Tiffany & Co. (TIF) Q2 2018 Earnings Conference Call Transcript

Tiffany & Co. (TIF)
Q2 2018 Earnings Conference Call
Aug. 28, 2018 8:30 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good day, everyone, and welcome to this Tiffany & Co. second-quarter 2018 conference call. Today's call is being recorded. Participating on today's call is Mr. Mark Aaron, vice president of investor relations; Mr. Mark Erceg, Tiffany's executive vice president and chief financial officer; and Mr. Alessandro Bogliolo, Tiffany's chief executive officer. And at this time, I would like to turn the call over to Mr. Mark Aaron. Please go ahead, sir.

Mark Aaron -- Vice President, Investor Relations

Good morning, and thank you, everyone, for joining us. On today's call, Alessandro will begin with some strategy-related remarks, I will review sales results, and then Mark Erceg will review other financial highlights of the second quarter and our outlook, before we answer some of your questions. I hope you've all had a chance to review the news release we issued earlier today. Before continuing, please note that statements made on this call that are not historical facts are forward-looking statements.

Actual results might differ materially from the planned, assumed, or expected results expressed in or implied by these forward-looking statements. The company undertakes no obligation to update or revise any forward-looking statements to reflect subsequent events or circumstances, except as required by applicable law or regulation. Additional information concerning factors, risks, and uncertainties that could cause actual results to differ materially, as well as the required reconciliations of the non-GAAP measures referenced in this presentation to their comparable GAAP measures, is set forth in Tiffany's Form 10-Q filed earlier today with the Securities and Exchange Commission as well as the news release filed today under cover Form 8-K. Those filings can be found on Tiffany's investor website, www.investor.tiffany.com, by selecting Financial Information in the left-hand column.

Now I believe we can proceed. So I'll turn the call over to Alessandro.

Alessandro Bogliolo -- Chief Executive Officer

Thank you, Mark. I'm pleased to have this opportunity to update you on strategic progress we are making at Tiffany. Our team is focused on the six key trade parities we have previously communicated. It's intended to drive further excitement among our customers as well as enthusiasm among our colleagues and strong performance that rewards our shareholders.

The 12% worldwide sales growth for the second quarter was slightly above our expectations and is, I believe, indicative of some of our earlier achievements on what I previously described as a long journey. And I'm pleased that the sales growth continued to be driven largely by increased demand that we attribute to local customers in every region, which included increased jewelry unit volume. At the same time, we have increased our spending in various expects of our business, which we expect to continue for the rest of the year, and we which we believe is necessary to generate sustainable sales and earnings growth in the future. I want to mention a few relevant examples.

To address the priority to amplify and evolve brand message, we have increased marketing spending across a range of media in the second quarter, and spending for the remainder of the year is planned to be well above prior-year levels. And I think our recent Believe in Dreams campaign created a modern interpretation of the historical legacy of Tiffany with addition of the beautiful things that can happen at Tiffany. And I won't share any details, but we have a whimsical holiday campaign planned for later this year. To address the priority to renew our product offerings, we are pleased with initial results of the Paper Flowers collection that we launched in May in North America and more recently, we have been rolling out globally.

This exquisite floral collection, platinum and diamonds, is filling an important need in our assortment. And I'm very pleased to share with you that in the coming weeks and into 2019, we will be introducing a new engagement jewelry design, called Tiffany True. Also from a product and marketing perspective, we are addressing substantial customer interest in personalization with our new make it my Tiffany program, which allows customers to create one-of-a-kind designs that can be engraved on jewelry and charms. We now offer that in-store and media service in our New York flagship store and more than 100 of our other stores globally.

During the quarter, we opened a pop-up store near London's Covent Garden that embraces individuality and the art of self expression. I have to say that this new initiative seems to be resonating very well with customers. And to expand with Tiffany's digital presence in China, I am pleased to say that we will partner with Luxury Pavilion, the luxury retail platform of Tmall with an exclusive pop-up online store that will debut in September. This follows the digital pop-up we did earlier in the year in China.

It is also worth highlighting our priority to enhance our in-store presentations in order to create a more interesting and interactive environment for our customers. We introduced a new look in our Chicago-Michigan Avenue store during the quarter, and expect that our global display enhancement initiative will touch all North American stores by this November and then other regions in 2019. And we recently announced that we will be embarking on a complete renovation of our New York flagship store, beginning in spring 2019, with an anticipated completion in the fourth quarter of 2021. Fifth Avenue and 57th Street in Manhattan is perhaps one of the most important luxury intersections in the world, and our flagship store is arguably one of the most iconic and recognized retail destinations in the world.

While the flagship has undergone several renovations since its opening in 1940, the last of which was completed more than 15 years ago, our plans now call for much more, a transformation that is aimed to delight our customers. We are still finalizing the details, but we have a unique opportunity to temporarily relocate most of our retail operations into the back-end space next door for the duration of the construction. We are thinking boldly on this project that while representing the building -- respecting the building's historical significance, we'll create an environment that we intend will be second to none, and the related objective is to significantly increase the store sales productivity in the future. I was pleased to meet many investors during the second quarter and look forward to seeing many more of you in the coming months.

I'm certainly pleased to hear your feedback and enthusiasm about our strategic initiatives. We have many opportunities to pursue in the coming years, and I appreciate your interest. Now I will turn the call over to Mark Aaron.

Mark Aaron -- Vice President, Investor Relations

Thanks, Alessandro. Well, it was clearly another quarter of solid results, similar to the first quarter, with strong growth in worldwide sales in total and on a comparable basis that span most regions and exceeded our expectations. There's certainly a lot of energy and enthusiasm throughout the Tiffany organization. The Americas performed well due to growth across much of the region that we attributed almost entirely to higher spending by local customers, while spending attributed to foreign tourists was not materially different from the prior year.

During the quarter, we opened our relocated score in Waikiki, Hawaii, and the store design and the location are truly amazing and we have great expectations for it. Sales growth continued to be strong in Asia Pacific, which primarily reflected spending attributed to local customers, but we did experience growth in sales to foreign tourists as well. We experienced growth across Greater China and in some other countries, and we also continue to see growth in wholesale sales in the region. During the quarter, we further enhanced our store base in China by opening stores in Changsha, IFF, and Hefei in the Intime department store, bringing us to 34 locations in China, and we relocated two stores in Nanjing and Harbin.

And I should just mention that we made some retail price adjustments in China after import duties were lowered on July 1. Our business in Japan continued to perform well, and that was on top of good results than last year's second quarter. This reflected strong demand that we attribute more to local customers but also to an increase in spending by Chinese tourists. Our business in Europe showed modest signs of improvement, with growth in the U.K.

and some parts of continental Europe due to higher spending attributed to local customers. During the quarter, we continued to experience pressure from lower spending attributed to foreign tourists, albeit at a lesser rate of decline than in the first quarter. We were also delighted to expand our European store base in the quarter when we entered the Scandinavian market with a store in Denmark in Copenhagen's Elune department store and added a second store in Munich in the Obar Polengar department store. And while sales in the other segment declined due to a reduction in wholesale sales of diamonds, we were pleased with comparable sales up 5% in the stores we operate in the UAE.

And during the quarter, we opened a new store in the Galleria Mall in Abu Dhabi. Lastly, I should add that contributing to worldwide comparable sales growth in the quarter was strong e-commerce sales with those sales increasing across all product categories. The strong results from a regional retail and e-commerce perspective were correlated with good performance across all product categories. Sales in our jewelry collections category rose 18% in the quarter, the same growth rate as the first quarter, based on the continued popularity of collections such as Tiffany T, Victoria, Keys, and Return to Tiffany.

In addition, we were pleased with the additional response to our new Paper Flowers collection, which was only in limited distribution in the second quarter. We continue to be encouraged with growth in our engagement jewelry category, consisting of diamond rings and wedding bands, where sales rose 8% in the quarter. We're pleased with the response to our engagement ring customization program in North America, and we are expanding the program to additional geographies. And as Alessandro mentioned, we will soon be introducing a beautiful new engagement ring design.

Sales in the designer jewelry category, which includes the designs of Elsa Peretti, Paloma Picasso, and Jean Schlumberger, were up 5% in the quarter. And beyond jewelry, we experienced growth in watch sales, we're pleased with sales in our home and accessories collection and we expanded our fragrance collection during the quarter with the introduction of Tiffany Eau de Parfum Intense, a richer and deeper version of the signature fragrance. I'll now turn the call over to Mark Erceg.

Mark Erceg -- Chief Financial Officer

Thanks, Mark. I'll briefly comment on our second-quarter financial performance before touching on our outlook for the balance of the year. As Alex already indicated, we were pleased with the 12% increase in worldwide sales growth we achieved during the quarter and with our 3% increase in earnings from operations. Since this was not only expected but fully consistent with the investments we're making in technology, marketing, digital, visual merchandising and store presentation, all of which are intended to help generate sustainable sales and earnings growth over the longer term.

High targeted spending across these five key investment areas drove a substantial increase in SG&A expense during the second quarter, which more than offset a higher gross margin largely tied to a reduction in the wholesale sales of diamonds, sales leverage on fixed costs and favorable product input costs. And without getting too granular, we do expect SG&A spending to continue at an elevated rate for the remainder of this year and to exceed sales growth for the full year. In operating earnings, we are clearly benefiting from the lower U.S. corporate tax rate enacted earlier this year, and we recorded a small gain on a discrete tax matter, which was favorably resolved during the quarter.

The combination of these two items led to an effective tax rate of about 21%, which in turn helped us achieve a 26% increase in net earnings. You will also recall that Tiffany's board approved a program in May to repurchase up to $1 billion of our shares and which included authorization for a $250 million accelerated share-repurchase program. We are pleased to report that we completed the ASR in the second quarter and also repurchased some shares under the previous program. These actions reduced the number of shares outstanding and allowed diluted earnings per share to grow slightly faster than net earnings.

Specifically, diluted net earnings were $1.17 per share versus $0.92 per share last year, an increase of 27%. Tiffany ended the second quarter with more than $800 million of cash and short-term investments and total short-term and long-term debt representing just 32% of stockholders' equity. With working capital being effectively managed and inventory growing below the rate of sales, our balance sheet remains very strong. In terms of our outlook for the full year, we continue to expect strong high single-digit sales growth in total, which factors in our assumptions regarding comparable sales growth as well as the U.S.

dollar remaining at levels stronger than a year ago. At current levels, the U.S. dollar would have some negative effect on currency translation and also perhaps on the pattern of foreign tourist spending. Relative to EPS, in addition to factoring in our second quarter on the top line, we believe it is reasonable and prudent to adjust our full-year forecast to account for a number of items.

First, we now expect our all-in effective tax rate to be in the mid-20s. This is down versus our prior estimate, which called for an effective tax rate in the high 20s. Second, the decision to lower retail prices in China, effective July 1, in response to the lower duty and tariff rates, brings with it negative P&L consequences in the near term, as we continue to sell product from inventory, which has already incurred the higher duty and tariff rates. Finally, the strategic decision to transform our New York City flagship store is expected to lower 2018 earnings per share by approximately $0.07 due to accelerated depreciation charges related to the existing store and preliminary development costs, both of which have been included in our updated 2018 guidance range.

However, the incremental costs associated with renting and fit out the adjacent space is not expected to begin until fiscal 2019. At that time and over the planned three-year construction project, total dilution should be somewhere between $0.10 to $0.15 per share in each of those years. It is also worth noting that we expect to remain open for business, utilizing this adjacent space and minimize disruptions during the renovation period. So with this context and in total, we are increasing our full-year EPS guidance from $4.50 to $4.70 to a new range of $4.65 to $4.80 per share.

From a cash-flow standpoint, there are three quick updates we'd like to provide. First, we remain comfortable with our 2018 planned capex spending of approximately $280 million. However, we do expect, as indicated in our recent press release, to spend 7% to 9% of sales on capex during fiscal 2019 through 2021 versus our typical spending of 6% to 7% of sales. This is being done in order to support the flagship renovation.

Second, just as we made the decision at the start of the year to increase investment spending in five key areas, which are now affecting SG&A expense growth, we plan to make additional investments in our high jewelry inventory assessment over the balance of the year in order to further strengthen that portion of our business. So we are now forecasting approximately $600 million of cash flow from operations for the year versus $700 million previously and now expect to generate at least $300 million of free cash flow versus our previous estimate of at least $400 million. Finally, we continue to expect to spend approximately $400 million to repurchase shares during fiscal 2018. That concludes my prepared remarks, and I'll turn the call back over to Mark.

Mark Aaron -- Vice President, Investor Relations

Thanks, Alessandro and Mark. We're now ready to take some questions. But again, we request that you ask single-part questions so that we can get to as many of you as possible in the next half hour or so. Operator, let's take the first question.

Questions and Answers:

Operator

[Operator instructions] And we'll go first to Omar Saad of Evercore ISI.

Omar Saad -- Evercore ISI -- Analyst

Good morning. Thank you for taking my question. I actually wanted to ask if you could expand a little bit on the decision around the New York City flagship. Maybe talk a little bit about how you've visioned -- how you envision that store from an experiential standpoint versus a commercial standpoint, are you going both in terms of the renovation there? I know you had mentioned in the past, some of the stores could take a better opportunity to kind of highlight their newness and the iconic products as well.

Maybe, Alessandro, if you could talk a little bit more about how you've kind of -- how your vision has evolved for the key flagship.

Alessandro Bogliolo -- Chief Executive Officer

Thank you, Omar, for your question. Well, the flagship is really an important project for us, and a lot of resources, internal and external resources, have been devoted to this project. Actually, you might know that we own the entire building, which is 124,000 square feet, and only 45,000 square feet are actually dedicated to customers to retail. So the reason why we really think is going to be transformational is that we will repurpose the space to maximize the client-facing space.

And this means that we will increase the surface dedicated to retail but also to events to hospitality for our customers as we leverage on the success of global and also space for VIP customers. So when we say it's going to be a revolution, I think it's going to be a revolution because, first of all, we will improve dramatically the customer service. We will increase capacity of the store because you must know that in peak season, that store is running actually at full capacity. So we will increase the capacity of the store.

We will add to the shopping, also, heritage brand and product and different product categories experience in many different ways. We will enhance the high jewelry customers delight and treatment, and we will definitely integrate in that historical building our omnichannel approach. So I would say that we really believe that it will be the most amazing luxury flagship in the world. And apart from being a big statement for the New York market, I'm really confident that it will enhance the brand and the customer perception of Tiffany on a worldwide basis.

So we have big expectations for this project, of course, it's a multiyear project, and I think it's also worth spending few words on the temporary arrangement, because this going to be a three-year project. But we have also leasing the space adjacent to our flagship. We will be able to really provide a great service, and we will have great capacity during the renovations. And because you have to consider that during the renovations of our flagship building that will be mainly in 2020 and 2021, still the ground floor of our current flagship will be operating for most of the time.

So we will have, for most of the time, our current ground floor plus the adjacent buildings, which makes us feel more confident for the renovations in order to entertain our customers and sell to them.

Omar Saad -- Evercore ISI -- Analyst

Thanks for the insight.

Alessandro Bogliolo -- Chief Executive Officer

Thank you, Omar.

Operator

And our next question comes from Michael Binetti of Credit Suisse.

Michael Binetti -- Credit Suisse -- Analyst

Good morning, guys. Let me add my congrats on a nice quarter and thanks for taking our question here. Mark, would you mind helping me with a little bit more clarity on the reduced operating cash flow and free cash flow guidance for the year? I'm surprised. It seems like the inventory outlook or the working capital outlook took a tick in the favorable direction versus what you previously had.

I think the EBIT is planned down a little bit because of some new expense related to the flagship store. I don't know if that affects cash flow, and then CAPEX is not changing. I think you mentioned something related to the jewelry inventory. I didn't quite understand it.

If you wouldn't mind helping us just understand the tweak to the cash flow guide for the year.

Mark Erceg -- Chief Financial Officer

Yes, absolutely. And you're right,l we are doing a very nice job managing working capital across the entirety of the business. But we have chosen to make an additional investment in our high jewelry assortment over the balance of the year. We have a very strong high jewelry business, but we see an opportunity to strengthen that even further.

So we're going to be bringing in additional high jewelry items, and that's what's really driving the full reconciliation between our prior commentary on cash flow and where we are today. One thing I would point out is that as people look at inventory, particularly on the high jewelry side, we're buying here is high-quality, large-size gems and gemstones. These are things that generally speaking do not depreciation in any way, shape or form, as you roll on. And we believe this is, again, a way for us to compete effectively in all of our product categories at all price segments.

So it's something we're very excited about. We think it's a good use of funds.

Alessandro Bogliolo -- Chief Executive Officer

OK. Next question.

Operator

And at this time, we will hear from Erwan Rambourg of HSBC.

Erwan Rambourg -- HSBC -- Analyst

Good morning and congratulations. Erwan Rambourg from HSBC. Just wanted to come back on the flagship project to understand what assumptions you make in terms of what portion of the business you believe will be transferred while the stores are being refurbished. Let's say, you had 100, what happens during the two years? Do you recoup 80%, 90% of that? And related to the flagship, will this be a one-off concept, or is there a new concept being built there that you can then leverage and roll out to other locations across the world?

Alessandro Bogliolo -- Chief Executive Officer

Thank you. Well, as said, during the renovation, we don't expect to have major disruption for our customers and especially also for our business. So we think we really have the best possible, ideal kind of arrangement for this major renovation. And between our ground floor of the existing building and the adjacent building, I think we have enough space to really run our business and without [indiscernible] for our customers.

Now when it comes to the concept, if -- here, we are talking about an institution and the landmark building. So what we want to do is, first and foremost, to respect the historical significance of the building. We want to be respectful. We don't want to do something fancy that could not preserve the long-term value of that building and also, the experience of the customers.

But at the same time, we will integrate better, for example, circulation in the -- vertical circulation in the upper floors. And -- but it will not be, let me say, something like an exercise of decoration and style, but it will really something more respectful of the building and especially of the experience of the customers.

Mark Aaron -- Vice President, Investor Relations

I would just add, Erwan, we publicly disclosed that about 45,000 square feet of that 124,000 square-foot building is devoted to retail and customer-facing areas. That percentage devoted to it will certainly be meaningfully higher once this project is done. We're not saying how much, but customers will experience a lot more in more of the store.

Erwan Rambourg -- HSBC -- Analyst

Thank you.

Alessandro Bogliolo -- Chief Executive Officer

Thank you.

Operator

And moving on. We will go to a question from Alexandra Walvis of Goldman Sachs.

Alexandra Walvis -- Goldman Sachs -- Analyst

Good morning. Thanks for the question. My question was around the store environment. You've innovated a lot with respect to the store environment in recent months.

For example, the new visual displays around the Paper Flowers launch. You mentioned in your prepared remarks that you'd be rolling out enhanced visual displays within your stores to more of the U.S. through the back half of this year and then further afield. What happened in those stores where you have those enhanced displays and enhanced environments to make you confident of the more broad roll out? And what elements of, for example, the Chicago store should we expect to be replicated elsewhere? And finally, are there any elements of things like the London pop-up that we should expect to see in stores in the U.S.?

Alessandro Bogliolo -- Chief Executive Officer

Well, thank you for your question. To be very factual, now I think what we were talking about six months ago about enhancement of our visual merchandising is getting clear because it's a -- starts being a reality. So the two things that we have already -- the two programs that we have already rolled out is, one is the Paper Flowers launch, and the other one make it my tiffany customization. Now for Paper Flowers, what I can say is that the VM, the visual merchandising, that we have done is definitely a changed compared to the past and is attracting a lot of attention by customers.

If I let -- have to look at the sales results, we are satisfied with the sales of Paper Flowers. But even more meaningful for me is that we are experiencing no cannibalization at all on any similar price points or other lines of jewelry. Actually, we are seeing even a hallow effect of the launch of Paper Flowers on other diamonds and platinum collections. As for personalization, we are at the beginning of the program.

It's quite wide. It's not only in the U.S. It's running globally. I was actually just last week in Australia, for example, and in our stores in Sydney and Melbourne, everywhere there were there's installations of the sorts of shopping shops.

And as to say, it was the hardest part of the store. And also talking with sales people, they were confirming to me that the reaction of customer was most positive, which is good in terms of vibe in the store, but it's also good for the average transaction because, of course, this is a service that is normally charged. And so it helps, on one side, to make the product memorable for the customer, but on the other side, as also to sell an additional service. So I would say, so far, so good.

As for -- also in terms of, I mean, LOI of these initiatives. As far as the Chicago store is concerned, that is -- have been really the pilot of what we plan to do in the rest of the stores. So with some small tweaks, but this is basically what we are going to roll out in the rest of North America in the -- at the end of this year, and I mean the rest of the world in the spring. And as far as the pop-up in Covent Garden, well, that is, as received, an enormous interest by customers, by press and then to sales by competitors.

And it's all based around personalization, and it shows how this concept is really resonating with customers, and it's really elevating jewelry, also silver jewelry, that thanks to this personalization, it's made even more special to customers. So it's -- I see it as a business, as a traffic driver, but also as an elevation of all our price points including the lower ones.

Alexandra Walvis -- Goldman Sachs -- Analyst

Great. Thanks.

Alessandro Bogliolo -- Chief Executive Officer

Thank you. OK. Next question.

Operator

And we'll go next to Brian Tunick of Royal Bank of Canada.

Brian Tunick -- Royal Bank of Canada -- Analyst

Great. Thanks. I'll add my congrats as well. I was wondering, Alessandro and Mark, maybe if you can talk about the SG&A buckets a little more here.

I think, broadly, you generally talk about technology, visual merchandising, marketing and communications. Can you maybe talk about, do you expect SG&A to grow faster than sales heading into next year too? Where do you think you're getting the most bang for the buck right now in the SG&A? And where's the most catch-up still left to come?

Mark Erceg -- Chief Financial Officer

Yes. But we've been very clear and very specific in calling out those five areas as a group because they're all areas that we feel warrant additional investment spendings. And frankly, they all kind of reinforce and work in harmony with one another. So it'd be very hard for us to call out and isolate and say one's more important than another or one's having a larger effect on the other.

I think you're seeing the total brand resonance in the Q1 results and the Q2 results. And you are correct in saying that we do believe that the SG&A growth over the balance of the fiscal year will be in excess of sales growth. That's something that we called out very clearly as part of this year, and we have chosen to reinvest in this beautiful 181-year old legendary brand. So we don't really want to piece out and parse it.

We believe that, collectively, the investments we are making are the right ones. And then the progress will start to generate. We have a long way to go still. Alex and I and others have been very open about the fact that this is the beginning of a very long and exciting journey.

And we'll continue to keep everyone updated as we make our plans for future years. But the key here is to create long-term sustainable sales and earnings growth and a lot of underpinned cash flow.

Alessandro Bogliolo -- Chief Executive Officer

Yes, I will add only about seasonality that, of course, the third and fourth quarter is really the best moment as a brand in order to increase our marketing spend. And there is, because of course, it's the higher selling season, but there is also the launch of Paper Flowers that finally now it's, at the beginning of Q3 is really rolled out on a global basis, so we have the full potential if it. And on the other side, there is -- there will be also the launch of Tiffany True in the United States. So this is an additional reason for increasing our marketing spending in Q3 and Q4.

Mark Erceg -- Chief Financial Officer

And we've been clear in saying that over the course of this year we expect operating margin to go down. But we've also been clear in saying that after this year, we would expect operating margin to continue to expand again.

Mark Aaron -- Vice President, Investor Relations

Exactly.

Operator

And we'll hear next from Paul Lejuez of Citigroup.

Paul Lejuez -- Citi -- Analyst

Thanks, guys. Can you talk about a little bit more about the Paper Flowers performance thus far? Do you feel you bring in a younger customer, and if there is any way to quantify that? Would love to hear about that. Also, just curios on SG&A spend. Did any specific regions get spend ahead of the other regions where there might be a catch-up in future quarters?

Alessandro Bogliolo -- Chief Executive Officer

Well, about Paper Flowers, I have to say that from the initial sales results and analysis we have, it's attracting both new customers as well as repeat and existing customers. And we have seen really both kind of customers, so we judge this very positive. On the other question...

Mark Aaron -- Vice President, Investor Relations

And on a wide age range too.

Alessandro Bogliolo -- Chief Executive Officer

Yes.

Mark Erceg -- Chief Financial Officer

Yes, as far as the whether or not the SG&A spend is somewhat regionalized, Alex made the point earlier that Paper Flowers began in the U.S. It's now rolling out to other markets. Alex was in Europe recently for the launch there. It's coming to Asia.

So there will be some spending that will follow, obviously, those large global product introductions. We've also talked about the IT foundational programs. We talked about the last quarter how we stood up China. Obviously, that drives some spending in that type of in the region.

As we go to other geographies, that spending will follow. But we're really looking at it more from a global standpoint and how to allocate our resources globally for maximum impact. And obviously, we want to reinvigorate the brand, doing that domestically with the U.S. and certainly with the Chinese and others, you could figure that this is going to be big focus area for us.

Alessandro Bogliolo -- Chief Executive Officer

Yes, China is, for, sure an important area of focus for our investment, also, marketing wise. I was there with Reed just a couple of months ago for the launch of Paper Flowers and also reviewing the marketing plans there, which are pretty solid, but is one of the key markets, among others, where we are investing.

Paul Lejuez -- Citi -- Analyst

Great. Thanks, guys. Good luck.

Alessandro Bogliolo -- Chief Executive Officer

Thank you.

Operator

And our next question comes from David Schick of Consumer Edge Research.

David Schick -- Consumer Edge Research -- Analyst

Hi. Good morning. Thanks for taking my question. It's exciting to see the sustained growth in engagement, sort of maybe not think about the quarter, but think about this year, the first half.

Is that coming from -- could you talk more about units, price? I know there is more plans as you mentioned, but just a little more detail on this sustained strength and engagement would be helpful.

Alessandro Bogliolo -- Chief Executive Officer

Yes, so we are very pleased with this growth in engagement. And also because it was in this two quarters, first two quarters. It was driven purely by customer demand and communication with Believe in Love campaign that we have but actually no product innovation. So it's even stronger in that respect.

And going forward, with launch of Tiffany True, I think we will benefit also from newness in this important category even if we know that newness in solitaire, diamonds and is -- diamond solitaire takes time in order to establish a new setting, a new design as a classic and as a best-seller. So yes, we are very encouraged by this. We will keep on promoting our new evolved brand message about diamond jewelry in being really not only an expression of buy the love, but love in all its expressions. And I think it's working very well with customers.

So we are really confident.

Mark Aaron -- Vice President, Investor Relations

And Dave, and in the second quarter, that increase in engagement jewelry sales was entirely driven by higher units. So we're really pleased with that.

David Schick -- Consumer Edge Research -- Analyst

Very helpful. Thank you.

Alessandro Bogliolo -- Chief Executive Officer

Thank you.

Operator

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

Lorraine Hutchinson -- Bank of America Merrill Lynch -- Analyst

Thank you. Good morning. I wanted to follow up on the pricing action in China. Can you talk a little bit about the magnitude of the declines in prices? I understand the P&L impact, but maybe your expectations about how that might impact the comp versus your efforts to get the customer to trade back up into the price point that they might have -- that they might have been in before this price decline?

Mark Erceg -- Chief Financial Officer

Yes, I'll start. And maybe then Alex can join on as well. The announcement about the change in the tariff and duties was fairly sudden, and we want to be very responsive. And so effective July 1, we did pass through the full differential that would otherwise have accrued to us from the reduction in tariff and duties.

So the full value of that was passed through effective and immediately upon that day. When we talked about the fact there was some negative near-term P&L effects, it's exactly that. It's simply the fact that the retails went down immediately, but we still had held inventory that had -- repaid those higher rates. As far as what happened thereafter as far as price elasticity and other things, it's still very early days.

We'll see. But we did want to be responsive to the Chinese government's changes. And so we didn't back -- pass the full value through.

Alessandro Bogliolo -- Chief Executive Officer

And also because it's even more difficult to measure which is impact of the price of reduction on sales because it's a country market where our sales are growing strongly. They were growing in Q1. They kept on growing at the same rate in Q2. So I mean, we just thought we had to be good citizens, transfer these savings to customers really very much on time.

And then we hope to keep on having good results there.

Lorraine Hutchinson -- Bank of America Merrill Lynch -- Analyst

Thank you.

Alessandro Bogliolo -- Chief Executive Officer

Thank you.

Operator

And our next question at this time will come from Rob Drbul of Guggenheim Securities.

Robert Drbul -- Guggenheim Securities -- Analyst

HI. Good morning. Just two questions, if I could. The first is, could you about just talk about the outlook for gross margin consolidated in the back half of the year and the drivers over the next few years? And then the second question is, can you elaborate a little bit on the trends throughout Europe? I think U.K.

got a little bit better, but if you maybe give us a little bit more color on the various markets, that would be very helpful. Thank you.

Mark Erceg -- Chief Financial Officer

Yes, as far as gross margin, I'll jump in there, and then Alex can answer the second half of your question. We do expect gross margin to continue to improve into the second half. Generally speaking, as we talked at the start of the year, we are still seeing favorable pricing actions as it relates to the input cost for rough diamonds. Metals are bouncing around a little bit.

You know that we go fairly far into the metal market, and so our exposure there for the near term is pretty well locked in. We have had a very favorable multiyear cycle here where, generally speaking, metal inputs have come down. We have not expected that to continue at the same rate going forward. But certainly, as we get sales leverage through the P&L based on the reinvigorated brand, we've seen no reason why gross margins shouldn't continue to progress as part of our real goal, which is driving operating margin expansion starting with '19 and beyond.

Alessandro Bogliolo -- Chief Executive Officer

Right. As far as European sales, while we've seen in -- I mean, slight improvement in the second quarter compared to the first one, where we had constant exchange rate, comp sales were still negative at minus 4 but not as negative, I think it was that about 9% negative in the first quarter. Now this negative comp sales is, first and foremost, due to the lower purchases from tourists, because all over the region we had positive and solid positive sales growth with domestic customers. This was both in the first quarter as well as the second quarter.

And look, going forward, we expect reasonably these comp sales to improve also because there is a change in the network of comp stores as we will be anniversary the opening of big stores last year. So let me say, of course, tourist flows, it's -- I mean, we cannot control. There is, obviously, now a moment where Chinese tourists demand that is there, it's very strong. It's a shift in more from Europe and also from United States to Asia, not only domestic China, but in general in Hong Kong, and Macau, in Korea, and Japan.

And so we're benefiting more of these flows in that part of the world rather than Europe. And those in the U.S., we have seen during the quarter, a decrease in sales to Chinese consumers tourists. But that was totally offset by a strong increase in sales to domestic customers as well as to tourists of other nationalities. So this is always -- it's a part of our business, the traffic of tourism can shift from one region to the other.

The positive thing is that being [Inaudible], we are equipped to get benefit of the business wherever it must.

Robert Drbul -- Guggenheim Securities -- Analyst

Great. Thank you

Alessandro Bogliolo -- Chief Executive Officer

OK. Thank you. Next.

Operator

And we'll hear next from Janet Kloppenburg of JJK Research.

Janet Kloppenburg -- JJK Research -- Analyst

Good morning, everyone, and congratulations on a nice quarter. Alessandro, was wondering if you could talk a little bit about the rather dramatic marketing that you conducted in the first part of May, the impact it had on the millennial customer and if you've been able to analyze it -- if you've been able to attain a greater share with that customer worldwide? Thank you.

Alessandro Bogliolo -- Chief Executive Officer

Thank you. Well, we have -- we constantly monitor the results of our campaign. So both for the Believe in Love, -- so the, let's say, solitaire campaign -- as well as for the Believe in Dreams --  so the one of Paper Flowers and other design collections -- what we have found and we are very encouraged by that is that, yes, it's a very effective language message to attract new customers but at the same time is also not alienating and on the contrary, is attracting as well as existing customers. We had a lot of existing customers that were a bit lapsed, a bit silent in the last few years that thanks to these new messaging have come back.

And so we witnessed this in all the markets and this is what basically is the engine behind the numbers you've seen in the last two quarters.

Janet Kloppenburg -- JJK Research -- Analyst

Thank you and good luck.

Alessandro Bogliolo -- Chief Executive Officer

Thank you.

Operator

And our next question comes from Jay Sole of UBS.

Jay Sole -- UBS -- Analyst

Great. Thank you. Mark, I just want to follow up on the comment in the press release that the earnings per share in the third quarter is expected to below the prior year. Can you talk about gross margin a little bit in the back half? Can you maybe give us a sense of where you see SG&A for 3Q, just give us a sense of the magnitude of the decline in 3Q EPS versus last year?

Mark Erceg -- Chief Financial Officer

Yes, I mean, that something that we won't want to be overly specific on. But I will tell you that, as Alec said, our business is somewhat seasonal is really going to be a big statement. One of the time to do it is in the lead up to the holiday period. So we are going to see a significant increase in SG&A as we support the business in a much more robust way.

There's also additional spending that will be coming from, as I talked earlier about our some of our IT products, we stood up in China, we said that we're going now into parallel waves with multiple markets. And so the cost will also follow along with respect to that to some extent. But we at least want to make sure that people understood we thought about the balance of the year with our revised guidance, which obviously took things up, how we're seeing the third quarter vis-à-vis the fourth quarter. The third quarter, we expect to be down.

You do the math, the fourth quarter, we expect to be up.

Jay Sole -- UBS -- Analyst

Got it. Thanks so much.

Alessandro Bogliolo -- Chief Executive Officer

And may be one more question.

Operator

All right. We'll go to a question from Laurent Vasilescu from Macquarie.

Laurent Vasilescu -- Macquarie Group -- Analyst

Good morning and thanks for taking my question. I wanted to follow-up on marketing. Marketing was 7.6% of FY '17 revenues. where should that rate go this year? Should it go increased by 50 to 100 bps for the year? And secondly, if I could just add in.

The Japan comp came in noticeably high, 8%, despite the toughest compare. Could you provide a little bit more color on the factors driving the strength in Japan?

Mark Erceg -- Chief Financial Officer

Without being vague or evasive of your question, I guess all I would say it's going to go up as far as marketing as a percent of sales. Now obviously, when you're posting 15% sales increases in the first quarter, 12% in the second, that helps. But we do expect marketing as a percent of sales this year to increase.

Alessandro Bogliolo -- Chief Executive Officer

And as far as Japan is concerned, of course, I think of the larger brands, we are experiencing in Japan that, a good flow of Chinese tourists. But I have to say that most -- the far-largest portion of our sales in Japan is to domestic customers. And we have seen very solid strong sales to our customers in Japan. But again, I think it resonates with the marketing messaging and the initiatives we are taking globally and they resonate very strongly with a market like Japan, where we are present since many years.

And we are clearly a leader there.

Mark Aaron -- Vice President, Investor Relations

OK. In the interest of everyone's time, I think, we'll now conclude this call. We hope you've all found it to be informative and productive. Of course, please feel free to call me with any other questions.

And please note that we expect to report third-quarter results on November 28 with a conference call at 8:30 a.m. Eastern Time. Thanks for listening.

Operator

[Operator signoff]

Duration: 51 minutes

Call Participants:

Mark Aaron -- Vice President, Investor Relations

Alessandro Bogliolo -- Chief Executive Officer

Mark Erceg -- Chief Financial Officer

Omar Saad -- Evercore ISI -- Analyst

Michael Binetti -- Credit Suisse -- Analyst

Erwan Rambourg -- HSBC -- Analyst

Alexandra Walvis -- Goldman Sachs -- Analyst

Brian Tunick -- Royal Bank of Canada -- Analyst

Paul Lejuez -- Citi -- Analyst

David Schick -- Consumer Edge Research -- Analyst

Lorraine Hutchinson -- Bank of America Merrill Lynch -- Analyst

Robert Drbul -- Guggenheim Securities -- Analyst

Janet Kloppenburg -- JJK Research -- Analyst

Jay Sole -- UBS -- Analyst

Laurent Vasilescu -- Macquarie Group -- Analyst

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