Blue Nile's CEO Discusses Q4 2012 Results - Earnings Call Transcript

| About: Blue Nile, (NILE)

Blue Nile, Inc. (NASDAQ:NILE)

Q4 2012 Earnings Call

February 12, 2013 5:00 pm ET


Nancy Shipp - Director of Investor Relations

Harvey Kanter - Chief Executive Officer, President and Director

David Binder - Chief Financial Officer


Andrew Ruud - Morgan Stanley

David Wu - Telsey Advisory Group

Ross Sandler - Deutsche Bank

Trisha Dill - Wells Fargo Securities

Kevin Kopelman - Cowen & Company

Shawn Milne - Janney Capital


Good afternoon, ladies and gentlemen. My name is Kendra, and I will be your host operator on this call. Your lines will be placed on a listen-only mode. At the end of the presentation, management will be available for questions. (Operator Instructions).

At this time, I would like to introduce Nancy Shipp, Director of Investor Relations of Blue Nile.

Nancy Shipp

Good afternoon and thank you for joining us on our conference call today to review our Fourth Quarter and Full Year 2012 Financial Results. With me today are Harvey Kanter, President and Chief Executive Officer; and David Binder, Chief Financial Officer. Both will be available for Q&A following today's prepared remarks.

Before we begin, I'd like to remind you that we will be making forward-looking statements during the call regarding the company's future performance. These statements are only predictions based upon assumptions that are believed to be reasonable at the time they are made and are subject to significant risks and uncertainties. You should not rely on these forward-looking statements as representing our views in the future, and we undertake no obligation to publicly update or revise these statements.

Our actual results may differ materially and adversely from any forward-looking statements discussed on our call. For quarterly reports on Form 10-Q, our annual reports on Form 10-K and other forms on file with the SEC identifying important risks factors and uncertainties that you should consider when making an investment decision regarding Blue Nile, and they may affect whether our forward-looking statements prove to be correct.

Also, please note that during the course of this conference call, we may discuss certain non-GAAP financial measures as we review the company's performance. We will discuss non-GAAP free cash flow, which is defined as net cash provided by or used in operating activities or operating cash flow, less outflows for purchase of fixed assets, including internally used software and website development.

We will discuss international sales on a constant exchange rate basis and we will also discuss non-GAAP adjusted EBITDA, which is defined as earnings before interest and other income, taxes, depreciation and amortization adjusted to exclude the effects of stock-based compensation expense. Please refer to the Investor Relations section of our website to obtain a copy of our earnings release, which contains reconciliations of non-GAAP measures to the nearest comparable GAAP measures.

Now, I would like to turn the call over to Harvey.

Harvey Kanter

Thanks, Nancy. Good afternoon and welcome to Blue Nile's fourth quarter and full year earnings conference call. Our execution during quarter four finished off a great year of growth for Blue Nile in 2012. In each quarter, we accelerated the growth rates and we ended the year with the highest growth rates since 2007. We are proud of this performance.

In our core U.S. engagement business, we hit all of the key milestones we set for ourselves at the beginning of the year. Our engagement business had the highest level of growth in five years. The customer clearly told us, we have a place to shop for engagement.

Blue Nile's approach of offering the highest quality diamonds in settings, online customization tools, in-depth product education and no pressure shopping environment continues to create such a disruptive and significantly competitive advantage, our customer asked and answered the question, why buy anywhere else, but Blue Nile.

We are excited by the momentum of the sales of our engagement products. The plan we communicated at the beginning of 2012 to increase investments and pricing, marketing and continuing to build our team to enhance the capabilities is the right path for the company. Although these investments drove down profitability for the year, we are really encouraged by the return to growth in earnings in fourth quarter of 2012.

I will cover international in more depth later in my comments, but I wanted to give a big shout out to the international team for the many great milestones achieved in 2012. We are very encouraged by the acceleration in growth rates in the fourth quarter. Conversely, we fell short of our expected sales of non-engagement jewelry during the holiday season, in part due to a weaker environment for consumer discretionary spending.

Through Cyber Monday, our weekly growth rates exceeded our expectations. However, we saw a marked slowdown in sales during the second and third weeks of December. This shortfall in our overall miss resulted in our overall profitability for the quarter. In determining what worked and what didn't work during the holiday season, we gained great insight and this learning will guide our evolution of the mix in non-engagement products.

We continue to believe that our strategy is on point and that we are well-positioned as we move into 2013. The last of my introductory comments are in regards to the powerful cash flow dynamics in our business model. These characteristics drove significant expansion in our operating cash flow and this is a great metric we can't underscore enough.

Now, let's discuss our engagement business in a little more detail. The sales of engagement rings is the core of what Blue Nile does, and I would like to take some time to reflect that how this part of our business performed over the course of 2012.

We recognized that the macro environment specifically a contraction in the growth rate in the cost of diamonds provided a great opportunity for us to expand growth, to take advantage of this opportunity we relied on the most valuable components of our business model. Our exclusive relationships with top diamond suppliers around the world, excellent selection of engagement ring settings, a superior customer service model, a comprehensive website, in-house skilled jewelers and our internationally recognized brand. With this platform, exclusive, distinct and unique, and with an investment in pricing to highlight our cost advantages, we accelerated the growth rates inherent in this part of our business.

Let me list some of the key metrics in our engagement business in 2012. Growth for the year in the sales of engagement products was 21.7% in the U.S. and 19.6% globally. Over 40,000 couples around the world got engaged or trade up to a superior ring with a Blue Nile diamond in 2012. At 276.5 million, we continue to build on our scale in the industry and our rates are the highest since 2007.

Our supplier base continues to strengthen. Throughout the year, we featured as many as 150,000 loose diamonds from around the world providing an incredible level of choice, selection and value to our customers. This scale is important to enable Blue Nile to reach our potential end market share within the $5 billion market.

The ongoing development of distinct elements in our assortment is also accelerating our brand and our scale. The rate of sales through our partnership with Monique Lhuillier exceeded our expectations and we are very excited by further product development opportunities and marketing opportunities that this three-year exclusive deal provides. All of these mentioned characteristics give us great confidence that we have a thriving business in engagement that clearly provides us with what we believe to be a strong competitive position as a leading supplier of engagement products and a platform for growth in non-engagement and the International segment.

Now on to our non-engagement business. This is an area of focus to accelerate growth and acquire customers. We are excited by the overall size and margin inherent in this part of the business. It provides additional scale and helps us develop our overall jewelry portfolio across a broad category segment. In 2012, this business represents $123.5 million and margin rates nearly double that of the sale of our engagement products.

Growth rate for the year was 5.7%, and while this was below our expectations for the year, we still believe there is great opportunity within the category and we will continue to learn, evolve and drive this strategically as part of our plan. We continue to believe we have great opportunity in non-engagement and are in a great position to sell diamonds and diamond basics. This position is what compels shoppers to buy their engagement products with us and gives us the same advantage for value, selection and offer as in engagement.

This is also a large market opportunity and the single biggest part of the $50 billion market in the U.S. In 2012, growth in this part of the business lagged behind our expectations. Compared to prior years, we underinvested in new product offerings in diamond jewelry and overinvestment the more broadly defined and higher fashion categories such as gems. This is an area for improvement and we see upside here by expanding the product offering across price points in diamond jewelry.

We also have greater opportunity drive wedding bands and are well-positioned to expand the offering in this subcategory of our non-engagement business for many of the same reasons. The market size of wedding bands in the U.S. rivals that of the engagement market of roughly $4 billion of sales and we already see many of our customers on our site who are researching their purchase and buying online, we believe there is a greater opportunity to ensure that couples who purchased engagement ring with Blue Nile also buy their wedding bands with us.

And like that in the diamond jewelry category, we believe there is a greater opportunity for growth driven by the [offer events.] This market has become increasingly competitive and is driven by low end of the mix, with product attributes like the metals and even with bands will help us further evolve this business. These dynamics in combination with a much greater opportunity to expand the selection of the specific insights, which compel us to further evolve and reinforces our belief in the product segments revenue upside.

Fashion jewelry. Fashion jewelry while it was a smaller portion of the overall addressable market continues to be an opportunity to drive revenue and profitability, as well as a great way to attract new customers to the Blue Nile brand. In 2012, we learned across the continuum from basics to high fashion that there is a great opportunity to grow this business within more natural product extensions. In 2013, we will focus our energies on more understandable fashion trends across a broad array of price points, product offerings, and a stronger level of adaptability through visualization of products on our website.

Now let's review the international business. We’re encouraged by the acceleration in growth rates in the fourth quarter. For the full year, this part of the business totaled $62.4 million. We are proud to have an international jewelry business of the scale, but we also see this is a very small beginning to what we plan to accomplish in the coming years ahead. Our investments in China are in early stage, but beginning to impact the business.

We ended 2012 with a physical presence in Mainland, China, and through our partnership in a minority investment in a local retailer we have the ability to fulfill orders for engagement products within the country. We're actively expanding our marketing reach in China and recently announced a partnership with to sell non-engagement products through their platform. Beyond China's growth opportunity, we also recognize that we have significant headroom for growth in Canada. In 2012, we greatly expand products that are available and this had a material impact in returning the business to growth in the second half of 2012.

After a great year of growth in 2012, we look forward to 2013 with the goal of continued growth scale and focus on profitability in the long-term. Much of this will be achieved by continuing to execute our core capabilities across the selection, service and value all elements that delight our customers and leverage the exclusive elements of our platform.

I would now like to discuss our key initiative for 2013. One of the top priorities for 2013 will be evolving the mobile customer experience. We are excited by new developments that we believe will enhance our growth. The convergence across phones and tablets which we refer to as phablet is a very exciting part of our business. In the fourth quarter of 2012, one-third of our visitors to our store came from a mobile device. Total visitors for mobile devices grew by over 40% from the prior year and we believe this will be over half of the visitors in 2013.

While we always have had a great mobile experience, we believe it will be even better in 2013. Another 2013 top priority will be the ongoing development of our websites, features and benefits that enhance the experience in choosing a diamond engagement ring, wedding band and diamond jewelry. Throughout the year, we will launch new capabilities aimed at further accelerating our growth rates in these areas and this will extended across not just engagement, but further into diamond basics bands and fashion jewelry.

In 2012, we launched a new consumer financing program offering a Blue Nile credit card behind the strength of Alliance Data. This year, we look to expand the offer and take advantage of the remarketing opportunities that it provides. We know that the availability of credit is an important factor in a customer's decision of where to purchase and how much to spend. It also provides the vehicles to communicate with those customers on a monthly basis and create the opportunities to suggest new products to buy for anniversaries and holidays.

Lastly, we will continue to grow our international footprint. Growth opportunities will continue to expand in Asia and we will focus on building our team with autonomous capabilities to drive marketing, product assortment and fulfillment within the region.

I would now like to turn the call over to David who will provide a financial overview.

David Binder

Thank you, Harvey. I would like to everyone on the call today. Before I go into the details of our financial performance, I want to highlight some of the key milestones Blue Nile achieved this year. Our revenue growth of 21.2% in the fourth quarter is the highest rate of growth for any quarter over the prior five years since the fourth quarter of 2007. This is primarily driven by sales of engagement rings.

In 2012, more people purchased a loose diamond or engagement ring from Blue Nile than in any other year in our history. Our international business also a key driver of growth exceeded $62 million in revenue equal to 15.6% of the company's total revenue. Sales of our non-engagement products totaled $123.5 million globally and $111 million in the United States. These results were below our expectation and resulted in an overall shortfall in revenue and profitability for the year. However, we continue to grow these parts of our business and are encouraged by the increasing scale.

New customer acquisition grew by more than 17% in the year. And most importantly, the total number of new customers to Blue Nile rivaled our peak in 2007. While accelerating our growth, we also increased profitability with higher levels of adjusted EBITDA, net income and earnings per share in the fourth quarter of 2012. The first sequential improvement we've reported since the fourth quarter of 2010. Finally, cash from operations increased to $55.4 million in the quarter and $34.4 million for the full year highlighting the fundamentally strong cash flow dynamics inherent in our business model.

Now turning to the details of the financial results, net sales in the fourth quarter of 2012 totaled $136.1 million compared to $112.3 million in the fourth quarter of 2011, a growth rate of 21.2%. U.S. engagement sales for the fourth quarter were $73.6 million compared to $56.2 million for the fourth quarter of 2011, a growth rate of 31%. We're encouraged by the distribution of growth across price points with double-digit growth and prices above and below $25,000.

Additionally, we recognize that the trend in the market price of diamonds influences our ability to grow and that diamond prices have declined in 2012 relative to 2011. Looking at the trends throughout 2012, and specifically in the fourth quarter, we see the relative decrease in pricing abating. We are further encouraged by the continued growth in this part of our business even as the year-over-year trends in diamond prices become less favorable.

U.S non-engagement sales for the fourth quarter were $42.5 million compared to $40.4 million in the fourth quarter 2011, a growth of 5.3%. We saw fairly balanced growth across our product categories which in total fell behind our expectation for the period. For the full quarter, order growth exceeded revenue and our average selling prices decreased as customers chose lower ticket items during peak of the holiday season.

Our international sales in the quarter were $20 million, compared to $15.7 million in the fourth quarter 2011, an increase of 26.8%. On a constant currency basis, international sales grew 24.7%. Growth in our international sales was fairly distributed across regions. However, we saw the highest rates of growth in both, Asia Pacific and the Americas region.

For the overall business, gross profit in the quarter totaled $25.7 million compared to $23.2 million in the fourth quarter of 2011, an increase of $2.5 million. As a percentage of net sales gross profit was 18.8% compared to 20.7% for the fourth quarter of 2011. The decrease in gross profit as a percentage of net sales is mostly attributable to the mix of revenue shifting to our engagement products.

In the fourth quarter of 2012, the sales of engagement products represented 65.7% of the total company's revenue compared to 61.2% in the fourth quarter of 2011. As we've noted before, engagement products generate approximately half the gross profit as a percentage of revenue compared to gross margin generated from the sales of non-engagement.

SG&A expenses totaled $18.6 million for the quarter compared to $16.9 million in the fourth quarter of 2011, an increase of $1.7 million. The increase primarily relates to higher marketing costs associated with the acquisition of new customers as well as variable expenses associated with the growth in revenue.

As a percentage of net sales at SG&A was 13.7%, compared to 15.1% in the fourth quarter of 2011. This improvement in the expense ratio is primarily the result of scale in our business as operating expenses grew at a rate lower than net sales. In the fourth quarter 2012, marketing expense equaled 5.6% of revenue versus 5.8% in the same period last year, contributing to the overall gain and cost-efficiency.

Net income totaled $4.9 million and earnings per diluted share equaled $0.39 in the fourth quarter of 2012 compared to $0.30 in the fourth quarter of 2011. Net income per diluted share for the fourth quarter included stock-based compensation expense of $0.06, which compares equally to $0.06 for the fourth quarter of 2011. Non-GAAP adjusted EBITDA for the fourth quarter was $9.1 million compared to $8.4 million for the fourth quarter of 2011.

Now, I'd like to touch on the highlights for the fiscal year 2012. Net sales in 2012 totaled $400 million versus $348 million in 2011; an increase of 14.9% U.S. engagement net sales totaled $226.6 million in the year versus $186.2 million in 2011, representing growth of 21.7%.

Consistent with the fourth quarter results, revenue grew relatively evenly across price points. U.S. non-engagement net sales were $111 million in 2012 versus $105.9 million in 2011, an increase of 4.9%. Order growth approximated 20% for these products. However, we saw a decrease in the average revenue per order as the mix in revenue shifted to lower price point jewelry. International sales increased 11.7% to $62.4 million in 2012 compared with $55.9 million for the prior year.

Excluding the impact from changes in foreign exchange rates, international sales increased 12.6% for the fiscal year. Growth was highest in Asia Pacific region, while we posted modest growth in the Americas region and declining sales in Europe.

Gross profit in 2012 was $75.1 million compared to $72.1 million in the prior year, an increase of $3 million. Gross profit as a percentage of net sales decreased to 18.8% in 2012, compared with 20.7% in 2011. For the full year, the sale of engagement products equaled 69.1% of total revenue compared to 66.4% in 2011. This shift in mix coupled with lower pricing of loose diamonds led to the reduction in gross profit as a percentage of revenue.

SG&A expense in 2012 was $62.8 million versus $55.2 million in 2011, an increase of $7.6 million. The growth in SG&A expense is primarily attributable to increases in our marketing expense as well as increases in variable fulfillment expense associated with higher levels of orders and revenue. As a percentage of net sales, SG&A expense equaled 15.7% in the 2012 versus 15.8% in 2011. Marketing expense relative to net sales grew to 5.6% for the full year of 2012 versus 5.2% in 2011.

Other operating expenses grew at a rate lower the net sales resulting in an overall gain in efficiency. Net income in 2012 was $8.4 million and earnings per diluted share was $0.63 versus $0.77 in 2011. Non-GAAP adjusted EBITDA in 2012 was $20.6 million versus $26.7 million in 2011. We ended the quarter with cash, cash equivalents and short-term investments totaling $87 million, compared to $89.4 million at the end of the prior year.

During 2012, we purchased approximately 1.5 million shares under our repurchase program for $38.9 million. We continue to value the repurchase program as an important use of cash, and under the reauthorization, we have $61.1 million approved for additional purchases over the upcoming year.

Cash flow from operations totaled $34.4 million in 2012 and $55.4 million in the fourth quarter. Our business continues to benefit from relatively low cash-based operating expenses as well as negative working capital associated with our revenue collection and vendor payment terms. Our inventory totaled $33.3 million at the end of the fiscal year versus $29.3 million in the prior year, representing growth of 13.7%. We are encouraged by the relatively low rate of growth in inventory this quarter below the rate of growth for revenue in both, the fourth quarter and the full year.

For the full year 2012, capital expenditures totaled $2.5 million compared to $5.4 million for the full year 2011. The decrease in capital expense relates to the relatively high levels in 2011 associated with the build-out of our headquarter office.

I'll conclude this portion of our call with a discussion of our guidance for the first quarter and full year 2013. Then turn the call over to the operator to take your questions. For the first quarter of 2013, we expect net sales to be between $94 million and $100 million and earnings per diluted share between $0.05 and $0.08. For the full year, we expect net sales between $440 million and $470 million and earnings per diluted share between $0.75 and $0.85.

I'll turn the call back to the operator now, so we will be able to take your questions.

Question-and-Answer Session


(Operator Instructions). Your first question comes from the line of Andrew Ruud of Morgan Stanley.

Andrew Ruud - Morgan Stanley

Thank you for taking the question. The first one I wanted to ask was just around diamond pricing and what sort of assumptions go into your guidance for the full year 2013. Specifically, towards the upper-end of the range, are you assuming that there's a subsequent decrease in diamond pricing? Then if you kind of dissect the guidance a little bit? Which parts of your business are you really looking to see acceleration in the coming year? Thank you.

Harvey Kanter

Hi, Andrew, it's Harvey Kanter. Two answers to your two different questions. Relative to diamond prices, we basically see moderation and we expect some small movement increase in prices, but we don't necessarily build any expectation beyond that, materially lower prices and materially higher prices, and that’s part of our guidance.

Then with respect to the other half of your question, we continue to have an expectation to see significant growth opportunities in the engagement category which is our core business, but as you might expect a greater growth as a percent of sales in the non-engagement business, and hopefully we've steered a little bit of that direction and insight into the categories where we see greater opportunity or not as great opportunity in our opening comments.


And your next question is from David Wu of Telsey Advisory Group.

David Wu - Telsey Advisory Group

Just first on your first quarter guidance assumes some level of op margin improvement, and I am just wondering if that's really just driven by your expectations for non-engagement to pick up.

David Binder

Hey, David, it's David Binder. As we are coming out of 2012 and into 2013, we've got some core improvements in our margin rates broadly across categories both, engagement and non-engagement and that was the trajectory that we had planned the business to be in coming out of a deeper investment in price in 2012. And, so the guidance going into the first quarter this year really reflects the current trends we are seeing in the business leading up to Valentine's Day which is our second largest holiday we have of the year and the plans we have to operate product pricing and our margin rates for the remainder of 2013.

David Wu - Telsey Advisory Group

Got it, and just secondly on non-engagement. Could you elaborate on your key learnings from the new merchandise mix and sort of what you plan to do to drive better traction there, and can you talk about your marketing initiatives in non-engagement and how you plan sort of communicate the new merchandise and reach that female self-purchaser?

Harvey Kanter

Sure. This is Harvey. I would answer the question with three kind of broad statements. One, our biggest learning is really how far that at least our current customer we can move in terms of the level of fashion in the mix. We explored a pretty broad range and I would tell you that it was relatively broad in its assortment and also not as deep in its offer. And so, ultimately, the good news is our inventory is really well aligned to our year end and the opportunity to accelerate some of those things that really worked was at some level not maximized, because we didn't invest as deeply.

Then conversely, the products that didn't sell as well for the lack of better words it would be the higher level of fashion and more trend-orient product, and you may or may not remember, but we've talked before specifically about things like [Threaders and Danglers], which are really more fashion-forward earrings. Those are the elements that were too far, if you will, conversely the things that work best what I would define is more updated classic or understandable fashion and the consumer seem to respond to those pretty well.

The second element of the challenge was our ability which we talked about over the 30 months transition of what we are trying to accomplish was our ability to evolve the website materially enough to help the customer to be able to shop it and have the experience, and while I certainly feel good about the actions we took and what was on the website in terms of the user experience, the ability to help her engage and to browse the offer through more curated pages and marketing elements which I'll get to in a second, we basically understood wasn't far enough, and the ability for her to move from search to browsing, we didn't make enough progress and so one of the challenges was making sure that she could assess in a fairly passive way the breadth of offer and see the full gamut of the non-engagement jewelry mix. And at some level, what our learning was is that we have to continue to push on the website experience, because the only way she can actually experience that in the way she wants to shop is to evolve the website more than we were able to in fourth quarter.

Then last but not least in terms of marketing, you may have noticed a whole series of different elements both, the creative execution, the way we positioned them on the homepage and some of the specific segments of the non-engagement business, we also explored some offline elements. And in totality, we believe we got less traction than we expected. Again, it goes back to I think the fact that we put our toe in the water, we thought we would get a better result out of some of the product that we brought to market and either it was too far forward or she really wasn't able to experience the breadth of offer that we did, bring to market in the way that we thought would be required and ultimately we fell short.

As we move forward into '13, I mentioned the word understandable fashion, and it's a question of balancing what we would call updated classics and understandable fashion in direct comparison to what we might call high fashion or trend product and today the consumer that we have is clearly oriented around more impulse, more non-engagement jewelry. It's the order of magnitude of how far we can push and acquisition strategies that we continue to pursue to really address the addressable market, if you will, in a more meaningful way.

David Wu - Telsey Advisory Group

Great and how much of engagement sales during the quarter was driven by the credit program with ADS?

Harvey Kanter

We don't discuss the specific metrics. To give you a little bit of context though the credit program that we launched earlier this year is performing at levels above what we've seen in the far history of the business when we had the best programs in place, so I would say that the program is exceeding our expectations. We don’t breakout the specific metric, but we definitely view this as something that is contributing to the momentum in the business.

David Wu - Telsey Advisory Group

Excellent, and then just lastly, can you perhaps just talk about the merchandising marketing plans that you have lined up for Valentine's Day?

Harvey Kanter

Well, for the most part what you see is what you get for lack of a better way to say two days away from the holiday, but what you can see if you've been on the website or go back and look at a few of the things that I'll talk to. We've continued to drive a positioning that resonates for both, him and for her and make really it easier to shop. We believe the simpler the shopping experience and the quicker that the consumer can really access the offer is critical, and so our Valentine's Day gift guide is a perfect example that that gift guide is really an extension of what we did in holiday and which worked well in the holiday, we've really focused that.

Number two, different level of imagery and you can see smaller elements of branding that are evolving that mix to create some level of inspiration as well as the curated pages, but I would tell you that our understanding at this point based on Q4 results is that we have a long way to go in that regard. Then last, but not least, I think probably the single biggest thing which is outside of the direct website is really our social media presence and partner deals. So, we've steered our marketing to a partnership with OpenTable. That is a really exciting promotion, if you will, to tap into their database that we partnered with them on, and then we've created a promotion on our social media where you basically have the ability send a love note, if you will, to someone and it's kind of a gamesmanship which is certainly something very relevant in the online world today with respect to social media. In both cases, they are really tapping into the success we had in the 12 extraordinary days of the holiday season which was one of our greatest avenues to acquisition of emails and new customers in Q4.

So, those are elements that are really resonating with our consumer and we'll continue to pursue those. They obviously most resonate with her and what I referenced earlier in my comments were the ones that resonate more with him in terms of the simplified shopping experience and the elements that will make it easier for him to buy a gift.

David Wu - Telsey Advisory Group

Great. Thank you.


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

Ross Sandler - Deutsche Bank

Thanks, guys. I guess three quick questions. First is the follow-up on earlier one. What growth is implied for engagement versus non-engagement in 2013 versus the 14% revenue guide mid-point, especially given that the engagement business up against tougher comps in the back half and has potentially less favorable diamond price inflation and then I'll follow up with the other two after?

David Binder

Hi, Ross, it's David. We don't breakout guidance as you know specifically for engagement and non-engagement, but we can provide a little bit of color behind how we see the business shaping up in 2013, sort of the thoughts behind the guidance.

We expect that both of the parts of the business engagement and non-engagement will grow in double-digit ranges and the variance high-to-low in our thought process as we issued the guidance has more to do with our ability to accelerate growth in non-engagement versus the ability to continue to grow engagement business.

As Harvey mentioned earlier, we expect diamond prices to sequentially rise in 2013, probably somewhere between low single-digits to mid-single digit rates. It's anyone's guess though, I mean, we've seen historic volatility both, on the upside and the downside and we think that if diamond prices were to grow at a slower rate or come down even, we would likely have opportunity to accelerate growth.

If diamond prices spike, we would definitely point to some risk in our ability to continue to grow double-digits. However, if you look at the history of Blue Nile, what we've been able to do well when diamond prices have grown gradually, we've been able to grow that part of our business at a double-digit rate and that's the mindset that's behind our guidance range.

Harvey Kanter

The other thing, this is Harvey, I might add is that, what we've seen in the fourth quarter is the flow of diamonds to the marketplace actually being pulled in. And on some level that has the ability to affect prices, and what we've seen most recently is the flow open back up in the last six weeks, the flow of polished diamonds is really coming to the market and we are optimistically believing that as that comes into the market the pricing structure will be at a minimum where it is today. And to David's point potentially, while we might see some small declines, but we don't have an expectation that will materially change going north.

Ross Sandler - Deutsche Bank

Got it. Okay. And then you guys have said historically that there is no shortage of female traffic coming to the site and how Harvey you mentioned that you are working on a non-engagement, fixing some of the assortment and then also testing the site to improve conversion rates.

How much of non-engagement can be improved based on those two versus going back and like retraining the customer to use Blue Nile for things other than what the original purpose of the site was, which is just buying engagement? Then the last question is was there any impact in the fourth quarter from sales tax in California, Texas and Pennsylvania? Thanks.

David Binder

So the first question, you covered a lot of ground there. I am going to answer the first question directly. I might need you to provide a little more color on the second half of that first question. But basically the customer we have today, and the one coming to the site is the customer that knows us for what we've done historically and that's where we have to continue to understand the balance of what I will call updated classics, understandable fashion and how far we can move and be much more capable of driving conversion through the traffic that's coming to the site. And so, we push the envelope to try to understand that customer's willingness to for lack of better words that respond to the offer and we believe that where we were would resonate at some level and it did but not necessarily the level we expected.

So, that customer is very meaningful part of our mix for lack of better words, optimizing that traffic to the site through expectation of greater conversion and the acquisition strategy we have in place that will drive more women to the business, but that will look like the current customer we believe represents the growth opportunity for us. You segued into a second question as part of that. If there's something else there you want to ask please repeat that.

Ross Sandler - Deutsche Bank

No. What I am trying to get a sense of is, if you go back to the Analyst Day from a couple of years ago, there was like 65% of traffic is female. The question was what are they going to the site to do, and if you get the assortment right will they convert and you won't have to actually go out and find these folks. They are already coming to the site, so is it just the case of getting the assortment right, getting the website to work correctly, you need both of those to work in order to see?

David Binder

Yes, so I can give you a little more color relative to that. I think the answer to your question is yes. What we've communicated historically in the last 12 to 24 months, I think it still point on. It's defining the appropriate balance between fashion, understandable fashion. Maybe Monique Lhuillier is a perfect example of that. Without talking about specifics, we launched Monique Lhuillier, she has definitely a higher level of fashion regard in the marketplace, but what we saw even her specific product sales is for lack of better words that the optimized assortment for her is pushing the envelope of understandable fashion and moving towards fashion, but the higher we went in fashion, the customer is basically saying there is a point where that customer will have to transition further and we are really comfortable with that as we talked about we are very happy with Monique's results out of the box. And so I think it presents more opportunity, but we have a customer coming to us today that we have to fine-tune the mix, and using the learning of Q4 and the period of time that we talked about which is literally 30 months, and in that regard I have been here 10 that it's a process and that we said we would take a stab at it in Q4. We hurried up for lack of better words to say to get there in Q4 and we are continuing to not just fine-tune, but evolve that mix based on selling results.

David Binder

Ross, last part of your question was regarding sales tax, and impacts on our business. I think the only thing I want to say to that is that we haven't really changed our practices around sales tax collection in the fourth quarter, so it's hard to tell whether or not what's going on externally with other retailers in those states is impacting our business one way or another. We haven't really seen a mix in states that would indicate there is significant shift in behavior.

Ross Sandler - Deutsche Bank

Thanks, guys.


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

Trisha Dill - Wells Fargo Securities

Good afternoon. Thanks for taking my question. First of all just a question on 4Q gross margins, just wondering if you responded to the sales go down in December with some increased promotions in non-engagement versus the original plan, or if you perhaps left some sales on the table in order to protect profitability?

Then second question on guidance in terms of the SG&A assumptions embedded in your guidance. How should we think about the dollar growth in expenses moderating relative to last year, or will you continue to invest at similar levels in marketing in international?


Ladies and gentlemen, this is the operator. We're experiencing technical difficulty. Could you please remain on the line?

Trisha Dill - Wells Fargo Securities

Hello. Operator?


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Trisha Dill - Wells Fargo Securities

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Trisha Dill - Wells Fargo Securities

Okay. Are we back on?


Ma'am, I can hear you very well.

Trisha Dill - Wells Fargo Securities

Okay. Is our conference call still on?


This call is still up and running.

Trisha Dill - Wells Fargo Securities

We're going to resume then. Can we resume?


Ma'am, would you like me to ahead to the next caller?

Harvey Kanter

I will answer Trisha's call. This is Harvey. Sorry?

Trisha Dill - Wells Fargo Securities



Okay. You are in the conference.

Harvey Kanter

Okay, Trisha. Sorry. We seem to have had a malfunction. I don't know that you heard my answer, so I will go back on the margin thing, promotional challenges in Q4 that you were concerned about from a raise and David answer the second question. The short answer is that there were competitive pressures in Q4 and heightened promotional pace certainly propelled us to evaluate how to market the business number one.

Number two, non-engagement certainly with the challenges of not everything working at the level we expected, we did increase the level of promotion, but the other thing which I think we can't make light of is the really incredible business results we had in engagement and we have already talked about the mix in balance of sales and that also had a material effect on driving the margin rate that we actually delivered in Q4.

So, I think when all said and done, we managed the inventory really well. I mentioned that already and we ended up in a really great position. Some of the margin was a function of non-engagement, but equally so a function of the balance of sales.

David Binder

The second part of the question is regarding operating efficiency and margins that's considered in our guidance. When you do the math you will see some sequential margin improvement in terms of EPS as a percentage of sales or net income as a percentage of sales. We're continuing to find ways to invest in the business to accelerate growth in areas where we are not picking efficiency, that's more focused on our marketing expense, our investment in technology and in our investment in our international platform.

The other parts of our business towards the core operations and even in the variable fulfillment parts of our business, we expect to pick up more efficiency on cost, and that's really where we are getting some overall margin improvements within our guidance range. It's where we pick up the margin improvement most pronounced in the fourth quarter results as well.


Your next question comes from the line of Kevin Kopelman of Cowen & Company.

Kevin Kopelman - Cowen & Company

Hi. Thanks. Could you talk a little bit about your investment in pricing? I know that was one of the key investments for 2012. For 2013, do you expect to further reduce relative pricing or more maintained at 2012 levels? Thanks.

David Binder

Hi, Kevin. It's David Binder. The investment and pricing was really focused on engagement business and specifically around loose diamonds and we started 2012 with an opportunity to really go aggressively at our pricing and it impacted our margins and that began to accelerate sales.

A lot of that opportunity had to do with the overall market dynamics, where the supplier prices were relative to the same period last year. And as that dynamics shifted throughout 2012, we moderated our investment and where we look for opportunities to balance growth rates with our overall profitability.

Going forward in 2013, we want to continue the momentum in the business and that doesn't necessarily mean that we need to go deeper on margins or reinvest in price. I think that that was a specific opportunity for that period of time back in 2012. And going forward this year, we are not necessarily going back to that lever unless the opportunity presents itself.

Kevin Kopelman - Cowen & Company

Okay. Thanks. Then just a follow-up on the engagement versus non-engagement and you've already addressed it somewhat, but just looking at the first quarter to-date has the non-engagement growth rate picked up compared to the second part of the fourth quarter, where growth rates slowed? Thanks.

David Binder

Sure. This is David. The guidance certainly reflects the current trends we see in the business and then it's our projection of what's going to happen for the rest of the quarter and the rest of the year. We are seeing an improvement in the rates of growth in particular in the non-engagement part of our business in total for the year-to-date.

As Harvey mentioned before, we saw this market slowdown during the peak weeks of the holiday season in December. It was really the second and the third week, and that coincided with more broad readings of consumer sentiments going negative, the equity markets really fell apart and there was a lot of discussion about tax increases in the fiscal cliff and that seems to be what generated a lot of the weakness in the holiday season. In December, exiting that and into this year, we saw the performance of the business improved sequentially and that's really factored into our guidance.

Kevin Kopelman - Cowen & Company

Okay. That's great. Thank you very much.


Your last question is from the line of Shawn Milne of Janney Capital.

Shawn Milne - Janney Capital

Thanks. It's Shawn Milne. Just a couple of questions, Harvey, can you talk a little bit about the mobile opportunity in 2013, and provide your conversion rates and some of your efforts around that and then just one quick housekeeping follow-up, what was the, I haven't had a chance to see the full disclosure on it. What was the spike up in the other income in the fourth quarter? Thanks.

Harvey Kanter

Yes. Sure. I will cover the conversation about mobile and some of the opportunity and little bit about conversion. I'll let David handle the balance. In mobile, we are really looking at the opportunity to take some of the great, great features and functions on the PC, and really continue to roll them out into the mobile, phablet environment as we've seen the level of traffic going to mobile whether it'd be phone or tablet is really accelerating.

And while we literally launched the first app in the jewelry category, we've had our mobile site for quite some time, some of the elements that we have not brought to the mobile environment we believe will materially affect conversion, diamond visualization, diamond search and things of that nature and we believe that that's a critical requirement as the customer continues to do channel shift not only from retail to the Internet, but now the PC-to-the mobile environment.

We believe it will have a significant effect on conversion both, across engagement and non-engagement. The other element that we believe that will help our non-engagement business both, in conversion and in accelerating our efforts in the fablet-based world is the fact that the consumer is shopping non-engagement and it's a much more for a lack of a better word I'd say way better way to say is grab and go opportunity. It doesn't require the level of time that most of our consumers are spending in the diamond search process and engagement process. In many cases, it's demand literally as we are seeing today ramp up like crazy for Valentine's as we peak, and the ability to access that via phone or tablet is really critical specifically for our non-engagement business and jewelry gift giving.

So, we think both of those things will have a material effect on the mobile environment and why we are putting some effort behind that. We believe it's a big opportunity, and then last but not least in terms of just what I've talked about in terms of the way the consumers engage and really specifically around social, we have over 400,000 fans on Facebook. We have over 30,000 fans on Pintrest, we are literally the number one jeweler on Pintrest, we are in the top three-tenths of 1% as indexed between likes and comments of jewelers on Facebook.

And the fact of the matter is, they are engaging, especially she is engaging vis-à-vis on social media and Blue Nile through mobile access and the convergence of that assess is critical for us to maximize, so long story short, we believe that really it's a critical requirement to really address how the consumer wants to shop, where she wants to shop and really bring what are the continued disruptive forces of what Blue Nile brings to the market and the service value to the mobile environment.

David Binder

Then pretty big shift in gears, the last part of your question. We benefited from a legal settlement that was brought in the industry from De Beers and that was the benefit that we saw in the fourth quarter in other income. It's a non-recurring benefit that we gained.

Shawn Milne - Janney Capital

Okay. Thank you very much.


No further questions at this time.

David Binder

Thank you, operator. With that, we will conclude this call.


That concludes today's conference call. Thank you for your participation at this time. You may now disconnect.

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