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Blue Nile Inc., (NASDAQ:NILE)

Q2 2009 Earnings Call

August 6, 2009 5:00 pm ET

Executives

Eileen Askew - Manager, Investor Relations

Mark C. Vadon - Executive Chairman of the Board

Diane M. Irvine - President, Chief Executive Officer, Director

Marc D. Stolzman - Chief Financial Officer

Analysts

Jack Murphy - William Blair & Company

Jim Friedland - Cowen and Company

Mark Mahaney - Citigroup

Lorraine Hutchinson – Banc of America Securities/Merrill Lynch

Doug Anmuth - Barclays Capital

Herman Leung - Deutsche Bank

Operator

Good afternoon ladies and gentlemen my name is Christian and I will be your conference operator today. At this time I would like to welcome everyone to the Blue Nile Inc., Earnings Conference 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 second 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, earnings per share, margins, expenses, income, operating cash flow, inventory, capital expenditures, international growth, tax rate, stock-based compensation expense, and other financial statement, 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 software and website development.

We will discuss international sales on a constant exchange rate basis. 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. Since the beginning of 2008 we have talked to you about the challenges faced by the entire retail landscape as a result of the global economic downturn and its significant impact on discretionary consumer spending. At the same time we have spoken about our unique positioning and our differentiated business model. Today I am pleased to report excellent Q2 results and positive momentum in our business in a still uncertain environment.

During today’s call I will review the business highlights for the quarter, provide thoughts on the overall environment, and update you on our progress related to our 2009 business initiatives. I will then turn the call over to Mark Stolzman for an in depth review of our financial results and a discussion of our financial guidance.

First I would like to touch on a few highlights of the quarter. Our Q2 sales totaled $69.9 million, a decline of 5.2% from the prior year. This was a sequential improvement from a decline of 23.3% in Q4 of 2008 and 11.4% in the first quarter of 2009. We expanded our gross margin by 100 basis points and operating margin by 30 basis points. We are very pleased with this margin expansion in a declining revenue environment. We generated $6.8 million of EBITDA, a record level for a non-holiday quarter and delivered strong profitability.

In addition we generated free cash flow of $14.9 million for the quarter and $22.8 million on a trailing 12-month basis. These accomplishments highlight our teams focused efforts to navigate the challenging economic environment. Our business is strong, profitable, and competitively agile. Our confidence in the business is stronger than ever and we are excited about the opportunities we see for the second half of 2009 and beyond.

I think it’s important to view our results in the context of what is happening in the retail jewelry market overall. The global market for luxury retail remains challenging. In the US consolidation continues to occur in the jewelry industry. In 2008 there was a 5% contraction in retail jewelry capacity. In the first half of 2009 the number of specialty jewelry bankruptcies has already surpassed the number for all of 2008, including the bankruptcy filing late yesterday of Finley Enterprises. In addition, many more jewelers have closed their doors thus far in 2009. Traditional jewelry stores are finding it difficult to continue operating in an environment of weak consumer demand. There is significant disruption in the industry and this presents perhaps an unprecedented opportunity for Blue Nile.

While we remain cautious about the economy and the consumer environment, we see clear signs that we are gaining market share in this environment at an accelerated rate. We have seen an improvement in our sales trends during the first half, whereas many high end jewelers and luxury retailers have reported comp store sales ranging from -20% to -30% or worse.

The Blue Nile brand, our product offerings, and our value proposition are resonating with consumers who are becoming more discerning and seeking value in the current environment. Our performance reflects the differentiation of our model, as well as our focus on continuing to enhance the customer experience. An obsessive focus on executing with excellence for our customers is at the heart of our success. We have the ability to enhance our product assortment, our website features and functionality, our customer service, and our value proposition at a time when other physical jewelers are closing stores and cutting personnel, store hours, product selection, and service.

Now I would like to focus on some of the trends we saw during the quarter. The best performing product category for the quarter was the bridal jewelry category including diamond engagement rings and wedding bands, which represented a larger portion of our overall sales mix compared to the previous year. Additionally, unit volumes increased year-on-year in both engagement rings and wedding bands during the quarter.

Sales of non-engagement jewelry had greater declines year-on-year as the category continues to be impacted from consumers pulling back on discretionary purchases.

Products at price points below $5,000.00 performed relatively stronger than the overall business, while higher end sales at price points above $25,000.00 experienced greater weakness. However, although sales from orders above $25,000.00 decreased year-on-year total sales in this price category exceeded fourth quarter 2008 levels.

I would now like to turn to diamond prices. As we discussed last quarter, diamond prices have been impacted significantly by the lower consumer demand that has resulted from global economic weakness. Diamond prices have declined substantially since the highs of 2008 and prices in Q2 were down approximately 15% to 20% year-on-year. Diamond prices are now at levels of three plus years ago. This declining diamond price environment is beneficial to our business as a result of our differentiated model. Whereas physical jewelers turn their inventory approximately once a year and are holding older higher priced inventory, we purchase diamonds from our suppliers on adjusted time basis when a consumer selects a diamond on our website.

As wholesale diamond prices decline we in turn pass those savings on immediately to our customers in the form of lower retail prices. Consumers today are finding incredible values on diamonds at Blue Nile. While our virtual diamond inventory model typically allows us to offer pricing that is 20% to 40% below traditional jewelry store pricing, the savings we offer consumers has been magnified in the current environment. Our price advantage relative to traditional jewelers has expanded as diamond prices have declined, thus enabling us to provide an even greater value proposition to our customers.

Our business has been built on providing tremendous selection and exceptional value to our customers and this proposition is especially compelling to consumers in today’s economic environment and is reflected in our Q2 results. Our differentiated model provides the foundation for us to out perform the industry.

Now I would like to provide an update on our key initiatives. First in the area of innovating and enhancing the customer experience we are excited about our website redesign that will launch before the holiday season. We are focused on new features and functionality that will provide customers with a new way to experience Blue Nile while retaining the elegance, simplicity, education, and information that have been instrumental in our success.

Turning to our international business, expanding our international reach is one of our key initiatives for 2009. We are now shipping products to customers in over 40 markets worldwide and we see tremendous opportunity for long-term growth in our international business. In the second quarter international revenue totaled $7.1 million representing over 10% of our total sales. While some of our largest markets are experiencing headwinds from both currency rates and the economic environment, other less mature international markets saw superb growth during the quarter despite the environment. All of our international markets are still in the early stages and hold great promise for the future.

Finally, while we approach the second half of 2009 with continued caution related to the economic environment we hold great optimism based on the strength of our competitive position. The trends in our business have continued to improve as we have progressed through 2009 and we expect his positive trajectory to continue for the balance of the year. We are focused on the fundamentals that have been key to our success, as we have built our business over the past ten years; paying attention to the thousands of details that differentiate our customer experience, executing with discipline and excellence and striving to exceed the expectations of each and every customer. We are investing in the customer experience, gaining market share, and enhancing our leadership position in the industry. This gives us great energy as we continue on our mission to build Blue Nile into an iconic consumer brand.

Now I will turn the call over to Marc Stolzman to review the details of our financial results.

Marc Stolzman

Thank you, Diane, and good afternoon. We are pleased to report the continued progress of our financial results this quarter. Sales trends continued to improve and our laser focus on cost controls and strategic product pricing resulted in improved margins across the board.

Our net sales totaled $69.9 million, a decrease of 5.2% compared to the second quarter last year. Domestic sales were slightly stronger with a decline of 4.3%. Our international sales declined 1% on a constant currency basis. In US dollars sales declined 12.3% to $7.1 million. Our more mature markets, Canada and the UK, make up the bulk of sales in our international business today. Macroeconomic headwinds in those markets and weakness of local currencies against the US dollar contributed to the year-over-year decrease. Additionally, the second quarter of 2008 was particularly strong and had several large orders from the UK which made for a more difficult comparison this year. Sales in our newer international markets are performing well. We have continued to see a positive response from customers since we added the option to purchase in local currency in March.

For the quarter the total number of orders declined from about 9% a year ago. Our average order value increased 2.6% to $1834.00 primarily due to mix. Engagement sales were higher as a percentage of sales mix during the quarter compared to the prior year. This is a trend that has continued since the fourth quarter.

Sales from engagement jewelry in the first half of 2009 accounted for 73% of total sales compared to 70% in the first half of 2008. It’s important to note engagement products carry a lower gross margin than non-engagement products. Despite this shift in mix of the business, we have been successful in expanding our gross margins in the first two quarters of this year.

Gross profit for the quarter was $15.0 million. As a percentage of sales, gross margins improved 100 basis points to 21.5%. We had continued success in the quarter capturing greater margins as a result of lower diamond prices, lower metal prices, and our overall improved cost for sourcing products. For the balance of the year we expect continued year-on-year improvement in gross margins.

SG&A totaled $10.7 million for the quarter compared to $10.8 million in the second quarter of 2008. SG&A included $1.9 million in stock compensation expense in the second quarter of 2009 consistent with the expense in the second quarter of 2008. Excluding stock based compensation expense SG&A as a percentage of sales was 12.6% compared to 12.1% in the second quarter of 2008.

We continue to execute well on managing costs through out the business. Operating income for the second quarter totaled $4.3 million. Operating margin expanded 30 basis points to 6.2% of sales in the Q2 2009 compared to the prior year quarter of 5.9%.

We achieved an EBITDA level in the second quarter that was slightly higher than the prior year. Even with the 5.2% decline in sales the EBITDA for Q2 was a record for Blue Nile outside of any holiday period in the Company history. 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 $6.8 million for the quarter. Our gross margin improvement, as well as tight control of key areas such as marketing and headcount allowed us to achieve this year-over-year EBITDA improvement.

Total other income was $38,000.00 for the quarter compared to $565,000.00 in last years second quarter. The year-over-year decline is attributed to a $269,000.00 decrease in interest income from significantly lower interest rates with the balance related to prior year legal settlements. The combined impact from these two factors is $0.02 earnings per share.

Our effective tax rate was 35.0% for both Q2 of 2009 and Q2 of 2008. Net income for the quarter was $2.8 million. Earnings per diluted share were $0.19 compared to $0.20 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 in both Q2 ‘09 and Q2 ‘08. Our inventory totaled $15.7 million at the end of Q2 representing a 6% year-over-year decline. We have managed inventory very effectively in the current environment. For the balance of the year we will continue to focus on a strong inventory management while also expanding our product assortment as we prepare for the holiday season.

We ended the quarter with a cash balance of $48.0 million compared to $47.2 million at the end of Q2 2008 and up significantly from the Q1 2009 balance of $32.3 million. The year-on-year increase in cash was achieved while also repurchasing $24.3 million of shares through our share buyback program during the past 12 months.

We have the financial strength to continue investing in and growing our business and expanding the customer experience. Turning to the statement of cash flows, on a trailing 12-month basis our non-GAAP free cash flow was $22.8 million an improvement from the $20.5 million reported in the prior year period.

Free cash flow for the second quarter was $14.9 million compared to $3.9 million in the second quarter of 2008. Our free cash flow in the second quarter this year benefited from the timing of the July 4th holiday, specifically relating to account payable. Due to the timing of the observed holiday falling on a Friday approximately $4 million in payable shifted from the second quarter into the third quarter of 2009. Even when removing this $4 million impact to free cash flow the trend of free cash flow has continued to improve. Because of this shift of payables the third quarter free cash flow will also be impacted.

I would now like to review the guidance we have provided within our earnings release issued today. We are encourage by the trends within the business and expect to achieve continued improvement for the balance of 2009. For Q3 we expect sales will be flat to slightly down compared to last year. We are projecting full year net sales between $288 million and $295 million with diluted EPS in the range of $0.78 to $0.82. Our capital expenditures are projected to be approximately $2.5 million for the year. While we are very optimistic about the second half of the year and in particular Q4, we are being cautious in our guidance due to the uncertainty that still exists in the current environment. We will continue to provide updates as we progress through the year.

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

Diane Irvine

Thank you, Mark. I want to take a moment to say thank you to everyone here at Blue Nile. We have a team of people who are passionate about our business and our customers: a team that obsesses about our customers every single day. We believe that by delivering an exceptional experience and taking care of our customers we will continue to build a truly great business. I believe this is the secret sauce behind our success and it is with the heart of this team that Blue Nile continues to out perform the jewelry industry.

Now we would be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jack Murphy with William Blair & Company.

Jack Murphy - William Blair & Company

First on the first quarter earnings report back in May you actually didn’t have specific guidance because of the economy and the uncertainty around the consumer. Beyond the sale trends improving somewhat, was there anything specific about what you’re seeing in the numbers that give you confidence to issue specific guidance? Then I am just wondering on the new sales guidance, if you could give us your thoughts on free cash flow for the full year 2009.

Marc Stolzman

I think you are right, we have continued to look at this year with cautious optimism and really the uncertainty that exists in the environment is what caused us to pull back on any specific guidance. With that said we are now two quarters past the economic challenges that we saw in the fourth quarter of last year and that has given us quite a bit of additional data to calibrate against what the Company has seen in 10 years of operating history of how each quarter responds to the previous quarter and the previous several quarters. So, it does give us some additional perspective and it has allowed us to tighten our thoughts on what we think will happen in Q3 and Q4.

With that said, and just echoing my comments earlier, we have provided that guidance with some caution of not knowing exactly how the fourth quarter will perform, but we did feel that given the directional guidance we have been providing over these last two quarters that we do know more and felt that we could provide this range with a greater degree of confidence.

I don’t have a specific comment about free cash flow and we haven’t provided any guidance regarding free cash flow, but certainly the range that we have predicted here and also the performance we have seen year-to-date with the reestablishment of a lot of our traditional working capital dynamics leaves us with a pretty good feeling about how free cash flow will perform.

Diane Irvine

I would just add that I think we have always felt we will always let you know our thoughts in terms of what our visibility is and I think that is what we want to do here today. I think we see great things in our business relative to the competition. We are a destination for value that is really resonating with consumers at this time. I think last quarter we talked a bit about some directional guidance on free cash flow. If anything I would say when you look at this quarter I think things are even better than when we talked last time, and certainly as we look ahead, while we don’t know anything more about the Christmas season we are very optimistic that with the comp we had last year that we will perform very well.

Jack Murphy - William Blair & Company

So the historical relationship that you’ve had with payables to sales and an accelerating sales environment you wouldn’t see any change in that dynamic that you’ve seen historically?

Marc Stolzman

No, in fact I think that historical relationship is what gives us a lot of belief that not only will our EBITDA out perform the prior year, but the traditional aspects of the working capital model will give us a continued contribution that we didn’t see as we exited last year.

Jack Murphy - William Blair & Company

Thank you.

Operator

Your next question comes from Jim Friedland with Cowen and Company.

Jim Friedland - Cowen and Company

My first question is on diamond pricing, in Q1 year-over-year there was a 140 basis point increase and then Q2 100 basis points. Was that more just because there was a mixed shift to the lower margin in engagement ring category, or are you just not seeing as much as a benefit from the spread as prices come down? Secondly do you think prices are showing signs of stabilization just from what you’ve seen over the past month?

Diane Irvine

I would say when you look at Q1 versus Q2 that is really a mix issues and we are heavier to the lower margin engagement category. At the same time, I think, in Q1 we talked about that we didn’t expect that same delta year-on-year to continue so I think we are thrilled with the 100 basis point increase year-on-year. I think it’s pretty remarkable to operate that way at a time when revenue is down.

In terms of stabilization of pricing, I think that’s happened a bit. I would say when you look year-on-year, obviously tremendous value being put forth to consumers. If anything, even though in the chain a lot of replenishment hadn’t been happening and so jewelers may be replenishing. I think when you look at the end demand and kind of the consumer demand dynamics I’d say all of that certainly seems to indicate that as we look out at the remainder of the year the pressure on pricing would be downward movement if anything.

Jim Friedland - Cowen and Company

Could you also follow up on metals, what you are seeing in pricing there?

Diane Irvine

Yes, in metals I think year-on-year in Q2 platinum prices, for example, were down 40%, so favorable things there which also factors into the gross margin performance.

Jim Friedland - Cowen and Company

Okay great, thank you.

Operator

Your next question comes from Mark Mahaney with Citigroup.

Mark Mahaney - Citigroup

Could you talk about the linearity of the quarter? Secondly, can you talk about managing the risk of a new website launch between now and the holiday season: what steps you are putting in place to make sure that you don’t have a UI mistake that people actually respond relatively positively to a new user interface and what is obviously going to be the most important quarter of the year for you? Then finally can you talk about how the dislocation in the retail jewelry industry actually affects your business like some things like marketing expenses, do you see less competition for some marketing terms? Is it that you are visibly seeing customers come to you who you have never seen before and expressly saying that they have not been able to go to their normal jeweler and they are looking for new options? How is that actually showing up in your business?

Marc Stolzman

For your first question about the linearity of the quarter, I think that we have continued to see progression as we have exited the fourth quarter through the first half of the year, so I think the quarter didn’t show any unique trends that we would call out as being anything different than a progression towards not only improvement in the quarter and then leading to our expectation of how that translates into the balance of the year.

Mark Vadon

On the new website it is more risky to do things as you head into Christmas. I would point to two things: one is timing, the launch of the site, we always said it would be prior to the holidays, but I think we’re leaving ourselves enough time to really get a sense for how consumers are responding to it before we hit Thanksgiving and things really start to pick up. The other thing is testing. There is a tremendous amount of user testing already happening on the newest version of the website so that we can understand the usability and whether or not we are picking up incremental usability and hopefully incremental conversion with the launch of the new website.

It is obviously a very big change for us and we will approach it cautiously, but everything we’ve seen so far in testing is that consumers really like the changes that we are planning on rolling out there.

Diane Irvine

In terms of dislocation in retail and what we’re seeing in terms of competition and bidding I think it completely depends on terms and positions and all of that, but I would say broadly speaking we have seen some markets where there are some of the physical players that have either exited or have had to discontinue their advertising where we have seen pick ups in our market share. At the same time, in our customer service center, for example, we have customers calling who have said, “I have heard this is a great place to buy a diamond, you have tremendous value”. So, to some extent there are new customers that perhaps prior to this economic environment may not have given us a chance. I think as consumers seek value and they hear more and more about us, I think we have an even better chance with consumers. So, I think that has been very favorable.

Mark Mahaney - Citigroup

Thank you.

Operator

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

Lorraine Hutchinson - Banc of America Securities

I am just wondering if you’re continuing to see signs of trading down within your assortment, or if that trend has started to stabilize a little bit on the engagement side.

Diane Irvine

I think, as you look by price point I think that is exactly what is happening. As you look at consumers and engagement for example coming in what we have always seen is a customer comes in with a budget in mind and so today that budget is a little bit lower than it was previously. At the same time, because of what is happening in diamond prices that consumer is getting an even better diamond, a higher quality diamond, a bigger diamond. I would overall when you look at all of our price points, and obviously we are going from a $40.00 price point up to tens of thousands, but sales performance kind of gets better the lower the price point. That is true in the engagement side and then we have seen overall that the higher tickets are more difficult.

At the same time, I think the real positive sign we saw in terms of higher price points during the quarter was that even though at $25,000.00 and up those sales were down year-on-year in total, the total sales of those price points were actually greater than in Q4 when historically that would be the biggest time for those higher ticket sales. So, I think that is a positive sign in terms of trends.

Lorraine Hutchinson - Banc of America Securities

Great and then as the cash balance is starting to build up can you talk about what your uses of that will be and if there are any triggers that you have in place, any levels that you would start, perhaps, a share buyback again?

Marc Stolzman

I think our share buyback program remains active and authorized and at this point we still consider it to be the best use of cash. We have continued to evaluate the price and also at the same time as we have exited the fourth quarter we employed a very cautious perspective on cash usage and wanted to make sure that we really protected those balances.

We believe that we can buy the stock continually going forward and we think it is the best place for us to utilize the capital at this time. Other than that we also look at ways that we can invest in to the business to accelerate the growth and really to bring forward some of our longer-term strategic initiatives.

Diane Irvine

I think that is exactly right. We love the buy back program. It is an active one. It is what we consider the most strategic allocation of capital. At the same time, with our financial health we are continuing to invest in the customer experience; a lot is happening in technology and we will also be investing in the international business. So, I think all of those things will be great for our future growth and for the long term.

Lorraine Hutchinson - Banc of America Securities

Thank you very much.

Operator

Your next question comes from Doug Anmuth with Barclays Capital.

Doug Anmuth - Barclays Capital

Can you comment on how conversion rates have trended here; is it pretty fair to think that they have moved along with sales improvement? Also, if you could call out some of the biggest changes on the new website and what you think is most differentiated. Then I am just curious if you have any comments on the impact from dropping affiliates in certain states and any updated view on the tax situation?

Diane Irvine

In terms of conversion if you look at traffic and conversion both were down slightly, but I think yes, we have seen an improvement sequentially in the trends as we have with sales. One of the things to look at though with conversion is that when engagement is a heavier part of the mix you do expect that conversion would be a bit lower, because what we are really looking for is revenue per visitor, gross margin dollars per visitor, those metrics are very healthy.

On the website there will be a variety of changes that we do not want to speak too much about, but certainly in terms of features and functionality that will surround diamond search and our ring customization capability; also some new features that customers will be able to utilize. Then I would say an overall kind of update to the look and feel and elevation of branding of the site, so kind of an updated look to the site. But, a lot is going into that, so I am certainly giving a broad view there.

Then in terms of state sales tax I will let Marc touch on that, but I would say we don’t have any predictions there. I think that when we look at our value proposition it is extremely strong before you even get to sales tax. As an example in Seattle where we have a 9.5% sales tax rate we have always had a very strong market share.

Marc Stolzman

I think the only thing I would add to that is everyone has seen the many published reports of both North Carolina and Rhode Island proceeding with a version of the sales tax and in those markets we have discontinued our local affiliate programs and we will continue to offer the proposition as we have in the past. Hawaii was vetoed by the governor and so that market we reestablished our program there after canceling it based on the movement of the greater government body. Then in California their budget and their legislation moved forward without an adoption of the tax, so there is another market where we continue to watch it, but we haven’t had to change course in any of our marketing activity.

As Diane said, we don’t predict or know where the different states or broadly the tax will go, but we will continue to evaluate it on a case-by-case basis and then take action where we need to.

Mark Vadon

As far as cutting affiliate programs, we are confident where we cut affiliate programs we can take that marketing spending and redeploy it successfully to continue to drive the business.

Doug Anmuth - Barclays Capital

Okay, great. Thank you.

Operator

Your last question comes from Herman Leung with Deutsche Bank.

Herman Leung - Deutsche Bank

If you look at the supplier relationships that you have can you talk about how that has fluctuated given the changes in the economy over the past several months? The second question is can you talk about the extra five days that you got in the quarter, I guess on July 5th if I sort of back into the math of five extra days at about $700,000 a day on 95 days, does that impact revenues a little bit this quarter in the second half?

Marc Stolzman

Let me start with the backside of the question. I think that the holiday timing I don’t think has quite the impact that you described. I mean you have to consider not only when orders occur, but also shipments and receipts of products and so I don’t believe there was any material impact from any greater number of days or a holiday impact that happened within the quarter.

Diane Irvine

Both were 13-week quarters, there is no change in the number of days.

Herman Leung - Deutsche Bank

Yes both quarters had 91 days exactly it is just where…

Diane Irvine

Just where the fiscal month ended because we are in a 52, 53-week year so the date is different, but the number of days is identical.

Marc Stolzman

So the only thing it impacted was cash flows because normally we have a check run on I believe it is on Friday and that money would go out the door and since July 4th fell on a Friday there was no mail service so the mail went out on Monday with those checks; so those impacts wouldn’t touch the income statement at all, it would just inflate both cash and accounts payable as compared to where it would be if July 4th wasn’t on a Friday.

Diane Irvine

Then in terms of supply relationships I would say in this environment we are such a great outlet for all of our suppliers directly to consumers and so I think if anything those relationships strengthen and as I have mentioned we have become a destination for value; so I think this model works very, very well and if anything there is more and more interest in working with us because we are such a great distribution channel for those suppliers.

Marc Stolzman

I think one of the things people miss with the supplier relationships is one of the hard things about being a diamond supplier is retailers don’t buy consistently through out the year. They buy more heading into Christmas and then if Christmas is bad they don’t replenish and they will go a very long time before buying. In the case of what happened in Q4 of ’08 people still aren’t buying at normal levels, they are still trying to burn off the inventory in the stores; so suppliers get kind of a magnified impact of that reduction in demand.

One thing these suppliers really love about our business is we are buying, every single day we are issuing a purchase order and buying diamonds. It lets them smooth out their manufacturing and it really helps them with cash flow in times like we are going through right now. So, those relationships are stronger than ever.

Herman Leung - Deutsche Bank

Got it and then just a follow up question on diamond pricing. If you look at right now you are seeing much easier comps in the business given last years increase in diamond prices. As the comps sort of fade and the markets sort of normalize and it appears that diamond pricing seems to be coming back a little bit in July. I am curious on what you are seeing there. I am also curious on how you plan to sort of offset some of the changes as to diamond prices when they come back.

Marc Stolzman

As far as diamond prices that is just a matter of supply and demand. I think what we have seen in the last six months or so is there has been a great reduction in demand; at the same time there has been an absolutely stunning reduction in supply. The major mining firms have basically stopped selling in any large quantities for the last six months. De Beers was probably in the first couple months of the year running at maybe 10% of normal levels. It still hasn’t come back to full speed yet. So, what you are starting to see is kind of stabilization to even a slight up tick in the pricing of rough diamonds, what the manufacturers themselves are buying from De Beers and from the Russian mining firm and the like; so that has started to stabilize.

That being said I think De Beers and there have been some recent moves with Alrosa in Russia, a change of management there which seems to indicate that there is going to be more diamonds. The Russians have been continuing to produce out of the mines and stockpile, so they have a very large stockpile of diamonds that people are scratching their heads and wondering when that is coming to market.

You have De Beers which has some debt payments coming up which really is probably going to start producing just to start generating cash. So, from where we are sitting what we are seeing is stabilization in rough diamond prices as the producers have really dried up supply, but there is so little demand at the consumer level that you really haven’t seen an up tick. Even with that massive reduction in supply you haven’t seen an up tick in polished diamond pricing.

No one really knows what is going to happen here, but there is a likelihood that there is going to be a lot more rough diamonds coming to market in the next six months then there were in the last six months and not necessarily a consumer demand to soak that up. So that would indicate to us that we are more likely to see a downward trend than an upward trend in polished diamond prices.

I think regardless of that our business has gained market share over time in markets where diamond prices are rising or falling and we are confident over the long run we will continue to gain market share regardless of the economy or what happens in diamond prices. You will just see, when they are coming down we have a tail wind and when they are coming up we have a little bit of a head wind, but we have so many other advantages over the traditional retail channel that I think we are going to gain share regardless of what’s happening out there.

Herman Leung - Deutsche Bank

Great, thanks a lot.

Operator

I will now turn the call over to Diane Irvine. Please go ahead with any closing remarks.

Diane Irvine

Thanks to all of you for joining us today and we look forward to updating you again next quarter.

Operator

Ladies and gentlemen that does conclude the conference call for today. We thank you for your participation. (Operator Instructions)

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