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Blue Nile, Inc. (NILE)

Q1 2007 Earnings Call

May 7, 2007 5:00 pm ET

Executives

Terri Maupin - Vice President of Finance and Controller of Blue Nile

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

Diane Irvine - Chief Financial Officer, Director, President

Analysts

Scott Devitt - Stifel Nicolaus

Mark Mahaney - Citigroup

Douglas Anmuth - Lehman Brothers

Julie Charsest - Merrill Lynch

Dan Geiman - McAdams Wright Ragen

James Hurley - Telsey Advisory Group

Jim Friedland - Cowen & Co.

Presentation

Operator

Good afternoon, ladies and gentlemen. My name is Mark and I will be your host operator on this call. (Operator Instructions) At this time, I would like to introduce Terri Maupin, Vice President of Finance and Controller of Blue Nile. Please go ahead.

Terri Maupin

Good afternoon and thank you for joining us on our conference call today to review our first quarter 2007 financial results. With me today are Mark Vadon, Chief Executive Officer and Diane Irvine, President and Chief Financial Officer.

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, net sales, gross margin, expenses, net income, operating cash flow, capital expenditures, international growth, stock-based compensation expense 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. 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 report 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. 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.

At the conclusion of the call, we will conduct a question and answer session. During the Q&A session, we ask that you please limit yourself to one question out of courtesy to others.

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

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Diane Irvine

Thank you, Terri and good afternoon, everyone. Welcome to today's conference call. The first quarter was a terrific one for Blue Nile. We experienced tremendous growth in our business and generated exceptional profitability. Our performance was driven by significant traction with consumers, as a result of the appeal of the Blue Nile customer experience and value proposition.

We delivered net sales of $67.9 million in the first quarter, representing year-over-year growth of 34%. This is the highest revenue growth rate we have reported since we became a public company in May of 2004, nearly three years ago. Net income of $3.2 million was up 34.3% from the first quarter of 2006. We are especially pleased with our reported net income per diluted share of $0.19, representing EPS growth of 46%. Our EPS of $0.19 for the quarter was $0.04 above the top end of our guidance range.

During the first quarter, our core business continued to grow robustly, and we made great progress in enhancing our leadership position in online diamond and jewelry retailing.

Let me give you some highlights of the quarter. While all product categories were strong in the first quarter, we are extremely enthusiastic about the performance of jewelry at price points above $25,000. Our net sales at these price points rose 84% year over year in the first quarter, representing our fastest-growth product category and reflecting the growing awareness and prestige of the Blue Nile brand. The number of orders at price points above $25,000 increased 69% from the prior year. In diamond jewelry, we had seven transactions above $100,000 during the first quarter.

Few companies know their customers as well as we do, and this allows us to continually become more adept at tailoring our website and our products to answer our customers' needs. This is visible through the healthy increases in the volume of traffic to our website, as well as our conversion rates during Q1. Total orders increased over 29% as compared to a year ago. Our average selling price per order was $1,536 in the first quarter, representing an increase of 3.6% from the prior year.

We performed very well in marketing during the first quarter. All of our marketing vehicles were strong across the board, generating positive returns and contributing to our financial results. We experienced strong growth in repeat and referral revenue at rates in excess of our overall top line growth for the quarter. We believe this is evidence that the details we focus on in our customer experience make a big difference.

We monitor the net sales growth in our geographic markets as a measure of the traction we are gaining with consumers. During the quarter, all of our geographic market tiers within the U.S. showed strong growth, with revenue in our top markets growing at 24% year over year. We believe that our ability to continue to increase penetration in our most established markets demonstrates the strength and potential of our business.

I'd like to touch on our international business. As we have discussed over the past year, one of our key initiatives is the expansion of our business internationally, taking what we have done for US consumers to consumers in other parts of the world. While our international sales are still a relatively small part of our total business, growth in this business was strong in the first quarter. We generated approximately $2.6 million in net sales through our Canada and UK websites, representing 84% growth compared to the same period last year.

International growth will become an increasing priority for us in the second quarter, as we launch updated international websites with expanded product offerings and the ability for customers to purchase in local currencies. We'll have more to say about these efforts on next quarter's conference call.

Let me spend a few minutes to review more of the financial details included in our first quarter results. Gross profit for the quarter was $13.2 million, compared to $10.3 million in the first quarter of 2006, an increase of 28.1% year over year. We are very excited about this growth in gross profits, which represents our highest quarterly gross profit growth rate since 2004.

Our gross margin for the quarter was 19.5%, compared to 20.4% a year ago, reflecting the aggressive diamond pricing strategy we implemented midway through the first quarter of 2006. This year-on-year gross margin differential of 90 basis points represents the strongest year-on-year quarterly comparison that we have experienced in the four quarters since we implemented this pricing strategy.

One of the numbers that we feel is very impressive and that we're most excited about in our first-quarter results is our operating income. Operating income rose 38.3% to $3.7 million for the quarter. This is the highest operating income growth rate we have reported in 12 quarters as a public company.

Our performance on costs during the first quarter reflects our keen focus on execution, as well as the disciplined mindset that exists across the company. Our SG&A costs totaled $9.6 million for the first quarter and included $1.3 million in stock-based compensation expense. As a percentage of net sales, SG&A declined to 14.1% in Q1, compared to 15.1% in the first quarter a year ago. We achieved this 100 basis point reduction in SG&A as a percentage of net sales year over year despite the addition of an incremental $400,000 in stock compensation expense, reflecting our ability to leverage our cost structure.

Interest income was $973,000 for the quarter, compared to $985,000 in last year's first quarter. I would also like to point out the inclusion of approximately $200,000 in other income. This amount relates to settlements that were finalized in Q1 in several legal actions that we initiated in connection with the protection of our intellectual property assets. As one of our most valuable assets, we expect to continue to aggressively protect our intellectual property.

Our effective tax rate for financial reporting purposes was 34.9% in Q1 2007, compared to 35.5% a year ago.

Now, let's turn to free cash flow, which we view as our most important financial metric as it relates to value creation. As a reminder, we define free cash flow as cash flow from operations including cash costs for taxes, tax benefits from stock compensation and changes in working capital less capital expenditures.

Free cash flow increased 7.4% to $32.2 million on a trailing 12-month basis, compared to $30 million for the trailing 12-month period ended April 2, 2006. Operating cash flow for the trailing 12 months was $33.7 million, compared to $31.5 million for the trailing 12-month period ended April 2, 2006.

I'd like to spend a moment reviewing the quarterly cash flow dynamics within our business. The first quarter of the year is generally a negative cash flow quarter for us. This is primarily a result of the working capital dynamics in the business, where we receive payment from our customers at the time products are shipped, but we pay our vendors 45 or more days beyond that time. In the first quarter, we generally have a significant pay down of our accounts payable balance that was built up during the fourth-quarter holiday season. This is the primary reason that Q1 is typically a negative cash flow quarter.

I also want to point out that our Q1 2007 cash flow statement contains an adjustment related to cash taxes that you will begin to see in 2007, as a result of the fact that our net operating losses were fully utilized for federal income tax purposes in 2006.Our cash flow statement for Q1 2007 reflects $1.1 million in cash taxes paid, as compared to essentially no cash taxes in the first quarter of 2006. In addition, we had superb results from working capital management at the end of the first quarter last year, which is reflected in the year-on-year comparisons. Given all of these dynamics, we are very happy with our Q1 free cash flow results.

Finally, I would like to provide an update on our share repurchase program. During the first quarter, we repurchased approximately 345,000 shares or 1.9% of shares outstanding, for an aggregate purchase price of $13.5 million. After these share repurchases, our cash and marketable securities balance ended the quarter at a healthy $59.2 million. It is noteworthy that since the inception of our share repurchase program in February 2005 through the end of the first quarter of 2007, we have returned over $88 million to shareholders through the repurchase of approximately 2.7 million shares of our common stock.

Over this time period, we have repurchased 15.2% of the outstanding shares of the company, at an average price of $32.75. Under our stock repurchase program, the company may purchase up to an additional $79.7 million of common stock through August 2008. Our share repurchase program underscores our commitment to enhancing value for our shareholders. Our strong balance sheet and continuing strong cash flows allow us to fund our operations, grow our business for the future and opportunistically repurchase our shares. We strongly believe that the repurchase of Blue Nile shares is a strategic means to create value for our shareholders.

Before I review our outlook for the second quarter and the remainder of 2007, I would like to remind everyone, as we have done in the past, about the seasonality in our business. As we have discussed many times, our first quarter is typically the highest-volume quarter of the year outside of the Q4 holiday season. The second quarter generally has lower volume than Q1 on a seasonal basis, and our third quarter is typically the lowest volume quarter of the year.

Looking at the analysts' estimates for Q2 as compared to Q1, this pattern of seasonality seems to have been overlooked. The consensus estimates prior to today had estimates for both revenue and earnings per share that were significantly higher for Q2 than for Q1. This does not make sense based on our historical seasonality pattern. I would encourage everyone to look back at our quarterly results for multiple years to review our historical seasonality on a quarterly basis.

I also wanted to make a few comments about last year's second quarter performance. Q2 a year ago was our first full quarter reflecting the implementation of our aggressive diamond pricing strategy, and revenue growth was extremely strong at 30% year over year. As a result, our Q2 revenue a year ago exceeded our Q1 2006 revenue by a significant amount, and did not follow the expected seasonality pattern that I walked through earlier.

In addition, in terms of our EPS performance, we had a lower effective tax rate of 31.7% in Q2 last year, which added $0.01 to earnings per share. We also had other income of $100,000 related to a legal settlement, which added approximately $0.004 to EPS.

With that as a backdrop, I would like to review our financial guidance for the second quarter and the year 2007. For the second quarter, we expect net sales to be between $65.5 million and $67.5 million. Net income is expected to be $0.16 to $0.17 per diluted share. This guidance includes the estimated impact of stock compensation expense of approximately $0.05 per diluted share. With our Q1 performance reflecting a strong start to 2007, we are raising our financial guidance for the full year. We expect net sales for the year to be between $295 million and $305 million. This range is an increase from our previous guidance for 2007 net sales of $290 million to $300 million.

We expect net income per diluted share to be between $0.86 and $0.91 for 2007, an increase from our previous EPS range of $0.80 to $0.85. This guidance includes the estimated impact of stock compensation expense of approximately $0.24 per diluted share. Actual stock-based 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.

We expect capital expenditures for the year of approximately $5 million, which includes investments related to the expansion of our US fulfillment center and a new international facility.

The effective tax rate for financial statement purposes for the remainder of 2007 is expected to be approximately 35.2%.

Now, I would like to turn the call over to Mark for his comments.

Mark Vadon

Thanks, Diane. This was a great quarter. Diane spoke earlier about the strength we are seeing high value orders. I think it is quite a statement about the stature of the Blue Nile brand that so many people trust us with such exceptional purchases. Some of the most impressive sales this quarter included a 5-carat engagement ring for $140,000 and a 6.5-carat pair of diamond earrings for $130,000. Our most memorable order during the quarter was a $195 garnet pendant that was shipped to a customer in Texas in late March. This order was very special to us because as it shipped, the company passed $1 billion in cumulative revenue since the inception of the company less than eight years ago. This was a tremendous milestone for the company, and I want to congratulate all of our employees on this accomplishment.

I also want to thank all the customers who have bought from us over the years. As we pass this milestone, I believe it is clear that a fundamental shift is underway in the way consumers purchase fine jewelry.

Investors often ask us about online competition. While there are many companies that offer jewelry for sale on the Internet, it is difficult to clearly identify a number-two player to Blue Nile at the high end of online jewelry. Investors and others in the jewelry industry have asked us what has made Blue Nile different? What has led to our growth and our great brand reputation in such a short time?

The real answer is there is no pat answer; there's no one silver bullet. Rather, there are a myriad of reasons, from our technology expertise to the skill of our web design team to the ability of our merchants to continually identify the best jewelry products. But more than anything else, it's our focus on seeing everything through the lens of the customer. You frequently hear us speak of our obsessive customer focus and our commitment to executing with excellence. Today I would like to give you some more insights into a sampling of the thousands of details that we execute better than anyone else. These details exist in every area of the business, but today I want to focus on fulfillment as one example.

In our fulfillment center, we have a process called the perfect order. As its name suggests, the goal of the perfect order is to ensure that when a customer receives his or her order, it's absolutely perfect. For most jewelers, that might mean the engagement ring is in good condition, or that the ring box is presentable. At Blue Nile, those details barely begin to skim the surface. The perfect order is so thorough that it analyzes minute details, from what most jewelers would consider an invisible blemish on the interior of the ring to the way bubble wrap is placed inside the FedEx box to a standard for how the shipping label is applied. To continuously measure and improve ourselves, a sampling of all finished orders is reviewed at random each day to ensure that they meet the standards of the perfect order.

This review process includes intercepting orders after they have been packaged and then opening the packages, checking them against the 26 criteria we use to evaluate an order and then repackage the orders so that they can be shipped. If any deviation from our standard is noted, we immediately work with the employee who erred and train him or her to ensure it doesn't happen in the future.

The number of packages that don't meet our standards are reviewed, just like revenue and profit, as part of our regular metrics evaluation. It is our goal to achieve a perfect order 100% of the time. While we are close, we are not there yet, and we won't be satisfied until we are.

Some people might question the wisdom of incurring the cost of opening finished products only to be forced to repackage them; but it is this level of rigor and this commitment to execute with excellence that not only creates loyal Blue Nile customers but compels those customers to go out and tell their friends to shop here.

To understand the enthusiasm that Blue Nile inspires, it's best to hear from our customers directly. So I'd like to take a moment just you read a few excerpts from a letter from a recent customer. This customer wrote:

“I just wanted to let you know that I was totally blown away by what I saw when I opened that beautiful wooden box. The engagement ring I purchased for my fiancée is so exquisite than anyone hesitating to buy such an important piece of jewelry from you should really just do the math. Why on earth would anyone in their right mind pay nearly twice as much for a diamond ring of lesser quality?

The 1.27-carat, F-color, internally flawless diamond in the six-prong platinum setting would have cost me double what I paid. Blue Nile is simply the only place to buy diamonds, period. I will never buy diamonds anywhere else.

Thank you for being smart enough to know what most men want and need in this regard: great price, great customer service, no hassle and all of the facts. Best of all though, she tells me every day how perfect her ring is, and how even strangers are amazed at how much it sparkles. Buy Blue Nile. You won't ever be sorry.”

We receive dozens of letters like this every day from across the US, and increasingly Canada and the UK. As long as we stay focused on the customer and adhere to our high standards for ourselves, I'm convinced we will continue on our current trajectory to become the leading jewelry brand in the world.

In closing, I want to thank our investors and analysts for participating on today's call. As we reflect on our first quarter results, we are proud of the success we have achieved, thanks to the hard work and commitment of our employees. Great teamwork and exceptional execution across the business led to our outstanding performance, and are at the core of everything we do.

This is the end of our formal presentation, and we will now open up the call for questions.

Operator, will you please poll for questions?

Question-and-Answer Session

Operator

Your first question comes from Scott Devitt - Stifel Nicolaus.

Scott Devitt - Stifel Nicolaus

Thank you. The outperformance that you attributed to the high dollar items in the quarter, it seems like there would have been other drivers as well. So I had a couple of questions around that.

The first one is that you noted last call a one-day improvement in lead times that would have been beneficial around Valentine's Day. I was wondering if you could quantify that in the customized diamond jewelry category?

Diane Irvine

What we did and we have maintained this lead time is we reduced our lead time in customized diamond jewelry from a four-business day to a three-business day receipt by the customer. So the example would be if a customer places an order for a diamond on Monday before 3:00 PM Eastern Time, they will receive their completed product on Thursday, in three business days. Certainly unmatched timeframe if you look at any other business. I don't think it's really possible to quantify that, but certainly we think that has an impact on conversions.

In terms of the high tickets, I think all of those things that we can do, as Mark talked about, in creating the perfect experience for our customers, then leads to that trust and, I think, the stature of the brand and the comfort of customers who purchase those high-end products.

Mark Vadon

Yes, I don't think we saw that improvement just at Valentine's Day. I think reducing that lead time helps us every single day, not just during holidays. It may have a slightly bigger impact during the holidays. We would hope that would be the case as we get to Q4 this year. I think that was one driver of growth, but not the only thing going on.

I think one of the great things about the quarter was we just felt strength across every product line, across every marketing vehicle. So it was hard to pull out a single marketing vehicle that drove it or a single product line. We certainly saw fantastic growth in the large-ticket orders. At the same time, our average order size only increased by roughly 3.5% because we had really great strength in entry level price points as well, which, again, we're very excited about that because it adds more names to the house file and lets us re-market to them.

We spent all of last year working really hard across the board on improving conversion, partly by reducing lead times, partly by advances on the website and advances on the product line and some more rigorous analytics and marketing. I think it's all starting to come together to pay off.

Scott Devitt - Stifel Nicolaus

The second question is around product mix. Inventory was only up 13% year over year. So I was wondering, just again around this question of the drivers of the outperformance, could you talk about changes in product selection on the domestic side year over year in the three different categories that you have: the diamond engagement, the non-engagement diamond and then all other?

Diane Irvine

I think the great news for the quarter, Scott, was that all categories were very strong. We did perform very well in inventory, as you mentioned, looking at the year-on-year growth. I think one of the strongest parts of the business is the customized diamond jewelry. So that's obviously operating off of virtual diamond inventory, if you will. So there we certainly have in stock all the settings so that we can sell those products, but that's much lower inventory investment as compared to what we're selling there.

Wedding bands are tremendous, probably our number 2 product category. Then if you look at non-diamond jewelry, we had great growth there. Sterling silver performed incredibly well, great growth during the quarter. I think across the board in all product categories, really great growth but also very strong inventory management.

Mark Vadon

If you look at the growth rate of items that we hold in stock versus items that we procure in real time, the growth rate of those two businesses was within a couple points of each other. So it wasn't mix driving the inventory. I think it was, over the last year or so, we've added a lot in selection.

One of the negatives of that was we didn't feel we'd gotten the traction in inventory turn that we would have liked. So I think as a team we really focused on that this last quarter to try to find ways to turn that inventory faster. We were pretty successful in doing that.

You mentioned international briefly there. I think as we go internationally there's a smaller business there that's going to require holding a little bit of inventory. When a distribution center is smaller, it obviously doesn't turn as fast. So I think that will be an item that we're going to need to perform well on the US side to compensate for. With the success we've seen over the last three months in inventory turn, that should be fairly straightforward to be able to absorb that inventory without even noticing it on the financials.

Scott Devitt - Stifel Nicolaus

Just on the international piece, the $1 million of incremental CapEx for it looks like international fulfillment, is that in addition to an existing international fulfillment facility, or is that new?

Diane Irvine

All of that was existing in the last quarter, Scott, so the change is really probably a little bit less international and more related to our US fulfillment center expansion. So the change from the last quarter's update going to $5 million in CapEx for the year reflects our updated cost estimates for our fulfillment center here in Seattle as well as the international facility, which is just one facility. Then we've also added a couple of technology projects since the last time.

Operator

Your next question comes from Mark Mahaney, Citigroup.

Mark Mahaney - Citigroup

Diane, on the free cash flow outlook, you mentioned a couple of reasons why free cash flow grew less quickly than operating income. Is it reasonable to assume that the free cash flow growth should, throughout the balance of the year, reaccelerate and grow more in line with the operating income growth?

Mark, one of the marketing tools that you have used since the beginning of the year has been Google Checkout. I think you have actually had one of the more extensive experiments, if you will, with Google Checkout. Any comments on what kind of results you have seen from that, to what extent Google Checkout may have contributed to the outperformance this quarter? Thank you very much.

Diane Irvine

Thank you, Mark. With respect to free cash flow, we don't provide guidance with respect to free cash flow. But I think the items that we're pointing out will have an impact for this full year where, broadly speaking for the 2007 free cash flow outlook we'd expect something similar to last year, in the sense that we do have a large one-time adjustment for cash taxes. But having said that, we think free cash flow will be very healthy in terms of its level and then build off of that as we go into next year.

Then, of course, there's also a significant working capital dynamic there. But you will see different results, I would anticipate, in the free cash flow growth as compared to operating income, for example, as a result of those items.

Mark Vadon

On Google Checkout, I'd say it's still a very young program. But I've been impressed with the number of orders flowing through it. We've implemented similar types of technology initiatives over the history of the company, and they have never worked as well, other kind of payment methods or wallet initiatives. This one definitely is driving volume that's more than any of those we've ever seen.

At the same time, it wasn't really a key driver of the growth of the business. Again, I think that's such a young program. We have hopes that it's going to do very well over time. But today, within the context of the larger business, it's not a driver of the top line at this point.

Mark Mahaney - Citigroup

If I could just do one quick follow-on on the cash flow outlook, Diane, are there still improvements in vendor terms that would cause the free cash flow growth to grow more organically or in line with the operating income growth? Is that a factor, or is it simply moving beyond these one-time cash tax issues, that's what brings the growth rate back in line?

Diane Irvine

In terms of the tax item, that will be the single biggest change going from ‘06 to ’07, mark. But if you look at working capital and our days payable, I think absolutely as you look out the next several years, we will be able to continue to see improvements there in working capital. So I think that will be, certainly, a positive benefit this year.

The other thing that happens, if you look quarter to quarter in free cash flow in terms of working capital, is that the timing within a quarter of purchases makes a difference as to how you end the quarter. So it's not always precise in terms of a quarter end but broadly, yes; we should continue to enjoy benefits in our working capital in terms of days payable over the next several years.

Mark Vadon

If you just take the financial statements and you look for the quarter at the days outstanding of our payables, you're not going to see a huge amount of progress this year versus last year in days and I think that's actually deceptive. When we look at the terms we're getting, they are significantly better this year than they were last year. But the dynamic happening last year mid-quarter, we lowered prices and we accelerated out of the quarter. So the payables for the quarter are better, are stated higher than the COGS for the quarter, if that makes any sense, in the first quarter of 2006.

I think overall, as we get larger and larger, we are one of the largest buyers in the world now of diamonds, and that carries a lot of weight in the supply chain.

Operator

Your next question comes from Douglas Anmuth - Lehman Brothers.

Douglas Anmuth - Lehman Brothers

Thank you. My question is regarding your price point activity during the quarter. I know that in 4Q you were able to raise some prices strategically as you saw some opportunities, and that obviously help your gross margins. Can you talk about what you saw this past quarter and then what you're thinking about leading into 2Q?

Also, can you talk a little bit about your conversion rate trend? Is it possible to quantify that in any way? Your change in conversion rates, either on a year-over-year or a q-over-q basis?

Diane Irvine

Sure, thanks Doug. In terms of price points, if you look at our pricing strategy I would characterize it as we have pretty much kept it the same. I think our goal is to continue to deliver value to our customers. There are always pockets of diamonds, for example, when we might see an opportunity based on supply/demand dynamics to increase prices a bit. But I think, as we look out at the year, we would expect that now that we have anniversaried the price reduction period from a year ago, that we will have our pricing structure approximately equivalent to last year.

That said, we're always looking at different categories of diamonds to look at the appropriate pricing. I think we'll always be of a mindset to deliver more value to consumers and provide the best possible pricing. But you're seeing great year-on-year growth in the gross profit, which is really what we are looking for so I think that is very, very healthy.

Mark Vadon

On your question on conversion, this quarter we saw double-digit improvements in both traffic and conversion so again, it kind of felt like a quarter where everything was clicking across the board. The improvement was driven almost equally by improvements in traffic and improvements in conversion.

Operator

Your next question comes from Jim Friedland - Cowen and Co.

Jim Friedland - Cowen and Co.

Thanks, a couple of quick ones. First in the quarter and then going into Q2, any changes in commodity pricing, either in your favor or against? How did you react in terms of pricing your products?

Then the second question is just in terms of what you're seeing on keyword pricing. You have been saying that some of the competitors out there, especially larger companies, are buying words at irrational prices. Have you seen them pull back at any point, and has that helped you guys?

Diane Irvine

Thanks, Jim. In terms of commodities pricing, if you look at diamonds, I think we're continuing to see at the high end with large carat sizes, that those prices continue to go up. That is the result of where the supply is. So rising price environment there, but we are, of course, very aggressive at those price points. I think you're seeing that growth in our business at the high end. So that has been fantastic. At the smaller carat sizes, we're actually seeing some price reductions, modest reductions. So I think in diamonds, that all feels pretty good.

In terms of other commodities, we have seen price increases this year. So we will, from time to time, take a look at the pricing of our metal products for example wedding bands or maybe platinum jewelry and make adjustments. But at the end of the day, while those increases are happening across the industry, you are still finding much more beneficial pricing at Blue Nile on a retail basis. We are very thoughtful about making those changes, but we are seeing increases in commodities. I think that at the end of the day, we're really looking for that gross profit growth, and so that was very, very healthy, even given those changes in terms of the cost input.

In terms of keyword pricing and marketing, that environment is also experiencing rising prices. I think we're doing a phenomenal job in our marketing team in terms of all of the work we're doing investing there. So we're being very, very efficient. We also, I think, get better and better in terms of our relevancy in the category. So that bodes very well for us in terms of search. When you look at other players, yes, we see other people in and out of the market but it's not having a significant impact. I think moreso we are the number 1 online in our category so I think that does good things for us in search. Also, our team is doing a tremendous job there.

Operator

Your next question comes from Jack Murphy - William Blair.

Jack Murphy - William Blair

Thanks and congratulations on the quarter. I just wanted to ask about the time period from before you cycle the price increase to after. Could you talk a little bit about the relative strength in sales there and also the relative margin, comparing both those periods and how that looked?

Diane Irvine

Sure, thank you Jack. In terms of strength in sales, I think as we talked a year ago on our first-quarter call, as we went through 1Q06 our growth strengthened through the quarter, with the beginning of the year of ‘06 starting out much softer than we would have liked to have seen in terms of growth. So if you look at this year, January was certainly tremendous in terms of year-on-year comps. But really, throughout the quarter it was very strong.

Looking at our gross margin, in the first half of the quarter this year 2007 we had lower overall gross margins than the previous period and then in the second half we're essentially equivalent in terms of gross margin levels. So we went through that period very, very well, continue to see great growth through the second half of Q1. So all of that is looking very healthy.

Mark Vadon

I think, if you look at the growth in gross margin dollars month by month, it has stayed relatively constant the entire quarter. As we anniversaried the price decrease, the revenue growth rates slowed down a little bit. If you look at fundamentally the economics of the business, of how many gross margin dollars were we generating, that growth rate was almost constant every single month of the quarter.

Jack Murphy - William Blair

Then just one follow-up on an earlier question. When you're talking about the earlier adopter, tech-savvy markets, I think you said up 28% or something like that, so obviously implying other markets growing even faster. What are the characteristics of some of those markets that are growing even faster than the markets that are established?

Diane Irvine

I think the figure was 24% growth in the Tier 1 markets, Jack. If you look at the other markets, they have been growing in excess of the overall rate of growth in the business for the past several years. We saw a dynamic last year where for a couple of quarters following our price reductions, we actually saw the top-tier markets accelerate, so that they were growing equal to or slightly above the overall rate of growth in the business. So I think the 24% growth is very, very healthy; those markets are growing very nicely. Than as you look at those other markets, I think we would expect to see the kind of Tier 2, Tier 3 markets growing above our overall rate of growth in the business, just because those markets are not quite as established. So those figures all came out very well for Q1.

Operator

Your next question comes from Julie Charsest - Merrill Lynch.

Julie Charsest - Merrill Lynch

Thanks, good afternoon. Can you talk about the growth of your non-engagement jewelry? What kinds of items are you having the most success with, and what are the implications for overall profitability?

Diane Irvine

In terms of profitability, if you look at non-diamond, of course, all of those products would generally speaking, have a higher gross margin percentage than diamond jewelry. So over the long term, as the mix shifts more in that way, you'll see gross margin percentage edging up.

In terms of what is doing well, sterling silver was tremendous in terms of its growth this quarter. We have some beautiful new gemstone items, non-diamond gemstone. Pearls are doing very well for us. As I mentioned, wedding bands are a great product category for us. We'd love to have every Blue Nile engagement customer coming back for their wedding bands. So the non-diamond, plain metal wedding bands do very, very well for us. But across the board, all of those products are doing well.

Those are some of the categories, some of the lower price points, where we can tend to add more fashion to our selections. So in areas like freshwater pearls, gemstones, sterling silver, we can add a bit of fashion. Those are great acquisition items for customers coming in the door.

Julie Charsest - Merrill Lynch

As that category grows, how have you tried to control that inventory risk? How do we think about inventory levels going forward as it becomes a bigger part of the business?

Diane Irvine

In terms of inventory levels, we do very, very well in our turns. Those products will turn three to four to five times a year, so much better turns than the typical jewelry store, which would have 1 to 1.2 turns per year, so great turns in those products. As we grow, inventory is turning very fast and we still have great working capital dynamics on those products. I think we feel great about that business.

The non-diamond is still roughly 10% of our revenue. So the diamond part of the business continues to grow so well. But we love the non-diamond products, because those provide opportunities for customers to make repeat purchases, to come back for other occasions. That's growing very, very nicely.

Mark Vadon

This last quarter, every one of those non-engagement categories actually had negative working capital. So they are turning faster than the payment terms we receive. So I think it is one of the good things about the business is we have relatively little inventory risk. Where we're holding inventory, the items tend to be fairly basic, fairly classic items.

Operator

Your next question comes from Dan Geiman - McAdams Wright Ragen.

Dan Geiman - McAdams Wright Ragen

It sounds as though the market for the high-end diamonds has been growing pretty strongly in the market as a whole. I just wanted to know what's driving the high end overall? What's the outlook for the segment going forward? Also, what impact do these sales have on your gross margin for the quarter?

Mark Vadon

I think we're seeing really strong growth in those products, but I don't believe the overall domestic market is seeing that same type of strength in those products. The thing that's driving prices up, just the other day, the wholesale price list on diamonds above 5 carats went up pretty significantly again. I think what's driving those things up is more the international markets. You've got very strong demand out of the Middle East. You've got demand out of Asia and Russia for that type of product that really, a decade ago, wasn't there. So I think it's more of those international dynamics. It's the relative weakness of the dollar, when these diamonds are denominated in dollars. So I think those items are driving scarcity in that product and driving the price up, but I don't think the overall domestic market is growing anywhere near what we're seeing in those products.

As we sell those types of products, as we get that growth rate, it does have downward pressure on our margins because if you get above $100,000, our gross margin on that product is in the single digits. We're offering just amazing value on those products that really has never been there in the marketplace before. So that's pushing down. At the same time, we're seeing really great growth in lower price-point items where, as Diane said, we run on higher gross margin. So that's countering that a little bit.

But overall in this business, we've got price points that go from $35 to $0.25 million; all of them run on very different gross margin percentages. So as you go quarter to quarter over time, the margin may move around a little bit due to mix. I think the overall from the long-term perspective, the engagement business is a $5 billion domestic market, and the non-engagement business is a $55 billion domestic market. So over time, our mix will continue to shift and as it shifts I think overall, it gives upward pressure on gross margins over time.

It's not our intent to raise prices to drive gross margin up, but I think the nature of mix will slowly edge up our gross margins over time.

Operator

Your final question comes from James Hurley - Telsey Advisory Group.

James Hurley - Telsey Advisory Group

One point of clarification relative to the last question. Mark, were you saying there was no palpable negative impact on the gross margin from those high-ticket purchases?

Mark Vadon

I think they would have reduced our gross margin. If those high tickets didn't exist last quarter, our margins would have been higher. I don't have a number in front of me, but by a noticeable amount. But there were a lot of other dynamics in the mix helping.

Diane Irvine

I think, Jim, what's great about those products is they tend to relate to the awareness and the appeal of the brand. It's a great product when someone has been referred to us and so the more of those high-end products from Blue Nile that are out in the marketplace, I think it just drives more sales. So I think it speaks to the awareness and the stature of the brand, so all of that is very, very positive.

James Hurley - Telsey Advisory Group

Absolutely. There's no more sophisticated customer out there than that customer. My question was more related to international marketing efforts for next quarter. Should we still think of the investment in marketing at that 4% level, even as you try to ramp up and do more interesting things on the international front?

Mark Vadon

I think you'll see our overall marketing as a percentage of sales staying pretty close to that 4%. In the international markets, we will be spending more aggressively but it's a small enough business where I think we can absorb that in, and you might see marketing running in the 10 or 20 basis points higher than 4%, but it will be pretty close overall.

James Hurley - Telsey Advisory Group

Finally, any special marketing initiatives, merchandising initiatives for Mother's Day this year versus last year?

Diane Irvine

We don't have anything totally different, Jim. We have our Google Checkout promotion and we have email drivers.

Mark Vadon

We have a promotion running with Google Checkout where if you buy from us using Google Checkout -- and I believe it has to be your first purchase through Google Checkout -- you can get $20 off any order with free shipping. So that's a pretty compelling offer at opening price points of $35 or $40 with free shipping. That will drive, we think, a lot of units; not a lot of revenue in the grand scheme of things, but a lot of units and that helps us longer term.

I think what we're thinking is going to be really good on the product lines, we have been doing a lot behind charm bracelets. We actually started that about a year ago and stocked out of them at Mother's Day. The demand around Mother's Day for that item was a lot better than we had been expecting, so we came in with much better inventory levels this year. There's a lot more selection in freshwater pearls going into this holiday.

Mother's Day tends to be, unfortunately for all mothers listening in on the call, tends to be the lowest price point time of the year for us. So what really moves is the sub-$100 price point. We've been out trying to find really high-quality merchandise, but where we can hit those types of price points and give people a quick, easy gift solution.

James Hurley - Telsey Advisory Group

It's always the thought that counts, right?

Mark Vadon

I hope so.

Operator

Ladies and gentlemen, we have reached the end of the allotted time period for questions and answers. Are there any final remarks?

Mark Vadon

No, we just want to thank everyone for joining us today and we look forward to updating you again next quarter. Thanks.

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Source: Blue Nile Q1 2007 Earnings Call Transcript
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