Blue Nile Management Discusses Q3 2013 Results - Earnings Call Transcript

Oct.31.13 | About: Blue Nile, (NILE)

Blue Nile (NASDAQ:NILE)

Q3 2013 Earnings Call

October 31, 2013 8:30 am ET

Executives

Nancy Shipp

Harvey S. Kanter - Chief Executive Officer, President, Director and Member of Stock Award Committee

David B. Binder - Chief Financial Officer and Member of Stock Award Committee

Analysts

Mark R. Miller - William Blair & Company L.L.C., Research Division

Deepak Mathivanan - Deutsche Bank AG, Research Division

David Wu - Telsey Advisory Group LLC

Trisha Dill - Wells Fargo Securities, LLC, Research Division

Andrew Marok - Cowen and Company, LLC, Research Division

Paul Judd Bieber - BofA Merrill Lynch, Research Division

R. Scott Tilghman - B. Riley Caris, Research Division

Rick B. Patel - Stephens Inc., Research Division

Operator

Good morning, ladies and gentlemen. My name is Jennifer, and I will be your host operator on this call. [Operator Instructions] At this time, I would like to introduce Nancy Shipp, Director of Investor Relations of Blue Nile.

Nancy Shipp

Good morning, and thank you for joining us on our conference call today to review our third quarter 2013 financial results. With me today are Harvey Kanter, President and Chief Executive Officer; and David Binder, Chief Financial Officer. Both will be available for Q&A following today's prepared remarks.

Before we begin, I'd like to remind you that we will be making forward-looking statements during this call regarding the company's future performance. These statements are only predictions based on assumptions that are believed to be reasonable at the time they are made and are subject to significant risks and uncertainties.

You should not rely on these forward-looking statements as representing our views in the future, and we undertake no obligation to publicly update or revise these statements. Our actual results may differ materially and adversely from any forward-looking statements discussed on this call.

Our quarterly reports on Form 10-Q, our annual report on Form 10-K and other forms on file with the SEC identifying important risk factors and uncertainties that you should consider when making an investment decision regarding Blue Nile, and that may affect whether our forward-looking statements prove to be correct.

Also, please note that during the course of this conference call, we may discuss non-GAAP financial measures as we review the company's performance. We will discuss non-GAAP free cash flow, which is defined as net cash provided by or used in operating activities or operating cash flow less outflows for purchases of fixed assets, including internally-used software and website development. We will discuss international sales on a constant exchange rate basis. And we will also discuss non GAAP adjusted EBITDA, which is defined as earnings before interest and other income, taxes, depreciation and amortization adjusted to exclude the effects of stock-based compensation expense. Please refer to our Investor Relations section on our website to obtain a copy of our earnings release, which contains reconciliation of non-GAAP measures to the nearest comparable GAAP measures.

Now, I'd like to turn the call over to Harvey, our President and CEO. Harvey?

Harvey S. Kanter

Thanks, Nancy. Good morning, and welcome to Blue Nile's third quarter 2013 earnings conference call. We achieved net revenue of $98.9 million, representing our sixth consecutive quarter of double-digit growth and a solid accomplishment for certain. Our growth rates demonstrate that we are gaining scale, adding to the customer base and building momentum around the world and most notably in China.

We continue to break records in the number of engagement rings and wedding bands sold, and importantly, we are thrilling an ever-growing number of customers who are becoming advocates for the Blue Nile brand. Later in this call, David will review the details of our performance in the third quarter.

Before then, I want to take a few moments to highlight the key initiatives for the all-important holiday season. As you know, Blue Nile's distinct advantages include the power of diamond supply chain, cost-efficient operations and a commitment to the highest quality product and customer service. At the end of the day, our business is about deploying those distinct capabilities in a way that continues to thrill our customers and acquire new ones.

That experience begins at the first interaction with our brand and extends through many touch points in the shopping experience. We've added capabilities this year to enhance the experience, and we're excited by what it means for the holiday season.

First, the website. When we arrived 13 years ago, we were viewed as a disruptive force in the jewelry industry, and we were told no one would buy a diamond online. Clearly, they did. Now our core customers has grown up with the Internet and e-commerce and is more comfortable with and increasingly using multiple devices to shop.

The shopping experiences needs to conform to the ways they expect to interact with us on any one of those devices. Over 40% of our traffic in third quarter was for mobile devices, and we expect that to exceed 50% in the fourth quarter.

Throughout this year, we've gradually launched web pages that dynamically adapt to user-specific device, which allows our in-depth product education and selection to be viewed in the most optimal way. As we approach the holiday season, the key elements of this migration will be complete. This is a critical milestone to providing customers the experience they expect in an increasingly mobile first world.

Adaptive web pages are the future of e-commerce. And not only are we among the first jewelers to offer such a robust mobile experience, we're among the first retailers.

Second, we are excited about the continued evolution of the mix we are bringing to consumers. We're more focused on the basics than in prior years, and we have a clearer vision that our fashion jewelry needs to be understandable fashion and of the highest quality with a tremendous value.

As part of this evolution, we've expanded the assortment of Monique Lhuillier's designer offering, moving from bridal now into fashioned diamond jewelry. Customers responded well to the first set of products, and we believe the continued addition of the fashion fine diamond jewelry will bring more customers to the Blue Nile brand.

This is a great opportunity for the holiday season. We're also offering a deeper assortment in wedding bands and coupled with enhanced navigation, visualization and customization. In part, this experience is enhanced by our recently launched vendor on demand program or as we call it, VODO.

Through a key partnership with one of our vendors, we are able to bring semi-customized ranges of weights and metal types to customers without investing in inventory. Basically, customers will be able to find, customize, visualize and purchase a greater number of wedding bands at the same level of quality, service and value for which we've always stood.

Third, our International business. Here, we expect in the fourth quarter to achieve a record level of orders and revenues across all product categories. The biggest area of focus for us continues to be China. We entered the holiday season with heightened capabilities to serve consumers in China, including greater product assortment, better customer service and enhanced fulfillment capability.

It's a long and gradual road, and we believe the fourth quarter will continue to demonstrate that our value proposition is compelling to customers in China, as well as in over 40 countries we serve throughout the globe.

Lastly, Blue Nile's social media practice. Our social media channels continue to have a very strong following. Social media has been a great channel for 2-way conversations with our advocates and give us the opportunity to showcase our products in a different and compelling way.

These conversations continue to build awareness for our brand. On Pinterest, we're literally the largest jeweler on the platform with over 55,000 followers. And on Facebook, we have over 530,000 fans and the highest level of interaction and dialogue among our competitors.

In the end, everything we're doing is about the customer and improving the consumer experience online and on mobile. I want to thank everyone on the Blue Nile team. They are the heart of this success of what we are creating. It is our team that obsesses about our customer and delivers an exceptional experience everyday. I'm incredibly proud of the efforts so far and the results we will create in the future.

And now, I would like to turn the call over to David. David?

David B. Binder

Thanks, Harvey, and welcome to everyone on the call this morning. Our financial performance in the third quarter represents solid progression in the execution of our strategic growth plan. We continued double-digit growth in the face of very high comps from the prior year and fundamentally maintained a strong 2-year performance across all areas of our business.

Overall, profitability expanded as we invested in marketing to generate momentum into the fourth quarter and the website features that will provide a more compelling customer experience in the long run. We are pleased by what this performance means as a checkpoint in our long-term plan and the progress we're making to drive results in the future.

Now turning to the details of the financial performance in the third quarter. Net sales totaled $98.9 million, representing an increase of 10.1% versus the third quarter of 2012. This resulted in line with the expectations we set at the beginning of the year and for this quarter.

It's worth noting that the growth rate this year is on top of a high growth rate last year of 19.8%. The average growth rate over the prior 2 years for this quarter was 15%, in line with our performance from last quarter and consistent with our long-term targets.

U.S. engagement sales for the third quarter grew 7.1% to $57.9 million compared to $54.1 million in the third quarter last year. The 2-year average growth rate was 19.3%, which also is in line with our performance last quarter and on track for our plan to build scale and gain share. Additionally, in this quarter, growth in core price points, which we define as those under $25,000, was significantly higher than those at higher prices.

Now looking at the sales of our non-engagement products in the U.S. Sales in this category grew 9.6% to $23.9 million versus $21.8 million in the third quarter last year. We are seeing solid momentum in the sales of wedding bands with the highest growth coming from these products versus any others in the category. This performance is consistent with our plan to first accelerate growth in bands, which is driven in part by the scale we're gaining in engagement ring customers.

Now turning to our international markets. International sales for the third quarter increased 22.9% to $17.1 million compared to $13.9 million last year. On a constant-currency basis, international sales increased by 27.6%, the highest rate of growth normalizing for currency in 2 years. Growth was relatively balanced with the highest rate coming from Asia-Pacific, but we also saw double-digit rates of growth across the Americas and Europe.

For the overall business, gross profit was $18.7 million, up by $1.8 million from our result in the third quarter last year. Gross profit as a percentage of net sales was 18.9% compared to 18.8% last year. This rate has been gradually improving sequentially throughout the year, and the third quarter represents the first period of improvement versus the prior year since the second quarter of 2011.

The mix of revenue from engagement was 72.8% in the third quarter, in line with the same period last year. As our growth rates are relatively balanced between engagement and other jewelry products, our gross margin rates are gradually improving.

Selling, general and administrative expenses increased 13.3% to $16.2 million in the third quarter compared to $14.3 million in the third quarter last year. Total SG&A expenses as a percentage of net sales equaled 16.3% compared to 15.9% in the prior year, an increase of 40 basis points. This increase was entirely driven by marketing expense, which was equal to 5.6% of revenue versus 5% of revenue last year, an increase of 60 basis points.

As the quarter developed, we identified opportunities to deploy spend to increase momentum into the fourth quarter and beyond. Non-marketing expenses in total grew at a rate slower than revenue as scale continues to drive leverage in these areas.

Operating income for the third quarter totaled $2.5 million compared to $2.7 million in the third quarter last year, slightly decreasing. This result is driven by increase in gross profit of $1.8 million, offset by an increase of SG&A of $1.9 million, and the lion's share of this increase is driven by marketing spend.

Net income totaled $2.9 million compared to $1.7 million last year. These results include the benefit of $1.1 million associated with certain discrete income tax savings. Including this benefit, our effective tax rate for the year-to-date period through the third quarter is 19%. Going forward, we expect our effective tax rate to return mostly to historic levels.

Third quarter earnings per diluted share was $0.23 compared to $0.14 in the third quarter of 2012. The discrete tax items represent $0.08 per share. Additionally, net income per diluted shares includes stock-based compensation expense of $0.06 in the third quarter this year, the same level of expense from the third quarter last.

Non-GAAP adjusted EBITDA was $4.6 million compared to $4.8 million from the third quarter last year, a decrease of $200,000. While gross margin increased by $1.8 million, the gain was offset by higher expenses, which is again mostly associated with marketing.

Cash flow generated by operations totaled $200,000 in the third quarter, and for the trailing 12 months, totaled $21.5 million. This level of cash flow over the prior 12 months compares to net income of $10.9 million. We continue to generate cash from operations significantly in excess of our operating income, which is consistent with the fundamentals of our business model.

Our inventory balance at the end of the third quarter equaled $30.9 million compared to $28.9 million at the end of the third quarter last year, an increase of 7%. As our inventory balance is growing at a rate slower than revenue, our turns are increasing. We look to continue this momentum to the fourth quarter, further enhancing our yield on operating cash flow.

We ended the third quarter with cash and cash equivalents of $47.9 million compared to $30.2 million in the prior year, representing an increase of $17.7 million. In the quarter, we purchased 147,000 shares for $5.4 million. And year-to-date, including activity in the fourth quarter, we've purchased 299,000 shares for a total of $10.4 million.

Today, we also announced a reauthorization of our share repurchase program to spend up to $100 million over the next 2 years. As we renewed our commitment for this use of cash, it's worthwhile to reflect on the history of this program. Since 2005, we've purchased a total of 7.8 million shares. We continue to see this program as a compelling way to utilize cash we generate to enhance long-term shareholder value.

Now turning to our guidance. For the fourth quarter of 2013, we expect net sales to be between $146 million and $161 million, and earnings per diluted share between $0.37 and $0.46. Given these ranges for the fourth quarter, our full year expectations for net sales are to be between $450 million and $465 million, and earnings per diluted share between $0.84 and $0.93.

Now I'll turn the call over to the operator, and we'll take your calls.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Mark Miller with William Blair.

Mark R. Miller - William Blair & Company L.L.C., Research Division

Could you go through in a little more detail on non-engagement components? And specifically since I know there's a lot a focus on the wedding bands, what kind of change are you seeing in the attachment rate, and what's your outlook going forward here?

Harvey S. Kanter

Yes, hey, Mark. It's Harvey. The attachment rate has grown about 10%, and I might remind you that we launched the beginning of the expansion really in late June. And VODO just really rolled out in kind of all its glory, if you will. So we're expecting that continue to accelerate, and you might remember that we've talked about really being able to double that band business over time. So 10% is a good starting point for initial results, and we expect to continue to grow.

David B. Binder

This is David. I'll follow up on the growth rate by category. Third quarter was interesting given recent historic trends where we actually saw non-engagement product sell at a rate faster than engagement. And that's a reflection more so of the prior year comps. If you remember, engagement sales in the U.S. last year in the third quarter grew by 31%, which is, I mean, that's a tremendous number to comp this quarter. And so the 1 year rates came in lower, and non-engagement sales are actually higher. We actually expect that dynamic to continue into the fourth quarter. Fourth quarter last year, U.S. engagement revenue grew again by about 31%. So we would expect a relatively low 1 year comp but really maintaining the 2-year average rates, which is how we've always talk about the business. We expect sales of non-engagement to really accelerate. In small part, it's because it was a relatively light comp. It was a tough comp in the third quarter. We grew sales for U.S. non-engagement by 11% last year. So growing it by nearly 10% this year was, for us, a pretty impressive performance. In the fourth quarter, we think the 1 year growth rates will accelerate, and that's what's included in our guidance. I would say the same is true for international. We see a lot of traction in the markets, and a lot of investments really starting to take shape. And so we think the growth rates accelerating in the International business is also part of what we're including in our outlook.

Mark R. Miller - William Blair & Company L.L.C., Research Division

Great, thanks for that color, and so just as a follow-up then within the non-engagement business domestically, I can infer from this that the wedding bands then were the fastest-growing part, and I guess the other piece is diamond jewelry and then the fashion piece?

Harvey S. Kanter

Yes. It's Harvey again. The diamond jewelry was up against actually the toughest comp on a year-over-year basis. Wedding bands has and continue to accelerate. It has been the strongest of the 3 categories. Diamond jewelry, we have a great expectation for. Our initial launch of Monique was really out of the box working well, and we'll look to see that really grow. And then obviously, the other category the fashion side of our business, which as I've mentioned, "We're making it more understandable." We have an expectation that we'll continue to grow but of the 3 components, it's the place we have the lowest level of expectation as compared to bands and diamond jewelry.

Mark R. Miller - William Blair & Company L.L.C., Research Division

Great. One final question, and then I'll turn it over. What is the minimum level of cash that you feel you need to have to run the business? And then the free cash flow did come down sequentially, but I mean, what kind of level of free cash flow are you expecting annually within the $100 million share repurchase plan?

David B. Binder

Sure. This is David. We have a pretty predictable cash flow based on historic sales. And in the third quarter, our cash flow was relatively low, and that's really a function of the dynamics last year versus this year and the sequential engagement revenue we drove from the second quarter to the third. Basically, we had a tremendous second quarter for engagement sales. And while it was strong in the third quarter, the total volume of engagement revenue dropped, and so payables went up in the second quarter and came down in the third. It's completely in line with the fundamentals of the business model. We would expect with the level of net income and EPS that we're guiding to this year that cash flow will be 2.5x to 3x our net income, and that's with a double-digit growth rate for a year that's been a fundamental metric that we've been tracking too, and we expect that to be going forward. The cash balance that we're sitting on right now is in excess of what we would consider to be a minimum requirement to run the business. So we have excess cash on the balance sheet now to deploy to the repurchase program. And given our guidance and our expectation for growth rates over the next couple of years, we see that as growing meaningfully, and that was part of the consideration for the $100 million reauthorization over 2 years.

Operator

Your next question comes from the line of Ross Sandler with Deutsche Bank.

Deepak Mathivanan - Deutsche Bank AG, Research Division

This is Deepak actually on behalf of Ross. Just a question on marketing. You said that marketing expense kind of de-levered by about 60 points. I mean, marketing expense was higher by about 60 basis points. So, I mean, is it because you're seeing de-leverage in some of the channels or is it mostly because investments, you're going to acquire new customers? And then is there -- has there any change in basically on a competition front from offline players for this fourth quarter? What expectations have you kind of factored on the competition front into the guidance?

Harvey S. Kanter

It's Harvey. I'm going to answer the second question first, and then we'll tag-team on the marketing specifics. Without commenting on what's specifically happening around us competitively, we certainly would expect that the season will be as competitive as ever. What we're excited about and looking forward to and quite honestly we believe that it is very difficult for many of our competitors to ramp in mobile the way we are. That's the place we're most excited about what we're bringing to the consumer market. The shift is accelerating probably faster than Internet from brick-and-mortar to now a mobile-based interaction. And so we're really excited about that, and we believe the investments we're making mobile across phone and tablet are probably not matched by many, if any at all. And that's the place competitively we're really putting a lot of emphasis and energy. We believe that the greatest opportunity for the consumer will be to shop the non-engagement part of our mix, which for lack of a better way to say it is cash and carry. It doesn't require the build-your-own element in the diamond business, which is a really great asset but in the gift-giving season, the ability to look at all of our wedding bands, our diamond jewelry and our non-engagement assortment in a really easy environment, that's very simple for the consumers via a mobile device is a really big win. And competitively, we think it will be again somewhat of a disruptive element as we've always been.

David B. Binder

And this is David. I can handle the first question. It's really about some distinct opportunities to deploy marketing to gain momentum. Last year, marketing spend was 5% of revenue. And in reading through the results of the fourth quarter, we felt like we may have pulled back a little too much and lost a little bit of momentum going into a really important merchandising season for us. So we felt like we needed to find some ways to keep traffic going and build our file to market too in the fourth quarter. So it was really about that. There's also a lot of interesting dynamics happening between mobile and search, which you're probably seeing across many of the companies that you cover. We are looking at strategic ways of deploying incremental marketing dollars to really get ahead of the mobile adoption curves and how to use the marketing platforms across Google and some of the display networks. So it was really about getting us better positioned given everything we're doing strategically for the fourth quarter.

Operator

Your next question comes from the line of David Wu with Telsey Advisory Group.

David Wu - Telsey Advisory Group LLC

On the back on the marketing spend again. So it sounds like you're starting to return sort of the marketing expense ratio back to more normalized levels in the third quarter. I was wondering if that's what we should expect sort of going forward, that marketing spending will normalize I call it sort of 5.6%, 5.7% of your sales.

David B. Binder

David, this is David. I actually -- I think it was a little bit higher than we would consider to be normalized. There's so many dynamics that are going on now with our evolving user experience and then what's happening in the ad platforms that we felt the extra dollars, especially given our financial performance, the extra dollars were good to spend now. Going forward and looking at it year-over-year, our plan is with scale to gradually gain leverage within marketing. And as we're seeing the momentum in the business, that may change. But right now, we would have expected not to have de-levered as much as we did in the third quarter, and we made a strategic decision that it was important for momentum in the business.

David Wu - Telsey Advisory Group LLC

Got it. So in the fourth quarter, should we expect pretty flat in terms of the marketing and sales ratio? Or should we still expect a slight de-leverage?

David B. Binder

If you're looking at it year-over-year, we were more de-levered last year than we would like to be this year. Last year, our sales came in lighter. Remember, we are always dealing with consumer confidence dips that have to do with the federal government, and that seems to be a constant theme in our business. Last year, we were talking about the fiscal cliff, and there was a 3-week period where we were spending the marketing dollars, and the consumers were just not coming. And that created more de-leverage than we expected. So if we don't have as much disruption in the shopping experience, we would expect that we would gain leverage year-over-year. And actually it would look sort of like it did in the third quarter. We always spend more marketing in the fourth quarter because our -- we're going after more customers, our margin rates, gross margin rates are growing up so we can invest more. So it goes up sequentially, but it shouldn't be higher than it was last year.

David Wu - Telsey Advisory Group LLC

Got it. Great. That's helpful. And in the engagement business, can you perhaps talk about how ticket versus unit trends have performed during the quarter?

David B. Binder

Sure. We're seeing a gradual, and I'll call it very gradual increase in the average ticket. And the interesting dynamic there is that the very, very high price points, we call them over $25,000, there really has not been growth recently in that part of the business. So where we're seeing increases is people instead of buying a $5,000 engagement ring are buying up to a $6,000 or $7,000 engagement ring. And on average, that core customer is spending more and it's slightly increasing our average selling price, but it's not coming from extraordinary purchases.

David Wu - Telsey Advisory Group LLC

That interesting. And do you think that's more a function of perhaps better consumer confidence or just a function of your merchandise offering that you're now catering more towards a sort of the higher ticket offering?

David B. Binder

I think it's less about the assortment. I think we've always offered great platinum and pretty much any quality and size of diamond that is available in the world, you'll find them at Blue Nile. I think it has a little bit to do with consumer confidence. I also believe it's about bringing more prospective customers into the Blue Nile experience. I think people that maybe 3 or 4 years ago would not have purchased online are coming in, and they're bringing in the higher budget. And then the last thing I would say is our credit program has been really successful, and that has helped people finance a larger portion of the spend. And where they have been coming in thinking that they're going to spend $6,000 with the line of credit and great terms, they're spending $7,000.

David Wu - Telsey Advisory Group LLC

Got it. And then in terms of the merchandise, it sounds like Monique Lhuillier, the diamond jewelry line is doing well initially. Can you talk about sort of what other launches that you have in store perhaps ahead of the holiday?

Harvey S. Kanter

Yes, it's Harvey. You can imagine that what we talked about with diamond jewelry, that's where we'll see the greatest extension of the line. It runs kind of the gamut, if you will, from opening price points where we have great success last year under $500 in things like minis and what have you to our extraordinary program, which has been really successful. And while it doesn't penetrate the mix at a Herculean level, it is a very meaningful part of the mix and especially in Q4, which is our core gift-giving period and where our consumer who's more affluent and better educated really responds well to the extraordinary offer. Our -- as you might imagine with what it was the experience we have last year in Q4, we're not extending, if you will, as far into the fashion side of the mix. And we're really leveraging the success we've had, i.e., things like Monique Lhuillier. And I would encourage you if you haven't gone online to look at that. It is very much the inspiration she brought to us in bridal, and we've literally out of the box seen some really nice sales results initially on that product, and we would expect to continue to grow. And you'll see it show up in some offline marketing vehicles at an accelerated rate to LY as we have a broader offer to bring to market and communicate.

David Wu - Telsey Advisory Group LLC

Excellent. And then just lastly, on China, it obviously, remains a very attractive growth opportunity. And I was just wondering sort of longer term what your strategy is to drive on better brand awareness? And how you plan to sort of reach that $100 million sales target over the next 3 years?

Harvey S. Kanter

Yes, there are a couple of things we're doing. It's Harvey again. We're specifically extending our reach in digital marketing and looking at things that are obviously working really well in the U.S. and extending that further, whether it's display or paid search or things of that nature. In addition, our partnerships are working pretty well. Show.com is an example of that where we've had some good success and then last but not least, the call center and experience as more dealer experiencing and while it's relatively small numbers today relatively speaking, it -- what we believe and have always articulated is the experience rated on the site and consumers talking with others about them, which is the #1 way consumers determine where they're going to go shop for engagement setting we believe is the richest part of our marketing program, and our Net Promoter Scores underline that, and so the fact of the matter is we're seeing a five- or sixfold increase on order count and again while that's may not huge numbers in an absolute way, it's meaningful as we accelerate, and we believe that will be our greatest avenue to grow the business. Consumers are young. They're very mobile-oriented. And in China there is a different element of social, but social is as important in China as it's here it. It just has a different perspective, and it's not Facebook-driven. But again that extension happens because of the experience people are having with the purchases being made.

Operator

The next question comes from the line of Trisha Dill Wells Fargo Securities.

Trisha Dill - Wells Fargo Securities, LLC, Research Division

Just quickly some of your e-commerce peers have noted some softness in the U.S. Just wondering if you'd seen anything in September and October or just maybe you can comment on the cadence of sales throughout the quarter.

David B. Binder

Trisha, it's David. That's a great question. There's a couple of events that happened externally throughout the quarter sort of there was a lot of news about those events throughout the quarter, government shutdown, and then there was a pretty poor performance in the equity markets. We did see that, and Harvey was just noting. Well, there was a lot of talk about Syria. So there is a lot of going on. August was great for us, and September was a little bit weaker, and we've recovered somewhat since then, just in terms of our sequential volumes. It does feel like our customers are a little bit affected by what's going on externally and particularly the government shutdown seems to have created a little bit of volatility in our business. We feel like we're back, and obviously, our guidance reflects that it's going to be a good fourth quarter. That's our belief. We have what I would consider to be a reasonably wide range because we're trying to make sure that we're factoring potential external factors. But yes, there was a little bit of pullback that we could see based on a lot of the external noise that was going on.

Trisha Dill - Wells Fargo Securities, LLC, Research Division

Okay. And then just one more. You've talked about strength in your core price points, but softer-than-expected trends at the high end. I guess I'm just wondering how dependent you are on the higher-end sales typically in 4Q. Is it -- are you more or less dependent on those in 4Q relative to the rest of the year and sort of what are you expecting there? Is that in your guidance?

David B. Binder

Sure it's a much bigger issue for the third quarter than the fourth. In the fourth quarter, and in the other quarters that have good gift giving holidays for jewelry, the high-end is a less influencer on the overall numbers. And frankly, we're expecting it to have a very small modest increase in the fourth quarter. So we're not banking a lot on the high-end really coming back. It's still an interesting part of our business. We think it's as important for the brand because we're thrilling customers who are spending -- they could be spending hundreds of thousands of dollars on our product, and they become a great advocate. But in the fourth quarter in particular, it's not a very large part of our mix.

Operator

And our next question comes from the line of Kevin Kopelman with Cowen and Company.

Andrew Marok - Cowen and Company, LLC, Research Division

This is Andrew Marok on for Kevin. I guess as an extension to the competitive question earlier, I was wondering if you could comment on the promotional environment in Q3 and into Q4 and additionally, if you could give us a little color on year-over-year diamond price changes in Q3.

Harvey S. Kanter

Yes, it's Harvey. Promotionally, our calendar was fairly static. We extended a little bit of our reach in promotional product as we cleared through summer, but it was pretty minimal, and obviously, you can see in our margin results we had a small improvement. Non-engagement continues to be something that we would expect margin to be higher, and we have the wherewithal to promote as need be. But our expectations for Q4 would not be to extend our promotional pace anymore than last year and actually hopefully not to see the challenges of some of the events in Q4 end of the month in December, which forced a lot of people to get pretty hot, if you will. And we did talk about that a little last year. The fact of the matter is we would expect the overall market to be promotional but in a normal context unless something were to change it. So long story short, we expect it to be as kind of as usual, so to speak, which is a season which is certainly driven by promotion but not at a hyper level. And we don't see, at the moment at least, anything outlier, if you will, from a competitive set right now. Second half of your question?

David B. Binder

The second half is diamond prices, and I can jump in here. So on average diamond prices are up, and I would say on average, they'll up in a normal range call it 5% to 10%. One of the interesting dynamics we're seeing, and that again is on a year-over-year basis. One of interesting dynamics we're seeing is that smaller-sized stones are up much more dramatically, and then what we're seeing is there's a relative shortage in certified high-quality small stones, and we're adjusting it accordingly. But it's much more of a normal pricing environment whereas last year, it was a tailwind. This year, it's up slightly.

Andrew Marok - Cowen and Company, LLC, Research Division

Got it, and if you could comment at all in terms of percentage of revenues or orders coming from mobile? I know you gave the 40% of traffic in Q3. But anything on orders or revenues?

David B. Binder

Sure. We talked about mobile traffic being over 40%. It's much less, it converts at a much lower rate, and revenue for mobile as well below 20%. So well below half of the rate of traffic that we have. One interesting about that is it is increasing pretty significantly in terms of the revenue you generate from the mobile visit. We are seeing pretty substantial increases year-over-year and substantial increases as we been gradually rolling out these site enhancements.

Operator

Your next question comes from the line of Paul Bieber with Bank of America.

Paul Judd Bieber - BofA Merrill Lynch, Research Division

You talked about the increase in the discretionary marketing spend. I was hoping that you could talk about overall just marketing efficiency in the quarter? And then I think I missed it but can you talk about the performance about the different categories within non-engagement in 3Q?

David B. Binder

Sure. This is David. On marketing efficiency, I would say that our core channels and what we do within those channels, we're seeing pretty stable levels of efficiency. And that's something that we measure as a revenue or expenses as a percentage of revenue and the cost to acquire customers. So within core channels like Search, we have been able to maintain a steady rate, and the de-leverage that you're seeing within that expense is really in expansion into other channels like display, where we see a much longer tail for us to have those investments pay back. So I would say that there was a lot of investments in those channels in the third quarter that you would expect revenue in the fourth quarter and beyond. The second question on the performance within the products in non-engagement, really virtually all of the growth is coming from wedding bands, which again we said is consistent with the strategy we are seeing significant double-digit growth rates there. Diamond jewelry what didn't grow a lot in the quarter and was up against a really tough comp from last year. Last year, we were in a position where our inventory value for diamond jewelry was high relative to the current market. So we liquidated a lot to get our inventory in good position. So we were pretty pleased with the sort of the stable level of revenue there. And then other jewelry, not a big gift-giving-holiday for us and not a core area of our focus in the third quarter. So it kind of performed the way we expected, which it really didn't grow versus last year. All the growth is really in wedding bands and again consistent with what our plans are.

Paul Judd Bieber - BofA Merrill Lynch, Research Division

Okay. And then just looking into next year, should we be expecting additional designer partnerships?

Harvey S. Kanter

Yes, without a lot of competitive insight, if you will, we are definitely looking to grow that business. We've talked about the fact that we would expect to bring more proprietary unique offer to market, and that obviously a piece of that would be driven by designers. And that's about the extent of what I can share at this point.

Operator

Your next question comes from the line of Scott Tilghman with B. Riley.

R. Scott Tilghman - B. Riley Caris, Research Division

Wanted to touch on the marketing spend and the customer acquisition again. Historically, it seems like most of the focus has been on attracting the customer around engagement and building lifetime value from there. Just wondering what the broadening of product lines, the additional non-engagement products, if that changes your thinking around marketing spend and when in the life cycle you acquire customers?

David B. Binder

This is David. That's a great question, and I will say that the core of what we spend on marketing, the majority of it is still in engagement and then building that life cycle of purchases. We have increased our spend specifically targeted at the strategic areas of growth for us outside of engagement. So wedding bands, and we're now focusing a lot more on keywords display affiliates to drive wedding bands and diamond jewelry. One of the interesting steps that we talked about in the past is 30% of our engagement revenue actually comes from repeat customers. So as we're bringing people in buying fine diamond jewelry and even to a certain extent, the fashion jewelry, they come back, and they buy their engagement ring from us. As we evolve the assortment and we get the shopping experience really right for those type products, we think that it actually gives us the ability to spend more marketing dollars for fashion jewelry and build lifetime value even through engagement purchases.

Operator

Your next question comes from the line of Rick Patel with Stephens Inc.

Rick B. Patel - Stephens Inc., Research Division

Can you talk about SKU count as relates to your non-engagement holiday assortment? I know you tried a number of new initiatives last year and you've refined some of these. So I'm curious if there's any way to quantify just how much your SKU count will decrease as you look to make the assortment more understandable. And as a follow up are there any gross margin implications as a result of SKU count changes?

Harvey S. Kanter

Yes, it's Harvey. Great question. Pretty logical I'll talk you through kind of in a macro level without sharing the very specific details. But if you think about what we talked about in the wedding band business, we're trying to grow the category in the attachment rate, and we're expanding a number of initiatives visualization, band matcher and now VODO. VODO gives us the greatest opportunity to expand the assortment and specifically address your question because we're not owning the inventory, we're basically casting on demand, and we're extending the assortment tremendously. And relatively broadly speaking, you'll see a 30%, 40% increase in SKU count in wedding bands as we really maximize the VODO initiative, and you can get online and actually start to see that now. One of the ways you'll see some of the detail behind that is different delivery dates that might be literally from overnight to 7 days. The longer dates revolve around the casting process shipping to us and then shipping to a consumer. That business will grow in SKU count the greatest because it has a basically kind of a quasi-virtual inventory for us and, it allows us to extend it across with metals and weights. In the diamond jewelry business, where we've said it's a logical extension and we saw an underdevelopment of style count over literally the last 5 years, we've really gone after that all spring. And our diamond jewelry business has actually appreciably grown albeit in third quarter, it was tougher but the year-over-year comp was pretty daunting, if you will. So that style count will grow as well not of the magnitude of the core wedding band business but over meaningfully. And then as you might imagine last year, to your point where we really stretched in fashion jewelry and we really went after that style count, we have reduced that style count to I would not necessarily more understandable product because you still have a very broad understandable mix, but we've narrowed it into what really worked last year. And we've actually reduce the style count in other flash fashion jewelry. So all in, you will see an increase in style count in our core businesses, a reduction of fashion, and net-net, you'll see a reduction in total.

Rick B. Patel - Stephens Inc., Research Division

Great. That's really helpful. And then just a question in market in China obviously, very strong growth there. Are you planning on offering more products in that market as well over the next few quarters as you look to -- as you might perhaps look more similar to what it is in the U.S. and then do you see the opportunity to scale the non-engagement business in Asia as well or do you primarily see it as a bridal market?

Harvey S. Kanter

Yes, you almost answered the question for me with that second note you made. Today, we're really taking our core business and really extending that and Vijay who leads our international business is really oriented around driving the core business. We've talked before about we have a license for in-country basically development of product and selling in country. We've started to actually do that in the setting category, and we're really extending our footprint in engagement today. We're going relatively slow. We talked about a long and gradual road of development for our International business, specifically in China. And in non-engagement, where there's more risk and more cultural differences and a unique orientation around what's important, it will be over the course of time, something we look to extend greater. But today, our core non-engagement for lack of a better way to say it is driven around wedding bands and the larger extension from engagement and really our core competency in loose stones. So that's basically things like studs and pendants as opposed to fashion. And our expectation is that over the 3- to 5-year horizon as we learn more and more about the Chinese consumer and what's important to them, we would expect to extend non-engagement but today, it's really driven on core competencies and what we bring to market historically since we've really been a company.

Rick B. Patel - Stephens Inc., Research Division

And then just lastly, can you provide any updates you might be seeing behind the scenes as it relates to the Internet tax? Do you think this effort is gaining any steam? And if it is, any idea on when this becomes a bigger issue?

David B. Binder

Sure. This is David. It's always hard to read what's going on in Washington. We think that there's been some interesting information that came out regarding the 7 principles that would make this something that the House would consider passing, and we think there's a lot of merit to those principles. So we were encouraged to see elements that make it more manageable for a company like us to implement. We're watching it closely. We're prepared to act depending on whatever the federal government does. I think that right now from our read on it, it's going to take a little bit longer for them to work through some of the details.

Operator

And at this time, we have no further questions in queue.

Nancy Shipp

Thank you for joining us today.

Operator

Thank you. This does conclude today's conference call, and you may now disconnect.

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