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Blue Nile, Inc. (NILE)

Q4 2006 Earnings Call

February 12, 2007 5:00 pm ET

Executives

Nancy Shipp - Director, Investor Relations

Mark Vadon - Chairman of the Board, President, Chief Executive Officer

Diane Irvine - Chief Financial Officer, Director, President

Analysts

Scott Devitt - Stifel Nicolaus

Jim Friedland - Cowen & Company

Mark Mahaney - Citigroup

Douglas Anmuth - Lehman Brothers

Julie Charsest - Merrill Lynch

James Hurley - Telsey Advisory Group

Dan Geiman - McAdams Wright Ragen

Presentation

Operator

Good afternoon, ladies and gentlemen. My name is Gerald and I will be your host and operator on this call. (Operator Instructions)

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

Nancy Shipp

Good afternoon and thank you for joining us on our conference call today to review our fourth quarter and fiscal year 2006 financial results. With me today are Mark Vadon, Chief Executive Officer and Chairman of Blue Nile; Diane Irvine, President and Chief Financial Officer.

During this call, we will discuss non-GAAP financial measures that supplement Blue Nile's consolidated financial statements presented in accordance with generally accepted accounting principles. We will discuss non-GAAP free cash flow, non-GAAP net income, non-GAAP operating income, non-GAAP SG&A costs, and adjusted EBITDA.

We report these measures to provide an additional tool to evaluate our operating results and financial condition. Please refer to our website at www.bluenile.com to obtain a copy of our non-GAAP financial measures, which contain a full reconciliation to their nearest respective GAAP financial measures.

As a reminder, during the course of this call, we will make forward-looking statements, including without limitation statements regarding expectations of future financial performance, net sales, gross margin and expenses, net income, operating cash flow, stock-based compensation expenses, capital investment and other financial statement or balance sheet items, as well as statements about 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. Actual results may differ materially and adversely from any projections in forward-looking statements given by management. Our quarterly reports on Form 10-Q, our annual report on Form 10-K, and other forms on file with the SEC identify important risks and uncertainties that you should consider when making an investment decision regarding Blue Nile, and they may affect whether our forward-looking statements prove to be correct. We undertake no obligation to publicly update or revise these forward-looking statements.

At the conclusion of the call, we will conduct a question-and-answer session. Now, I would like to introduce Mark Vadon, Chief Executive of Blue Nile.

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Mark Vadon

Thank you, Nancy, and good afternoon, everyone. Welcome to our fourth quarter and fiscal year 2006 conference call. 2006 was an outstanding year for Blue Nile, as we delivered strong financial performance while enhancing our strategic position. We increased our share of the U.S. diamond engagement ring market, expanded the percentage of our business coming from fine jewelry other than engagement rings, and continued to build our international business. We accomplished all of this while generating strong profitability and cash flow.

I believe our performance in 2006 was exceptional, particularly since we started off the year with the headwinds of a difficult fourth quarter in 2005 and a challenging environment for online marketing. We made the decision early in the first quarter of 2006 to be more aggressive in our retail pricing and our customers responded overwhelmingly. Because we focused on maximizing our dollar profit growth and free cash flow, we believe that this pricing strategy would provide an even greater ability for us to manage the balance between sales growth and earnings.

You can see from our results for 2006 that this strategy was successful. However, I believe that this strategy was even more important for our business when viewed from a longer term perspective. Our low-cost position and pricing strategy represents a significant competitive advantage in an industry where relative pricing is so important. We are a young business that is in the early stages of transforming the way consumers purchase diamonds and fine jewelry, and as a result, our business is very much about acquiring new customers and capturing market share in a competitive marketplace.

I believe we are a much stronger company today with an even better competitive position than we were a year ago. We exited 2006 and entered 2007 as the world leader in online diamond and jewelry retailing. In 2006, we continued to do what we do better than anyone in the world and that is to offer an exceptional customer experience through an unmatched selection of high-quality diamonds, coupled with our unique diamond jewelry customization capabilities.

Our obsessive focus on the customer has helped us and will continue to help us grow market share. We were able to deliver great results for the year due to the strengthening of our core business and our focused execution.

We continue to innovate throughout the business in 2006 -- in our website features and functionality, in our product offerings, in our marketing initiatives, and throughout our operations. We are extremely well-positioned to capitalize on the many opportunities that lie ahead.

I would like to review an example to relate to you how we are constantly innovating in our business on behalf of our customers. Beginning in the fourth quarter, we shortened our lead times for shipments of customized diamond jewelry to take one day out of the process. This reduced the lead time for customized jewelry from four days for most diamonds and three days for our signature collection to three days and two days respectively.

The result of this for Valentine’s Day is that customers are able to order customized diamond engagement rings from Blue Nile up until noon Pacific Time today, just a couple of hours ago, in time for receipt of their rings on Valentine’s Day this Wednesday. No one else in the industry performs at this level.

To make this happen, our key goals for 2007 are simple. First, we will remain laser-focused on generating profitable growth. We are building market share in the U.S. market for diamonds and jewelry. This market continues to be our first priority and our largest opportunity.

Second, we will expand our business internationally through an increased presence in the U.K. While our international sales are still relatively small, we are seeing great growth in this business and continue to see tremendous opportunity.

Third, we will continue our efforts to perfect the Blue Nile experience for our customers, so that they become Blue Nile customers for life and a great source of referral.

Fourth, we will continue to have an overall focus on disciplined cost management throughout the company in accordance with our goal of achieving even stronger growth and profitability than in top line performance.

Finally, and perhaps most importantly, we will continue to invest in our team, which I believe is today among the strongest management teams in all of e-commerce.

With respect to our team, we announced today that Diane Irvine has been promoted to the position of President and I want to tell you how happy I am about this announcement. Diane has been my partner at Blue Nile for the past seven years, as we have built Blue Nile into the leading online retailer of fine jewelry. From the beginning, we have had a goal to build Blue Nile into an iconic consumer business, and Diane shares my passion for and dedication to that goal. I look forward to continuing to work together with Diane and our incredible management team as we lead the company into its next phase of growth.

I am now going to turn the call over to our new President, Diane Irvine.

Diane Irvine

Thank you, Mark. We started off the year 2006 facing challenges in terms of the environment for online marketing, where costs had risen dramatically. We made the strategic decision to become more aggressive in our retail pricing early in 2006, and our customers responded overwhelmingly. This helped us to achieve sales growth of 23.8% for the year. We delivered more than $250 million in net sales in 2006, which is a tremendous milestone for our company, less then eight years after the start of our business.

We generated $20.6 million in non-GAAP operating profit for the year, and ended the year with $98.4 million in cash, even while we repurchased more than $57 million of stock during the year.

Net income for the year totaled $13.1 million, or $0.76 per diluted share. Our net income for the year includes approximately $4.1 million of stock compensation expense under FAS-123R, which Blue Nile adopted at the beginning of our 2006 fiscal year. Excluding this stock compensation expense and the related income tax affect, non-GAAP net income was $15.7 million, or $0.90 per diluted share for the year, an increase of 26.8% over 2005 earnings per diluted share of $0.71.

I would like to review our non-GAAP free cash flow, which we view as our most important financial measure as it relates to delivering value to our shareholders. As a reminder, we define free cash flow as cash flow from operations less capital expenditures.

For the year, we generated free cash flow of $38.6 million, an increase of 27.8% from $30.2 million for 2005. Net cash provided by operating activities increased 29.6% to $40.5 million for the year, compared to $31.3 million for 2005.

Our free cash flow results reflect strong revenue growth as well as the favorable working capital dynamics inherent in our business model. We achieved significant improvements in working capital management during the year and we believe there is great opportunity to continue to drive working capital benefits in the years ahead.

Now I would like to recap some of the highlights related to our fourth quarter. We achieved record net sales, record income before income taxes, and record free cash flow. Our net sales growth was robust and our profitability was exceptional. We enhanced our competitive position as we saw excellent growth in our key markets and continued strength in our repeat and referral business.

We executed with excellence in all areas of the business and demonstrated once again our ability to generate both growth and profit.

Net sales grew by 23.9% to $90.7 million, with net income of $5.8 million, or $0.35 per diluted share. Our net income included $1.2 million of stock compensation expense under FAS-123R. Excluding this stock compensation expense and the related income tax effect, non-GAAP net income was $6.5 million or $0.39 per diluted share for the quarter, compared to GAAP net income of $5.3 million, or $0.29 per diluted share in the prior year, an increase of 34.5%.

Importantly, free cash flow for the quarter increased 28% to $47.1 million, from $36.8 million in the prior year.

Let’s review some of the key drivers behind our fourth quarter results. First, our holiday season sales were fantastic, with revenue growth remaining strong in virtually all product categories. We offered consumers an even broader selection of fine jewelry, from diamonds to sterling silver. Among our most successful gift items for holiday were our new sterling silver charm bracelets, as well as our new Journey Diamond pendant line and diamond eternity necklaces up to $70,000.

In diamond jewelry, sales grew significantly in large carat sizes and higher price points. We had 40 transactions of $50,000 or more during the quarter, an increase of 74% over the prior year.

We believe that our aggressive diamond pricing strategy was very effective in generating profitable growth.

I would like to take a moment to discuss our international business. In the fourth quarter, we generated approximately $2.9 million in net sales through our Canada and U.K. websites. This represents 66.9% growth compared to the same period last year. For the year, we generated approximately $8.3 million in net sales through these websites. Growth in this part of our business will increasingly become a priority for us in 2007.

In the fourth quarter, traffic to our website, conversions, and average order size all showed healthy increases. Total orders increased 21% during the quarter, as compared to a year ago. Our average selling price per order was $1,314 compared to $1,284 a year ago, representing a year-over-year increase of 2.3%.

We performed very efficiently in our marketing efforts during the quarter. Our investments in key marketing initiatives and channels are generating positive results and contributed to our Q4 performance. We continue to innovate and optimize within each of our marketing vehicles and our focus is on generating a profitable return on our investment.

This disciplined approach has been extremely successful for us in an inflationary online marketing environment. We are constantly digging deeper and driving efficiency with data-driven analysis, testing, and feedback.

In the fourth quarter, we continued to perfect the execution of our customer experience. Our relentless focus on the basics, the many details that make up the Blue Nile customer experience, is the foundation upon which we have built Blue Nile and our execution throughout the business was strong in Q4.

We survey every one of our customers about the quality of their experience with Blue Nile. In the fourth quarter, our customer satisfaction rating increased to 4.5 on a 5-point scale, from 4.43 in the prior year. Our focus has led to a growing base of customers who are passionate about Blue Nile and who are not only returning to purchase from us but are also referring their friends to Blue Nile.

From the quality of our products and our compelling value proposition, to our expert customer service and our industry-leading shipping times, we focus on creating a perfect customer experience.

I would now like to turn to more of the details of our profitability in the fourth quarter.

Gross profit for the quarter was $18.7 million, compared to $16.1 million in the fourth quarter of 2005, an increase of 16% year over year. We are extremely pleased with this gross profit growth, which represents our highest quarterly growth rate in 2006.

Our gross margin for the quarter was 20.6% as compared to last year’s fourth quarter gross margin of 22%. While our gross margin was lower year on year, primarily as a result of the aggressive diamond pricing strategy we implemented during the first quarter of 2006, the year-on-year gross margin differential of 1.4 points reflects our strongest year-on-year quarterly comparison for 2006.

Our Q4 results reflect our keen focus on execution throughout the business. We performed at a high level for our customers and also demonstrated the very disciplined cost management that has become a hallmark of our operations. In so doing, we delivered outstanding results for the quarter.

We continued to realize economies of scale in our SG&A costs. Overall, our non-GAAP SG&A costs, which exclude stock compensation expense under FAS-123R, represented 10.4% of net sales in the fourth quarter, compared to 11.8% in the fourth quarter a year ago.

In addition, our adjusted EBITDA performance during the quarter was exceptional. Adjusted EBITDA, which we define as net income before income taxes, interest, depreciation, amortization and stock compensation expense, was $9.8 million for the quarter, an increase of 22.4% from EBITDA of $8 million in the fourth quarter of 2005.

This represents the highest incremental adjusted EBITDA performance of any quarter in the year. We were able to achieve superb profit margins in the fourth quarter as the result of our focus on execution and cost management.

Interest income was $787,000 for the quarter, compared to $776,000 in last year’s fourth quarter. Our effective tax rate for the quarter was 35.5%, compared to 36% for the fourth quarter of 2005. Our effective tax rate for fiscal year 2006 was 34.6% compared to 36% for fiscal year 2005.

I would also like to provide an update on our share repurchase program. During the fourth quarter, we repurchased approximately 92,000 shares for an aggregate purchase price of $3.2 million. Ideally, we would have like to purchase more shares and we will continue to look for those opportunities.

After these share repurchases, we ended the year with $98.4 million in cash and marketable securities. Since the inception of our share repurchase program in February 2005, through the end of 2006 we have retired more than 13% of our outstanding shares for an aggregate purchase price of $74.8 million, an average price of $31.79 per share.

As of year end, $93.2 million remained to be spent under our total stock repurchase program of $150 million. Our share repurchase program underscores our confidence in the long-term prospects for our business, as well as our commitment to enhancing value for our shareholders. Our strong balance sheet and continuing strong cash flows allow us to fund our operations, opportunistically repurchase our shares, and continue to grow the business for the future.

Looking ahead, I would like to review our financial guidance for the first quarter and fiscal year 2007. This is the first time that we are providing financial guidance for 2007.

For the first quarter ending April 1, 2007, we expect net sales to be between $61 million and $63 million. Net income is expected to be $0.14 to $0.15 per diluted share. This guidance includes the estimated impact of stock compensation expense of approximately $0.05 per diluted share.

For fiscal 2007, we expect net sales to be between $290 million and $300 million. We expect net income per diluted share to be between $0.80 and $0.85 for the year. The estimated net income per diluted share includes the estimated impact of stock compensation expense of approximately $0.24 per diluted share. Actual stock compensation expense for the year will be based on the nature, timing, and amount of stock options granted, the assumptions used in valuing these options, and other factors.

Capital expenditures for the year are expected to be approximately $4 million. This amount includes an estimated $1.8 million related to the expansion of our fulfillment center.

The effective tax rate for financial statement purposes for the year is expected to be approximately 35.4%. The estimated effective tax rate does not include any potential impacts from the exercise of stock options.

In summary, we are pleased with our strong financial performance for the fourth quarter and fiscal year 2006. We are proud of what we accomplished during the year and we look forward to a successful 2007.

I would like to turn the call back over to Mark for some closing comments. Mark.

Mark Vadon

Thank you. In closing, we want to thank our investors and analysts for participating on today’s call. As we reflect on our fourth quarter and 2006 results, we are proud of the success we have achieved thanks to the commitment of our employees who establish a standard of excellence for the Blue Nile brand each and every day.

I truly believe that Blue Nile is in the very early stages of building a great consumer business. With exclusive Internet rights to a vast selection of diamonds, the most efficient cost structure in the jewelry retailing industry, and a growing base of customers who are ecstatic with their Blue Nile experience, we are uniquely well-positioned for long-term success.

I believe we have tremendous growth opportunities ahead of us and we are dedicated to capturing those opportunities and generating profitable growth into the future.

This is the end of our formal presentation and we will now open up the call for any questions you may have. Operator, will you please poll for questions?

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from Scott Devitt of Stifel Nicolaus.

Scott Devitt - Stifel Nicolaus

Thanks, and congratulations, Diane. I have just a few questions. First, the free cash flow generated for the full year, could you give us a gauge as to what the cash tax rate was embedded in that free cash flow so we could try to come to an ’07 number?

Diane Irvine

Sorry, Scott, could you ask me that again?

Scott Devitt - Stifel Nicolaus

Sure, the cash tax rate, or maybe just the cash taxes in absolute dollars that were paid in 2006?

Diane Irvine

Yes, I do not have the absolute dollars, but it was small last year, so most of the taxes are in accrued liabilities and will be paid in the first quarter of this year, and so that will be a difference, as you know, because we really burned off the NOL as we came into the third quarter of ’06 as opposed to earlier in the year. So this year we will have full cash taxes for the whole year in ’07 as opposed to a very small amount last year.

Scott Devitt - Stifel Nicolaus

Okay, so should we expect free cash flow growth?

Diane Irvine

Well, while we are not giving guidance, I would say you will see a bigger impact in ’07 from the fact that we do not have the deferred tax add-backs, Scott. So likely, you will see a one-time change downward in the free cash flow in ’07, related to the cash taxes.

Scott Devitt - Stifel Nicolaus

Okay, and on the international business, I thought I saw somewhere that you had attained a status, attained a business status in Ireland. Is that related to expansion or something else?

Diane Irvine

No, that is exactly right. That is looking at a physical presence in the U.K. for this coming year.

Scott Devitt - Stifel Nicolaus

Okay, and then finally, incremental operating margins I think this quarter were 11%. It is the highest rate it has been in over a year, and they have been positive for three quarters now. In 2007, you are going to lap the price adjustment so should we expect incremental operating margins to sustain the high-single digits in ’07 on an incremental basis?

Diane Irvine

Yes, and I think that incremental operating margin, Scott, was the real story of Q4. I mean, that was a tremendous performance for us. So if you look at the gross margin dollar growth, the gross profit growth of 16% for the year, that was our highest growth, so there is a very healthy underlying business there. So I think as we anniversary the price change from a year ago, which we did just a few days ago, we feel good about what is there in the underlying business and our ability to show continued leverage.

Mark Vadon

Yes, I think in Q4 we had two things: one is we started to close that gap on the year-on-year of gross margin percentage differential. A lot of that came about because in the diamond area, we were seeing opportunities to take a little bit of extra margin in the marketplace.

So we were able to close that gap while doing I think a great job of managing the cost structure, and I think both of those impacts will carry over into the year.

We had a great start to Q1 and have been very, very strong starting out the quarter. That being said, we just lapped the price increase a couple of days ago, so to some degree, we feel like we are in a position to have a really good quarter, but there is a little bit of uncertainty out there as we go over that change in pricing. But if things continue as they are, I think you are going to see very healthy incremental profit growth because the gross margin should come back into line with where they were a year ago, or maybe even be, knock on wood, maybe even a little bit higher than last year, and at the same time, we have the cost structure leaned out from where it was a year ago.

Scott Devitt - Stifel Nicolaus

At the risk of asking too many questions, any thoughts on this Rapaport features exchange and anything that they are doing, or is that a non-event?

Mark Vadon

I think people have been talking about trying to create a futures market for diamonds for a long time. We have not seen anybody actually do it, so I think it is, at this time, kind of speculative out there. Even if it does happen, I do not really think it will have much impact on us. Potentially, it will make it easier for us and a number of other people to kind of manage the price changes in the marketplace, but it is a pretty tough industry, I think, to create a financial vehicle like that.

I think it is still early and we have heard people trying to create an exchange like that for years now.

Operator

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

Jim Friedland - Cowen & Company

Thanks, a couple of questions. First, on the gross margin, so on a year-over-year basis, even given the price decrease, there was a significant improvement there. It was down something like 3 percentage points year over year and much less than that in Q4. Did some of that have to do with the mix toward in Q4 of non-engagement rings? As a second part of that, you had also talked about commodities prices increasing earlier in the year, but you did not say much this time. Did you get any relief there?

Based on your answer to the previous question, as far as pricing strategy goes, it sounds like you are not thinking about another price cut here. Am I correct in interpreting that?

Diane Irvine

Thanks, Jim. In terms of our strategy, you are absolutely right. We are not planning a price reduction. We think the underlying business is very, very healthy. You saw continued growth in gross profit quarter on quarter through ’06. We feel great about that.

The mix helped a bit in Q4 in terms of you have a little bit less of the diamonds and engagement, but most of that change really was we were able to move up some prices, whether it was from metal cost increases or even on the diamond side in certain areas.

So I think the business was very, very healthy and we have narrowed that gap, so we, as Mark said, there is some uncertainty for the rest of the quarter, we feel great about where we are today and have now anniversaried that price reduction.

Jim Friedland - Cowen & Company

Just on the mix between first-time customers and repeat customers, you had said that had improved in Q4. Is it still generally 80-20, or was there a material increase?

Diane Irvine

Yes, we have moved slightly above 20 now for our repeat business in terms of dollars, but repeat was a little bigger piece of our business this quarter than in the past, so that has continued to grow every quarter. Our e-mail program has done phenomenally well. A lot has happened there in terms of segmenting our customer base and testing e-mails, so I think that has gone very, very well. That is another part of the business that looks so great that really gives us confidence as we move ahead and look at this year.

And our goals this year, as we move through that price reduction anniversary, is to continue to increase our conversion, whether it be from website improvements, traffic increases. I think traffic was up double digits in the quarter. We are getting very high-quality traffic, so we are not focused on traffic growth for its own sake, but getting the right traffic. So all of that looks really great.

Jim Friedland - Cowen & Company

Okay, thanks a lot.

Operator

Your next question comes from Mark Mahaney with Citigroup.

Mark Mahaney - Citigroup

Thank you very much. You I think at least once during the script mentioned that you thought Nile gained share in 2006. Could you quantify that, to what extent you gained share during the year?

Mark Vadon

I think as we were talking about gaining share in the industry, we are really talking about the overall jewelry industry, which I do not think there are any hard number out there right now, but has been growing kind of low to mid-single digits versus our growth that we see out there.

As far as gaining share in the market for the Internet market for jewelry, I think it is a lot harder. We saw one statistic out there in the marketplace that the online jewelry market grew by 67%. That seems pretty far-fetched to us, honestly, but I do not think there is anybody doing a great job of tracking how fast this market is growing.

Mark Mahaney - Citigroup

You had mentioned the conversion rates rose, using third-party data and with all the caveats associated with that. It also seems to indicate your conversion rates rose this December quarter. Could you single out perhaps one or two factors that may have caused that? I know you mentioned the improved shipping times, but were there particular techniques that worked at exiting the third quarter, entering the fourth quarter that were particularly effective in proving that conversion rate?

Mark Vadon

Sure, and you know, that is the case. We saw traffic growth up in the double digits. That was some of the better traffic growth we have seen in a couple of years. But on top of the traffic growth, and as traffic growth gets higher, actually increasing your conversion gets harder, if that makes any sense, because every layer of additional traffic you put on the site tends to be lower quality traffic. Obviously the first handful of visitors that come to your website organically convert extremely well, and then as you keep marketing and getting diminishing quality of the marketing, that goes down.

But despite the kind of acceleration and the growth rate of traffic, we did see good improvement in conversion. I think it is hard to pinpoint it down to one thing. I would just point to a few things. One is better marketing, so as we are bringing in not just traffic but better qualified traffic, it tends to convert better. The repeat visitors definitely help that as well. People who bought from us before and come back convert at a tremendously high rate, and so as that mix changes over time, it improves conversion.

Better merchandising -- I think we had a phenomenal product offering out there and we had incredible selection at the high-end of diamonds, so I think we really had something for everybody who is visiting the site.

Then, just over the last 12 months, we put a tremendous amount of effort into upgrading the quality of the functionality on the site. We definitely made some huge jumps forward in the functionality to search for diamonds. We are showing roughly 50,000 or 60,000 diamonds on there, so we really need good robust functionality to help people sort through that and find the right one for them, and I think that was probably, as far as website innovation, that was probably the most important thing we worked on this year.

Mark Mahaney - Citigroup

One final question: Diane, you made a comment to the effect that you would have liked to have purchased back more shares in the quarter. Was there something to that statement? Were there factors, windows that limited the amount of shares you would have bought back in the quarter? I am just trying to peel back that statement. Thank you very much.

Diane Irvine

When you look at share repurchases, clearly that is a strategic objective within the company to deliver value to shareholders. We are doing our repurchases through a pre-planned program, and that is primarily because, to your point, Mark, we do have very short open windows.

So when you are doing it through a program, I think you just do not always hit it quite right in terms of what we are estimating. When we look at the program life to date since February of ’05 and the prices at which we have purchased shares, we feel we have done a good job in terms of the price we paid. So if you look at had we purchased all of those shares evenly over time with the dollar amount we spent, we have done more than 6% better than an open market purchase. But I think the question is would we be better off to just buy more evenly. We could get more volume done in that way, and we have tried to have the benefit of better than average costs.

That is the way we look at the program, Mark. So when I say that was probably a disappointment in Q4, our goal is to buy back more shares and I wish we had done that.

Mark Vadon

Yes, as Diane said, I think there is always a trade-off with the buy-back between dollar cost averaging into the stock versus trying to be more opportunistic. By being opportunistic we, as Diane was saying, we have paid about 6% less than if we bought an equal dollar amount every day the plan has been in existence. That is the positive. The negative is we probably have gotten back fewer shares than we would have liked. Internally, we continue to debate what the best approach there would be, and I think our thinking around that will continue to evolve over time. But if you look at our cash balance coming out of the year, we feel over-capitalized still, even with all the buying we have done over the last 12 months. We feel like there is too much capital on the balance sheet.

Operator

Your next question comes from Doug Anmuth with Lehman Brothers.

Douglas Anmuth - Lehman Brothers

Thank you. I was hoping you could comment, I know it is very early, obviously, but I was hoping you could comment on the early adoption of Google check-out thus far. Then, as I look on the site, it looks like there were a number of different types of products that Google check-out is not available for, including orders above $5,000, and then customized three-stone and five-stone rings.

I am wondering if you can comment on what the addressable percentage of your business you think that Google check-out currently applies to. Thank you.

Mark Vadon

We have been accepting Google check-out for roughly 10 or 15 days now, and the intent is to pretty quickly here accept it for a wider range of products, if not all products on the website. We started out with a $1,000 limit and have been upping that limit over time. Really, what we are trying to do is just handle fraud risk there as we move into this. There are a couple of other products, like you mentioned, three-stone ring, five-stone ring, and that is simply a little bit more technology work to do before we are ready to do that. All of those products, the three-stone, the five-stone, or build-your-own-rings are very unusual products from a technology perspective because they are custom-built, so it takes a little bit more effort to integrate those products into the pre-packaged payment plan that is out there.

More and more will be available. We have been very pleased with it so far. I think Google has been an excellent partner with us on the marketing front, and with this program, we are seeing customers adopt it and I think customers really trust that Google name, so hopefully it helps with conversion over time as well.

Diane Irvine

If you look at our tickets, Doug, we are probably the highest ticket retailer using the program. If you look at the units that we are selling, clearly the vast majority of the items that we are selling are eligible for Google check-out on a units basis.

Douglas Anmuth - Lehman Brothers

Diane, could you also just comment on your advertising spend during 4Q? Is it safe to think it was below the 4% of sales?

Diane Irvine

We are in roughly that 4% level. Yes, Q4 generally is a little bit better because of the volume levels, and that is our expectation for ’07 as well.

Douglas Anmuth - Lehman Brothers

Thank you.

Operator

Your next question comes from Julie [Charsest] of Merrill Lynch.

Julie Charsest - Merrill Lynch

Thank you, good afternoon. I was wondering if you could give us a little more detail on what is going to drive free cash flow in 2007 to help offset the higher cash taxes?

Diane Irvine

Sure, in terms of our free cash flow, the big components for us obviously are the income that we are generating, which will be better this year, and also the working capital dynamics. If you take a look at payables at the end of the year, that is something we continue to drive, so one of our goals when we talk about improvement in working capital management is our ability that we have shown over time to continue to extend our days payable. We were very successful at that in ’06, and I think there is a lot of room there as we look ahead, so while we will have reduction in the benefit from deferred taxes, as the business grows and we grow our cogs and have the ability to extend terms, then you will continue to have a great working capital dynamic as well.

Julie Charsest - Merrill Lynch

How long are your average contracts?

Diane Irvine

The average diamond supply contracts?

Julie Charsest - Merrill Lynch

Yes.

Diane Irvine

It is about five years, kind of three to five years.

Julie Charsest - Merrill Lynch

But in terms of the payable terms?

Diane Irvine

Oh, sorry, in terms of the terms of the payable.

Mark Vadon

It would be great if they were five years.

Diane Irvine

That is right. That would be a great working capital dynamic. Our terms are generally 45 to 60-plus days.

Mark Vadon

And that just depends on the product. There will be different suppliers are giving us different terms based on the product that they sell.

Diane Irvine

And if you look at certain products, we are 120 days plus, so -- but I am sticking to loose diamonds, which I thought might have been your question.

Julie Charsest - Merrill Lynch

Thank you.

Operator

Your next question comes from Jim Hurley of Telsey Advisory Group.

James Hurley - Telsey Advisory Group

Good afternoon. Congratulations for a great quarter, and Diane, especially to you for a promotion well-deserved.

Diane Irvine

Jim, thank you.

James Hurley - Telsey Advisory Group

My question is I would love to hear from all of you about just the competitive environment this holiday season, if you noticed anything different with brick and mortar retailers gravitating to the web, or maybe some independents getting a little bit more aggressive with their online presence?

Mark Vadon

Backing up, I think the season felt like a little bit of an odd one to us, as we were going the early part of the season looked really weak, and then it was about two weeks left in the season, maybe even less time, about 10 days left, the volume hit us tremendously. So it was a very, very back-ended season.

I think to some degree, we may have even -- it was so back-ended from consumers that I think that might have hurt us a little bit on the amount of revenue we were able to capture in those closing days of the quarter, or the closing days of the season. I think that was probably the thing that struck us as the most unusual.

I don’t know. I think there are many elements leading to that. I think some of it is people are becoming more and more confident with the ability of Internet purchases to be delivered in time for Christmas, and because of that, they just keep procrastinating. There may have been some weather impacts or other impacts as well, but it was definitely back-end loaded.

I think in general in the marketplace, we saw people being very, very promotional. That might have also been fed by the season being late. People might have gotten a little scared and started getting very promotional.

I think people were being very aggressive on pricing. If you look at surveys within the industry of the margin levels that jewelers are running at, year after year they keep coming down, and I think the Internet is having an impact on people’s margins. Probably at the low-end of the market, Wal-mart is having an impact on people, Costco is having an impact on people. But we are in an industry where traditionally, people were running a 50 margin and they are needing to cut and get more aggressive. I think we saw that continue through this season.

As far as people playing on the web, I think people in our industry continue to talk about the Internet, but we do not see much activity there, or much successful activity. I guess every year, we see new people kind of coming to the web and trying it out, but they do not last very long. I think it anything, over this last year, we saw the people on -- some of our traditional competitors on the web disappear, so I think the market continues to evolve. I think our whole industry is trying to figure out how to use the web or capture the web, but in more cases than not, they are doing that pretty unsuccessfully.

Diane Irvine

I would say also, Jim, when you look at who is on the web and look at Q4 behavior; I think that through 2006, we made so many improvements on the marketing side. I talked about how we are looking at each of those vehicles and channels and I think we have done a great job managing through that rising price environment. I think we feel great about our position and did not feel there was any negative impact from the competitive standpoint during the quarter.

James Hurley - Telsey Advisory Group

So you think you are still gaining I guess share of voice online with folks looking for jewelry?

Diane Irvine

Absolutely, and I think if you look at Google, for example, with its relevancy criteria, we do so well there. I think we can monetize better than anyone and we have the traffic and that just works so well for us.

Mark Vadon

I think that has always been an interesting one for us. If you look at the way Google works, they take into account relevancy, or basically how much or how frequently people are clicking on our link versus someone else’s link. Yahoo! traditionally, up until they launched the Panama platform a few weeks ago, has not used that as a measure, and because of that, over time Google has been more successful for us because we are very -- within our industry, we are very relevant. We have much better brand awareness of the online jewelry buyer than other people do. I think that is one thing we are excited about going forward, is Yahoo!’s new platform, potentially. I think it is still too early to tell what impact it is going to have on us, but theoretically, it should have a pretty good impact.

So in looking at things like that and looking at traffic levels of ourselves versus other people, and even if you look at, if you try to get data out there on how often people are typing in our branded terms versus other people’s branded terms, we feel like we just have a very good and probably strengthening competitive position on the web as far as just awareness and the relevancy of us versus some of the other players out there.

James Hurley - Telsey Advisory Group

Great, and then just I guess a tactical question. On the CapEx spending, how should we expect that to unfold as the year progresses?

Diane Irvine

Most of the spending, Jim, will not begin -- well, actually none of the spending will begin until Q2, so it will be heavy Q2, Q3. In terms of the fulfillment center, our goal is to be pretty much done with that by the time we get to the beginning of Q4.

James Hurley - Telsey Advisory Group

Great. Thanks again, and congrats.

Operator

Your final question comes from the line of Dan Geiman of McAdams Wright Ragen.

Dan Geiman - McAdams Wright Ragen

Good afternoon. Could you talk a little bit more about your margins on the international side, and also what your expectations might be for the coming year? Do you expect that international might create a material drag on margins?

Mark Vadon

Yes, international is -- it is interesting. We didn’t talk about it in the script, but if you look at the growth rate of revenue, it was pretty robust, in the upper 60s, but that is slower than we have been experiencing lately. Part of what has happened there is a year ago, we were running our margins on international pretty low -- lower than our U.S. business, just trying really to seed that first set of customers and get the awareness going.

As we worked our way through this year, we got the margins in our U.K. business to be the same as in the U.S. business. So if you look at a diamond on the U.K. site and the U.S. site, if you look at the same diamond today, they should be priced at parity.

As we did that, we saw very good growth in the product margin dollars coming out of the U.K. site, but it slowed down the revenue growth a little bit.

I think as you have those two businesses going, there is less selection in the U.K. site than in the U.S. site still at this point, and it skews toward the lower margin products. It skews toward the higher price point, lower margin items, so I think on an overall blended basis, the U.K. business brings our margins down by a little bit. It is still such a small business that it is not really that meaningful, but at the product level, it really has no impact on the gross margin.

So as we build up the product line, which we will be doing more of as we work our way through this year, as we build out the product line and that mix gets more similar to the U.S. mix, we do not think it will have really much of any impact at all.

Dan Geiman - McAdams Wright Ragen

Okay, great. Also, what is your share count assumption for ’07?

Diane Irvine

We are just shy of 17 million, Dan, when you look at fully diluted.

Dan Geiman - McAdams Wright Ragen

Okay, great. Thank you.

Operator

I would now like to turn the call back over to management for any closing comment.

Mark Vadon

Thank you. I just want to thank everybody for participating on the call and we look forward to a good Q1 and hopefully we will be talking to all of you in 91 days from now. Thanks very much.

Operator

Ladies and gentlemen, this does conclude the Blue Nile Incorporated conference call. You may now all disconnect.

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Source: Blue Nile Q4 2006 Earnings Call Transcript
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