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Blue Nile, Inc. (NASDAQ:NILE)

Q1 2009 Earnings Call Transcript

May 7, 2009 5:00 pm ET

Executives

Eileen Askew – Manager, IR

Diane Irvine – President and CEO

Marc Stolzman – CFO

Analysts

Mark Mahaney – Citigroup

Sujay Shah – Barclays Capital

Jack Murphy – William Blair & Company

Jim Friedland – Cowen & Company

Herman Leung – Deutsche Bank

Trisha Dill – Thomas Weisel Partners

Lorraine Hutchinson – Banc of America Securities

Bridget Fleisher – JPMorgan

Chia Kuo – Telsey Advisory Group

Operator

Good afternoon, ladies and gentlemen. My name is Jody 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 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 first quarter 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, or operating cash flow, less outflows for purchases of fixed assets including internal use of 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 Diane Irvine.

Diane Irvine

Thank you, Eileen and good afternoon everyone. As noted in our earnings release, we are very pleased with our first quarter results. We delivered strong profitability for the quarter and gained market share in a challenging economic environment. We expanded our gross margins, managed our cost diligently, and achieved an EBITDA level that was higher than the first quarter a year ago.

Importantly, we are providing our consumers with high-quality products at a compelling value and demonstrating our ability to enhance our competitive position in this climate. I will go into further detail about the current environment and the market dynamics we saw in Q1, but first I’d like to review some of the key financial results of the quarter.

Overall for Q1, sales declined 11.4%, reflecting an improved sales trend as compared to the fourth quarter. Looking at specific business trends during the quarter, the bridal jewelry category, which includes diamond engagement rings and wedding bands, performed better than our overall sales average and represented a larger portion of our overall sales mix compared to the previous year.

As we saw in Q4, sales of non-engagement jewelry appear to have been more impacted by consumers pulling back on discretionary purchases. High-end engagement and jewelry sales at price points above $25,000 were the most affected and had greater year-over-year declines as compared to our overall sales.

Our operating performance during the quarter was excellent and our team executed well across the business. Our ability to achieve EBITDA growth from a year ago despite a decline in sales is significant and it was driven by our focus on profitability, specifically the expansion in gross margins and a laser focus on costs.

Our highly variable cost structure served us well in optimizing our profitability for the quarter. When we spoke to you last quarter, we discussed our ability to show improved margins in 2009 as we adjusted the macro environment and we did just that. Our first quarter results reflect the strength of our business model and our ability to navigate through the economic environment.

We’ve often pointed to the cash flow generation capabilities of our business as one of the great features of our model. In this regard, we achieved a significant improvement in our trailing 12 months free cash flow at the end of Q1, which totaled $11.8 million as compared to trailing 12 months free cash flow of negative $4.9 million one quarter ago.

We mentioned last quarter that we expect to generate positive free cash flow for the year and that expectation was reinforced in Q1. In fact, we expect that we will generate free cash flow for the full year that is significantly greater than our Q1 trailing 12 months figure of $11.8 million. We have a strong balance sheet with a healthy cash balance, an inventory position that was 17% below a year ago at quarter-end, and no debt.

I’d like to turn to the macro environment and the trends we saw in Q1. As I mentioned, our Q1 sales trends improved sequentially over Q4. At the macro level, we are seeing signs of improvement in consumer sentiment and overall retail sales in the US, although there are key issues that continue to impact consumers including tight credit markets, job uncertainty, and other economic indicators. We continue to be cautious about the near term, but we are very positive about our longer-term opportunities and outlook.

Turning to the jewelry retail landscape, we spoke last quarter about the turmoil in the industry. Events this year have moved at an accelerated pace with a significant number of additional bankruptcy filings and store closures. Traditional jewelry stores, many of which are highly leveraged, are finding it difficult to continue operating in this challenging economy and we expect to see additional store closures and consolidation in the weeks and months ahead.

This industry consolidation is creating tremendous opportunities for our competitive position. We are strong and profitable in the midst of turmoil throughout the retail jewelry industry and there is no doubt we are gaining market share.

I’d now like to provide an update on diamond prices, which have declined since late last year. Demand for diamonds has fallen on a global basis as a result of economic weakness and prices have been impacted significantly. Diamond prices have declined approximately 20% since the highs we saw last year and prices were down 5% to 10% in Q1 compared to a year ago.

As we have discussed in the past, a declining diamond price environment is beneficial to our business as a result of our differentiated model. Because we purchase diamonds from our suppliers on a just-in-time basis, after a consumer selects a diamond on our website, we are able to pass on savings to consumers in the form of lower prices as wholesale prices for diamonds decline.

In the first quarter, consumers saw a significant price advantage compared to physical jewelers when shopping for diamonds at Blue Nile. Our price advantage relative to traditional jewelers expands in a declining price environment, delivering even greater value to consumers.

This environment is a win-win for Blue Nile and our customers as we are able to capture some of the benefit of lower diamond prices in our gross margin, while at the same time passing on savings to our customers.

Incorporated in our business model is the fundamental belief that consumers are smart and we saw a compelling value proposition resonate with consumers as diamond prices declined during the quarter. Another factor in our gross margin performance was an improvement in our non-diamond product cost, driven by lower year-over-year metals prices, as well as sourcing improvements.

Now, I would like to touch on some of our key initiatives and update you on our progress. One of our top initiatives for 2009 is innovating and enhancing our overall customer experience. Later this year, we will launch a redesigned website with enhanced branding and innovative website functionality in important areas such as our Diamond Search and our Build Your Own Ring Process.

Our new website will also include enhanced product visualization, as well as additional customer features. Work on this project is well underway and we are very excited about it. We are also focused on elevating our branding message across the many details of our entire customer experience.

Another key area of focus is product development, quality, and aesthetics. This is particularly important to our goal of ensuring that every customer is enthused about their Blue Nile experience and will return to us for their future jewelry purchases. We recently introduced beautiful new diamond bands and ring settings, as well as well as pearls, gemstone, and sterling silver products at price points for every budget.

Next, I want to update you on our international business. Our international reach has grown dramatically over the past year. It was only in February of 2008 that we began to expand our business beyond Canada, the UK, and Ireland. Today, we offer shipping to over 40 markets worldwide. International sales currently represent a small part of our business, but the longer-term opportunity for growth is tremendous.

An important step for the future of our international business was the implementation of currency localization for all of our international markets in late March. This launch provides the capability for customers in every country we serve to make purchases at Blue Nile in their local currency.

Previously, all transactions on our websites were completed in US dollars, Canadian dollars, and British pounds. While there are currently some headwinds in the international business as a result of the strengthening of the US dollar combined with global economic weakness, this localized currency capability is an investment that positions us well in these markets for the future.

Finally, we continue to believe the current environment presents an ideal opportunity for Blue Nile to gain market share. As we demonstrated with our results today, we are operating from a position of strength. While other jewelry retailers are closing stores burdened by high overhead costs and debt payments, we have gained domestic market share, while also enhancing our international business.

While competitors are pulling back on selection and service, we are investing in the customer experience, providing our customers with tremendous value, exceptional quality and selection, and the ability to customize their diamond jewelry and have it delivered in as little as two business days.

Our team is energized to achieve our mission of becoming the world’s premier specialty retailer of jewelry. We remain confident in our ability to emerge from this environment with a greater share of the diamond and jewelry market and with an enhanced leadership position in the industry.

I’d now like to turn the call over to Marc Stolzman to review further details of our quarterly results.

Marc Stolzman

Thank you, Diane and good afternoon everyone. We are pleased to report the achievement of our profitability and cash flow goals for the first quarter. Our net sales totaled $62.4 million, a decrease of 11.4% compared to the first quarter of 2008. Domestic sales declined 12.1%. Our international sales declined 3.4% to $5.6 million due to the strengthening of the US dollar and the impact of the global economic weakness.

On a constant currency basis, our international sales grew 19.0% year-over-year compared to the first quarter of 2008. We are encouraged by the early results of our newer markets in Europe and Asia-Pacific. As Diane mentioned, in late March we added local currency functionality to our websites. We have seen positive consumer response with increased activity in a substantial number of countries since that launch.

For the quarter, the total number of orders was down 13% from a year ago. Our average order value increased 1.5% to $1,662, driven by engagement sales, which were a higher percentage of the sales mix during the quarter. Gross profit for the quarter was $13.2 million. As a percentage of sales, gross margin for the quarter improved to 21.2% compared to 19.8% in Q1 2008. The 140-basis point increase is a result of three factors, our ability to capture greater margins as a result of lower diamond prices, lower metal prices, and improved cost for sourcing products.

SG&A totaled $10.3 million for the quarter compared to $10.9 million in the first quarter of 2008. SG&A included $1.8 million in stock compensation expense in the first quarter of 2009 compared to $1.7 million in the first quarter a year ago. Excluding stock-based compensation expense, SG&A as a percentage of sales was 13.7% compared to 13.0% in the first quarter of 2008.

Operating income for the first quarter totaled $2.9 million, representing an operating margin of 4.7%. This was an improvement from 4.3% operating margin a year ago. Through disciplined cost management, we achieved our near-term objective of improving EBITDA and EBITDA margins year-over-year.

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 $5.3 million for the quarter, up from $5.2 million in the first quarter of 2008. We managed our gross margin very well in addition to all areas of spend. In marketing, we found greater efficiency as we adjusted our spending and plans to the external environment.

Net interest [ph] income totaled $67,000 for the quarter compared to $835,000 in last year’s first quarter. The decrease in interest income is predominantly due to significantly lower interest rates compared to a year ago, as well as a lower average cash balance as a result of our share repurchases.

Net income for the quarter was $1.9 million. Earnings per diluted share were $0.13 compared to $0.16 a year ago. It is important to note that the decrease in interest income accounted for the entire difference in EPS year-on-year. Net income per diluted share for the quarter includes stock-based compensation expense of $0.08 compared to $0.07 for the first quarter of 2008.

We ended the quarter with a cash balance of $32.3 million. Our cash balance reflects the paydown in Q1 of a significant payables balance that was built up in the fourth quarter holiday period as is typical in our business.

Turning to the statement of cash flows, as a reminder, our cash flow from operations is typically negative in the first quarter due to the working capital dynamic I just mentioned, the reduction in accounts payable from our fourth quarter.

On a trialing 12-month basis, our non-GAAP free cash flow was $11.8 million. This is an improvement compared to our 2008 free cash flow of negative $4.9 million, which reflected Q4 2008 sales trends that impacted our free cash flow generation dynamics. As we stated on our fourth quarter call, we expect to generate positive free cash flow for 2009. This Q1 performance was anticipated and is consistent with our full-year goal.

With respect to inventory, we achieved an improvement in our year-over-year inventory level in the first quarter. Inventory declined 17% year-over-year. We continue to manage inventory in accordance with a cautious outlook for 2009. We continue to make improvements in our sourcing methods with our suppliers and are able to maintain flexibility in inventory management while ensuring that our product assortment and selection are strong.

On the topic of our outlook, as we announced in the press release today and consistent with the previous quarter, we are not providing specific financial guidance due to continued uncertainty in the economic and retail environments. However, on a directional basis, we do want to provide additional context on our view of the fiscal year.

The improvement in both sales and profit trends from the fourth quarter is encouraging. We expect to achieve improving sales trends as we progress through the balance of 2009. We anticipate Q2 and Q3 will post sales declines compared to the previous year, but we are expecting sales growth in the Q4 compared to the prior year. In addition, we expect that EBITDA for 2009 will exceed our 2008 EBITDA level.

Finally, the combination of our sales expectations and year-on-year EBITDA improvement is projected to produce free cash flow for the year at a level significantly higher than the $11.8 million reported in the first quarter on a trailing 12-month basis.

Now, I’d like to turn the call back to Diane.

Diane Irvine

Thank you, Marc. In summary, our first quarter performance demonstrates the resilience of our model and our ability to generate profitability and strengthen our competitive position in a difficult economic environment. We are focused on executing with excellence for our customers and providing exceptional value to our customers every day.

We are enthusiastic about the launch of our redesigned website that will occur later this year. We see significant opportunity for our business in this climate and we are focused on capturing it.

Now, we would be happy to take your questions.

Question-and-Answer Session

Operator

(Operator instructions). We will pause for just a moment to compile the Q&A roster. Your first question comes from the line of Mark Mahaney with Citigroup.

Mark Mahaney – Citigroup

I’m sorry, can you hear me?

Diane Irvine

Yes.

Mark Mahaney – Citigroup

Sorry about that. Two questions, please. First, I know you talked about already the impact from the currency localization. Could you quantify that at all in any of the international markets? And just to clarify, are you localizing in every one of those 40 markets? And then secondly, are you – did you see particular steps you can take to accelerate market share gains on the US through the balance of the year, given the falloff in some of the competitive set? Thank you very much.

Diane Irvine

Thanks Mark. In terms of the currency localization, of course the largest part of our international sales relates to Canada and the UK, which already had local currencies. So, the new currencies that we launched would relate to all of those new markets that we opened up last year.

So again, those are a very small part of the business today, but I think the great thing is that anything we can do to take away a hesitation to purchase or any impediment to purchasing I think is fantastic for the customer, where someone is more likely to purchase perhaps in their own local currency. So, it’s very early Mark, but we are pleased with what we see and I think the international story for us is one that’s – long term, there is a great opportunity for us.

In terms of domestic market share, I really think the landscape today plays in our favor, plays to our strengths, we are able to be profitable, have a great cash flow, we can improve our customer experience while the landscape in physical retail is very, very troubled today in jewelry. So, I see our ability to continue to enhance market share there as we go through the year.

Mark Mahaney – Citigroup

Thank you, Diane.

Operator

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

Sujay Shah – Barclays Capital

Hi, this is Sujay Shah in for Douglas Anmuth. Thanks for taking my question. You seem to have made good progress on managing inventories this quarter. I was wondering what you think is the right kind of inventory level going forward and especially, since you are factoring in a recovery later in the year, do you expect an increase in inventories?

Marc Stolzman

This is Marc. Thank you for the question. I think that right now you are seeing inventory levels that are declining year-on-year more than we would expect as we approach the end of the year where we had anniversaried what was a year-on-year inventory decline.

I think the inventory level is such a small overall component of our opportunity especially since so much of our inventory is virtual on the diamond side. I do think when we get to the end of the year where we have indicated we expect the fourth quarter to have a sales increase, I think you would expect to see inventory more consistent with where we ended the year in 2008.

Sujay Shah – Barclays Capital

All right. Thank you.

Operator

Your next question comes from the line of Jack Murphy with William Blair & Company.

Jack Murphy - William Blair & Company

Thanks. Just – first question is, I’m not sure if I understood, but did you talk at all about just how sales progressed throughout the quarter?

Diane Irvine

Jack, we didn’t talk about that, but I guess if you look at our – in our previous call, we talked about sales to date, which was right around Valentine’s Day, being down about 15%. So, the second half was improved from the first half of the quarter.

Jack Murphy - William Blair & Company

Right. And I wonder if – given all of the consolidation that you’ve had on the retail side and what might – may come, could you just help us get some insight into the sort of condition of your vendors? Are you continuing to see benefits of vendors looking toward you and is there any sort of business risk with your vendors for yourself given the weak state of demand, at least leading into the present?

Diane Irvine

Thanks, Jack. I think the thing you said that sums it up best is that vendors are looking to us. So, I would say because of our model and the sales that we are making every single day, we have more and more people who would like to work with us and we really have two sets of vendors if you will, those on the diamond side where we are buying those diamonds virtually, and then on the jewelry side, we have a set of different set of suppliers.

And so, I think as we look at the landscape, you are right. Every one is being impacted. For example, in diamonds, there has been very little production from the mines this year as demand has weakened across the globe. So, supply is working its way through the system. I think within diamonds, we have such a strong position with our suppliers that whatever it is that happens, consolidation in that industry, I think we will be working with the strongest people there.

And with respect to jewelry manufacturers where clearly you’ve had bankruptcies and there are companies on those creditor lists. I think we are talking with our suppliers and if anything, I would say we have more inquiries from people who would like to work with us. So, those are very strategic and important relationships to us and we stay close to them. I think we are in great shape.

Jack Murphy - William Blair & Company

Great. And then just final question, you mentioned enhanced branding as part of your initiatives. Could you just say a little more about that to help us understand what it is you are – what it is you are going to try to achieve that?

Diane Irvine

Sure. I think first and foremost, our brand happens for customers through their experience with Blue Nile. So, from the time they come to our website and they’re searching for products and getting educated on diamonds, when they pick up the phone and call our customer service experts here in Seattle or whether they are visiting with us over live chat, when they receive their products, I think the brand is across hundreds of details of the customer experience.

I think we’d like to always have that be as complementary as possible across the experience and continue to elevate that experience, in the way we speak to customers or the way things appear.

With respect to the websites, specifically I think you’ll see a very significant change in our new website that we’ll launch later this year before the beginning of Q4 and it will really be the most significant change we’ve done to the website from a branding standpoint. So, I think elevating the level of specialty of our brand and the beauty of the product that we are selling, but it’s really designed to showcase the premier aspect of our brand.

Jack Murphy - William Blair & Company

Okay, thank you.

Diane Irvine

Thank you.

Operator

Your next question comes from the line of Jim Friedland with Cowen & Company.

Jim Friedland – Cowen & Company

Thanks. A question on seasonal trends. If you look at your US Q1 revenues in ’09 and then you go back on a Q-over-Q basis and then you look at the revenues in – on a Q-over-Q basis in Q1 of ’07 before you really entered the difficult economic environment, the trends are very similar and so, basically what I’m asking, are you actually – do you think you are seeing returns of the seasonal patterns that you experienced before we saw this big dropdown in demand? And then just a quick follow-up to that is, in the international business last year, you saw in Q2 a sequential meaningful bump-up in revenues. And is there anything on a local currency basis, should we see that type of seasonality every year? Thanks.

Marc Stolzman

On the seasonality or the trends, I guess the way I’d describe what happened, I think in Q4, our business took a – if you look at the run rate of the business, not the – not necessarily the revenue of the quarter, but the kind of a pace at which we were bringing in revenue, it took a step down in Q4 as I think many consumer businesses did and then, as we came into Q1, we bounced back somewhat.

The run rate of the business – if you kind of correct for seasonality, the run rate of the business in Q1 was faster than in Q4 and as Diane said before, we improved in the back half of Q1 as well.

The normal seasonality for our business, if you kind of strip out growth from it, you are going to put up a revenue number in Q1, Q2 will be slightly smaller than that absent – if you take away any growth, Q3 slightly smaller than that again and that’s because Valentine’s Day is in Q1. Mother’s Day is in Q2, but it’s slightly smaller for us than Valentine’s Day. And then in Q3, there is no real gift-giving holiday. So, you kind of slow and then as you go into Q4, Q4 is obviously the – by far, the largest quarter and then we cycle back in again.

So, I think what we are seeing right now in Q1 is a faster pace of business than in Q4 and our hope from here is that we would follow the normal seasonal pattern wit a little bit of growth layered on top of that as we work our way through the year.

I think the one thing as I look at how people are – I’ve looked at everybody’s kind of models and tried to see how people are understanding our business. I think that drop-off in business in Q4 of ’08 presents some challenges when you try to – when you just try to understand the pace of our business because I think what you are going to see is a – the growth rate accelerate very fast we go from Q3 of ’09 to Q4 of ’09 and we anniversary that step-down in growth for the business.

Jim Friedland – Cowen & Company

Right. And then just focusing in on Q2 in the international business, last year there was a big sequential bump-up. Is there anything in terms of seasonality that happened in Q2 or was that just sort of the beginning of the ramp of that business?

Diane Irvine

Yes, I think what you are seeing in Q2 was – that was the first full quarter that we had all of those new markets last year and it was before we had currency impact as well, the strengthening of the dollar happened later in the year. So, it is important to remember that this Q2 will be the first quarter that you’ll fully comp those newer markets, if you will, that we launched last year and of course, the UK and Canada are the bigger drivers of international, but those were some of the things happening last year.

Jim Friedland – Cowen & Company

Okay, great. Thank you.

Operator

Your next question comes from the line of Herman Leung with Deutsche Bank.

Herman Leung – Deutsche Bank

Thanks. Two quick questions. First I think is the – when you look at your supply in terms of the market, it sounds like De Beers is out there limiting diamond production by about 90% in the first quarter and with this influx of bankruptcies that you are seeing out there, do you see that there is a risk of just a much larger diamond inventory kind of flooding the market? And that’s my first question. Second question, I was wondering if you can talk about some of the trends you are seeing in April and early May and I have a very quick follow-up.

Marc Stolzman

Yes, on the supply side, definitely the production of rough diamonds in the first quarter was cut back by all the mines significantly. Then, that’s – there is two things going on there. One is the lower consumer demand, but a much bigger part of that is that the – as consumer demand slowed down, there was way too much merchandise in the channel. There was too much rough diamonds that had been aggregated by manufacturers. There was too much polished diamonds at the wholesale level and at the retail level.

And so, what you are seeing is people have stopped buying rough diamonds in Q1 because they are working through all the inventory that’s already there and people are in a hurry to work through the inventory because prices are dropping, the value of the inventory is dropping. So, they want to get rid of that and they don’t want to replenish it. I think what you are seeing just over the last few weeks is mines starting to produce in quantity again because people have worked through the chains.

So, as the mines start producing again, I don’t think you’ll necessarily see a flood into the supply chain. You are just seeing – the cutback in mining was to get the supply that was already in the channel back to a normalized level and now hopefully the mines will be able to scale up and continue the throughput through the channel.

Diane Irvine

And Herman, I think in terms of trends, what we would say about Q2 is that our expectation would be that will be improved from the overall Q1.

Herman Leung – Deutsche Bank

And I guess, is it – I mean, are you seeing any weekly trends improving throughout this second quarter here or not really?

Marc Stolzman

Herman, we don’t give weekly comps.

Herman Leung – Deutsche Bank

Got it. And I guess my last follow-up is, are you seeing anymore direct competition from some of your site holders that are out there or – I mean, there is an anticipation that eBay is going to come out with a – I guess, a more verticalized site on the fourth quarter – before the holiday season. Have you heard anything about that or kind of expect more competition from the standpoint of this holiday season? Thanks.

Diane Irvine

I mean, I think Herman, what we’d say there is we’ve had significant competition since we started ten years ago and I think we’ve shown our ability to keep that lead position I’d say every quarter. I think we enhance that position in terms of online competition and the real competition for us is that independent jeweler in any city across the country. So, we are very confident in our ability to keep building the business.

Marc Stolzman

As far as the people in the supply chain, a number of them over the years, over the last decade, have tried to go more direct to consumers without a lot of success. And I think in this environment, when everybody is hurting, people are pulling back and focusing on their core business and not necessarily branching out and trying to do things radically new.

The hard part for any major diamond supplier about going direct to consumers is they’ve obviously got a lot of conflict with their retail accounts. And so there is – it’s very, very infrequent that anybody will try that.

Herman Leung – Deutsche Bank

Got it, thanks.

Operator

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

Trisha Dill – Thomas Weisel Partners

Actually, it’s Trisha Dill in for Matt. Just a couple of questions. First, with regards to gross margin, you sort of highlighted the three areas where you saw improvement. I’m wondering if any of that improvement was also related to mix. You’ve talked before about some consumers trading down to bands. That would have higher margin rate than solitaire engagement rings. I’m wondering if you are still sort of seeing that and if that’s impacting the margins as well.

Diane Irvine

One of the interesting things about the quarter, when we talked about bridal and engagement, as a part of bridal being relatively stronger, so a larger part of our mix. And when you think of all of our products, our engagement category, because it has the highest ticket of all of our products, carries the lowest percentage gross margin.

So, actually the mix of sales this quarter was more engagement than it was a year ago, which would mean that you’d expect maybe the percentage gross margin is lower. So, I think it was out ability to capture the benefits of all those things that Marc talked about and the diamond side as well, the non-diamond product cost.

Trisha Dill – Thomas Weisel Partners

I guess I was just referring within the engagement category to smaller stones, the kind of weakness that you referred to at the high end.

Diane Irvine

In terms of the – yes, I mean if you look at the overall business, the dynamic that Marc talked about with respect to engagement – yes, really the distinction there is that the 25,000 and up price points were – had a much more significant decline than the other price points. So, that is a fair point.

Trisha Dill – Thomas Weisel Partners

And then with regards to average order value up 1.5%, you’ve given in the past for just the engagement ring the average price decline. I wonder if you could give that again for Q1.

Marc Stolzman

We have – we talked about that on our fourth quarter call and the trend that we saw in the first quarter was very consistent with the decline in average price inside of the engagement category that we saw in the fourth quarter.

Diane Irvine

And again, that’s related to the dynamic of the high end being relatively weaker.

Trisha Dill – Thomas Weisel Partners

Got it. And then just lastly on the international business, I was just wondering if there is anything that you can share there now that you’ve sort of tested many different markets, any markets where you plan to specifically focus, perhaps with more advertising, et cetera going forward?

Diane Irvine

I think what we’d say there is I think we have done a great job of opening up new markets and really finding that consumers love this way of shopping. The brand resonates with them and certainly, that value proposition, as well as the tremendous selection really resonates.

And so, I think we feel like there is great opportunity there and what we’ll do is just keep learning in each of those markets where should we invest more and dial up some of our efforts. But it’s still early days there I would say, but I think we feel great about the opportunity because it’s really working.

Trisha Dill – Thomas Weisel Partners

Great. Thanks, that’s all I have.

Operator

Your next question comes from the line of Lorraine Hutchinson with Banc of America Securities.

Lorraine Hutchinson – Banc of America Securities

Thank you. Good afternoon. In light of the decline in commodity prices, how are you thinking going forward about either realizing more gross margin yourselves or passing some of that along to your customers?

Marc Stolzman

Yes, I think we’ve seen commodities’ prices dropping and that’s especially significant for us in diamonds because the amount we spend on diamonds is so much greater than on precious metals. In general, we’ve kept a little bit of that for ourselves and passed along the vast majority of it to consumers and I think that’s what we’ll continue to do.

Commodities’ prices keep falling; we’ll keep passing that along to our customers. That tends to help us a lot because our retail competitors in stores are holding roughly a year’s worth of inventory. So, the merchandise that they are selling on their shelves, they bought at higher prices than we are buying in the spot market today. But in general, I think our rule of thumb is we keep a little bit and pass the bulk of it on to customers.

Lorraine Hutchinson – Banc of America Securities

And when you think about marketing over the next few quarters, have you been able to realize any type of cost declines in what you are paying for some of your key words and how are you expecting that to trend going forward?

Diane Irvine

Lorraine, I think we’ve seen some stabilization there in terms of the pricing in the online vehicles. Certainly paid search, a lot has been written about what’s happening there in terms of cost per click. So, I think that competitive dynamic is better and as we talked about last quarter, we were really going to focus in Q1 on all of our efficiency, especially as you think about the landscape for maybe not as many consumers who were in the market, so we’ve adjusted those vehicles.

But I think you’ll continue to see us be appropriately aggressive in those efforts. We look for every dollar of marketing to have an ROI. So, we’ll continue that mindset, but we do better than anyone in this category. So, I think we’ll continue to drive therein online marketing.

Lorraine Hutchinson – Banc of America Securities

Thank you very much.

Diane Irvine

Thank you.

Operator

Your next question comes from the line of Imran Kahn with JPMorgan.

Bridget Fleisher – JPMorgan

Hi, this is Bridget Fleisher. I have two questions. The first one is, looking at diamond prices, as you noted, they are down quite a bit from the highs. Are they reaching about a median level for pricing or can we expect future declines in them?

Marc Stolzman

Yes, prices of diamonds are back now to roughly the level they were at in 2004, 2005 before they ran up pretty sharply over the last couple of years. As far as where they go going forward, it’s kind of a commodity market with supply and demand dynamics and I don’t think anybody really has a definitive answer on what will happen with prices.

I think as long as consumer demand remains relatively weak, we wouldn’t expect diamond prices to make any strong upward moves. So, I think our best guess is that diamond prices will remain kind of trading sideways to slightly down, but again, it’s an actively traded market and those prices will go where supply and demand send them.

Bridget Fleisher – JPMorgan

Great. And then my second question is we’ve heard from other e-commerce companies that there has been an increase in comparison shopping. Can you give us some indication into the traffic trends and conversion trends you are seeing on your site?

Marc Stolzman

Yes, I think comparison shopping, I’ve heard from other e-commerce companies similar things, but comparison shopping engines don’t fit very well in the jewelry category because the products are not – they are not UPC-coded, they are not – they are kind of differentiated products as you go from merchant to merchant.

So, price comparison is not as prevalent for us, but I think the overall theme there is that consumers are more value seeking right now than they have been in a long time. And I think that’s definitely right, we are seeing consumers responding more aggressively to promotional activity and being very price sensitive, and we are trying to gear our marketing to be appropriately tuned to that mindset.

Diane Irvine

And I think that’s exactly what happened in diamonds as well where even though that’s not a promotional tool that we use, consumers find the value as prices decline. So, that value was definitely the mindset in Q1.

Bridget Fleisher – JPMorgan

Great. Thank you.

Diane Irvine

Thank you.

Operator

Your last question comes from Chia Kuo with Telsey Advisory Group.

Chia Kuo – Telsey Advisory Group

Hi, good afternoon. I just want to get more color on how sales trended through the back portion of the quarter. My back-of-the-envelope calculation implies down mid-single digits for the remainder of the quarter given the weighting of Valentine’s Day and so, I’m just wondering if that’s a fair assumption.

And then secondly, can you talk a little bit more about the competitive environment? I mean, clearly, there are still a lot of jewelers going out of business, but at the same time you have big players like Whitehall that are gone now and Zales taking a less promotional stance. I’m just wondering if it’s your sense that in general, there is less competitive pressure out there versus the last quarter.

Diane Irvine

Sure. In terms of the sales trends, I mean I think because we have talked about being halfway through the quarter I think that math makes sense overall. With respect to the competitive environment, I think anywhere you go today, any jewelry store, you are seeing a significant promotional activity and that’s because all of the jewelers are trying to get cash in the door.

When you look at this environment, it’s a very tough model and in these difficult times, I think we’ll continue to see that as you just see people trying to stay in business. I think that’s a great opportunity for us as we have such great value every day, and a model that allows us to keep improving our selection and service to the customer, and I think we’ll continue to see share gains as we work our way through this environment.

Marc Stolzman

Yes, I mean as you mentioned – I think you referenced Whitehall, okay. There were some people who filed three months, six months ago, who are working through their inventory or almost through their inventory, but for everyone that’s done liquidating, there is new ones lining up to start liquidating today.

If you just go and do a quick LexisNexis search, you are going to find a lot of people – do people still use LexisNexis? You’ll find a lot of people who have just gone bankrupt in the last four to six weeks and their liquidation activities are going on now and will continue for some time.

And I think that’s the cycle that is going to continue for probably at least the remainder of the year of seeing a constant inflow of new liquidation merchandise out there and I think we are just thankfully priced appropriately where even when people are heavily liquidating, we still offer tremendous value to consumers. But that’s one of the things going on in this environment; you’ve got to fight your way through the liquidation. And on the other side of it, there is a lot less competition for you to have to deal with, but the promotional activity is a headwind in the meantime.

Diane Irvine

And that liquidation activity also tends to be in the non-engagement sector. So, that’s the more discretionary jewelry purchases and I think that’s where you see all of the retail news where you see the biggest trouble that people are having, because there is so much competition for that discretionary jewelry purchase.

Chia Kuo – Telsey Advisory Group

Great. Thank you.

Diane Irvine

Thank you. Okay, well, thank you everyone for participating with us today and we will look forward to talking with you again next quarter.

Operator

Thank you. That concludes today’s conference call. You may now disconnect.

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