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Blue Nile, Inc. (NILE)

Q4 2008 Earnings Call Transcript

February 18, 2009 5:00 pm ET

Executives

Eileen Askew – Manager, IR

Diane Irvine – President & CEO

Marc Stolzman – CFO

Analysts

Jim Friedland – Cowen and Company

Jack Murphy – William Blair

Mark Mahaney – Citigroup

Vijay Shah [ph] – Barclays Capital

Herman Leung – Deutsche Bank

Matt Nemer – Thomas Weisel Partners

Rick – BAS-ML

Chia Kuo – Telsey Advisory Group

Operator

Good afternoon ladies and gentlemen. My name is Kara and I will be your host operator on this call. (Operator instructions) At this time, I would like to introduce Eileen Askew, Manager of Investor Relations of Blue Nile.

Eileen Askew

Good afternoon and thank you for joining us on our conference call today to review our fourth quarter and full year 2008 financial results.

With me today are Mark Vadon, Executive Chairman; Diane Irvine, Chief Executive Officer; and Marc Stolzman, Chief Financial Officer. All will be available for Q&A following today’s prepared remarks.

Before we begin, I would like to remind you that some of the comments we will make on this call are forward-looking including without limitation statements regarding expectations of future financial performance, sales, margins, expenses, income, operating cash flow, inventory, capital expenditures, international growth, tax rate, stock based compensation expense, and other financial statements or balance sheet items, as well as statements about the global economic environment, diamond and metal prices, the stock market, the credit market, consumer behavior, currency, competition, the industry, market share, future plans and objectives, beliefs, expectations, targets, goals, outlooks or predictions for the future.

These statements are only predictions based on assumptions that are believed to be reasonable at the time they are made and are subject to significant risks and uncertainties. You should not rely on these forward-looking statements as representing our views in the future and we undertake no obligation to publicly update or revise these statements. Our actual results may differ materially and adversely from any projections and forward-looking statements discussed on this call.

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

Also, please note that during the course of this conference call, we may discuss 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 for operating cash flow, less outflows for purchases of fixed assets including internal use software and website development. 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 reconciliation of non-GAAP measures to the nearest comparable GAAP measures.

Now I would like to turn the call over to Diane Irvine.

Diane Irvine

Thank you Eileen. Good afternoon everyone. As you know, the 2008 holiday season was the most challenging one for retailers in four decades. And certainly the most difficult since Blue Nile’s inception in 1999.

Consumers have been faced with significant external pressures from the loss of jobs to significant declines and volatility in stock market, lower housing prices and frozen credit markets. These factors have combined the results in historical lows in consumer confidence.

The lack of confidence on the part of consumers has had an impact on purchases of high-ticket items including jewelry. Master Card’s spending pulse reported that luxury items showed the highest year-over-decline of any retail category during the holiday season with sales down more than 34%, and jewelry was the poorest performer in the luxury category.

The holiday sales reports from high-end public jewelry retailers reflected US comp store sales declines of 31% or greater year on year. Given this environment, we are pleased with our performance for the quarter. Overall, for Q4, sales declined 23% after increasing 23% in the fourth quarter a year ago.

In a difficult environment, we achieved a significant level of earnings and $25.1 million of adjusted EBTIDA, and most importantly strong relative performance for the year. We ended the year with no debt and has maintained strong liquidity.

Our fourth quarter’s sales results in comparison to other high-end jewelry retailers are evidence that we continue to build market share during this turbulent time. For the year, while our sales of $295 million declined 7.5% from the prior year, comScore estimated that online jewelry sales declined 12% in 2008.

We believe that we are not only gaining share online but we are certainly also increasing our market share overall, compared to offline and online competitors. Looking at specific business trends during the quarter, the engagement jewelry category performed relatively better than non-engagement jewelry and represented a larger portion of our sales mix compared to the fourth quarter of 2007.

Sales of non-engagement jewelry appear to have been more impacted from consumers pulling back on discretionary purchases. High-end jewelry sales at priced point above $25,000 were the most affected and had greater declines as compared to our overall sales on a year-over-year basis.

Turning to our profitability for the quarter, our highly variable cost structures served us well. While it’s difficult to immediately adjust the entire cost structure to adapt to a change in sales trends such as we experienced in Q4, we were able to take action on some of our costs during the quarter.

We are actively managing our cost structure and believe that we can show improved margins in 2009 as we adjust to this difficult macro environment. From an inventory standpoint, we took steps with our suppliers to reduce our inventory during the quarter and achieve the 10% year-over-year reduction in our inventory balance.

We will continue to manage inventory at appropriate levels in line with the cautious outlook for 2009. One of the great features of our business model is its cash flow generation capabilities. For seven consecutive years from 2001 through 2007, our business generated substantial free cash each and every year.

In 2008, we experienced a different dynamic as a result of the significant change in our sales trends in Q4. While we saw the benefits of our negative working capital model, worked against us in a period of sales decline.

Despite that, the cash flow generation dynamics of our business remains strong. Looking ahead, we fully expect that to generate positive free cash flow in 2009.

I would like to touch on the diamond pricing environment. On our last call, we indicated that diamond prices had risen nearly 20% over year earlier levels in the third quarter. This was the highest year-over-year diamond price increase in the history of our business. Demands for diamonds globally has fallen as a result of the economic environment, and this having an impact on diamond prices.

We began to see diamond price decreases in the fourth quarter and we continue to see prices decline in Q1. We believe that our business will benefit significantly in a declining diamond pricing environment. In such an environment, our competitive advantage versus a tradition jeweler who holds inventory will be clear to the consumer as we will pass those savings on to consumers in the form of lower pricing on real time basis.

Further, since we generally purchase a diamond after heading it has been selected by a customer, we have the ability to operate within our traditional margin structure in this environment. And our P&L will not be strained with markdowns like the physical jeweler.

Given all the turmoil within the jewelry industry, I would like to explain why we believe this environment is beneficial for our business over the long term. The number of jewelers operating in the United States continues to shrink. In 2008, there was a 5% reduction in retail jewelry capacity including the bankruptcies of Whitehall and Friedman's Jewelers.

Already this year, there have been several additional bankruptcies including Shane Co., Fortune Of [ph] and Christian Bernard Jewelers, and we expect that there will be more significant bankruptcies to come. More of the brick and mortar retailers are highly leveraged, and their business model cannot sustain a prolonged period of sales decline of the magnitude experienced during the holiday season.

The consolidation in the industry creates further opportunities for Blue Nile. With relatively low fixed costs, low inventory and low capital requirement, we are able to operate with strength in this economy. We are offering beautiful jewelry with exceptional service to our customers, and we believe that we are gaining share in this difficult environment.

I would like to turn our focus to our priorities for 2009. As we managed through this climate, we will be guided by the over-arching priority of gaining market share in a difficult economic environment. Our key initiatives for the year in support of this objective are, number one, to innovate and enhance the Blue Nile customer experience. Number two, to continue to build out our international business to take advantage of the long-term opportunity, and number three, to optimize profitability and cash flow.

Our first key initiative is to innovate, enhance the Blue Nile customer experience. In the area of innovation, we will focus on website functionality, product visualization and enhanced customer features on our website. We will also be focused on an elevated branding message across the customer experience as well as product development, quality and aesthetics.

We believe we have a significant opportunity to offer an incredible selection of beautiful jewelry products at a tremendous value to consumers in an environment in which many stores are cutting back on selection and service. We also believe it is critical to invest in the customer experience. This is a key element in building a lasting brand.

Before I move on to our second initiative, I would like to take a moment to share a few customer stories that I believe demonstrates in a way financial metrics cannot. The way the Blue Nile brand comes alive for our customers and our commitment to go above and beyond to ensure customers have an exceptional experience.

The first story is a bit humorous. Over the holidays, one of our customers’, a woman worked with our customer service team to purchase a single diamond stud earring for her husband for Christmas. When he unwrapped the gift and saw the Blue Nile box, he laughed, urging her to open her gift from him. Telling the rest of the story in her words, she writes,” he handed me a package that contains the exact same Blue Nile box. I opened it and found two diamond stud earrings just as beautiful as the one I gave him. It doesn’t end there, he also gave four other women in the family matching Blue Nile pearl bracelets. So, I guess we can say, we had a Blue Christmas.

When two people in the same family are finding and purchasing from us, independently of each other, we know we are doing something right in reaching our customers. Sometimes we forget how deeply a gift from Blue Nile touches people's lives. A recent customer reminded me of that fact. For the upcoming birth of his third child, the gentleman worked with our customer service team to create a truly costumed three-stone diamond ring as a gift for his wife.

The ring happened to arrive on the same day as their new daughter. I’ll let him take it from here. “ I must say that if I could afford to buy a diamond ring everyday and give it to my wife, it would be the most addicting high imaginable. She literally had her breath taken away”.

Finally, you may have heard about the snow that Seattle received over the holidays. Ten inches of snow in a city without snow plough creates for interesting traffic conditions. The snow also created a delay in the completion of an engagement ring order for one of our local customers. Instead of simply apologizing and offering to get it to him when the snow cleared, our customer service and fulfillment teams worked to arrange to meet the gentlemen and hand deliver his diamond ring so he could propose on Christmas morning.

This is the commitment we have to our customers, and it’s one of the reasons we consistently generate some of the highest customer service marks in all of retail. It’s also one of the reasons we see a bright future for the Company.

I would now like to move on to our second key initiative for 2009, continuing to invest in our international business and expand our geographic presence. The opportunities for our business internationally is tremendous over the long term. In 2008, we expanded our shipping capabilities to over 35 new markets in Europe and Asia Pacific, and we increased our sales in international markets by more than 60% to over $27 million or 9% of total sales.

In 2009, we intend to improve the customer experience in our international markets with currency localization along with the expansion of our product assortment.

And third, we are focusing on optimizing profitability and cash flow through the disciplined management of our gross margins as well as cost across the business. We are operating from a position of strength. In the current environment, we have the ability to generate strong EBITDA and cash flow within our business model.

We are rigorously managing inventory and other key balance sheet items that impact free cash flow. We will manage all parts of our business prudently and proactively through this challenging environment, while making the right decisions for the long term.

We will continue to build the foundation for the long-term growth of our business. We have a strong team in place to execute on our priorities. Throughout the business, we are energized and excited as ever about the opportunities that lie ahead for Blue Nile.

We are laser focused and taking advantage of the external climate to grow our leadership position in online jewelry and elevate the Blue Nile brand. Blue Nile is a business that is built for any economic environment, but our competitive position is strongest in the current environment. We are a nimble business founded on a unique and differentiated economic model and a passion for our customers.

We offer a compelling value proposition for our consumers and that is especially relevant in this economic environment. When the economy turns, we expect to emerge in an even stronger position owning a larger share of the jewelry market.

I would now like to turn the call over to Mark Stolzman to review the details of our quarterly and annual results.

Marc Stolzman

Thank you Diane and good afternoon everyone. As Diane mentioned in her remarks, there has never been a better time in our history to extend our lead and capture share. Our business model provides us the flexibility to weather this period and to emerge as a stronger player in the jewelry market.

For 2008, a 53-week year, our net sales totaled $295.3 million a decrease of 7.5% compared to the 52-week year of 2007. Our international sales in 2008 grew 62.9% to $27.7 million and now account for approximately 9% of sales, compared to 5% of sales in 2007. Today, we ship to over 40 markets world wide in the Americas, Europe and Asia Pacific, which is quite an increase from the four markets we served at the end of 2007.

As we noted in our press release, 2008 was a 53-week year for Blue Nile. Excluding sales from the additional week in 2008, our net sales decreased 8.7%. We reported operating income for the year of $16.0 million and operating margin of 5.4%. We generated non-GAAP adjusted EBITDA of $25.1 million or 8.5% of net sales, a particularly noteworthy achievement in the current environment.

Though we experienced deleveraging of expenses as demand slowed, we tightly managed costs and reported net income for 2008 of $11.6 million or $0.75 per diluted share. In the fourth quarter, we posted net sales of $85.5 million, a decrease of 23.3% from the fourth quarter of 2007.

Total orders declined approximately 20% and our average order value decreased 3%. Our selling price per order was $1,370 in the fourth quarter. Our fourth of 2008 was a 14-week quarter, compared to the 13 weeks in 2007. The additional week of the fourth quarter added just under $4 million in sales. Excluding this additional week, fourth quarter sales decreased 26.8%.

The year-over-year comparisons discussed from here will compare the 14-week period in 2008 to the 13-week period in 2007. On a geographic breakdown, US sales declined 24.6%. For the first time since launching into the UK and Canadian markets, we saw a decline in the international sales of 4.2% in the quarter. This is the result of the strengthening US dollar coupled with global economic weakness.

It’s important to note that diamonds are denominated in US dollars on a global basis. Therefore foreign currency movements relative to the US dollar have a significant impact on the purchasing power of the consumer paying in foreign in currency. For example, in Q4, the British pound declined in value by more than 23% relative to the US dollar year over year, a significant reduction in buying power for a UK customer.

This dynamic existed for most foreign currencies in our international markets during the fourth quarter, and thus had a notable impact on our international sales results. Removing the currency impact, our international results would have reflected a year-over-year increases compared to the fourth quarter of 2007.

Gross profit for the quarter was $17.7 million. As a percent of sales, gross margin for the quarter was 20.6% compared to 21.1% in Q4 2007. The 50 basis point decline in gross margin is the result of product mix shifts.

Sales in our engagement jewelry category, which carries a lower margin were a much grater part of our sales mix in the fourth quarter as compared to Q4 of 2007. For the full year, sales of engagement jewelry accounted for 69% of net sales, compared to 68% of sales in 2007. The average price of an engagement ring purchased from Blue Nile in 2008 was approximately $6000, a slight decline from the $6200 in 2007. This is well above the US average of $3200.

Net income for the quarter was $3.5 million. Earnings per diluted share were $0.24. Net income per diluted share for the quarter includes stock based compensation expense of $0.08 compared to $0.06 for the fourth quarter of 2007.

SG&A totaled $12.4 million for the quarter. SG&A included $1.8 million in stock compensation expense in the fourth quarter of 2008, compared to $1.7 million in the fourth quarter a year ago. Excluding stock based compensation expense, SG&A as a percentage of sales was 12.4% compared to 10.6% in the fourth quarter of 2007. We will be focused on driving down these costs through rigorous management across all areas of the business in 2009.

Operating income for the fourth quarter totaled $5.3 million representing an operating margin of 6.2%. Non-GAAP adjusted EBITDA which we define as earnings before interest and other income, income taxes, depreciation and amortization, adjusted to exclude the effects of stock based compensation expense, was $7.7 million for the quarter down from $12.4 million in the fourth quarter of 2007. The rapid change in sales trends from mid-September made it difficult for us to completely adjust expenses in line with lowered sales. However, we were able to adjust our cost downward in the quarter.

Interest income totaled $121,000 for the quarter, compared to $1.0 million in last year’s fourth quarter. The decrease in interest income is due to lower interest rates and lower average cash balance compared to the prior year period as a result of our share repurchases.

We ended the quarter with a cash balance of $54.5 million, up on a consecutive quarter basis from $26.6 million in the third quarter. During the quarter we repurchased 31,400 shares of our common stock for a total of $1.2 million. For the full year 2008, we purchased 1.6 million shares for $66.5 million representing approximately 10% of outstanding shares at the beginning of 2008.

Looking at the statement of cash flows, our full year non-GAAP free cash flow was negative $4.9 million compared to $36.6 million in 2007. In each of the first three quarters of 2008, we reported positive free cash flow on trailing 12-month basis. However, as the pace of business changed in mid-September, the dynamics surrounding our free cash flow generation were impacted and did not allow for the (inaudible) payable comparable to the prior year level.

The fourth quarter was further impacted by the fact that our fiscal year 2008 contained one extra week ended January 04, 2009. Though the timing of fourth quarter sales negatively impacted free cash flow, we anticipate this situation will reverse itself in 2009 as year-over-year growth comparisons moderate and as we manage our working capital dynamics.

With respect to inventory, we achieved an improvement in our year-over-year inventory level in the fourth quarter. With diligent management, we ended the year with 10% decline and inventory year over year. We continue to manage inventory in accordance with a cautious outlook for 2009.

It is important to note that we do not hold significant levels of inventory unlike traditional retail jewelers. Our inventory is comprised primarily of engagement ring and finished jewelry that is classic in design.

On the topic of our outlook, as we announced in our press release today, we have decided not to provide financial guidance given the uncertainties surrounding the economic environment and consumer spending. While we are not providing guidance for Q1, we would like to comment on trend in the business thus far in 2009.

On a quarter-to-date basis, demand is down approximately 15% year on year. At the same time, gross margin has increased by approximately 100 basis points year over year. We are focused on managing our costs in a disciplined manner in the current environment with the goal of improving EBITDA margins in 2009 relative to 2008.

There are two additional items that we would like to provide perspective on for 2009. Our capital expenditure plans and our stock compensation expense. First our capital expenditures expectation for the year is $2.0 million, similar to the level in 2008. And second, for 2009, our stock compensation expense is expected to be approximately $0.31 per diluted share, which is $0.02 higher than stock compensation expense in 2008.

2009 will be our fourth year of expense stock options. As our options vest on our four year schedule, we anticipate that 2009 will be the last year in which we will have a material year-over-year difference in stock compensation expense.

For 2010 forward, we anticipate our stock compensation expense will be more consistent on the year-over-year basis.

Now, I would like to turn the call back to Diane.

Diane Irvine

Thank you, Mark. Before we move on to the Q&A session, I want to reiterate our commitment to our priorities. Our objective is to take advantage of the disruptions in our industry and to gain share in this environment.

This spring, Blue Nile will celebrate its 10th Anniversary. We have revolutionized the jewelry industry when we started this business and we intend to continue to enhance our leadership position to further the growth of our business and our brand.

Now, we would be happy to take your questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question will come from the line of Jim Friedland with Cowen and Company.

Jim Friedland – Cowen and Company

Thanks. Question is regarding some of the comments on tightening the expenses. Is – some of that has to do with the work force reduction, and if so when did that happen or when is it likely to happen? And in terms of areas to target, where are you targeting for those cost cuts and what are they likely to scale in? Thanks

Diane Irvine

Thanks Jim. In terms of work force reduction, we did a reduction in January, mid month, obviously having about having 175 employees, that’s smaller numbers for us. So, it’s not the most significant difference in terms of cost. But obviously it’s all very meaningful when you look through our cost structure. I would say in other areas it’s things like in marketing, I think in this environment we want to be able to pull back if necessary where, you know, you think increase your spend in an environment where there’s not consumers who are interested in their message. And in Q4 one other things happened is that we had some fixed programs already in place in marketing. So, things like that you are not able to change, whereas moving into this year, I think will just be fully gotten sense of that.

Jim Friedland – Cowen and Company

So, those are the key areas pulling back, and marketing has been more targeted and the headcount reduction, those are the two largest areas –?

Diane Irvine

I would say as you look at the G&A, cost structure it’s literally every area of the business where you look at professional fees, any cost item around the business. Obviously, the cost inputs in terms of our products in other area, I think in this environment is a huge opportunity. That’s something you will more on margin, obviously. But I would say it’s everything but the two things that I pointed to initially would be probably the most obvious that we would be working on.

Jim Friedland – Cowen and Company

Okay. Great. Thanks.

Operator

Your next question will come from the line of Jack Murphy with William Blair.

Jack Murphy – William Blair

Thanks. Couple of questions on cash flow. First, could you – I think you said that the timing of the year end with the extra week impact to free cash flow, wonder if you could quantify that for us, and then what you think the opposite – will the benefit be exactly the same in 2009? And then secondly, you did say that you thought you could generate free cash flow this year, and I’m wondering what sort of minimum level of sales you think you need to generate free cash flow for ’09?

Marc Stolzman

Thanks Jack. This is Mark Stolzman. The impact of the year end really is in two different areas. One is that our fiscal year ended on January 4th, which by happening in January had several of the year end payable such as marketing and our accrued liabilities of pay roll and related expenses. Both get paid down in that period as a use of cash. Overall, that the larger dynamic in our cash flow model is the accumulation of sales in the subsequent accumulation of accounts payable. And with the sales being down within the fourth quarter, it didn’t allow for the build up of the payables as we had in the previous comparable years. I mentioned in my remarks the additional week. It is a post-holiday week, so certainly it’s a volume level than the pre-holiday sales and given that it’s one additional week further, it removes a week of our accounts payable that would have been from earlier in the holiday cycle, so that the net result of that impact is that it brings the free cash position down. More specifically in your comment about 2009 in terms of minimum sales levels, I don’t think that we would be prepared to specify the sales level that it would breakeven free cash flow. But I think that we have anticipated that the more rapid decline we saw in the fourth quarter, that impact largely reflected within the free cash flow as we enter the year, and therefore we have a much more favorable comparison when we come up against fourth quarter of last year.

Diane Irvine

Jack, I would add one other thing. When you think about the free cash flow dynamics, obviously, the working capital piece is a significant part of our model. So, it’s the change in COGs in any one year or quarter that will drive the free cash flow numbers. So, when you look at 2008, I think the big thing there is the Q4 dynamic that Mark was talking about is in Q4 ’07, our sales were up 23%. In Q4 ’08, sales were down 23%. So, when you look at that pay down in Q1 of ’08 from the big build up of payables in prior quarter, that’s when you get the kind of plus 23%, minus 23% impact within one year. So, I would think of that as we have seen the step down so to speak from that dramatic change in the sales growth. So, now that we’ve seen that and hopefully we don’t have that same type of negative numbers this year, then we would be able to build off of that. And I would say, while it’s difficult to give a number, I think you would be looking at positive free cash flow for the year if the sales are north of say $230 million something like that.

Jack Murphy – William Blair

Okay. That’s helpful. And then just to clarify though on the much smaller issue of the extra week and that going into January, compared to the swing of very positive sales growth to a – here we have a decline in sales growth, that extra week is I assume fairly small?

Diane Irvine

You are correct. The biggest piece is obviously that big change in the sales level.

Jack Murphy – William Blair

Perfect. Thank you.

Diane Irvine

Thank you.

Operator

Your next question will come from the line of Mark Mahaney with Citigroup.

Mark Mahaney – Citigroup

Thank you. I want to ask two questions. First, you mentioned some of the – you mentioned broadly that changes you want to make today, user experience, the interface. Are there a few examples you could provide or may be of things that you – or at least areas you would like to improve if – don’t want to go into specific details of the changes you would like to see? And second, you made a comment about seeing a bit of a fall off in the competitive landscape, I would think that there would be a pretty large swop unfortunately are brick and mortar jewelers that will be going out of business, shuttering up in the next 6 months to 12 months. Are you seeing more evidence of that in the US market versus in any particular international markets? Thank you.

Diane Irvine

Thanks Mark. In terms of the website innovation, we have a lot of plans there this year. And I guess I would say competitively that’s something we don’t normally share. But I think there a lot of great things we can do. Obviously, our goal is always continue to improve user experience. And if you look at some of the things we did last year in terms of our diamond search as well as Build Your Own Ring functionalities on the website. We made improvements there and I think our goal is to keep innovating there and customers love that. So, more to come and I apologize for not sharing there, and I think Marc would like to jump in on the brick-and-motor question.

Marc Stolzman

Hi, Mark. In competitive landscape we obviously pay a lot more attention to the US market than the individual – international markets. But in the US market there is a lot of people who are on the ropes right now, and we care about mostly for the supply chain where those guys are obviously very focused on their payables and getting that back. A lot of supply chains have already taken a significant hit from the bankruptcies that happened so far. And I don’t think it would be good for us to go into individual names, but there’s several significantly sized jewelry retailers who – if the current environment continues are just not going to make it through the year.

Mark Mahaney – Citigroup

Thank you, Marc. Thank you, Diane.

Operator

Your next question comes from the line of Douglas Anmuth with Barclays Capital.

Vijay Shah – Barclays Capital

Hi, this is Vijay Shah [ph] filling in for Doug Anmuth. So, thanks for taking our question. I was wondering if you had mentioned earlier that the gross margin was up 100 basis points in a quarter-to-date basis. So, just can you provide some additional insight into what’s driving this improvement? And I also have a follow up question.

Diane Irvine

Sure. I think if you look at margins, we have had improvements on the cost side in terms of our products. And also think about – we have talked in the past about in times were metal prices were increasing dramatically as well as diamond prices increasing dramatically. We are not always immediately passing those costs down to consumers. So, we benefit in times when prices are coming down. So, when metal prices came down and we got better prices. And now with diamond prices declining, I think we are able to capture more margins. Obviously, we will be very careful in terms of where our retail prices lie from a consumer standpoint. But I think this environment gives us the ability to raise margins, and so it’s something we are very focused on.

Vijay Shah – Barclays Capital

Alright. And the other part of the question. Could you just provide some color on traffic growth on the best side and conversion rates, so if you have seen any trends?

Diane Irvine

Yes, I don’t think we give a lot of color on that. But I would say in Q4, we saw declines in traffic but those were modest declines, certainly in single digit level in terms of traffic unlike some published reports but I think had at minus 40% decline or something in traffic.

Marc Stolzman

And so the flip of that – the extension of that conversion is off slightly and when I talked to other people in E-commerce are saying the same thing. Consumers are – traffic is difficult but conversion is the bigger pieces of puzzle where consumes are coming and looking and shopping but don’t necessarily have the courage to pull the trigger and follow through on the purchase.

Vijay Shah – Barclays Capital

All right. Thank you.

Operator

Your next question will come from the line of Herman Leung of Deutsche Bank.

Herman Leung – Deutsche Bank

Hello! Hi, thanks. I guess two questions on international expansion. I think it’s still kind of remains under invested from the local language even in campaigning system. Can you talk about the thoughts of your timing and cost initiatives there and how much it’s going to cost post some of these investments there? And secondly, can you talk about – you talked about some diamond price trends declining in the fourth and first quarters. Can you talk about the monthly trends from November, December and into January?

Diane Irvine

In terms of international, I would say when you look at investments, the things we did last year as we opened up 35 new markets internationally, there wasn’t a significant capital investment and certainly no physical presence. It’s really our internal efforts. It’s all about the technology in your systems there. So, similarly this year as you look at, we mentioned local currency as an improvement we would like to make. That’s something as well involves, while the technology effort. It’s really one of opportunity costs, what you focus on as a business. But I think that would all be relatively modest investment if you will. It’s all in our people. It’s not a physical presence. We don’t speak to timing, but certainly as we look at improving those localized experiences for the customers, that’s very important to us. We see great opportunity there for the future.

Marc Stolzman

And on diamond pricing, more of the price decline in diamonds happened towards kind of the middle of the back half of the quarter. I think demand in the industry has started to fall and the supply chain held prices a little bit before starting to come down. So, we saw some of the impact in the back half of the quarter, and it’s continued into first half of Q1 as well. We jus t offered a price reduction while most of the industry over the last couple of weeks. One thing I would point out there is we’ve got kind of the downward trend in diamond prices which is a tailwind for us, which we are starting to see in – we told about gross margin in the quarter in Q1 to date. But there’s kind of a counter headwind which is the heavy liquidation activity and heavy commercial activity from most jewelers is – certainly Q4 was offsetting, more than offsetting some of those price decreases. So, I think we have got kind of a – as people continued to liquidate here, we’ve got to work through that. The good part and the other side of that has a lot less capacity in the industry. But in the short term, we’ve got some very, very aggressively priced competitors. And I think throughout the foreseeable future, we would expect weakness in diamond which should be beneficial to us.

Herman Leung – Deutsche Bank

And I guess a very quick follow up on you diamond pricing. Given the fact that you are seeing diamond prices elevate a little bit, what did you guys – where you guys happy with the trends that you saw in Valentines Day or not really?

Diane Irvine

I think the over-urgent [ph] factor is still there. It’s the economy – Marc gave our trend for the quarter to date. So, six weeks in demand is down to about 15%. So, I guess you would say compared to Q4, may be that’s a little bit better, but I think it’s really all about what’s happening in the economy today and higher ticket purchases and whether kind of what the mind set of consumers is. And I think as you have seen this year with all of the job reduction announcement, I think that probably weighs most heavily on consumers mind.

Herman Leung – Deutsche Bank

The demand metric that you are giving out, is that sales or is that units in terms of –?

Diane Irvine

It is sales.

Herman Leung – Deutsche Bank

Got it. Perfect. Thank you.

Diane Irvine

Thank you.

Operator

Your next question will come from the line of Matt Nemer with Thomas Weisel Partners.

Matt Nemer – Thomas Weisel Partners

Hi, good afternoon everyone. My first question is on the international business. I’m just curious, excluding the impact of FX, if you are pleased with the revenue growth on a constant currency basis, it seems like with 40 new markets during the year, it would have been – I want a tailwind from turning on a market from zero to some number?

Marc Stolzman

Yes. I think overall, we are pleased when you do compare on a constant currency basis. But I think there are really two factors when taking a constant currency, one is the straight foreign exchange rates year over year. And the second is the rather purchasing power the consumer faces because of the economic climate and that the global chain in purchasing power. So, I think that we anticipate we have a lot of room in international and that not withstanding this currency differences that we continue to develop and grow our share internationally. So, I would say, yes, we are pleased but certainly we aren’t internationally immune to the same economic issues we are discussing here in the US.

Diane Irvine

And then I would say Matt, that’s going to be a great business for us over the long term. And so lot more for us to do clearly and will be on getting after that this year as well. But I think when you look at our business versus others, the additional impact we have again is the fact that diamonds are denominated in US dollars on a global basis. So, as the currency changes you will see that real time impact on part of the consumer and their purchasing power and the largest markets we have are the ones we have been in there longest, which would be Canada and the UK. So, while we love the new markets and saw great demand there, and we will continue to do more in those markets this year. The biggest headwinds there was currency changes in places like Canada and the European and Asian markets.

Matt Nemer – Thomas Weisel Partners

Okay. And then secondly, turning to payable I just want to make sure I’m clear. Where there any I guess on a day sales basis, it looks like that changed pretty dramatically, and I’m just wondering is that purely the extra week or is there something in terms of your terms and vendors have changed?

Diane Irvine

In terms of terms met, no I think there we continue to get better. Days payable in the quarter actually was up year on year. So, we felt great about our ability to continue to extend there. It’s really more about the – it’s the overall sales decline and then the timing of the sales within the quarter and then what the mix becomes as to how you build up payables. But on the plus side, we had the higher days payable.

Matt Nemer – Thomas Weisel Partners

Okay. And then lastly, you talked about the environment in retail. And it seems like you have taken the largely sort of defensive tactic against that. And I’m just wondering if there is any kind of an offensive move that would make sense against some of the liquidations, whether it be lowering prices or buying customer list [ph] or specifically marketing in those markets to try to accelerate the demise or potentially it will take some customers?

Diane Irvine

I think we have chosen to not jump into the fray in terms of all of the discounting that’s happening. And obviously there are differences in terms of what’s the quality of the product, it might be a different end of the spectrum in terms of the exact product being sold. But I think we are still confident that once this shakeout has occurred that will be in an even stronger position. We have a great value proposition today, but you can get disruption from all the liquidation. But I think we are doing the right things in terms of building the brand. It’s also as you look at the engagement business, unfortunately there aren’t lists to target who’s about to get engaged. And that’s where I think we rely very heavily on word of mouth and referral and people finding us through online searches and things like that.

Matt Nemer – Thomas Weisel Partners

I guess my question really is in the case where you have someone like a Shane Co. closing the doors and they were very active in local media. How do you activate one of those customers into your channel, if you thought about being more aggressive in terms of that activation?

Marc Stolzman

I think in cases where people are literally liquidating merchandise because they are going out of business as opposed to some other instances you have people who are getting on aggressive on pricing to lower their inventory levels. But when people are liquidating to close the doors, they are going to keep dropping those prices until the merchandize moves out. So, we can start dropping our prices to compete with them, but obviously they are going to keep on lowering the prices until the merchandize sells. So, I don’t think we benefit or gain by taking our prices down to make a more difficult for people to get out the door and shut their business down. So, I think the tack we have taken is to try to keep our economic models solid and fight our way through the shorter-term issues in the sales decline and be here on the other side of it. So, that has been our approach and just when you look at our margins, I think most of our competitors consider us extremely aggressive on a day-to-day basis without ever cutting low than we are today.

Matt Nemer – Thomas Weisel Partners

Great. Thank you.

Operator

(Operator instructions) Your next question will come from the line of Lorraine Maikis with BAS-ML.

Rick – BAS-ML

Hi, it’s Rick [ph] for Lorraine. Thanks for taking the question. Could you just discuss the sell through of your new assortment that you launched before the holidays and was this (inaudible) during the quarter?

Diane Irvine

I would say in terms of new products every year we do launch in advance of the holiday season. And so, I think we were overall pleased with that. I think there’s probably the other thing I would point to in terms of significant changes for us because it’s like something we continue to do to freshen the assortment. But the bulk of what we are selling in the bulk of our revenue dollars would be very classic diamond jewelry product, obviously with diamond rings leading the way in terms of revenue dollars. But certainly as we add new jewelry, new settings for our customers, al of that helps to move the diamonds.

Rick – BAS-ML

Okay. Can you provide some little more color on the marketing strategy for this year with a little more – with little bit less investment for the year. Are you expecting the message to change as well?

Diane Irvine

No, not at all. I think we’ll have very consistent brand messaging. I think what I’m talking about is more – if you look at the landscape there is some marketing vehicles that are becoming more efficient. We certainly see broadly a lot of people putting their money into search. Clearly online marketing is what works for us, but I would say it’s just ensuring the profitability of every vehicle. So, it’s more on kind of a surgical approach just making sure that we are getting the right ROI and the investment. Whereas in a period like Q4, I think as the dynamics are changing so quickly and we always feel like you are investing your marketing dollars based on the rear view mirror and how things used to be. So, I think as you adjust to this environment, we will be able to invest at higher ROIs in the marketing area. But certainly online will be the bulk of marketing as well as our direct marketing program that we have.

Rick – BAS-ML

Thank you very much.

Operator

And your final question will come from the line of Chia Kuo with Telsey Advisory Group.

Chia Kuo – Telsey Advisory Group

Thanks. Just a quick follow up to the decline in diamond prices. Has the drop been mostly concentrated in the higher carat rate, or are you seeing that across the board? And then will all else being equal, lower diamond prices clearly would have an adverse impact to the top line. So, I’m wondering is it your expectation then that the lower prices would generate enough market jugging, prompt customers to trade up enough to concentrate. Thanks

Diane Irvine

Sure. I don’t remember all this, but Marc will jump in. One thing I would say to be clear that as you look at lower diamond prices that does not hurt us on the top line. What happens is that customers will come in with the budget in mind whether that is $5000, $10,000, and they will then maximize their diamond purchase. So, we have not seen in the past that would hurt it all. In fact, we love lower diamond prices to create environment for our business, and so it’s something I think we can really take advantage of.

Marc Stolzman

Yes, that’s right. And I think one data point to look at there. If you look over history at Blue Nile going back, that’s almost 10 years now, our average engagement transaction has been fairly constant. In our first days in business it was roughly $5400. Today it’s about $6000. And during that period we had many different environment as far diamond pricing. And so, as Diane described it, our typical customer comes in knowing how much they are going to spend. And so when we are offering them lower prices, then they get to the normal brick and mortar retailer, they are not putting the money back in their pocket, they are just buying more diamond. So, that shouldn’t impact us from a revenue standpoint. It is should just help us because we are not holding the inventory that’s devaluing every day. As far as you first question about in which areas of diamonds we are seeing price drops. I think we are seeing price drops across the board, but they are defiantly more significant as diamonds get larger, where we softness in the quarter in transactions above $25,000 and that’s same across the market. The higher the price points get, the weaker the market’s been. So, as you get to larger diamonds, prices are definitely falling faster.

Diane Irvine

And the other thing I would say about is the high end, the larger carat sizes where we saw the most significant increases in the second, third quarters. So, as Marc said those are where there been more significant decreases.

Marc Stolzman

Just to clarify what Diane is saying. We saw the highest price increases in the supply chain of large diamonds back in Q2 and Q3. So, the market’s kind of giving back that inflation now.

Chia Kuo – Telsey Advisory Group

Great. Thank you.

Operator

And there are no further questions, you may proceed with any closing remarks.

Diane Irvine

Thanks everyone for joining us today and we’ll look forward to updating you again next quarter.

Operator

And that concludes today’s conference call. You may now disconnect your line.

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Source: Blue Nile, Inc. Q4 2008 Earnings Call Transcript
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