $0.09 expense will continue.

Rick B. Patel - Stephens Inc., Research Division

And do you have confidence that the gross margin part of Ultra or at least the impact of that to the total gross margin line is going to improve as you go through the year?

Ronald W. Ristau

I believe it will -- I believe that the gross margin in Ultra will do a little better, yes.

Rick B. Patel - Stephens Inc., Research Division

Great. And then can you talk to us about how we should be thinking about SG&A for the remainder of the year? I'm curious if you can achieve a leverage in the back half and how we should be thinking about the fourth quarter specifically, given last year's 53rd week and the acquisition of Ultra?

Ronald W. Ristau

Well, we don't give specific guidance on that. I think our SG&A spending, as I indicated, was well controlled. If you look at our SG&A spending, excluding Ultra, we actually leveraged it. And we believe that our excellent control in SG&A will continue as we go through the year. That's probably the best I could say about that. We all experienced some deep -- we'll experience some deleveraging as it relates to Ultra, but we expect that the base business will continue to perform well.

Michael W. Barnes

I would just add to that, pretty much what Ron said, and as he talked about in his remarks earlier and that is, we have had a successful transition of Ultra now. We had a dilution of $0.09 in the first half of the year, it's going to be very minimal in Q3 and then it's going to become accretive. So as we continue to ramp-up these new Kay stores that we've converted, things should look better over time.

Rick B. Patel - Stephens Inc., Research Division

Great. And then just the last question around made-for-outlet products, just curious what you've learned from Ultra so far and how we should be thinking about that going forward?

Michael W. Barnes

That's a great question, Rick. We've learned a lot. And prior to the acquisition, we were a much smaller player in the outlet market and we were operating the stores primarily as normal Kay stores within the outlet realm. And there's a lot of specialized marketing, not just merchandise but specialized marketing that we've learned from them that we're going to put into place going forward, that we think is going to be a real win for us. But also doing made-for product allows us to kind of engineer the product so that we can gear it for the bargain-hunting consumers that want to shop the outlet malls. And so we're going to have a much more desirable product mix out there for those consumers that like to shop the outlet malls. So we think that with the learnings that we got, both from Ultra and now that we have a really solid team of people moving forward with a pure outlet strategy, that we're just going to see more and more improvement over time. And like I mentioned, this is a channel of distribution that's actually growing in the U.S. They're building new developments. I think they're slated to have another 51 outlet malls opened over the next 3 to 5 years, I'm not sure what the timeline was on that, but I heard that number the other day. And we want to be a part of it. We want to be the leader in the outlet industry. We're going to have 120 outlet stores for Kay by the end of this year compared to only having about 30 last year. So we think it's a big win for us, and we're looking forward to driving that part of the business.

Operator

And our next question comes from Jennifer Davis from Lazard Capital Markets.

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

First, Ron, could you help us understand third quarter guidance? I guess I was a little bit surprised to see you guide to a decline in earnings. I mean, I think maybe a part of it is the fact that Ultra is a lower margin business still. And then a follow-up to that would be, how long do you think it will take for the outlets to reach the productivity levels of the Kay outlets?

Ronald W. Ristau

Sure. Well, the third quarter is -- Ultra is, of course, a fact in that. And you could see in our statements that we think Ultra will be -- it won't really contribute and it might contribute negatively by a couple of pennies. We do believe it will become accretive in the fourth quarter of the year. And we've always said we can't predict how rapidly the productivity should increase, although we are seeing some good results out of the stores that we have converted to Kay and some light sales increases there. So we're hopeful that next year will be significantly better than this year with results in Ultra. And more importantly, as Mike indicated, that Ultra is only a part of our outlet strategy. We've opened and we'll have, just exclusive of Ultra, 53 total stores that were just Kay to begin with, because we've opened up quite a number of them this year. So by the end of the year, we'll be operating 120 total combined Kay outlet stores and about 39, I believe it was, Ultra Stores. So as it goes forward, the outlet strategy should become a much greater contribution. But it's not just from the Ultra Stores, it's the Ultra Stores as well as these new Kay outlet stores that we are opening up. When we think about the guidance in the third quarter; number one, we've given a, hopefully, a prudent view of what we believe comps will be. We do expect that we will see some impact in our margins as it relates to the issue that we're having in bad debt, which we believe will be primarily offset by other operating income. We have projected, for now, because we'll be doing a lot of test work in the third quarter in our U.K. business. But the U.K. business will continue to lose money in the third quarter, as it always does, but we've been a little a conservative with our U.K. business because our idea is to allow them great latitude for testing on new products and to try some different things to get ready for the all-important fourth quarter to make sure that we're 100% positioned there. So third quarter is our lowest quarter of the year, as you know. And very small movements can cause some changes in the level of operating EPS for the quarter. For the full year, we think we're in very good shape and we just have to get through this third quarter.

Michael W. Barnes

Yes. Jennifer, this is Mike, I would just add on to that, reiterate Ron's point. This is our smallest quarter of the year. Having said that though, as I mentioned, we started off positive in both the U.S. and the U.K. And 3 weeks does not a quarter make, obviously, but we just wanted to give you an update on the trend as we start the quarter, as we usually do, at least the directional trend. But we're trying to be prudent with our guidance. Again, there's a lot of noise out there and gosh only knows what's happening to the geopolitical climate with all that stuff going on. So we think that we're well positioned to outrun the competition, whether we're in good times, bad time or indifferent times. And that's really the key here. We need to outpace the competition in whatever environment is given to us. And that's what we always try to do. And frankly, in tougher times, we -- generally, it's a little bit, in my opinion, it's easier to gain market share in tough times than it is in good times because people start running for the hills. While we still have our strength, our financial flexibility, we're able to invest, and we're continuing to invest in so many great strategic initiatives. And we're going to talk a lot about those at the Investor Day on October 8. So this is a situation where we feel great about the back half of the year, we feel well prepared, we think the team is well prepared, and we're just being prudent. We like to be good forecasters of our business.

Ronald W. Ristau

And there's one other point I'd like to make, Jen, for your excellent question. In the third quarter this year, we have increased our advertising a little bit because of some new exciting programs that we're going to be running in September, October time frame. And we've taken a prudent view on the sales impact on that, but we have included in our guidance the additional advertising spending. So that's also having some impact...

Michael W. Barnes

That we didn't have last year.

Ronald W. Ristau

Yes. It's having some impact on our guidance, and we'll see how it all turns out.

Ronald W. Ristau

And that third quarter TV advertising was not part of our program last year.

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

All right. Great. And no, I completely understand the fourth quarter is when you generate about 50% of your earnings. So obviously, the fourth quarter is a quarter that matters. So Ron, can you quantify maybe how much you are planning on losing in the U.K. in the third quarter?

Ronald W. Ristau

I -- well, we've never been that specific, although I'd say that the level will be a little greater than that experienced last year.

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

Okay. All right. And then one more question...

Ronald W. Ristau

Unless the business surprises us and gets a little better. We're planning it conservatively outside.

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

Okay. All right. And then, finally, with your online merchandise. Do you think you have an opportunity to expand that and begin to carry online exclusive merchandise? And if so, when do you think we should start seeing that?

Michael W. Barnes

Well, I think that what we have the ability to do is have an expanded range online which, I guess, you could call that exclusive because it's not in the stores. We have physical limitations within the stores. And then online, there are no physical limitation. The other thing that we're doing is, and this is a really exciting program, is we're really ramping up our custom jewelry manufacturing. And this goes beyond personalizing a ring. We've had build a ring for a while where you can pick a ring, you can pick the metal, silver, 14 karat gold, et cetera, you can pick diamonds, emerald, rubies, whatever, and you can kind of build the ring. But we've got a custom program in place that we're really putting a lot into where people can actually design custom jewelry themselves. They can walk in with a sketch and our guys have the ability to put it into 3D CAD renderings and design it out and get it custom made and delivered. And what's the delivery time on that Ron, do you remember?

Ronald W. Ristau

Like less than 2 weeks.

Michael W. Barnes

It's like 2 weeks or less delivery. I mean, this is custom-made jewelry to their specification. So it's pretty exciting program and it's in early stages right now, but it's something that we believe has a lot of legs to it for the future. So a lot of the personalization that we can do. But yes, I think that what we can do with our online business is we can have a much broader product offering, and then it's going to drive great performance for us. The U.S. was up 36%, I mean, the growth that we have seen recently online has just been spectacular. And we're looking forward to continue driving that business at full speed.

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

All right. Great. And congratulations, Mike and Ron, you both -- you guys have done a great job since you started. I mean, with the Ultra acquisition, expansion of outlets and online, and all of the strategic initiatives. So best of luck.

Operator

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

Jeffrey S. Stein - Northcoast Research

A couple of questions. First of all, gold jewelry. With the price of gold coming down, are you beginning to see -- first of all, are you changing your strategy at all with regard to how you either price gold or perhaps bringing in more gold product to your customers now that it's becoming more affordable? It seems to me that gold jewelry sales have began to pickup in the U.S. during the second quarter, and I'm wondering if you're seeing that and what your strategy is in the segment of your business for holiday? Obviously, that's more of the fashion part of the business and therefore, could weigh more heavily in the back half of the year.

Ronald W. Ristau

Okay. That's a very good question. As it relates to gold, a couple of key points. Number one, the gold prices have -- were favorable. They're much more favorable a couple of months ago, but they seem to be right now. But I would remind you that number one, we're on an average costing system. So it will take us a little longer to realize the impact from gold swings in our P&L. It's not as dramatic as somebody on different inventory system, so I'll just make that point. We also see, with gold, some dynamics that are in our P&L that you might not be thinking about. Number one, is it's favorable to us, of course, in our purchase of gold. It's also unfavorable to us as we scrap gold and go through our turn-in programs and so on. So there's some negative signal throughout our P&L, along with the benefits that we get. And we are working through some losses that we had on our hedge positions from earlier in the year, as we have disclosed that. So all those things together are playing into the way we think about this. Be that as it may, there's still a benefit from gold. Has it changed our strategy in pricing, I'll let Mike speak to that a little bit. But in the U.S., our pure good business is not a lion's share of our business, and it's more -- we do have some in the U.K. And in the U.K., we have moved to take price adjustments in the U.K. and we are seeing some response in people repurchasing gold where it had been on declining trends. So that's probably the biggest manifestation that I could speak to. Mike, I don't know if you want to add to that.

Michael W. Barnes

Yes. I would just add to that, Jeff, that -- Ron mentioned the U.K., we have taken price adjustments in the U.K. to bring prices down, quite frankly, because of the move that we've seen in gold price. We tested that and it tested out very well. And we've just, for the fall, kind of put it into motion. So we have high hopes that, that's going to help what has been a difficult gold business for us in the U.K. Because the U.K. does sell a pretty good amount of gold, they we have a little bit more balanced merchandise mix in the U.K. Whereas 75% of our business is some type of diamond jewelry-type jewelry in the U.S. So we think that we're going to get a benefit in the U.K. from the gold. We will see the benefits as it rolls through our inventory but to Ron's point, it's on an average basis. So it takes about a year for changes in prices to really roll through. And to his point, on the scrap side, you get that hit immediately as you're scrapping. So there's a couple of different moving parts in there. Overall, net-net-net, it's going to be a benefit, like Ron said. And we're hoping that the prices remain stable.

Ronald W. Ristau

And I hope we don't wake up tomorrow and see gold back at the $1,700, Jeff.

Jeffrey S. Stein - Northcoast Research

One additional question, Ron, and again, this gets back to the third quarter. In your prepared remark, you've kind of indicated that you expect your credit income to be up in the third quarter. Ultra is going to be kind of breakeven. So I'm just trying to isolate how much of your guidance in Q3 is just being cautious and conservative? And how much of it, is, for example, of this bump in marketing, or is credit expected to possibly get worse before it gets better? And if that's the case, maybe you can talk a little bit about some of the execution issues you're having on training and so forth?

Ronald W. Ristau

Sure. Well, first, I don't believe credit will get worse before it gets better, let me be clear about that, it just won't work. What I said about the third quarter was that I expect it to be up. There's 2 components to it, the bad debt, which sits up in our gross margin. And I think that, that will be up 30, 40 basis points versus last year, primarily on the basis on mix -- I'm sorry, on the mix itself, on the base of growth and receivable balance, and with the small little impact from the mix and efficiency, as I've discussed in the second quarter. I believe that, that will be largely offset by increases in other operating income so that the 2 will move in tandem and have de minimis impact on the P&L, Jeff, net, okay. Well, when I think about the guidance for the quarter, number one, we have included in there some additional spending on advertising. We have prudently not really projected a lot of sales on that. We'll see how it turns out. It's really the first time we've done this. So that is impacting our guidance somewhat, so that spending range is impacting the numbers, for sure.

Michael W. Barnes

It's an interesting dynamic, Jeff. As the non-financial guy here in the room, I find it very interesting that as customer shift more to our regular interest-paid program, they get lower payments, but it stretches out the payments longer. Because you have that receivable sitting out there for a longer time period, it generally doesn't operate quite as well as a 12-month interest-free program, but you get the benefit of collecting that interest. And as a Ron mentioned earlier, on a net basis, we actually came out to the positive, I think it was $1.4 million.

Ronald W. Ristau

Yes, that's correct.

Michael W. Barnes

So it's a little bit of a trade off there, but because of the interest collections going up at the other operating income, it actually has been a positive net for us in the second quarter.

Ronald W. Ristau

And for that point, Jeff, that the metric that we evolved and grown, you see us using and we present it, by the way, which is bad debt as a percentage of sales, it will go up because the receivable balance is growing at a faster rate than sales because of the penetration increases. And we've been talking about that for, I think 2 years now, but that is going to go up somewhat. But it's driven by the volume increase, and that's a pretty easy number to calculate.

Jeffrey S. Stein - Northcoast Research

Sure. And Ron, could you possibly quantify the increase in marketing spend, the incremental marketing spend for Q3?

Ronald W. Ristau

I don't think we could be that specific. I really can't be that specific. It's significant but not a huge number. Problem you have in the third quarter is that small movements in these numbers move the EPS a couple of pennies. So it looks -- because it's a small quarter, you get more -- a little more distortion, which I'm sure you know from working the model yourself.

Operator

And our next question comes from Bill Armstrong from CL King & Associates.

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

Just to follow-up on some of that. So the bad debt issues, are these training or -- and internal issues, are there any issues with your customer mix and maybe consumer ability to pay?

Ronald W. Ristau

No. I wouldn't say there's any issue with our consumers ability to pay. Our overall credit portfolio statistics continue to remain very strong. And I want to make sure that you understand that point. When we look at the bad debt issue, again, about 75% of it. So in the quarter, we had a $5 million increase in our bad debt, about $3.5 million, $3.6 million of it is directly traceable to increases in the volume with the residual being comprised of several things: Number one, is the impact of this change in the credit programs that people are selecting. Remember this phenomena started like last year and we're seeing now, as it works its way all the way through the cycles, that it's increasing the risk up slightly. I mean, it's a couple of hundred thousand dollar impact in there, maybe as much as $0.5 million. And the residual we're having of some short-term issues because of the 12% growth from the receivable balance that we experienced is that we've had to bring on a lot of new people and train them and get them up to speed, and we're seeing some -- it's a high-volume activity. So as you make small changes in the activity that pass through the collection, we've seen some impact there, which we hope to correct as we go forward in the next quarter or 2. But I don't see that there's anything wrong with our consumers' ability to pay. Consumers are behaving strongly. They are making more than the minimum down payments very strongly. They are using the credit appropriately. Our credit approval rates remain relatively consistent to prior years, so there's no big change in anything that we're doing there. So I don't want to cause any alarm, but I do want to properly describe the situation as mostly volume with some tweaks, if you will, in the collection profile, primarily caused by the change in these programs.

Michael W. Barnes

Yes. All the indicators that we track that speak to the health of the consumer have stayed very strong. And not only are they making more than the minimum down payment, but they're continuing to overpay their monthly payment at a strong rate as well. So the indicators, as far as the health of the consumer, have been good.

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

Okay. And then, I guess, part of this guidance that reflects the higher advertising expense, but it sounds like you're not -- you're assuming no actual sales benefit from it? So I guess, why bother doing these advertisement?

Ronald W. Ristau

Well, people have to test things every now and then. We have to see what happens and you try to do something that is a little different. I didn't say we didn't put any impact, I said we've been conservative of the impact. We'll see how it all turns out. If you never try anything new, then you never get a different result, so sometimes you have to try and test things. And we've tested these programs, and we believe they'll be effective. So let's see what happens.

Michael W. Barnes

Yes. It's a new program that we haven't done before. And it's a test, so we were naturally conservative on the impact. But of course, yes, we expect to see some impact from it.

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

Okay. Fair enough. And just kind of broadly, mall traffic is kind of soft, the panel retailers are reporting softness in sales. Are you guys seeing any impact on that maybe more on the fashion jewelry side compared with the bridal side?

Michael W. Barnes

Well, as we said, we started off on a positive in both the U.S. and the U.K. But with the macro retail environment being what it is, we've all seen the same reports from the companies that you're referring to on the apparel side, we're being prudent about our expectations to some degree. But we started off positive and we feel well prepared for the back half of the year. So that's kind of where we're at. We've given the guidance out there, and we've given a little bit of directional color on how we started off in August, and that's pretty much as far as we can go along those lines.

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

Okay. And then just final question. It looks like you've increased your store openings by about 5 units this year. Anything to call out there with the -- maybe the thought process behind that?

Michael W. Barnes

Yes. The real estate team is doing a great job. Ron and I have been asking these guys to continue finding these great locations that they've done so well at over the years and to speed it up, because the stores that we're opening have been doing very well and we are stretching into other areas. We began, a number of years ago, opening Kay off-mall stores, in centers, power-type centers, et cetera, they've done very well, just like Jared has. And so we have asked them to continue doing the great job they're doing and find some more successful real estate for us. And they're succeeding at it, thank goodness. So we're very pleased to be opening the number of stores that we are. I think it's fantastic. We're in a little bit of a growth mode here with the acquisition and -- plus the organic stores that we're opening, we're excited about the future. And we think we've got a great long-term strategy to really drive this company higher and higher over time.

Operator

And our next question comes from Lorraine Hutchinson from Bank of America.

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Just one longer-term question on credit. As you roll the programs out to your outlet customer, how do you expect that to change your bad debt reserves or metrics?

Ronald W. Ristau

Well, it's a very good question. We don't have a different scoring mechanism for outlet customers as opposed to normal mall customers. So the outlet customers must meet the same credit granting profile, if you will. So we do not expect that it will be significant in any way. What we saw as we rolled it out, as a Mike indicated, just to reiterate, when we purchased the company, the credit penetrations were in the low-20s, given the programs they were offering. We started in late June to roll out our credit offering to the stores, so they really have been at it a little better, not even 2 months yet. And it jumped from the low-20s up to around 40, okay. Because people have to learn how to sell the credit and how -- what the benefits are and so on, but we thought that, that was a very good short-term impact, that was a movement about a 6-week period. We're not experiencing, as of yet, nor do we anticipate to experience, any major changes in the bad debt because the way people select the program is the same, and the programs they select are the same. So therefore, it shouldn't be different. It's not like the credit consumer there is less worthy. We'll see how the approval rates go. We don't know, over time, whether the approval rates will be the same or different, but that should -- as long as you're not changing the criteria, what should change is the approval rate. If it's a lower quality credit, then it should be lower approval rates. But we don't have enough information at this point in time. Does that answer your question?

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

It does, yes. And then when you think about the holiday calendar with 6 fewer days between Thanksgiving and Christmas, do you view that as a comp hurdle? And how are you changing your marketing and merchandising to reflect that?

Michael W. Barnes

Well, what that means is that every single week and every single weekend are very important. And so what it means is that we've taken very careful look at our calendar. We've made sure that we feel we have a robust calendar with events, with marketing. We've upped our marketing spending and impressions during time frame. So it just means you have no -- there's no room for error. And you've got to be right on top of it. And we are, I can assure you.

Operator

And our next question comes from Brian Tunick from JPMorgan.

Brian J. Tunick - JP Morgan Chase & Co, Research Division

Two questions, I guess, maybe Mike, just on the bigger picture side. What do you think the industry consolidation looks like from here? Do you expect the pace of industry closings to slow? Are you seeing the department stores reenergize and doing something different in the category? And then on the U.K. side, can you maybe talk about the recent management changes you've made and how that affects your thoughts. On maybe getting back to that, I think you said 10% operating margin goal longer term?

Michael W. Barnes

Sure. Thank you. On the consolidation side, it has slowed as we have gotten further and further from the old dark days of the recession 5 years ago or so. And -- but I think it's stabilized and it continues to consolidate, albeit, a little bit slower year-to-year-to-year. We believe that we're primed to continue to take market share from that consolidation. It's interesting, and I'm glad you mentioned the department stores, because one of the things that we focus on here is making sure that our team understands. Know who your customer is and don't be focused on only specialty retail jewelers. Because there are these big guys out there like the department stores of the world and some of the mass merchants that are considerable competition to us in the mid-market jewelry. And we have to realize that, focus on it and continue to drive great product selections that our customers desire to win that game. It was just fairly recently, a couple of years ago, that we overtook Wal-Mart, quite frankly, and became the #1 jewelry retailer in America. Not just the #1 specialty retail jeweler, but the #1 jewelry retailer. So even as the specialty retail jewelry market has consolidated down, we've continued to grow, not only within specialty retail jewelry, but also within jewelry in general, as far as retailing in America. So we feel very good about continuing on that path that we've been on and we think that we're well prepared to do that. As far as the U.K., we have had management changes there. Rob Anderson has decided to leave the company and we have promoted Sebastian Hobbs, who was our Commercial Director for the past 2.5 years, to the Managing Director position in the U.K. Seb is a great leader. He's got a great eye for the commercial business out there in the marketing side of things. So we think that he's going to continue to drive the U.K. to become better and better in their product offerings and their marketing objectives and in really driving the business. We've also had some -- a promotion on the store operations side. We've promoted an 8-year veteran to the position of Director of Store Operations, and she is a fantastic individual. It's working out very well. The transition has gone very well. As I said, we actually started all positive first 3 weeks of August, which was a nice trend change. And I know that's not a long trend, but we'll take what we can get and continue to build upon it. So there's a lot of exciting things happening. We're also continuing to really work in collaboration between the U.K. and the U.S. teams. And this is an exciting thing. They're more collaborative than they have ever been. In the U.S. management team, starting at the top, with Mark Light as the CEO, our Senior Vice Presidents of Merchandising, of Store Operations, they're all very excited to be working in collaboration with the U.K. And the idea is, we want to find best practices wherever they sit. Best practices can come from anywhere and they can be executed everywhere. And so we're having the teams work together to find the best practices, and this is a long-term strategy for us. And we believe it's going to be very successful. We've already started working on a lot of the same product ranges, the U.K. tested the Neil Lane range last year. It did very well, and they're rolling that to a lot more stores for holiday. So there's a lot of exciting things happening in the U.K. Everyone is really pumped up about the direction that we're going. We do still have our eye on that 10% operating income, and we believe that we can get there. And we believe that we've got a team on the ground that can make it happen working in close collaboration with our team here in the U.S.

Brian J. Tunick - JP Morgan Chase & Co, Research Division

Mike, that sounds very exciting. Just one quickly for Ron. On the 75 to 85 stores this year, is that the right place for us to be thinking as far as next year as well from a planning and budgeting perspective? Is that the right either square feet or growth rate?

Ronald W. Ristau

I would tell you that -- I would certainly stay -- we'll probably say more about this at our Investor Day. I don't think our range in the future will be significantly different, although we'd really like to give you an update at our Investor Day on that issue as we take a look through our budgets and so on. We're seeing, as Mike indicated, some nice real estate opportunities. Were doing a great job in our real estate community with that. And I don't think it will be materially different, but before I lock an exact range I'd like to defer and wait until then.

Operator

And our last question will come from Oliver Chen from Citigroup.

Oliver Chen - Citigroup Inc, Research Division

Regarding the environment that we're seeing now, we are seeing national specialty competitors get a little bit stronger, probably thanks to a lot of execution around similar strategies on better proprietary product and bridal. So what are your thoughts there in terms of your competitive flexibility going forward and what kind of leverage you may have? And also, how was the competitive environment in your view?

Michael W. Barnes

Thanks, Oliver. Yes, you're absolutely right. Our competitors are not standing still. They're all running at us. And of course their goal is to take the business, and we won't let them have it. We intend to continue gaining profitable market share. And a lot of the successful things that we have done over the years, people are going to emulate those. And if it's a successful strategy, it might work for them as well. And there's a lot of competitors out there that are trying to do that. So what we have to do is we've got to continue moving fast. We've got to be innovative, we've got to be fresh, we've got to have new products and we've just got to stay in front of it. And that's the best way to compete in this industry. We've got a team that can do that. This team is nimble, they're very experienced and they're continuing to drive some great ideas in marketing, great ideas in execution in the field, great marketing merchandise. This is what we have to do to stay in front of it. And that's what we are doing. We intend to stay the #1 jeweler in America and in the U.K., and we're going to do everything in our power to keep moving forward. That's our job. Their job is to try to catch us. Our job is to try to keep them in the rearview mirror. So we're working towards that, and I believe that we're going to be successful. We have worked on some big strategies and we have a strategic vision with a lot of great new innovative ideas going forward. We're going to talk a little bit about strategy at our October Investor Day conference on October 8. So I hope that you and everyone else can be there because it's going to be an exciting day. And we'll lay out a little bit more about what we're doing to really win in this environment.

Oliver Chen - Citigroup Inc, Research Division

As a final one, Mike and Ron, could you just share us what's your thoughts on the health of the consumer? From this perch, we're just getting all these mixed messages, I was just curious on your thoughts on how the consumer feels and if they're thinking there's continued volatility in the market place or if you think that they feel encouraged about the ability to spend?

Michael W. Barnes

I think the consumer is fairly healthy, but they run in cycles. And I think that from what I've heard from the macro environment, they've been focused a lot on different categories and it moves around. I saw a positive comment about the gross domestic product this morning coming out in the U.S. So hopefully, the consumer will continue to gain strength over time. Again, we can only talk about how we feel, and we feel well positioned for the back half of the year unless we see some dramatic trend changes or have some big black swan event that hits us. So I think we're well prepared and I think the consumer will be there for us.

Operator

And I will now turn the call over back to Mr. Barnes for closing remarks. Please go ahead.

Michael W. Barnes

Thank you so much. And thanks to all of you for taking part in this call. We really appreciate it. Our next scheduled call is on November 26, when we'll review our third quarter results. But remember, before that, we do have our Investor Day conference in New York City, and that's on October 8. I hope to see you all there. Thanks again, and goodbye.

Operator

Thank you. And thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.

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