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Executives

Melissa Payner – President, CEO

Pat Barry - COO, CFO

Brad Matson -CMO

Analysts

Teri Gehry - Merriman Curhan Ford

Brian Gilmore - Tejas Securities Group

Bluefly (BFLY) Q3 2007 Earnings Call November 13, 2007 5:00 PM ET

Operator

I would like to welcome everyone to the Bluefly third quarter earnings conference call. (Operator Instructions) Thank you. Mr. Barry, you may begin your conference.

Pat Barry

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

After we go through a few administrative details, Melissa will share some highlights from the third quarter and then I will take you through our third quarter financial results. At the conclusion of the call, we will conduct a question-and-answer session. As a reminder, you can find a copy of 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 that constitute forward-looking statements, usually containing the words believe, project, expect, or similar expressions. These statements are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements inherently involve risks and uncertainties that could cause the actual results to differ materially from the forward-looking statements. These statements are only predictions based on assumptions that we believe to be reasonable at the time.

The risks and uncertainties are detailed from time to time in the reports we file with the Securities and Exchange Commission including Forms 8-K, 10-Q, and 10-K and you should consider them when making to investment decisions regarding Bluefly. 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.

In addition, our discussion today is being recorded and archived for at least 30 days for those of you who wish to listen at a later date. Those of you listening to an archived version should recognize the statements that we make are current as of November 13, 2007 and will not have been updated to reflect subsequent events or changes in the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 mentioned during our last quarter's earnings call, in order to improve our overall customer 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 financial results were significantly impacted by the costs associated with the transition to our new fulfillment center. The impact of these challenges offset many of the positive aspects of the business. It's important to state that the fundamentals of our business are strong. We consider this quarter's performance a misstep and not a reflection of the business' future strength.

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

Let me start with the financial summary. After delivering ten straight 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 not up to our expectations. In the third quarter, year-over-year net revenue grew by 11% on a decrease in marketing spend and gross margin was 31.7%.

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

The third quarter reported margin was our lowest recorded margin 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 joined and we have targeted full year margins in the 38% to 40% range and believe we can get back to these levels once we get through the transition.

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

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

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

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

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

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

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

I'm sure you've all seen the comp store sales over the past few months for apparel companies. Our growth rate is pretty strong versus many of the more established companies. In fact, comScore reported that total online sales 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 the move of our warehouse, our overall growth is respectable.

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

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

As an official sponsor of Project Runway, Bluefly will benefit from strong on-air presence to this perfectly targeted audience. Some of the features include an on-air mention at the beginning of each show that will state that the winner will have the opportunity to sell their line on Bluefly; we have the Bluefly accessory wall which will also be featured prominently on most episodes; in addition, we have supported this investment with a rigorous online program that combines Bluefly merchandising with show content 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 a grand prize of two tickets to the Project Runway finale at Fashion Week in New York, including travel accommodations, a $5,000 Bluefly shopping spree and a makeover courtesy of Beauty.com. Each week on Thursday morning, Bluefly will have a feature on our site called “Get the Winning Look”. This section of our site will showcase styles with the same look and feel of Wednesday night's winning design. Customers and viewers will be able to shop for items or similar items to those featured on the show's Bluefly accessory wall, as well. We will also have a fashion commentary that relates to that weeks' episode and important trends of the season. And, we will have access to behind-the-scenes video that we will show on our site.

It's important to note that the first episode airs tomorrow night 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 launched this fall with Ford Model and Beauty.com to create videos that include the latest fashion and beauty trends plus models discussing and selecting products from our site. The videos can be seen on our site at Fly TV. Bluefly is also the online host of LuckyShops.com and you can go to our site to see Lucky Shops at Bluefly. We've also launched a new program with Facebook which allows you to send people in your Facebook community images of the product you purchased on Bluefly.

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

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

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

Pat Barry

Thanks, Melissa. Let me walk you through the major income statement and 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 the prior 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 Q3 2006. Gross margin was negatively impacted by a $550,000 charge to earnings related to an inventory reconciliation. Absent that charge, gross margin dollars 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 in the quarter to two-day shipping which added approximately $2.00 to the cost of every order.

The decline in the gross margin percentage was caused mainly by the inventory charge which accounted for 3 points of the gross margin percent decline. Upgraded shipping on customer orders accounted for approximately 1.1 points of decline and the balance was related to mix and foreign exchange issues related to product.

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

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

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

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

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

Ecommerce expenses increased by 12% in the third quarter versus the prior year. The increase in expenses was a result of the salary and software-related expenses. Marketing expenses . Our total marketing expense for the 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 our print and television advertising versus $1.4 million in the third quarter of 2006. As Melissa noted, a portion of this decrease is a result of timing related to production costs. For the nine months ending September 30, marketing expenses were about even for last year, as a percent of revenue were 14.7% of revenue versus 18.5% in the same period. So as we continue to grow, we continue to become more efficient.

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

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

Other current assets of $7 million include $2.8 million in accounts receivable, which is comprised of dollars due from credit card companies; and $3.8 million of prepaid expenses which is mostly marketing related. Fixed assets increased by $1.8 million and that related to capital costs associated with our AGG implementation. That $1.8 million is for the year.

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 million shares of common stock outstanding before FX conversion of the remaining Series F 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 to summarize where we are. Despite all of the issues surrounding the warehouse move, the health of our business is strong. We continue to see solid growth in major categories like designer accessories, dresses and the men's contemporary business.

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

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

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

Question-and-Answer Session

Operator

Your first question comes from Teri Gehry - Merriman Curhan Ford.

Teri Gehry - Merriman Curhan Ford

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

Pat Barry

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

I think the important thing also to note is the full year number is still going to be the $15 million that we said it was going to be at the 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 areas where you thought you were over or maybe even under-assorted in the merchandise?

Melissa Payner

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

Operator

Your next question comes from Brian Gilmore – Tejas Securities Group.

Brian Gilmore - Tejas Securities Group

Sounds like a little different quarter. Your July and August numbers which was where you had the transition obviously were slower. But, did you see a pickup in your September number 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 the last week of September where all the inventory was back online because what ends up happening if you remember from the last call we took the winter product off and the spring product was still at the old warehouse and some of our best accessories etcetera, until everything got moved into the new warehouse, we were in through the month of September.

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

Brian Gilmore - Tejas Securities Group

Do you feel like for fourth quarter, is it back to north of 25% growth year over year with the distribution center online?

Pat Barry

I think it's probably a little early to tell. We moved a lot of our marketing into the fourth quarter and Project Runway, where we're really supporting that. We break a new ad tomorrow with the airing of Project Runway. So, there's a lot that's going on in the fourth quarter. We haven't seen any of that start. Tomorrow night will be the first day. So it's going to take us a couple of weeks to get a good read on that.

Brian Gilmore - Tejas Securities Group

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

Pat Barry

A little north of $8 million.

Brian Gilmore - Tejas Securities Group

So, fourth quarter should 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 coming back and talking to you again after the holiday season. Have a great holiday, everyone.

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Source: Bluefly Q3 2007 Earnings Call Transcript
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