Good afternoon ladies and gentlemen. My name is Paige and I'll be your host operator on this call. Your lines will be placed on a listen-only mode. At the end of the presentation management will be available for questions. Operator Instructions
At this time I would like to introduce Nancy Ship, Director of Investor Relations of Blue Nile.
Nancy Ship, Director IR
Good afternoon and thank you for joining us on our conference call today to review our third quarter 2005 financial results. With me today is Mark Vadon, Chief Executive Officer of Blue Nile and Diane Irvine, Chief Financial Officer.
During this call we will discuss non-GAAP free cash flow which is defined as net cash provided by operating activities or operating cash flow less outflows for purchases of fixed assets including internal use software and Web site development. We report this measure to provide an additional tool to evaluate our operating results and financial condition.
Please refer to our Web site at www.bluenile.com to obtain a copy of our press release which contains a full reconciliation of free cash flow to 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, including expectations of net sales, gross margins, expenses, net income, operating cash flow, 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 we believe 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 and 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 risk factors 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. 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 introduce Mark Vadon, Chief Executive Officer of Blue Nile.
Mark Vadon, Chief Executive Officer
Thank you, Nancy. Good afternoon, everyone, and thank you for joining us today.
I would like to start the call by reviewing our third quarter financial performance and discussing our business priorities for the remainder of the year. Blue Nile posted excellent results again this quarter which speaks to our compelling consumer proposition.
We delivered strong sales and earning growth and expanding gross margin and operating margin. We achieved net sales of $42 million, up 23.9% from the prior year and net income growth of 49.1% to $2.5 million.
Earnings per diluted share totaled $.013.3 and were up 51.9% from the same period a year ago. At the end of the quarter cash and marketable securities totaled $81.1 million.
These results add to our history of growth and consistent profitability. Our performance reflects the appeal of Blue Nile brand, the power of business model, our disciplined focus and our ability to execute with excellence.
Our sales growth during the quarter was driven by strength across all product categories with growth in our non-engagement business continuing to be even more rapid than in engagement. Products in this category include customized diamond jewelry, such as diamond earrings and pendants as well as non-diamond products, such as pearls and gemstones.
We are experiencing tremendous consumer acceptance in the customized non-engagement jewelry category as our customers continue to embrace the selection and value that customization allows. In addition, we continue to drive non-engagement sales with new product introductions and expanded product assortments.
The third quarter is generally the period in which our engagement product line is expected to be at its highest percentage of our overall product mix, reflecting the fact that Q3 does not contain a major gift-giving holiday. As a result, we typically expect our average order size to be at its highest in Q3 as engagement products carry the highest ticket of all our product categories.
In the third quarter our average order size was $1,773 compared to $1,777 a year ago, and $1,441 in the second quarter of this year. A primary driver for growth in the current quarter was 24.2% increase in total orders compared to a year ago.
While we saw unit growth across all categories we were especially pleased with the growth in our wedding band business, which had the highest unit growth of any product category. This growth was driven by the return of our base of engagement consumers during the summer wedding season.
Overall repeat revenue growth continued to be very strong. As we acquire new customers we are focused on delivering an extraordinary consumer experience. If we do this successfully we will secure valuable lifetime customers.
On the cost side our business continues to demonstrate tremendous leverage.
Overall, our selling, general and administrative expenses grew by 20.2% year-on-year in the third quarter while supporting sales growth of 23.9%. Our SG&A expenses in Q3 contain public company costs including expenses associated with complying with the provisions of Sarbanes-Oxley Section 404, which Diane will discuss in more detail later in this call.
While our financial results for the quarter reflect significant operating leverage, the leverage was even greater excluding the additional Sarbanes-Oxley costs. This speaks well to the scalability of our business model and our ongoing ability to drive gains and profitability.
Wholesale prices of diamonds have risen moderately in 2005 and are up approximately 5% year-to-date. For the year 2004, wholesale diamond pricing increased as much as 25 to 30% with the most dramatic increases occurring in Q3 a year ago.
As a result of the moderation and wholesale diamond prices increases this year we believe that our competitive pricing position relative to offline retail, has reached a normalized level in which our retail pricing is typically 20 to 40% below what a consumer would pay at a traditional jewelry store.
In merchandising we have had a number of promising product launches that build upon the success of our diamond jewelry customization capability. We have expanded our Build Your Own Diamond jewelry categories to include 3-stone cluster pendants, 6-stone cluster earrings and 5-stone rings.
Asher Diamonds have been added to our customized earring assortment which already includes princess and round-cut selections.
In anticipation of the holidays we have expanded our offering of higher-priced point extraordinary jewelry held in stock and available for shipment the same day as ordered. These products retail for up to $70,000.
In the marketing area repeat and referral sales continue to show solid growth in the third quarter. We invested in some marketing tests in the third quarter and we will test additional vehicles in the fourth quarter to leverage the Blue Nile brand over the longer term.
Throughout all of our marketing efforts our focus is on the maximizations of gross profit contribution in keeping with our overarching objective of free cash flow generation.
While the U.S. market remains the main growth engine of our business, we are beginning to develop our presence in international markets, specifically in Canada and the U.K. On September 28th we began offering customization tools for diamond jewelry on U.K. Web site providing customers with the ability to choose from more than 60,000 loose diamonds, and customize their diamond jewelry products such as engagement rings, earrings and pendants.
This launch is off to a very promising start and we're optimistic for the U.K.'s performance during the upcoming holiday season. We believe that our value proposition to consumers is even more compelling in the U.K. market than it is in the U.S.
I'd like to provide an update on our share repurchase program.
During the third quarter we repurchased 199,975 shares for an aggregate purchase price of $6.5 million. From the start of our share repurchase program in February through the end of Q3, we have retired approximately 2.7% of the outstanding shares of the Company for a total purchase price of $13.9 million.
Since Q3 of 2004 we have reduced the number of diluted shares outstanding every single quarter. This is in keeping with our stated intention to maximize free cash flow per share over time.
Our share repurchase program underscores our commitment to enhancing value for our shareholders.
We are very pleased with our performance for the third quarter and year-to-date 2005, and we are confident that we are well-positioned to achieve our 2005 goals. Our operational focus is dedicated towards executing with excellence for our consumers during the upcoming holiday season and beyond.
We are focused on building our brand and expanding our market share in order to further extend our leadership position in online diamond and jewelry retailing. I believe we are still very early in the process of developing a dominant brand in the retail jewelry category.
We plan to continue to grow our international business. While this part of our business is small today we believe the potential exists for this to be a significant contributor to sales and profit over time.
We remain committed to providing an exceptional experience to our customers while delivering strong profitability to our shareholders.
I will turn the presentation over to Diane to review our third quarter results in more detail.
Diane Irvine, Chief Financial Officer
Thank you, Mark, and good afternoon, everyone.
We're very pleased with our results for the quarter, which reflect continued strong growth. Net sales for the quarter were $42 million, a 23.9% increase over last year's third quarter.
It is important to understand that the third quarter is generally the lowest volume quarter of the year for Blue Nile on a seasonal basis, reflecting the fact that there's no major gift-giving holiday in Q3. We're especially pleased with our 23.9% top line growth given that our engagement business, which is lower growth as compared to non-engagement, is at its highest level of the year as a percentage of net sales in the third quarter.
Gross profit for the quarter was $9.2 million compared to $7.4 million in the third quarter of 2004. This represents gross profit growth of 25.5% year-over-year.
Our gross margin is typically expected to be at its lowest level of the year in the third quarter based on product mix with engagement representing a higher percentage of net sales on a seasonal basis. Engagement products carry the highest ticket and accordingly the lowest gross margin percentage of all of our product categories.
Gross margin for the quarter increased to 22% compared to 21.7% a year ago. This year-on-year expansion in gross margin of 30 basis points is a result of two factors, product mix and slightly higher margins in our core engagement business.
With respect to product mix, our Q3 2005 mix consisted of a higher percentage of non-engagement items as compared to the product mix a year ago. These products carry a higher overall gross margin as compared to engagement products.
Our net income grew 49.1% in the third quarter to $2.5 million from $1.7 million in the prior-year period. Earnings per diluted share were $0.13 compared to $0.09 per diluted share in the third quarter of 2004.
On the cost side, we maintain a disciplined focus and have a very efficient cost structure. Our selling, general and administrative expense, or SG&A, as a percentage of net sales is one of the lowest in all of retail.
For the third quarter SG&A expenses as a percentage of net sales declined 50 basis points to 14.4% compared to 14.9% a year ago. SG&A expenses totaled $6 million in the quarter, an increase of 20.2% from the prior year quarter.
SG&A expenses include variable costs that move with sales volumes, such as credit card processing fees and marketing expenses.
Marketing costs increased approximately $360,000 in Q3 compared to a year ago, as a result of higher sales volumes and an increase in investment spending on new vehicles. Costs associated with being a public company also increased during the quarter primarily related to corporate governance and the implementation of Sarbanes-Oxley Section 404.
Because the year 2004 was Blue Nile's initial year as a public company, we are required to implement Sarbanes-Oxley Section 404 in the year 2005. Costs associated with being a public company increased approximately $180,000 for the quarter as compared to the third quarter last year.
Operating income of $3.2 million grew 36.8% from the prior year.
Operating margin, or operating income as a percentage of sales, was 7.6% for the quarter, an expansion of 70 basis points from 6.9% in the prior year. We achieved this operating margin level despite the addition of significant public company costs in the third quarter of 2005 as compared to the third quarter a year ago.
This performance demonstrates our ability to continue to leverage our SG&A costs while generating significant top line growth.
Interest income was $663,000 for the quarter compared to $241,000 in last year's third quarter. The increase was due to our higher cash balance and higher interest rates compared to a year ago.
We believe one of the most informative measures of our financial performance is non-GAAP free cash flow. For the quarter non-GAAP free cash flow of $6.2 million grew 106.3% from $3 million in the prior year.
Due to the seasonality in working capital, we also believe that trailing 12 months free cash flow is a meaningful metric. At the end of the third quarter our trailing 12 months free cash flow increased 76.6% to $23.1 million compared to $13.1 million for the trailing 12-month period ending October 3, 2004.
The ability to generate strong free cash flow is fundamental to what we believe is a special business model and we therefore focus on free cash flow generation as a key financial goal throughout our business.
Turning to our balance sheet as of the end of the third quarter inventory totaled $9.1 million. Our average inventory turnover, which we view as an important measure in the business, increased to 16.8 times for the trailing 12-month period at the end of the quarter compared to 16.2 times for the trailing 12-month period at the end of the third quarter a year ago.
Our financial position remained strong at October 2, 2005. We ended the quarter with $81.1 million in total cash and marketable securities and we have no long-term debt.
Before I review our sales and earnings guidance for the remainder of the year, I would like to note that we anticipate higher public company costs in the fourth quarter as this will be the most intensive period for our Sarbanes-Oxley Section 404 work.
We expect that public company costs will total up to $2.8 million for the year 2005. These costs are reflected in our financial guidance for the full year 2005, which I will review now.
On a seasonal basis the fourth quarter is generally our highest volume quarter of the year as a result of the holiday season. In addition, we expect our sales mix to be at its richest level of the year in Q4 with non-engagement jewelry representing a larger percentage of our net sales compared to other quarters.
We are very optimistic about the upcoming holiday season but appropriately conservative as a result of the macroeconomic environment.
For the full year 2005, we are maintaining our net sales guidance of 205 million to $212 million. Based upon our Q3 and year-to-date performance, we are raising our earnings guidance for the full year to a range of 70 to $0.74 per diluted share.
It should be noted that our guidance for 2005 does not reflect any impact from the expensing of stock options under the new rules of FAS 123R share-based payment. Blue Nile will begin expensing stock options under 123R in the first quarter of our fiscal year 2006 in accordance with the SEC's guidelines related to implementation.
We project capital expenditures for the year 2005 to total between 1 million and $1.5 million. The effective tax rate for financial statement purposes for the full year 2005 is expected to be approximately 36%.
As a reminder, Blue Nile is not yet a cash taxpayer as a result of net operating loss carry forward. We expect to begin paying cash taxes for federal income tax purposes in 2006.
I will now turn the call back to Mark for a brief closing comment. Mark?
Mark Vadon, Chief Executive Officer
In closing, I want to thank our investors and analysts for participating on today's call. We are committed to building value for our shareholders by executing our strategy and realizing the tremendous growth opportunities that are available to Blue Nile.
I also want to thank all of our employees for their exceptional work in preparing for the holiday season.
In our first employee meeting back in 1999, I told our employees, who numbered less than 10 people at the time, that our goal was to one day be to be the largest jeweler in America. I'll admit that's a very ambitious goal but I believe that we are firmly on the path to achieving that goal over time.
This is the end of our formal presentation and we will open up the call for any questions you may have. Operator, will you please poll for questions?
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