Zulily's (ZU) CEO Darrell Cavens on Q2 2014 Results - Earnings Call Transcript

Aug. 6.14 | About: Zulily, Inc. (ZU)

Zulily (NASDAQ:ZU)

Q2 2014 Results Earnings Conference Call

August 6, 2014, 5:00 p.m. ET

Executives

Erica Yamamoto – IR

Darrell Cavens – President and CEO

Marc Stolzman – CFO

Mark Vadon - Chairman

Analysts

Debra Schwartz - Goldman Sachs

Mark Miller - William Blair

Mark Mahaney - RBC Capital Markets

Shawn Milne - Janney Capital Markets

Neil Doshi - CRT Capital

Justin Post - Bank of America Merrill Lynch

Diana Katz - Lebenthal

Operator

Good afternoon, ladies and gentlemen. [Operator instructions.] At this time I would like to introduce Erica Yamamoto, Investor Relations Manager at Zulily.

Erica Yamamoto

Good afternoon, and thank you for joining us on our conference call today to view our second quarter 2014 financial results. With me today are Darrell Cavens, Chief Executive Officer; Marc Stolzman, Chief Financial Officer, and Mark Vadon, Chairman. Each will be available for Q&A following today’s prepared remarks.

Before we begin, I would like to remind you that we will make forward-looking statements during this call regarding future events and financial performance, including our guidance for Q3 2014 and fiscal year 2014. These statements are based on assumptions that are believed to be reasonable at the time they have made and are subject to significant risk and uncertainties. You should not rely on these forward-looking statements as predications of future events, and we undertake no obligation to update or revise these statements.

Our actual results may differ materially and adversely from any forward-looking statements discussed on this call. For a discussion of factors that could affect our future results and business, please refer to the disclosure in today’s earnings release, our most annual report on Form 10-K, and subsequent reports we file with or furnish to the SEC, in particular our quarterly report on Form 10-Q for quarter ended June 29, 2014, to be filed with the SEC.

Also, please note that during the course of this conference call we may discuss certain non-GAAP financial measures as we review the company’s performance. Please refer to the investor relations section of our website to obtain a copy of our earnings release, which contains descriptions of our non-GAAP financial measures and reconciliations of non-GAAP measures to nearest comparable GAAP measures.

This call is being recorded and webcast live on our investor relations website, and a replay of this call will be available there as well for the next 30 days. Now, I would like to turn the call over to Darrell, our CEO. Darrell?

Darrell Cavens

Thanks, Erica. Good afternoon everybody, and thank you for joining us on Zulily’s second quarter earnings conference call. I am pleased to report a great second quarter as a result of continued active customer and order growth.

Our discovery-based shopping model, strong brand relationships, and the constant innovation and attention to detail that we put into our daily experience is resonating with more and more customers. Our second quarter revenue grew 97% year over year, as a result of 86% growth in active customers to $4.1 million and total order growth of 92% to $5.4 million. Our continued innovation in mobile, personalization, and curated product and category offerings are helping to drive strong repeat engagements from our existing customers as well.

For the last 12 months, through the second quarter, 84% of North American orders were placed by customers who had previously purchased from us. Our bottom line also came in strong this quarter as we stayed disciplined around our unit cost economics. We continue to deploy marketing dollars in new and efficient ways to acquire subscribers that convert into new customers over time.

GAAP adjusted EBITDA for the quarter was $14 million, up from $7 million in the previous year. Our non-GAAP diluted net income per share also increased, from $0.05 to $0.09 year over year. Marc Stolzman will discuss our guidance in detail later in the call, but as a result of our strong second quarter performance, we’re raising the range of our fiscal 2014 revenue guidance and reaffirming our adjusted EBITDA and pretax net income guidance.

When we started this company four and a half years ago, we did so with a view to do things differently than we were seeing others do. We weren’t going to replicate the ecommerce companies that focus on search and needs-based shopping. Instead, we created a new way for people to shop that more closely resembled the shopping experience in your local boutique or shopping mall.

From the way we source and manage our inventory to the way we personalize the shopping experience, we’re doing things differently. I’ll start with our product. We’re focused on finding new and unique product at an incredible value. On a typical day, we launch over 100 events and 9,000 product styles on the site. We’re able to maintain that freshness and newness by having one of the largest U.S. merchandising teams in retail.

We ended the second quarter with a merchandising team of over 400 people who are out there sourcing product at an incredible value of our customers. More and more vendors are coming to us with their newest and current inventory, all while maintaining an average MSRP discount of 50%. We also have over 300 people in our studio and editorial teams telling each brand’s story.

We want to be our customer’s destination to discover interesting and new product, for many aspects of her life. It’s our customer who leads us into these new categories. With our offerings changing every day, we’ve been able to constantly test and react to what our customers tell us.

For example, with our growth in women’s apparel, we’ve found new opportunities to expand across size, age, and styles. We’ve added active, plus size, and juniors, to name a few. Whether in home, children’s, women’s, or more recently, in men’s apparel, we believe our expanded categories and product diversity enhance the customer experience and offer her a reason to come back every day and see what’s new.

As we’ve continued to grow, our channel opportunities for marketing dollars have expanded. As a reminder, our marketing is aimed at generating high-quality subscribers. While some of those subscribers become customers immediately after joining, many of them receive emails or push notifications for an extended period of time before activating into customers. Then, over long periods of time, these customers continue to purchase with us, generating extremely attractive returns on our investment.

Our marketing team is also working closely with our technology team to optimize both the site functionality and our customer acquisition programs to make the user experience as fresh as possible. I constantly push our technology team to move fast and adapt to our customers. This is especially true with our relevancy and site experiences, as well as in mobile.

We’ve developed our relevancy technology to the point where we’re now producing millions of different versions of the site so that each experience across platforms is tailored to an individual. In as few as five or six clicks, we can start to optimize the events and styles that are most interesting to you.

We believe our product selection and value, combined with this personalization, makes our customers come back to us again and again. This is driving highly consistent purchase behavior and allowing us to add categories without sacrificing the individual experience.

We’ve also seen incredible growth in mobile since we launched our first app back in August of 2011. In the second quarter, 49% of our North American orders were placed on a mobile device, up from 42% in Q2 of last year. I’m excited to announce that later this month we’re also launching an updated iPad app and our first app for Android tablet.

Our growth in mobile is incredibly significant, as we think about the future of retail and how people are shopping. Our goal is to deliver a great experience for our customer, no matter where or when she chooses to shop with us.

As discussed on the last two earnings calls, we’re on track to have our new fulfillment center in Nevada up and running at the end of September. Our new automation in Ohio launched earlier this week and will be ramping up volumes using the updated mechanization over the next two months.

Just to give you a sense of the scale, our new Nevada facility represents 17 acres under a single roof, and we’ve put over six miles of conveyor into our Ohio facility. These conveyors will move product to our associates, rather than having our associates walk product around the building, enabling us to maintain an efficient process, even as we build capacity and scale.

As a result of our strong first half performance, we plan to accelerate investments related to our Nevada facility. In Q3, we initially planned to go live in Nevada with our existing processes and add more automation and investment in the first part of next year.

As we look to our growth and the success we’re seeing with the testing of our automation in our Ohio facility, we decided to move forward with automation in Nevada concurrently with the buildout. I believe these investments will provide us with more capacity and allow us to continue to improve on our unit cost economics over time.

Given the continued growth of the business, we will build out a third fulfilment center in early 2015. With our existing presence in Ohio and Nevada, the new facility will be located on the East Coast. We will remain disciplined in our capital spending, but will invest ahead of time to ensure we have the capacity needed to support our growth. I will provide additional details on our next location and our expanding fulfillment network by the end of this year.

As I look at our growth opportunities over the next several years, I have no doubt that we’re still in the very early days of building this business. As we scale our customer base, we’ll continue building our brand presence and diversifying marketing channels.

Our ability to offer unique product at significant value is ultimately what makes us different. Our merchandising organization will continue to build on our strong relationships with our vendors and overall, I want to continue and challenge our team to obsess about the daily customer experience and test and innovate as quickly as possible.

With that, I’ll turn the call over to Marc Stolzman to review the numbers in more detail.

Marc Stolzman

Thanks, Darrell. We were excited to report great results for the second quarter. Net sales totaled $285 million, representing an increase of 97% versus $145 million in the second quarter of 2013, driven primarily by active customer growth.

Our active customers increased 86% year over year to reach 4.1 million, from 2.2 million as of Q2 last year. Total orders placed increased 92% year over year from $2.8 million to $5.4 million, and average order value was $53.85, up from $53.42.

Gross profit, which is our net sales minus all product, shipping, and fulfillment costs, grew from $43.9 million to $81 million year over year. As a percentage of net sales, gross margin declined from 30.3% in Q2 2013 to 28.4% in Q2 2014.

The decrease from the second quarter of 2013 was primarily driven by higher shipping and fulfilment costs to support higher unit volumes. Our existing processes in both Ohio and Nevada are highly manual and rely on people moving to the product rather than the product moving to the people.

As our order volumes have increased, that has lowered productivity in both facilities. Additionally, this year’s fulfillment center investments in both capital expenditures and hiring to support Q3 and Q4 projected volumes have put the near term pressure on gross margins as we continue to operate in the facilities while we transition into our new operations. Later this year, and into next year, these investments should help improve our productivity and capacity.

Compared to Q1 gross margin results of 26.8%, Q2 shows an increase, which reflects the impact from working through the effects of a backlog of the first quarter orders during the first few weeks of April.

Marketing for the second quarter of 2014 totaled $24.3 million, compared to $12.6 million for the second quarter of 2013, an increase of 92% year over year. As a percentage of net sales, marketing was 8.5% compared to 8.7% for the second quarter of 2013.

We continue to see opportunity to invest in marketing to acquire customers as the business expands in both existing and new categories. This continues to allow us to develop an increasingly diverse stream of marketing channels. The results of our marketing investments can be seen in the growth of our active customers, which we define as customers who have made at least one purchase in the previous 12 months.

Selling, general, and administrative expenses for the second quarter of 2014 were $49 million, compared to $27.3 million in the second quarter of 2013. Selling, general, and administrative expenses include stock based compensation expense of $3.5 million for the second quarter of 2014 and $1.6 million in the second quarter of 2013. Excluding the impact of stock based compensation expense, SG&A decreased to 16% of net sales compared to 17.7% for the second quarter of 2013.

Operating income for the second quarter of 2014 totaled $7.7 million, compared to operating income of $4 million in the second quarter of 2013. Consistent with previous quarters, we recorded no tax expense during the second quarter.

Net income totaled $7.8 million for the second quarter of 2014 Second quarter basic and diluted income per share was $0.06 compared to basic and diluted net income per share of $0.00 for the second quarter of 2013.

The non-GAAP diluted net income per share for the second quarter of 2014 was $0.09 compared to $0.05 for the second quarter of 2013. The non-GAAP diluted net income per share calculation normalizes the treatment of the convertible preferred shares to an as-converted basis in the prior year to show the quarter consistent with the way the preferred shares affect our going forward earnings per share post the IPO.

Starting this quarter, our non-GAAP diluted net income per share calculation also adds back stock based compensation expense and related tax adjustments. We’ve made the same adjustment to our historical non-GAAP diluted net income per share calculations to improve comparisons between periods.

Non-GAAP adjusted EBITDA for the second quarter of 2014 was $14.4 million, compared to $7 million from the same quarter last year, an increase of 106%. Cash flow generated by operations totaled $21.9 million in the second quarter. We continued to generate cash from operations significantly in excess of our operating income, which is consistent with the fundamental design of our business model.

Non-GAAP adjusted free cash flow for the second quarter of 2014 was $0.1 million, up from negative $4.8 million year over year.

We ended the second quarter with cash, cash equivalents, and short term investments of $310.6 million, compared to $308.1 million at year end. I should also point out that we made a change to our credit card processing in the quarter that increased both our cash balance and deferred revenue.

Previously, we would authorize a customer’s credit card at the time of order, reverse the authorization, then recharge the customer upon each shipment. The resulting customer experience showed multiple charges and reversals on the customer’s credit card statement and resulted in some customer confusion.

Our new process now does a single credit authorization at the time of order and the charge occurring on day five instead of the shipment date. The result was a decrease in customer contacts and improved customer experience, while also resulting in an increase to both cash and deferred revenue at the end of the quarter of approximately $15 million when compared to year-end and prior year deferred revenue balances. This processing change will likely have a similar effect on our cash and deferred revenue balances going forward.

In addition to our cash balance, we also have a $50 million revolving credit facility. We’ve made no borrowings under this credit facility to date.

Our inventory balance at the end of the second quarter equaled $18.7 million, compared to $13 million at the end of 2013. We maintain a low level of inventory as a result of our business model design. To illustrate that point, our annualized 2014 inventory turns, using Q2 year to date results, was 47.8 times.

Now turning to our guidance, for the third quarter of 2014, we expect net sales to be between $275 million and $287.5 million, representing an increase of 65% to 73% year over year. Net loss is expected to be between $12.5 million and $7.5 million. Non-GAAP adjusted EBITDA is expected to be between negative $5 million and breakeven.

As I mentioned on the last earnings call, and will reiterate today, we continue to see some short term pressure on gross margins as we transition into our new Nevada facility and complete the implementation of process and equipment automation in our Ohio facility.

For the full year, we are raising our fiscal year 2014 net sales guidance and expect net sales to be between $1.2 billion and $1.225 billion, up from prior guidance of between $1.15 billion to $1.2 billion. We are reiterating our bottom line guidance with net income before tax expected to be between $15 million and $25 million.

Based on our projected guidance, we expect to exhaust our cumulative net operating loss carry-forward and start paying income tax beginning in the fourth quarter of this year. Finally, we are reiterating our non-GAAP adjusted EBITDA to be between $45 million and $55 million for the year.

As Darrell highlighted earlier on the call today, we are accelerating our investments in our new Nevada facility, and as a result, raising our guidance range for capital expenditures for the year from $45 million to $55 million to $55 million to $65 million, which are net of tenant improvement allowances.

The increase from prior guidance will be primarily for the acceleration of automation investments in the Nevada facility into 2014 that were previously planned for 2015.

Now, let me turn the call back over to Darrell to wrap up before we take your questions.

Darrell Cavens

Thanks, Marc. In closing, we are pleased with our overall performance for the second quarter. The investments we’re making across the business, including in hiring, technology, and fulfillment, will continue to drive incredibly strong growth and long term shareholder value.

I want to take a minute to thank all our employees and our vendors, who are vital in creating our truly unique customer experience and allow us to feature thousands of new and exciting products each and every day.

With that, I’ll turn the call over to the operator, and Marc, Mark, and I would be happy to take your questions.

Question-and-Answer Session

Operator

[Operator instructions.] Your first question comes from the line of Debra Schwartz from Goldman Sachs.

Debra Schwartz - Goldman Sachs

I’ve been noticing a couple of back to school events on the site. Just curious if you have an early read on how back to school is trending. Sort of what you’re seeing this year compared to where you were a year ago. And then two, give us a little bit of personalization that you’re doing in targeting and using data for both personalization and merchandising. Just sort of curious if there’s been any change in the frequency for which you do events of both small, local vendors as well as some of the national brands.

Darrell Cavens

If I look at back to school, I’d say this season, as we come back into kind of back to school season, I wouldn’t say there’s anything different that we’re doing this year than in prior years. And I think the guidance that we have out there kind of tells the story of what we’re thinking for the back half of the year.

I think if I look at the personalization and repeat rates, similarly, there hasn’t been any kind of dramatic change in frequency that we’re going after brands. We have a typical cadence with different vendors depending on the size or who they are, or how many brands they have. That is, it’s fairly consistent, and we work with different brands in different ways, but I wouldn’t say we’ve had any material shift in any way from how we’re working with the brands.

Operator

Your next question comes from the line of Mark Miller with William Blair.

Mark Miller - William Blair

Could you give us a handle on what the level of the backlog was, shifting from Q1 to Q2? I think it was something on the order of $15 million, but if you can confirm that. And what was the EBITDA, the flow through, associated with that?

Marc Stolzman

First, your estimate of the $15 million is consistent with how we’ve phrased what we thought the overall impact of the backlog was, out of Q1 into Q2. In terms of the impact to the bottom line flow through, the biggest thing I would point to, rather than putting an estimate out there of what it is, is to look at the gross margin differences between Q1 and Q2, which largely take into account the cost differences of the fulfillment and shipping cost that we had in Q1, even though we deferred the revenue versus then reporting that revenue without the shipping costs in Q2.

Other than that, normal gross margin for the deferred revenue flows through for the product margin that affects the second quarter. And obviously, all of the top line and the bottom line were projected into the guidance that we had set last quarter.

Mark Miller

And then the marketing expense rose at nearly the same rate of second quarter sales, actually a little faster backing out that backlog. So can you address the potential concern that new customer acquisition might be getting more expensive? I know the company’s got a long term framework for marketing to be 6% of sales, but does this at all suggest that there’s some change in the payback for that expense? Just how is it different now than we’ve been seeing it previously?

Darrell Cavens

I think as we look at our marketing spend, I think we’ve talked in the past about, and I think I referenced it briefly in the script, but we look at the marketing on a longer term payback window.

And I wouldn’t say that we’ve made any kind of shifts in that payback window in this quarter. We continue to look at marketing, have very, very similar consistent paybacks to what we’ve seen in the past. I think what we’re finding is just there’s good places to deploy money, and as we look at that, we’re finding those places to invest, and when it makes sense economically within that payback period, we’re going to go after it. And I think that’s what you’re seeing in the numbers.

Mark Miller - William Blair

And then a final question for me is you did run some interesting new events, like the global bazaar I saw during that period, and so I know international is not a focus for you, because of the large domestic opportunity, but what did you learn about customer demand from some of those events as well as sourcing on those?

Darrell Cavens

We’ve sourced goods primarily from the U.S., but since the very beginning of the business, we’ve been sourcing goods from around the world as we find vendors. I don’t know that there’s any specific or new learnings that I’d point out from that international sourcing, other than we continue to think that there’s long term opportunity there.

As we continue to add buyers here, we’re focusing across categories, we’re expanding that. And as we outreach to vendors, as we go to trade shows, we’re finding kind of diverse folks from around the globe, but I wouldn’t say our international to U.S. sourcing mix has shifted in any meaningful way. Again, I think what we’ve said before is there’s opportunity there, but we haven’t focused the team on it to go chase it yet.

Mark Miller - William Blair

Actually, I’m going to ask one more merchandising question. You’ve added more home items and intuitively, these are higher ticket items. I’m surprised the average order value didn’t climb more than what it did. So maybe you can just comment on whether that’s due to mix of new customers or what. Because it seems like relative to items offered that ticket value might be higher.

Darrell Cavens

Some of those home items, you see high-priced items, but you also see a lot in home that is the more tabletop items, the more items around your home. And so as we’ve expanded that category, the diversity of what we’re offering is similar to what we see in other categories. So for example, in the kids category, we can sell multi-hundred dollar furniture items or strollers and gear there, and so it’s really just all about the diversity every day, and trying to make sure that we’ve got both a style diversity and a price point diversity.

And I think I talked last quarter a little bit about how we’d been able to sell backyard play sets at multi-thousand dollar price points. I think, you know, when you look at the units we’re selling on a daily basis, though, and on a quarterly basis, there’s just so many more units in that average price point than in those large. And our customer is coming back to discover something new every day, and if we can find those big items, we’ll help them, but there’s not so many units moving in those big price point items that moves the average order value in any meaningful way.

Operator

Your next question comes from the line of Mark Mahaney from RBC Capital Markets.

Mark Mahaney - RBC Capital Markets

One of the events was Father’s Day during the quarter, and I know you did run a little bit of a promotion there. What kind of impact you may have seen in terms of expanding beyond non-children’s apparel? Could you give us an update on what percentage of sales or units or orders were non-children’s apparel?

Darrell Cavens

Interesting you bring up Father’s Day. I couldn’t tell you anything specific from that event. As we look at the launching 100 events a day, there’s a tremendous amount of diversity going on every day. So we haven’t necessarily had a big mix shift in any meaningful way. If I think about where the sales from a kind of mix shift side, I guess I’d throw that over to Marc to talk about for a sec.

Marc Stolzman

Yeah, we had about 67% of our business in the second quarter was non-children’s apparel. It continues to grow.

Darrell Cavens

And with the Father’s Day event, one thing you’ll have noticed on the home page, we’re now featuring men’s apparel events. It’s actually broken out on the page. Depending on how your particular page is personalized, you may see it higher or lower, but every day, we’re now running men’s apparel. We’re not really trying to acquire men as customers, although we have some. More, we’re looking for our kind of core female demographic, which is buying apparel for men in their families.

That’s done quite well. I think across the board, as we’ve launched more merchandise that sells well, we point out women’s apparel has just been phenomenal for the last year. So that’s been driving really well. Home has been driving well. Men’s is small but doing really well out of the gates. Just we continue to see, when we test and stretch into new things, we pretty quickly find an audience.

Mark Mahaney - RBC Capital Markets

I’m one of those customers, and I’ve noticed just in the last week, a lot of Under Armour promotions on the site, which works extremely well with me and my sons. Are you that good? Or did you just get lucky?

Marc Stolzman

Well, I think we’ve run Under Armour in the past, and you know, again, like I said, we have a cadence with these vendors. Different vendors will work with different ways, and you know, I think we try to make sure that there really is a strong diversity so that you coming to the site find something, and that woman who’s coming to the site, who many not have kids, finds something, and that mom with three kids finds something for each of her kids at different age ranges.

So we’re trying to make sure that we’re really curating the day and providing that diversity of offering. And I think with the merchandising team we have, and the size that we scaled it to, we can now do that better and better than we ever have in the past.

Darrell Cavens

But it definitely personalizes well. I mean, like, for instance, our head of corporate development doesn’t have any kids. He’s not married. His version of the site, the site’s learning that and reacting to it. So the entire men’s category is actually the top thing on his page. My wife gets kids’ apparel as what’s featured on her page. I get actually a lot of kitchen and home inventory at the top, so the site learns pretty quickly what you’re interested in, and just algorithmically tunes itself to you. So it should learn that you like Under Armour, and you should see more of it over time.

Mark Mahaney - RBC Capital Markets

The Nevada facility, when exactly does that come up and become operational? Will you start shipping out of that in the fourth quarter of this year? And in this ready to ship category, are there any statistics you have about how popular of a feature that is? You know, how often do you find customers go there specifically because there are some products that you sell that you can ship within two to three days?

Darrell Cavens

If you look at Nevada, I think the plan is to start shipping out of it right around the end of September. And so as we head into Q4, shipping an increasing volume out of that facility in Q4, and eventually moving out of our existing facility in Nevada. Literally, the buildings are right next to each other, so we’re moving kind of across the street into a brand-new building there. So that will be ramping up in Q4.

When you look at the ready to ship, it’s interesting, we’ve had that functionality on the site now for two years. We continue to invest in it, and improve the offering over time, and I think you’ll see us continue to invest there. I think one of the surprising things is, there were a number of folks early on in the business had a hypothesis that as we put that out there, customers would gravitate to it and be excited.

And what we’ve found is our customer doesn’t come to us for that. And if you’re coming in to look for a particular item for tomorrow, our customers just generally don’t think of us that way, and so we see good volume out of that, but it’s still tiny. And I think we look to see this continued opportunity to improve that, but it’s just not a meaningful part of the revenue that we see.

Operator

Your next question comes from the line of Shawn Milne from Janney Capital Markets.

Shawn Milne - Janney Capital Markets

Marc, I just wanted to try to reconcile a few of the metrics in the quarter to the forward guidance. Your order go, obviously we had the backlog issue from the first quarter, but the order growth remained strong. And even if I adjust the deferred revenue for the $15 million, it looks like it’s still up 140% year over year. But then you’re pointing to a midpoint of about 69% growth in Q3. I don’t know if you can add a little more color around that. I’m trying to put those pieces together. It looks like deferred revenue still is a little bit high at the end of the quarter.

Marc Stolzman

It’s a good question. I’ll try to articulate the components of it. I think first, when we look at our third quarter guidance, there’s a lot that goes into it. The timing and the cadence of back to school and how our business ramps into the late Q3/Q4 period. We also look at year over year, and we had very strong results at this time last year. Third, the trend of order growth year over year, which when you compare Q1 to Q2, you see that figure moderating. We expected that to occur, and we’ve said that order growth of this scale will moderate over time, but it’s the combination of each of those.

And then also, just recognizing that the third quarter, we have a lot going on right now, with our fulfillment centers both having significant transition, and really trying to make sure that we maintain the customer experience. So I think we’re setting a figure out there that we think is consistent with where we believe the business will be, and I think yes, it’s a different growth rate coming off of the first half of the year, but we’ve raised revenue for the full year and this Q3 and ultimately how Q3 fits into that have been anticipated in terms of our overall volume expectations.

Shawn Milne - Janney Capital Markets

And then just on that fulfillment side, I may have missed it. Did you give the ship days? And if you look at the upside in the quarter in terms of where you had given EBITDA guidance, and let’s just use about $7 million at the midpoint, and then keeping the full year unchanged, out of that $7 million, how much of that is investment in I think you said gross margins would be a little bit pressured versus just perhaps some of the work being done in both those facilities. If you can kind of break that out.

Marc Stolzman

Sure. On your first question, order to ship was 12.6 days in the quarter. That compares to 13.2 in the first quarter. As I mentioned in the last call, the 13.2 in Q1 was an average for the quarter, and certainly with the backlog, we had a larger order to ship at the end of the quarter. This quarter’s 12.6 also influenced by that higher starting point coming off of Q1, the end of the quarter was better than that. And we do see a trend improvement there, and have improved that side of the business.

Darrell Cavens

The only other thing I’d add that I think you asked is, are we clean as of the end of the quarter, and I think yes. We’re in a great spot with the fulfillment centers and the order to ship at the end of the quarter.

Shawn Milne - Janney Capital Markets

And then just lastly, maybe, Darrell, just big picture on the supply side, in terms of adding brands and adding merchandise, sort of expanding the merchandising team. Where do you feel overall with that, and I think one of the things you’ve consistently said is you don’t believe there’s any supply constraints. If you can maybe add a little color around that.

Marc Stolzman

Before Darrel does, let me answer the second half of your question. I just didn’t get to that. In terms of exceeding our second quarter high end of the guidance on EBITDA, and then holding the number constant, we’ve continued to invest in growth for the business, and really that comes in three places: the gross margin, as you mentioned, as we’ve worked through; the fulfillment centers, the investments, the training, and the growth needed there; and really the transition over to the new facilities.

A continued strong posture and opportunity within marketing, where we’re always looking at places to deploy, and with strong returns there. It’s just a very natural place to continue to grow. And then overall, it’s about growing the people and the company, and making sure that we continue to support future growth.

Darrell Cavens

On your question on kind of big picture brands and merchandising, and with the team and supply, I would say my mindset is very similar to where it’s been in the past. We’ve got a team north of 400 in merchandising today. If you go look at the website, I think that there are somewhere in the north of 200 open positions right now, and my guess is about a third of those are in, just off the top of my head, in merchandising.

So there’s a lot more opportunity for us to continue to grow that merchandising team, because as we work with these vendors on inventory, there’s just a tremendous amount of inventory out in the marketplace, and I don’t see that as a constraint at all.

Operator

Your next question comes from the line of Neil Doshi from CRT Capital.

Neil Doshi - CRT Capital

Darrell, can you talk about how you could maybe improve the marketing and technology to get more customers who are at that top of the funnel to spend with you sooner and more often?

Darrell Cavens

Well, I think a big part of it comes from acquiring the right people on the marketing side. So it’s making sure that we are out sourcing the right customers, going to the right channels, and that when we’re acquiring them, we’re showing them relevant information.

And so if you go out and spend a little time on the web, whether it be search or partners we’re working with, and you see an ad, for example, for a plus-size women’s dress, or you see an item for a crafts ad, you’re going to see the site get personalized there right from the get-go, based on the information and how you interact.

And you know, it comes down to the hundred little details that we execute every day, that make that experience better. And it’s optimizing our marketing at the micro level. If you look at our marketing team, a tremendous amount of them are kind of data scientists. They’re in there optimizing constantly and managing, and then partnering that with the site and technology to make that experience go through.

And so it’s looking at the payback periods across those programs, and then the constant optimization that happens.

Marc Stolzman

I’d just also add that in marketing we don’t really need people to buy right away. Our marketing works different than a lot of internet retail that’s out there. A lot of internet retail is very transactional, and very infrequent. It doesn’t have a lot of repeat purchasing. So people are very focused on when I spend money, how do I get a return right now? Because you can’t count on a stream of revenue into the future.

And I think if you go back and look at our S1 and the cohort of customers we put in there, I think one of the really special things about our business, when we spend marketing dollars, it pays back rapidly. It pays back in less than a year.

But once it pays back, it just keeps paying. Those customers and members just keep spending money with us, and when you look at it on a per-member basis, actually the amount spent per member rises as the years go on. So we kind of get this growing annuity stream out of members that we acquire into the business.

So our focus isn’t so much on when we spend money, how do we get them to pay back right now, and I think if we focus that way in marketing, it can lead to some of the wrong behaviors, actually. You know, what we’re more interested in is what’s your payback over a very long period of time, and as we deploy marketing dollars to channel A versus channel B, if channel A pays back faster, but channel B has a much higher ROI over a period of years, we’ll go for channel B.

I think this also feeds back, actually, to Shawn’s question earlier around spending. We’re seeing an opportunity to put money into marketing, and if you say it pays back in less than a year and we’re increasing marketing spending into the back half of the year, we’re not looking for it to pay back in 2014. But it should pay back really well in 2015, 2016.

And so we’re making those investments now and building the momentum of the business, and you know, hopefully we’ll see tremendous amounts of payback out of that, as those members and customers that we’re acquiring in 2014 continue to spend into 2015 and 2016, and we don’t have the spend the marketing on them again and again to bring them back.

So just kind of more of a holistic view of marketing. I’m not sure everybody out there - you know, they’re looking intraquarter at what is marketing as a percentage of revenue, and we’re looking at it much more as the spending of these customers, which I think is different than a lot of ecommerce.

Neil Doshi - CRT Capital

It looks like discounts and credits were relatively low in the quarter at about 3.8% of revenue. Any comments around there? Are you guys just doing a better job with fulfillment? Or is there something else kind of at play there?

Darrell Cavens

I don’t think we’ve given any numbers on discounts and credits, but I think what I’d say is there hasn’t really been anything different that has changed. I think from day one, we’ve had a mindset of living in a world of incredible prices every day, and then not doing big promotional discounts on top of that. And so unlike other retailers, you don’t see us screaming with coupons and discounts, kind of constantly going out there. So I think that hasn’t changed materially, and our mindset is just obsessively great pricing and value every day. There hasn’t really been much in the way of change there that I can think of.

Operator

Your next question comes from the line of Justin Post from Merrill Lynch.

Justin Post - Bank of America Merrill Lynch

It looks like you added another large amount of customers this quarter, and one of the things people are looking for is the transition from moms to maybe women without children. Are you seeing the demographics of your customers change as you expand categories? And what are you seeing as far as your customer’s demographics? Is it broadening?

Darrell Cavens

I think as I look at our customers over the last three years, it certainly has broadened a lot. And I think even as we told the story at kind of the IPO, I think we talked about that a lot. And I think folks who looked at the site said, okay, it’s a kids’ site. And I think we walked away from a lot of those conversations saying, but we’re so much more. And I think that has continued to expand over time.

I don’t have any specific demographics. It’s not like we’ve gone out and surveyed our customers on how many kids they have, and how that has transitioned, but what I’d say is, when we look at the purchase behavior happening, we’re seeing expansion into those women, home, and other categories and you know, a whole set of customers that we believe now don’t have children. But I don’t have any great metrics. It’s probably something for us to do over the next six months, is to kind of do some more customer surveys to show that.

But I think we’re finding a lot of customers are coming in, buying product with us that they’re not buying children’s products. And there’s an assumption there that a lot of them don’t have kids.

Justin Post - Bank of America Merrill Lynch

And then a second question, last quarter you had some capacity issues. It looks like you’re making some pretty big changes, and it definitely seems to be impacting gross margins a bit. Has the capacity limitations limited your growth ability as far as the type of items you could possibly offer, or the marketing spend that you’re looking at doing? And will the capacity additions maybe change that as you go into next year?

Darrell Cavens

I don’t think there’s been anything that we’ve really held back from. But what I’d say is, you know, as we look at the marketing, and just as Marc was saying a minute ago, we look at that investment and know that we can look at the cohort behaviors and see what that growth is going to be, and how all those historical cohorts compound over one another to be able to predict that out, and really making sure that we’ve got the capacity. So as we sum all those, kind of future purchasings that we’ve got the capacity for.

And I think we feel good about that. We talked a little bit on the script about adding an additional distribution center. You’re going to see us continue to invest, but it’s not that we’ve been held back. I think what you see is when you’ve got an associate that is walking through the facility, and they’ve got to walk through 100,000 square feet, and they can take a pick cart and go do that in 30 minutes, and then you ask them to do that same thing across 600,000 square feet, it’s kind of an exponentially slower walk past as you get bigger and bigger and bigger.

And so that’s where you’ve seen some of that compression happen, and that’s what this mechanization and automation will do, is to help bring the product to people rather than having kind of expanding that core pick area. And I think we feel like this is more about ensuring that we can get the capacity out of the people in those buildings. I mean, the two buildings today in Nevada and Ohio have over 1,000 associates in each of them. And you know, it’s all about just making that as efficient as possible, which will ultimately head towards the gross margin line.

Justin Post - Bank of America Merrill Lynch

I think someone previously asked about marketing spend growing kind of close to revenue growth. For leverage to really occur on that line, what kind of needs to happen over the next two or three years?

Darrell Cavens

You know, right now, if we slowed down marketing spend to slow the growth of the business, the growth would slow a little bit, but not much in the current period. So if we wanted to just manufacture flow-through and put up numbers in Q2 of 2014, that’s very possible to do. We’re taking a different view on this, which is we’re not maximizing for Q2 of 2014, we’re maximizing over a much longer time horizon.

So we have a lot of control over that. It’s not like we needed to spend that level of marketing to get that growth. I think we gave out the number that 84% of purchase are coming from repeat buying.

And that’s for the trailing 12 month period. But if you work through those numbers, basically the marketing we’re spending is for a relatively small number of customers now, but then those customers keep spending into the future, if that makes sense.

So I’d say it’s in our control. If we wanted to grow marketing at a slower rate, you’d see sales pull back a little bit from these growth rates, but not a tremendous amount, and you’d see it flow through, but we’d rather build a much bigger business and have much higher EBITDA in 2015, 2016, and going forward from there.

You know, almost all the marketing we’re spending is for acquisition of new members, who then become customers into the future. That marketing isn’t being spent to drive the sales out of the existing base of customers.

Operator

Your next question comes from the line of Diana Katz of Lebenthal.

Diana Katz - Lebenthal

Wanted to start off with gross margins again. You know, it appears that the third quarter the [a point] down, at the midpoint around [unintelligible] basis points fourth quarter. And it seems like you expect it to go back up around 70 basis points on the midpoint. I guess what gives you the confidence that you can return to gross margin expansion Q4? And then should we anticipate gross margins under pressure next year, before you add that new facility?

Darrell Cavens

I’ll let Marc walk through some of the specifics there, but what I’d say is, we’ve continued to see very, very consistent product margins. So as you look at the gross margin number, it is really driven by the fulfillment and logistics piece of it. And I think as Marc talked about, those investments that we’re putting in will allow us, we believe, to maintain that kind of gross margin that we’ve been at, even as we continue to scale.

Marc Stolzman

The only thing I would add is, you know, and I know you’re backing into where you think gross margin, marketing, and SG&A would be, but our EBITDA guidance takes into account what the investments are in the third quarter for gross margin. I think, like we said, in terms of year over year stronger expansion, we still think we’ll be pressured in Q3.

Our confidence in Q4 is really in a bottoms up build of how the facilities work, how our growth and spend quarter to quarter in support of the overall business. But I think we do have confidence that fourth quarter gross margins will begin to see turning the corner to a tailwind. We’ve also expected that that will carry into 2015 as these facilities show stronger productivity compared to today’s diminished productivity.

Darrell Cavens

And on your question on the third facility, by the start of 2015, the Nevada and Ohio facilities, our current two facilities, should be automated and running on that automation with more automated processes. And the orders shipping out the door should be coming from those facilities. And as that’s happening, we’ll be building the new facility, and that facility will be more for demand of running through kind of back half of the year. So, you know, theoretically, we should be running on automated solutions by the time we’re building that facility.

Diana Katz - Lebenthal

How should we model share count for the third quarter and the year? And do you have any guidance in terms of the tax rate for fourth quarter?

Marc Stolzman

Share count is disclosed within our reports. I think if you’re asking about float in terms of what’s out in the marketplace, that’s not something that we can really guide to or predict what may happen in terms of shareholders and whether the initial shareholders will sell, more specifically.

The taxes, we’ve anticipated our variable, our marginal tax rate, to be a 35% effective tax rate. We had a substantial, approximately $6 million, net loss carry-forward into this year that, when you take into account our guidance for the year, you take into account the net loss carry-forward impact, we have some R&D tax credits, and also the tax effect of stock based compensation specifically disqualifying dispositions, all of that will yield a tax rate this year that will be substantially lower than 35%. And then any movement in whatever you think that assumption is, higher or lower, moves at a rate of 35% for this year.

Diana Katz - Lebenthal

Can you just talk about how you brought those operating expenses down in the quarter, and maybe what you’re looking to do for the balance of the year?

Marc Stolzman

I think a lot of it comes down to our daily discipline of what we do, and the team that we’ve got in place, focused on executing well every day, and staying very, very disciplined on our cost structure. I think you see us continuing to invest aggressively in technology, both in our engineering team as well as in some of the capex that we talked about in the warehouses to drive efficiency.

And so whether that’s within our studio operations, we’ve got an incredible team there that is working to drive efficiency in the studios to make our sets and our production more efficient, or whether in our merchandising team, we’ve got a group of folks who are working to improve how we adopt events, and how we get efficiency out of those systems.

And so I think that’s ingrained in our DNA from day one, and we’ve got a mindset of those hundreds of little things every day that drive the discipline, and that’s what allows us to push this value to customers. And I think we talked before that our mindset is, as we can drive more and more value out of the business, we can pass that on to customers, and I think we had a team that’s really rallying around that. I think that’s a lot of what it comes down to.

Operator

There are no further questions at this time. I will turn the call back over to Darrell Cavens.

Darrell Cavens

Great. Well, I just wanted to say a big thank you to everybody for spending the last hour and a half or so with us. I think we feel like we had a great quarter, and we’ve got a team that is obsessively focused on what’s important to the customer, and I’m looking forward to giving you an update next quarter. Thanks, and we’ll talk to you in three months.

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