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Bluefly (NASDAQ:BFLY)

Q3 2007 Earnings Call

November 13, 2007 5:00 pm ET

Executives

Melissa Payner – President, CEO

Pat Barry - COO, CFO

Brad Matson -CMO

Analysts

Teri Gehry - Merriman Curhan Ford

Brian Gilmore - Tejas Securities Group

Operator

I would like to welcome everyone to the Bluefly third quarterearnings conference call. (Operator Instructions) Thank you. Mr. Barry, you maybegin your conference.

Pat Barry

Thank you, Michele. I want to welcome everyone to theBluefly third quarter earnings call. With me today is Melissa Payner, our CEOand President; and Brad Matson, our Chief Marketing Officer.

After we go through a few administrative details, Melissawill share some highlights from the third quarter and then I will take youthrough our third quarter financial results. At the conclusion of the call, wewill conduct a question-and-answer session. As a reminder, you can find a copyof our third quarter 2007 earnings release at our investor relations site,www.investor.Bluefly.com.

During the course of the call, we will make statements thatconstitute forward-looking statements, usually containing the words believe,project, expect, or similar expressions. These statements are made pursuant tothe Safe Harborprovisions of the Private Securities Litigation Reform Act of 1995.Forward-looking statements inherently involve risks and uncertainties thatcould cause the actual results to differ materially from the forward-looking statements.These statements are only predictions based on assumptions that we believe tobe reasonable at the time.

The risks and uncertainties are detailed from time to timein the reports we file with the Securities and Exchange Commission includingForms 8-K, 10-Q, and 10-K and you should consider them when making toinvestment decisions regarding Bluefly. They may affect whether ourforward-looking statements prove to be correct. We undertake no obligation topublicly update or revise these forward-looking statements.

In addition, our discussion today is being recorded andarchived for at least 30 days for those of you who wish to listen at a laterdate. Those of you listening to an archived version should recognize thestatements that we make are current as of November 13, 2007 and will not have been updated toreflect subsequent events or changes in the business.

I will now turn the call over to Melissa.

Melissa Payner

Thank you, Pat and good afternoon, everyone. As I mentionedduring our last quarter's earnings call, in order to improve our overallcustomer experience we made a decision to move to a new fulfillment center.Unfortunately, this move did not go as well as we had planned. Our financialresults were significantly impacted by the costs associated with the transitionto our new fulfillment center. The impact of these challenges offset many ofthe positive aspects of the business. It's important to state that thefundamentals of our business are strong. We consider this quarter's performancea misstep and not a reflection of the business' future strength.

I am particularly excited by the potential of some of thepartnerships that we've put in place over the past few months. Specifically,Project Runway, Beauty.com, Lucky Shops and the Ford Model Agency partnershipsand I will get into those details in a little bit.

Let me start with the financial summary. After delivering tenstraight quarters of 20% plus year-over-year growth and gross margins above 36%in each of those quarters, the financial results of the third quarter were notup to our expectations. In the third quarter, year-over-year net revenue grewby 11% on a decrease in marketing spend and gross margin was 31.7%.

The margin was directly impacted by fulfillment transition-relatedissues which negatively affected the margin by 4.1 points. Absent thetransition-related expenses within the third quarter, we believe that the grossmargin percent would have been 35.8%.

The third quarter reported margin was our lowest recordedmargin since the third quarter of 2003 when I joined the company. As you know,improving the gross margin has been a major focus of the company since I joinedand we have targeted full year margins in the 38% to 40% range and believe wecan get back to these levels once we get through the transition.

Gross profit in the quarter decreased by 6% and operatingincome excluding the non-cash impact of FAS 123 R expense fell by $536,000.

As we told you last quarter, portions of our inventory wereunavailable for sale during much of the quarter. We believe this had a majorimpact on the overall sales growth during the quarter. In addition, we wereunable to fulfill all of the orders we received and in some cases we had tocancel items or entire orders. This negatively impacted not only the sales, butthe margin and the overall customer experience.

In addition, we recorded a $550,000 charge against ourinventory, based on an inventory reconciliation. At this time, we believe thatthe charge that was taken will be enough to cover any loss of inventory thatmay result from the transition to the new warehouse. Obviously, we will performa physical inventory in January, as we do every year, to ensure the accuracy ofour inventory.

I just want to take a second to apologize to any customerswho were negatively impacted by the issues surrounding our fulfillmenttransition. We've had multiple contacts with these customers to make sure thatthose negatively affected during this transition were treated appropriately.

Some of the things that we did include: upgrading all ordersto two-day delivery, creating a special VIP customer team and offeringcustomers credits and special discounts. The response to the communicationswith the customers has been extremely positive, which shows how important it isto build a relationship with our customers.

Let's look at the growth of the business for a minute. Salesgrowth for the year grew by 24% and by almost 11% for the three months endedSeptember 30. As we mentioned last quarter, the slowdown in the growth began inthe month of June when we began removing inventory from the site in order tomove product to our new fulfillment center. We continued to move inventory inJuly and August and it wasn't until late September that the inventory was backin stock and available for sale.

So, let's talk about where the business came from in thethird quarter. We continue to see explosive growth in the designer accessoriesarea which was up 58% over the third quarter last year. Dresses grew 24% and aswe have begun our focus on the men's business, we saw it grow 29%. With thewarm fall, we saw our tops and tees business grow by 34%, but that waspartially offset by an almost 2% decline in the cold weather category.

I'm sure you've all seen the comp store sales over the pastfew months for apparel companies. Our growth rate is pretty strong versus manyof the more established companies. In fact, comScore reported that total onlinesales were up 23% in Q3 and the online apparel sector was up 11% in the quarter,consistent with our growth. So, given all of the issues we had related to themove of our warehouse, our overall growth is respectable.

Now, let's turn to marketing and advertising-relatedexpenses. While sales for the quarter grew 11%, we had a 19.7% reduction inmarketing spending, improving the ad to sales ratio for the quarter 2.4 pointsfrom 11.7% last year to 8.3% this Q3.

Spending for online programs increased 10% versus the sameperiod last year while spending for offline declined by approximately 45%, or$850,000 versus last year. The reduction in offline spending is mostly due totiming of production expenses and a shift in our media plan to support oursponsorship of Project Runway Season 4 which premieres on November 14. That'stomorrow night, at 10 pm.

As an official sponsor of Project Runway, Bluefly willbenefit from strong on-air presence to this perfectly targeted audience. Someof the features include an on-air mention at the beginning of each show thatwill state that the winner will have the opportunity to sell their line onBluefly; we have the Bluefly accessory wall which will also be featuredprominently on most episodes; in addition, we have supported this investmentwith a rigorous online program that combines Bluefly merchandising with showcontent that will be featured at Bluefly.com as well as Bravo TV, ProjectRunway.com,Elle.com, and Beauty.com.

We are sponsoring a sweepstakes with daily prices and agrand prize of two tickets to the Project Runway finale at Fashion Week in New York, including travel accommodations, a $5,000Bluefly shopping spree and a makeover courtesy of Beauty.com. Each week onThursday morning, Bluefly will have a feature on our site called “Get theWinning Look”. This section of our site will showcase styles with the same lookand feel of Wednesday night's winning design. Customers and viewers will beable to shop for items or similar items to those featured on the show's Blueflyaccessory wall, as well. We will also have a fashion commentary that relates tothat weeks' episode and important trends of the season. And, we will haveaccess to behind-the-scenes video that we will show on our site.

It's important to note that the first episode airs tomorrownight but the show airs every Wednesday starting tomorrow through mid-March.There are a total of 16 episodes.

We're also excited about marketing partnerships launchedthis fall with Ford Model and Beauty.com to create videos that include thelatest fashion and beauty trends plus models discussing and selecting productsfrom our site. The videos can be seen on our site at Fly TV. Bluefly is alsothe online host of LuckyShops.com and you can go to our site to see Lucky Shopsat Bluefly. We've also launched a new program with Facebook which allows you tosend people in your Facebook community images of the product you purchased onBluefly.

So, we've had a very busy fall for our marketing team withmuch of the impact to be realized in the next several weeks.

As we told you over the past few quarters, we expect toincrease our marketing spend by approximately 19% to $15 million for the fullyear in 2007. Spending for offline programs in combined Q3 and Q4 will be flatto last year. Spending for online programs are planned to increase 30% in thecombined Q3 and Q4. So our full year mix will be right on target of 50% onlineand 50% offline.

Now I will turn to call back to Pat who will run throughsome of the third quarter details.

Pat Barry

Thanks, Melissa. Let me walk you through the major income statementand balance sheet items. Net revenue for the three-month period grew by 11% to$18.1 million. Average order size was up almost 7.5% to $280 from $261 in theprior year. We added more than 37,000 new customers in the quarter, a 4%increase on a 20% lower marketing spend.

Gross margin for the quarter was 31.7% versus 37.4% in Q32006. Gross margin was negatively impacted by a $550,000 charge to earningsrelated to an inventory reconciliation. Absent that charge, gross margindollars per order continue to increase by 8% in the third quarter 2007, up to$58.36 from $57.87 in 2006. Also remember, that we upgraded customer orders inthe quarter to two-day shippingwhich added approximately $2.00 to the cost of every order.

The decline in the gross margin percentage was caused mainlyby the inventory charge which accounted for 3 points of the gross marginpercent decline. Upgraded shipping on customer orders accounted forapproximately 1.1 points of decline and the balance was related to mix andforeign exchange issues related to product.

Third quarter sales in the designer accessory and shoecategories grew by over 58%. Typically, these categories have lower productmargin than the other categories that we sell. In addition, the weakness of thedollar against the Euro had a significant impact on the costs, which negativelyimpacted the gross margin percentage. The product margin in the non-designercategories is slightly up year-over-year both in the quarter and for the fullyear.

Based on the financial results in the first nine months ofthe year and the promotional nature of the current marketplace, we believe wewill be at the low end of the 38% to 40% gross margin percentage target for theyear. As a reminder, cost of sales include the net product cost. This includesall inventory reserves, including the $550,000 charge to inventory that wepreviously discussed; cost of freight including the $200,000 additional forupgraded orders; and third-party carrier costs related to getting the productto the site plus packing material.

Moving to the selling and fulfillment line. Selling andfulfillment expenses were $4.6 million in the third quarter versus $3.9 millionin the same period last year. The major components of selling and fulfillmentare as follows: operating costs which include credit card fees, pick and pack,warehousing, customer service, increased by 28% or $547,000. As a percentage ofnet revenue, operating costs increased from 11.9% to 13.7% in the quarter.

Included in the operating costs are $462,000 of expensesdirectly related to the physical move of the warehouse, i.e. transportationcosts and insurance and labor. If you exclude the transition costs, operating-relatedcost would've been 11.2% of revenue, a slight improvement over last year. Inaddition, customer service cost increase in the period due to additionalinquiries related to delayed orders.

Technology spending was up 6% driven largely by softwaresupport, depreciation and web hosting. In the quarter, we capitalizedapproximately $646,000 of expenses related to the AGG upgrade.

Ecommerce expenses increased by 12% in the third quarterversus the prior year. The increase in expenses was a result of the salary andsoftware-related expenses. Marketing expenses . Our total marketing expense forthe quarter was $2.8 million versus $3.5 million for the third quarter of 2006.The third quarter included approximately $693,000 in expenses related to ourprint and television advertising versus $1.4 million in the third quarter of2006. As Melissa noted, a portion of this decrease is a result of timingrelated to production costs. For the nine months ending September 30, marketingexpenses were about even for last year, as a percent of revenue were 14.7% ofrevenue versus 18.5% in the same period. So as we continue to grow, we continueto become more efficient.

General and administrative expenses increased by $1 millionover the third quarter of 2006. Included in the G&A expense for the thirdquarter were $1.3 million of expenses related to stock-based compensationversus $463,000 for the same period last year.

Turning to the balance sheet, our cash at the end ofSeptember 30 was $7.2 million. Inventory was $30.3 million. The third quarteris a quarter where we traditionally build inventory to support the demands ofthe fourth quarter business. Our inventory grew from 25% in the period December 31, 2006 to September 30, 2007. Last year theinventory build during that same period grew by 58%. We would've liked to haveended the quarter with a slightly lower level of inventory but we believe theinventory is fairly stated for accounting purposes.

Other current assets of $7 million include $2.8 million inaccounts receivable, which is comprised of dollars due from credit cardcompanies; and $3.8 million of prepaid expenses which is mostly marketingrelated. Fixed assets increased by $1.8 million and that related to capitalcosts associated with our AGG implementation. That $1.8 million is for theyear.

The company has no debt on the balance sheet and we have$3.7 million available under our line with Wells Fargo.

As of September 30, we had approximately 132.4 millionshares of common stock outstanding before FX conversion of the remaining SeriesF preferred stock, warrants, options, and deferred units.

Now, I will turn the call back over to Melissa.

Melissa Payner

Thanks, Pat. Before we take questions, I would like tosummarize where we are. Despite all of the issues surrounding the warehousemove, the health of our business is strong. We continue to see solid growth inmajor categories like designer accessories, dresses and the men's contemporarybusiness.

This growth in the third quarter came on a reducedyear-over-year marketing spend and during a time when we did not deliver theexpected Bluefly customer experience. In addition, we made great progress onthe marketing front, building some key relationships in the quarter and we'revery excited about the Project Runway relationship and the prospects of theholiday season.

I will end my prepared comments as we do on all of our callswith a little fashion advice for the holidays. Metallics are very importantthis holiday. Silver is important, but gold is most important. Red continues tobe the color as it was for fall and continues through holiday in handbags,shoes, sportswear and coats. Everything cashmere is important from sweaters tothrows to robes to slippers for both men and women. Bright accessories areabsolutely a must for the holidays. Of course, dresses will remain importantthrough the fourth quarter and even beyond that.

Now I would like to turn the call over to Michelle forquestions and answers.

Question-and-AnswerSession

Operator

Your first question comes from Teri Gehry - Merriman CurhanFord.

Teri Gehry - Merriman Curhan Ford

I wanted to know if the reduction in the marketing expensesfor the quarter, if I understood you right, did that come from this ProjectRunway that you are doing now? You maybe did a move of that, or was it justthat you reduced offline marketing?

Pat Barry

Both actually. Thereduction was in response to the warehouse move as we saw we had inventoryissues, we cut back on our online spending in the quarters so we weren'tdriving people; say in a category like dresses, if they weren't available tothe extent that we would like, we cut back the spend there as well as some ofour other online programs. The other portion is a reduction in productionexpenses for advertising.

I think the important thing also to note is the full yearnumber is still going to be the $15 million that we said it was going to be atthe end of last year So, the full year number hasn't changed.

Teri Gehry - Merriman Curhan Ford

Was there any area, excluding what happened with the move,and then maybe some items and orders that got canceled, were there any areaswhere you thought you were over or maybe even under-assorted in themerchandise?

Melissa Payner

I think the biggest challenge was cold weather areas becausewe had an unseasonably warm fall. That's where we saw growth in categories likeT-shirts. We had 34% growth and a slight decline in our cold weather area. Our inventory is turning faster than last yearoverall so I don't think that it's a matter of being over or under assorted asmuch as it is a timing issue. So as it gets colder, we will sell through thecold weather merchandise category.

Operator

Your next question comes from Brian Gilmore – TejasSecurities Group.

Brian Gilmore - Tejas Securities Group

Sounds like a littledifferent quarter. Your July and August numbers which was where you had thetransition obviously were slower. But, did you see a pickup in your Septembernumber that points to some evidence that this was just a one-time deal?

Pat Barry

Brian, it wasn't really until the last couple of weeks or thelast week of September where all the inventory was back online because whatends up happening if you remember from the last call we took the winter productoff and the spring product was still at the old warehouse and some of our bestaccessories etcetera, until everything got moved into the new warehouse, wewere in through the month of September.

I think that it's fair to say that we were on a run ratecoming in out of the first quarter of a revenue growth of 31% and then Apriland May were good and June as we started pulling stuff off, it dropped and weknew we were doing some of it to ourselves and it took a while to get all theinventory flushed out and get it back up on the site.

Brian Gilmore - Tejas Securities Group

Do you feel like forfourth quarter, is it back to north of 25% growth year over year with thedistribution center online?

Pat Barry

I think it's probablya little early to tell. We moved a lot of our marketing into the fourth quarterand Project Runway, where we're really supporting that. We break a new adtomorrow with the airing of Project Runway. So, there's a lot that's going onin the fourth quarter. We haven't seen any of that start. Tomorrow night willbe the first day. So it's going to take us a couple of weeks to get a good readon that.

Brian Gilmore - Tejas Securities Group

So, if I'm correcthere, you spent $8 million so far this year in marketing or is it $9 million?

Pat Barry

A little north of $8million.

Brian Gilmore - Tejas Securities Group

So, fourth quartershould be $7 million?

Brad Matson

Yes, the high sixes I think.

Pat Barry

Yes.

Operator

There are no further questions at this time.

Melissa Payner

Thank you everyone for coming. We look forward to comingback and talking to you again after the holiday season. Have a great holiday,everyone.

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