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Blue Nile, Inc. (NASDAQ:NILE)

Q2 2014 Earnings Conference Call

August 5, 2014 08:30 am ET

Executives

Harvey Kanter – President & Chief Executive Officer

David Binder – Chief Financial Officer

Nancy Shipp – Director Investor Relations

Analysts

Ross Sandler – Deutsche Bank

Rohit Kulkarni – RBC Capital Markets

Trisha Dill – Wells Fargo Securities

Paul Bieber – Bank of America

Rick Patel – Stephens Inc.

Operator

Good morning, ladies and gentlemen. My name is Jennifer, I will be your host operator on this call. (Operator instructions.) At this time I would like to introduce Nancy Shipp, Director of Investor Relations of Blue Nile.

Nancy Shipp

Good morning and thank you for joining us on our conference call today to review our Q2 2014 financial results. With me today are Harvey Kanter, President and Chief Executive Officer; and David Binder, Chief Financial Officer. They’ll also be available for Q&A following today’s prepared remarks.

Before we begin I would like to remind you that we will make forward-looking statements during this call regarding the company’s future performance. These statements are only predictions based on assumptions that are believed to be reasonable at the time that they are made, and are subject to significant risks and uncertainties. You should not rely on these forward-looking statements as representing our views in the future and we undertake no obligation to publicly update or revise these statements. Our actual results may differ materially and adversely from any forward-looking statements discussed on 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 and we’ll 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 a reconciliation of non-GAAP measures to the nearest comparable GAAP measures. Now I would like to turn the call over to Harvey, our President and CEO.

Harvey Kanter

Good morning and welcome to Blue Nile’s Q2 2014 Earnings Conference Call. Today we announced Q2 sales of over $106 million. We also announced earnings per share of $0.18, a $0.01 increase over Q2 2013; net income of $2.2 million and adjusted EBITDA of $5.2 million.

Our results for the quarter were challenged by two factors: first, record sales and exceptional growth in Q2 2013, and second, volatile diamond prices this year. As we mentioned last quarter, we have seen a greater level of change and inflation in the price of loose diamonds this year than last year, and the breadth and depth of these changes accelerated greater in late March. This impacted our results and most significantly in the sales of US engagement and diamond jewelry products.

In our fifteen years of business we’ve seen this headwind before. At the start of 2012 we employed a strategy to reinvest in our margins, and coupled with our fundamentally more cost efficient structure Blue Nile’s diamond prices were by far the best value among any retailer, period. That strategy helped add over $100 million of sales to the business by the end of 2013.

As it became clear that the current diamond price environment was affecting our results, we took two main actions. First, we executed targeted price changes to offset the volatility and drive growth. We began to make these changes at the end of June and will continue to adjust throughout the rest of this year.

It’s important to note that the level of investment in margin is not as large as it was in 2012, and we’re using efficiencies in other areas of the business to offset this. These price changes were executed across a far deeper part of the supply chain that today includes over 160,000 high-quality certified stones. We’re also utilizing a growing data science program that allows us to better understand the inflection points around price elasticity.

Second, and equally important, we’re further driving communication across all customer touch points, to ensure that no matter what Blue Nile’s superior value is absolutely clear. This strategy is reaccelerating growth which will achieve greater scale and strength in our leadership position in loose diamond supply. The financial impact of these changes is included in our current financial guidance for the rest of the year, and we believe this is the right strategy for both our short- and long-term business.

Adjacent to our core engagement ring business is our non-engagement business, which continues to be an important natural extension and provides for higher margin as we’ve communicated before. Revenue in this category increased by 2.6% and was led by double-digit growth and a record number of wedding bands purchased in Q2. We continue to build momentum and we are getting results from the efforts in the wedding bands category.

In other jewelry we achieved good initial results from the Q2 launch of our designer collective and we have solid expectations for fall. Diamond jewelry and our Build-Your-Own features were materially impacted by the volatility in diamond prices like our core engagement business.

Turning to the user experience, we continued our investment in an adaptive platform that works seamlessly across any internet-enabled device. We know this is the future of ecommerce and the millennial customer who relies heavily on mobile technology coming of age, and is true to Blue Nile’s roots. And Blue Nile continues to be well ahead of the curve in this remark.

It is a long-term solution that lays the groundwork to convert the increased traffic that we’re seeing from mobile devices. Further, enhancements to the adaptive platform were recently completed and continued development of the UX remains a major initiative. In addition we just updated our iPhone app and plan to launch several new features in the coming months ahead.

Looking outside of the US, international sales accelerated with an increase of 4.8% despite continued currency headwinds. Sales in Asia-Pacific, our largest international region, increased nearly 15%. This is a marked year-over-year improvement and is largely due to investments we’ve made in China and the Chinese consumer recognizing our value proposition.

In August we will execute our third bridal show in China where we expect 60,000 attendees plus. Taken together with other bridal shows, we expect to expose over 0.25 million Chinese consumers to Blue Nile’s value proposition by the end of this year. We are building our brand among this important consumer base and are encouraged by the results.

In closing, halfway through 2014 and with another six months to go we are focused, first and foremost on reaccelerating and growing our business, and second on driving our leadership position in the user experience.

We are making investments to ensure consumers clearly recognize there is no better place to buy diamonds, and for our suppliers, there is no better place to sell diamonds. As I noted, the adjustments we made over the past six weeks have already had an impact. These actions will further strengthen our position as the worldwide leading retailer of bridal and fine jewelry.

As I always do I want to acknowledge the incredible team here at Blue Nile. They are a committed bunch, driven by the knowledge that we help our customers during one of the most important times of their lives and do so by providing a better, smarter way to buy diamonds and fine jewelry at incredible value. It’s very rewarding work and I want to thank them for their dedication.

I will now turn the call over to David to discuss the details of our financial results. David?

David Binder

Thanks, Harvey, and welcome to everyone on the call this morning. As Harvey mentioned we generated $106.6 million in net revenue in Q2, a decrease of 1.3% versus Q2 in the prior year. This represents a two-year average growth rate of 8.7%.

Now, turning to the details, engagement products in the US generated $60.9 million in revenue. This represents a decrease of 4.6% compared to the same period last year and an average rate of growth of 8.7% over the past two years. We struggled to maintain growth specifically in the sale of diamond products in carat ranges with the highest levels of inflation and/or price volatility.

In the quarter, the prices of small-size stones were up by significant double-digit percentages versus the prior year; and the prices of mid-sized diamonds increased significantly at the end of March. Cost increases for larger diamonds were more moderate, and in these areas we continued to grow.

Sales of non-engagement products in the US generated $27.7 million and grew by 2.6% versus last year and by an average rate of 7.0% over the past two years. As in our engagement category, we struggled to maintain growth rates in the sales of diamond jewelry.

While sales from these products posted double-digit growth rates over the prior two quarters it was difficult to maintain that pace given the inflation and volatility of diamond prices. By contrast, growth in the sales of wedding bands exceeded 15% representing the fourth quarter of double-digit growth and actually accelerating from the growth rates over the past three quarters.

We continued to increase the attachment rate of our engagement ring customers buying their wedding bands from Blue Nile. In addition, we also recognize that an equally important contributor to growth are new customers buying their wedding bands from us.

Our international business drove $18.0 million in sales, up by 4.8% and equal to 16.8% of the company’s total revenue. On a constant currency basis, international sales grew by 6.7%. The currency headwinds we experienced earlier this year primarily in Canada and Australia continued in Q2.

In contrast, sales in Asia-Pacific grew by nearly 15% and continues to represent over 50% of our total international revenue. This result was driven by our performance in greater China. We continue to see this international marketplace as the number one opportunity for long-term growth and have an ongoing plan in place to enhance our customers’ experience in the market.

For the overall business gross profit as a percentage of net sales was 18.9% compared to 18.6% last year, an increase of 30 basis points. In total gross profit was $20.2 million compared to $20.1 million in Q2 2013, an increase of $100,000. We posted increased margin rates as the mix of revenue shifted from engagement products to non-engagement, and improved profitability was driven across the sales of wedding bands and other jewelry.

We note that with scale in our customer base and with the development of our non-engagement products we have the opportunity to continue to increase our gross margin rates. However, we also recognize the opportunity to invest more in the prices of our loose diamonds now to drive greater sales and profitability in the future.

As Harvey mentioned earlier, we began to make these investments at the end of Q2 and expect these to impact the financial performance in the second half of the year. Our guidance for the rest of the year includes the expectation of reaccelerating revenue growth along with a moderate reduction in our gross margin rates. We are able to invest more significantly in lower margin rates for the sale of loose diamonds while benefitting from the continued shift in mix of revenue coming from the sale of higher-margin, non-engagement products.

Non-GAAP adjusted EBITDA income for Q2 was $5.2 million, decreasing by $300,000 and equal to 4.9% of net sales. Net income for Q2 remained flat at $2.2 million year-over-year, and diluted earnings per share increased to $0.18 versus $0.17 last year. Net income per diluted share includes stock-based compensation expense of $0.05 in Q2 compared to $0.07 in Q2 2013.

SG&A expense totaled $17.0 million for the quarter compared to $16.7 million in Q2 2013, an increase of $300,000. As a percentage of net sales, SG&A was 15.9% compared to 15.4% for the same period last year. Marketing expense as a percentage of revenue remained flat at 5.2%.

With the short-term volatility in the price of diamonds we’re focused on driving qualified traffic in a cost-effective way to our website. We also continue to roll out improvements in the user experience across mobile devices, tablets, and on the PC. We believe these are important investments and coupled with actions we’re taking to lower diamond prices we’ll increase conversion rates which in turn drives greater scale, operating leverage and long-term profitability. In total these actions and our expected results will benefit our customers, our suppliers and our shareholders.

We ended the quarter with $39.5 million in cash compared to $47.3 million last year, representing a decrease of $7.8 million. Cash flow from operations over the trailing twelve months equaled $18.8 million, and the decrease in our cash balance is due to our repurchase of sales. Year-to-date through August 1st we purchased 1.2 million shares for a total of $40.3 million, in line with the plan we announced at the beginning of the year. Specifically in Q2 we purchased approximately 675,000 shares for a total of $22.2 million.

Now I’ll conclude this portion of the call with a discussion of our guidance for Q3 and full-year 2014, and then turn the call over to the Operator to take your questions. For Q3 of 2014 we expect net sales to be between $105 million and $108 million and earnings per diluted share between $0.13 and $0.16. There are a few items that I’ll highlight in these ranges. First, our guidance for net sales represents growth between 6% and 9% in the quarter. We began to see improvement in our growth rates at the end of June and this accelerated through July. We believe much of the improved performance is driven by our investments in pricing.

Second, as I mentioned earlier, we expect gross margin rates to contract in the quarter and this will be partially offset by efficiency gains in the other areas of our cost structure. Third and final, it’s important to note that EPS last year included a one-time tax benefit equal to $0.08 for out-of-period tax adjustments. Excluding this benefit our range of guidance for EPS is generally in line with last year’s performance.

For the full year we expect net sales between $475 million and $490 million and earnings per diluted share between $0.81 and $0.86. Our expectation for the full year includes accelerating revenue growth rates in Q4.

I’ll turn the call now over to the Operator so we can take your questions.

Question-and-Answer Session

Operator

(Operator instructions.) And our first question comes from the line of Ross Sandler with Deutsche Bank.

Ross Sandler – Deutsche Bank

Hey guys, thanks for taking the questions. David, you just mentioned that you’re seeing improving growth rates in June and July from some of the price reductions, so why not just embark on a more aggressive strategy there? Do you guys see some elasticity as you get to certain price levels that it just doesn’t help at some prices? Or could you potentially accelerate your growth rates much further and kind of use that as a marketing vehicle?

And then Harvey, can you just talk about if you go back a couple years, a big part of the bold thesis around Blue Nile was improving the repeat purchase frequency from non-engagement. Can you just talk about where we are in that lifecycle, and then what do the repeat purchasing characteristics of mobile customers look like versus traditional desktop?

David Binder

Hey Ross, it’s David. I’m going to start with the question about pricing changes and then Harvey will follow up with the repeat rates. There’s a lot of complexity in diamond prices and supply which includes the level of inflation versus six months, nine months, or a year ago as well as what we’re seeing with consumers’ willingness to pay. And so there’s points and times that we recognize it makes sense to invest more in lower markups to drive more sales, and there’s also points and times when incremental changes in prices really aren’t going to move the customer.

What we learned in 2012 was that the dynamics of the market were such that prices were moving in one direction and we could make moves that would accelerate price changes that really got the customers going. And what we recognized coming out of June is that we were at a similar inflection point with some of the supply. What’s different now than a couple of years ago is that we have more data, more history and really more IP around this, and we’re applying an ever-growing and evolving level of science around the analytics to figure out where we could not only lower prices to drive sales but also moderate that investment in pricing to make sure that we maintain reasonable margins, which really enables us to invest in other areas.

So I think it’s an exciting part of what we’re doing, really providing a lot more science and analytics to the problem and the opportunity, and we’re definitely in a better position now than we were in 2012.

Harvey Kanter

Ross, on the comment about repeat rate, what I can tell you is basically we’re seeing a modest growth in the repeat rate and it’s definitely more relevant than the new customer growth. So we continue to believe new customer growth is important, but as you might imagine with the increase in diamond prices versus the core customer who has had the experience already on Blue Nile, we are seeing a modestly improved rate of repeat versus new customers.

And specifically on a mobile phone we continue to see the lion’s share, at this point the majority of traffic coming from a mobile device. While it’s not accelerating at the same pace it was it continues to be the most improved and relevant part of the traffic at this point and we’re seeing a greater level of revenue attribution, partially driven by repeat, partially driven by new but in general for the total company repeat rate is outpacing new.

Ross Sandler – Deutsche Bank

Great, thanks guys.

Operator

And our next question is from the line of Rohit Kulkarni with RBC Capital Markets.

Rohit Kulkarni – RBC Capital Markets

Great, thank you. On just a different question on elasticity – have you tried or tested any shipping elasticity, as for example one of the other Seattle ecommerce companies has tested shipping elasticity quite a bit. I would imagine for a high-ticket item like for a diamond somebody would be willing to wait a month to get the right price particularly in this volatile environment. And second is any updates on your relationships with your diamond suppliers, as in how does all the volatility change your ability to get inventory listed through all the contractual obligations that you have? And does that change the amount of inventory that you have online?

David Binder

Rohit, this is David. On the shipping elasticity, I’m not sure that I understand the question specifically so I’ll answer and you can ask again if I don’t get to it. We offer free shipping virtually for any engagement purchase or diamond purchase, free shipping overnight. And we can do that because the unit economics provide enough margin for us to invest in that customer experience and we think it’s very important for the customer to get the product as soon as it’s ready to ship to them. So free overnight shipping via FedEx is a fundamental tenet of the service that we provide and we don’t think that there’s marginal improvements we can do in that part of the business to acquire more customers.

Diamond suppliers is an interesting area of development for us. Harvey mentioned earlier that we have over 160,000 diamonds listed on the site and our supply is deeper now than it’s ever been in the history of the company. We are working more closely with them on some of the analytics that we talked about around pricing to help encourage them to do things that are really appropriate for the business, whether that’s accelerating turns or mining margins and it all depends on the life cycle of the supplier. In all of this our supply base is very important and we are continuing to invest more dollars in marketing than we ever have, more margin points to ensure that diamond suppliers who list with us turn their inventory or maximize the margins as best they choose.

Rohit Kulkarni – RBC Capital Markets

Okay. Just as a follow-up on the shipping elasticity, what I meant was have you considered a use case wherein perhaps not overnight shipping but potentially offering a more delineated shipping with the promise or the potential promise of a lower price, particularly around the volatile pricing environment as for example Zulily does with baby products?

David Binder

Yeah, I think for us when the customer has made the purchase decision and they’re ready to propose they really value getting that ring as quickly as possible. And we have an interesting business model where it’s very technical, it’s rich in education and guidance and counsel. At the point when the customer has made the purchase decision it becomes a bit more of an emotional decision and a deeper emotional connection, and for us at that point providing quick and excellent customer service we think is more important than saving the potential dollars on shipping.

Rohit Kulkarni – RBC Capital Markets

Huh, okay. Got it. And one more quick one – and updates on competition from offline players, their online culled parts or any other online players as you’ve seen this tough environment over the last few weeks, couple months?

Harvey Kanter

We wouldn’t say that there’s anything specific in the market now versus what’s been the trend over the past couple of years. It’s a highly competitive market. We all are trying to wow our customers in our own way specific to our business model and nothing has really fundamentally changed.

Rohit Kulkarni – RBC Capital Markets

Okay, thanks for the questions.

Operator

And your next question is from the line of Trisha Dill with Wells Fargo Securities.

Trisha Dill – Wells Fargo Securities

Good morning, thanks for taking my questions. Just first a question on non-engagement. You talked about growth in wedding bands accelerating and growing 15% during the quarter, so just taking that a step further is it fair to say that non-engagement as a whole ex diamond sales accelerated versus the previous quarter? Or is there anything else to point out in terms of softness in the consumer outside of diamond price volatility?

David Binder

Hey Trish, it’s David. That’s a great question. If you look at our product sales and exclude the elements that have spot market prices around diamonds associated with them, growth rates were significant double-digits and exceeded all of the other subcategories that we talk about. And that comes in an environment where we spent less on marketing this year versus last year, so for us that tells us that the rest of what we’re doing is working outside of the volatility around diamond prices. We’re generating good traffic to our properties. The products are good and the conversion rates are good, and that’s one of the data points that really highlights to us that it’s a current market trend around diamond prices that’s affecting us more so than anything else.

Harvey Kanter

And Trisha, this is Harvey. The other data point that we mentioned and you might not have caught is the designer collective and the other category continues to evolve and we’re happy and comfortable with our designer collective offering. We’re very happy with Monique’s business and continued acceleration.

And we’ve talked about it before but we will formalize that we will be launching another designer that we like to think of as the same level and significance as the designer collective now on a national basis across both bridal and non-engagement jewelry, and we believe it’ll be a pretty meaningful addition to the collective and more importantly continue to accelerate our efforts around non-engagement. And that will be launching in early Q4 and we’re excited about that launch. We’re not yet at a point where we can announce the designer but it’s a pretty material and meaningful introduction.

Trisha Dill – Wells Fargo Securities

Okay, great. And then just wondering if you have any updates on your brick and mortar tests, thanks.

Harvey Kanter

You know, the last word you used is probably the best word – it is a test. It continues to be a test. We’re learning a lot of things. One of the things we’re seeing is that the customer is definitely responding but we’re in a learning mode and we really don’t have a view of what will happen as we move forward, not because there’s not opportunity but we’re trying to navigate what’s the best balance in terms of our model, our strategy and ultimately converting the customer and creating exposure for the brand. So all-in we’re happy and comfortable with where it is but it is a test and continues to be just that.

Trisha Dill – Wells Fargo Securities

Okay, thanks.

Operator

And your next question comes from the line of Paul Bieber with Bank of America.

Paul Bieber – Bank of America

Hi guys, thanks for taking my questions this morning. I was hoping that you can provide a little bit of color about the improved growth that you’ve seen since you implemented the changes in late June and then secondly how’d you characterize your progress in improving the mobile conversion rates as we move into the second half? Have you made the progress, are you satisfied with the progress and are you where you want to be for Q4?

David Binder

Hi Paul, this is David. I’ll start with the second question and then go to the first. We continue to roll out the elements of the adaptive platform and we’re seeing actual improved conversion rates across each platform – mobile, tablet and PC are all seeing higher revenues per visitor and higher click-to-convert rate. We’re also seeing that the shift from PC to tablet and to the phone more specifically continues to happen at a very fast pace, and obviously conversion rates and revenue per visitor for us on the phone are the lowest. So we’re making progress on getting each platform performing better and we’re somewhat offsetting that improvement with shifts toward the lower-performing platforms.

We’re actually very optimistic that some of the things that we continue to work on and some of the things that we’re launching now well before peak will actually help us in the long run with an inflection point on this, and if we get diamond prices where we hope they can be that this can come together really well for us.

Paul Bieber – Bank of America

And then my first question, can you provide a little color on the improved growth since you implemented the changes?

David Binder

Sure, yeah, thanks for asking that again. We really saw it happening at the second half of June, and I can’t go into the specific numbers too much but I will say that the last three weeks of June took us from somewhat flat to decent improvements in growth; and July was much more significant. And so we recognize that we have to be a little bit cautious because diamond prices continue to be volatile but the sequential improvements were encouraging and definitely reflected in our guidance range.

Paul Bieber – Bank of America

Okay, and one quick follow-up on the guidance. Are there any share repurchases included in the outlook?

David Binder

No, and we don’t include share repurchases in the diluted share count.

Paul Bieber – Bank of America

Okay, thank you.

Operator

(Operator instructions.) And our final question does come from the line of Rick Patel with Stephens.

Rick Patel – Stephens Inc.

Hi, good morning everyone, thanks for taking the question. International had much better performance versus the US despite the inflationary diamond pressure, which I would think is a global issue. On the engagement side specifically I would think that everyone’s either a first- or second-time customer, so how should we think about that disparity? Are international customers just more resilient right now? Is there something structurally different about international markets that makes inflation less of a concern? Just help us think about that.

David Binder

Hey Rick, it’s David. Definitely the international business performed better than the US but I wouldn’t call it necessarily robust. And international definitely saw headwinds from rising diamond prices and we could see that more so in our mature markets where we’ve gotten deeper penetration in the addressable market. Where I think we do well in particular is in Asia where we’re at a pretty early stage of the customer penetration –relatively small given the size of the addressable market. And so growth rates can hold up pretty well when the scale of your business is relatively small. And I would say that if diamond prices were less volatile we would have expected better performance coming from international.

Rick Patel – Stephens Inc.

Alright. And then can you give us a little bit more color on your new designer collaboration? It seems like you’re pretty happy with the progress you’ve made so far. Maybe highlight what’s going right, what you need to improve upon and to what extent you’re committed to your existing designers for the long term or are you going to remain nimble based on what you see play out in the marketplace?

Harvey Kanter

Yeah, it’s Harvey. We wouldn’t divulge everything so to speak about strategy, but at a broad macro level what we’ve said is that we will bring some designers in and they will be more evergreen in nature, and we will expect to have multiyear relationships with them. Monique is a perfect example of that where we expect to move forward that for the foreseeable future and quite a few number of years.

Some of the designer collective which are more emerging designers where we’re curating a mix, in cases where they’re very good we may still take them out of the mix because some of the challenge and opportunity for us is to continue to bring newness on the site for new customers and interests; and in other cases where they obviously may not work as well we will certainly take them off. But we expect a portion of the mix will evolve and a portion of the mix will be evergreen.

In terms of the new designer we have emerging designers which are very important and significant in their own regard but maybe not as visible or well-known as Monique. The designer we’ll be launching in fall is more of the caliber of Monique and is very well-regarded with an established following that we feel really great about. And the reason we’re launching both across bridal and jewelry is the success of Monique, and that has been really well done.

As you might recall we launched initially the bridal; a year later rolled out diamond jewelry and across both of those categories it’s worked really well and given us [an interval] of confidence that that design – which is really understated and classic but yet very on point with our target customer – is resonating. And so we’re moving forward with that in a more meaningful way.

Rick Patel – Stephens Inc.

Thanks very much.

Operator

And we do have a follow-up question on the line from Paul Bieber with Bank of America.

Paul Bieber – Bank of America

Hi guys, one housekeeping issue – did you say what the advertising expense was in the quarter?

David Binder

We said the advertising expense was 5.2% of revenue in the quarter which was the same rate as the prior year.

Paul Bieber – Bank of America

Okay, thank you.

David Binder

You’re welcome.

Operator

And we have no further questions in queue at this time. I would like to conclude today’s call. Thank you for joining, you may now disconnect.

David Binder

Thanks everyone for joining the call today.

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