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Blue Nile, Inc. (NASDAQ:NILE)

Q4 2007 Earnings Call

February 12, 2008 5:00 pm ET

Executives

Eileen B. Askew – Manager of Investor Relations

Mark Vadon – Executive Chairman

Diane Irvine – President & Chief Executive Officer

Robin Easton – Chief Financial Officer

Analysts

James Friedland – Cowen & Company

Mark Mahaney – Citigroup

Lorraine Maikis – Merrill Lynch

Bridget Weishaar – JP Morgan

Doug Anmuth – Lehman Brothers$

Jack Murphy – William Blair & Company

Jennifer Bennett – JMP Securities

Operator

Good afternoon ladies and gentlemen. My name is Marcelo and I will 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 Eileen Askew, Manager of Investor Relations of Blue Nile. Please go ahead.

Eileen B. Askew

Good afternoon and thank you for joining us on our conference call today to review our fourth quarter 2007 financial results. With me today are Mark Vadon, Executive Chairman; Diane Irvine, President & Chief Executive Officer; and Robin Easton, 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 margins, expenses, net income, operating cash flow, capital expenditures, international growth, stock-based compensation expense and other financial statements for balance sheet items as well as statements about our future plans and objectives, 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 publically update or revise these statements. Our actual results may differ materially and adversely from any projections and forward-looking statements discussed on the call. Our quarterly reports on Form 10Q, our annual reports on Form 10K 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 pre-cash flow which is defined as net cash divided by or used in operating activities or operating cash flow less out flows for purchases of fixed assets, including internal use software and website development. We will also discuss non-GAAP adjusted EBITDA which his defined as earnings before interest and other income, taxes, depreciation and amortization adjusted to exclude the effects of stock-based compensation expense. Please refer to the investor relations section of our website to obtain a copy of our earnings release which contains reconciliation of non-GAAP measures to the nearest comparable GAAP measures.

At the conclusion of the call, we will conduct a question and answer session. Now, I would like to turn the call over to Mark Vadon.

Mark Vadon

Good afternoon everyone and welcome to today’s conference call. In addition to releasing our quarterly and annual financial results today, we made another big announcement. Last week our board of directors promoted Diane Irvine to the role of CEO. Along with that change I have assumed the role of executive chairman. Diane as retained her position on the board of directors and I will continue as chairman of our board. Investors who have followed us over the years release that Diane and I have taken an extremely collaborative approach to managing this business. That approach will not change with our new roles. I started Blue Nile in 1999 with the dream of using the Internet to transform the $60 billion dollar retail jewelry market. In the fall of 1999 I met Diane and instantly new that she would be an essential part of making my dream a reality. Diane joined me at Blue Nile as chief financial officer and over the years she has been my partner at Blue Nile through the best and worst of times and through it all her faith in what we are doing has not wavered. I always said, if one person believes in our mission more passionately than I, it is Diane.

Through the years, in addition to managing the finance function, Diane has been responsible at different times for every functional area of the business and in January, 2007 she was appointed president of Blue Nile. Diane has had full operating responsibility for the business since this summer leaving me the time to work on the longer term growth strategy for our business. With the change announced today we are formalizing the role that Diane had already begun to play. As we move into the next stage or our business, my role will be to continue to help articulate the long term vision for the business, to help manage critical relationships with our partners and to be a sounding board for Diane and the rest of the management team in our mission to create an iconic global brand.

On today’s call I will take us through the highlights of Q4 and the full year. Diane will talk more about where we are going in 2008 and Robin will take us through the details of the Q4 numbers and provide financial guidance for Q1 and 2008.

A year ago, I informed you of our key goals for 2007. I’d now like to revisit these objectives and provide an update on how we performed. First, we said we would focus on generating profitable growth. We drove sales growth of 26.9% in 2007 and delivered an operating margin of 7%, an improvement over the 6.6% in 2006. Our EPS in 2007 grew 36.8% to $1.04. Second, we committed to expand our international operations. We launched two local currency websites in 2007, serving the Canadian and UK markets and opened an operation center in Dublin to service the UK and greater European markets. Our international sales doubled in 2007 from the prior year from over $17 million and grew over 150% in Q4. We have much more to do on the international front and I’ll talk more about this in a moment. Third, we continue to perfect the Blue Nile experience for our customers.

Repeat and referral continues to be the greatest source of business for Blue Nile so it is important that we exceed our customers’ expectations in every way. For the holiday season we enhanced the customer experience by offering free priority overnight shipping on all orders. Additionally, we enhanced all three of our websites in November to highlight our focus on guidance and education and to improve the usability of the sites. Lastly, we committed to continued disciplined cost management. I touched on this a moment ago when I highlighted our improvement in operating margin. For 2007, SG&A excluding stock-based compensation fell from 11.9% of sales to 11.6% of sales. We accomplished this while opening a new operation in Dublin that is still coming up to scale. We continue to capitalize on the leverage in our business model and are working towards our long term goal of SG&A expense equal to 10% of net sales in our business.

The fourth quarter was another good quarter for Blue Nile and capped an excellent year for the company. Revenue for the quarter was up 23.3%. Importantly, we achieved this growth against the backdrop of deteriorating macroeconomic environment in the fourth quarter. As other jewelry retailers announced negative same store sales growth for the holiday season, Blue Nile achieved excellent growth in comparison. For perspective, there are five other significant publically traded US jewelry retailers. For the holiday season Tiffany reported US comp store sales excluding their New York flagship of -4%. Signet reported -8.1% comps for the holiday, Zales was at -9%, Finley at -5.9% and Birks & Mayors reported -10% holiday comps for their US stores. In this environment we reported 23.3% growth including 18.3% growth in December.

As a luxury category the jewelry sector is perhaps more volatile and more prone to economic downturns than other categories of retail. Within the category, we have steadily gained market share over the years. If you look at an index of comp store sales for the major industry players and then compare our growth numbers over time to this index you’ll see that for several years we have consistently been growing some 20 points faster than the category but, our quarterly numbers do tend to move up or down with changes in comp store sales of other industry leaders. For us as a business, the goal is really to consistently gain share through good and bad markets. If our category is negatively impacted by a macroeconomic slowdown, our goal will be to continue to rapidly gain share focusing on the relative growth versus the category. You will see that our guidance for 2008 today is more conservative than historically. This guidance is reflective of our view of the environment for high end jewelry. With the current uncertainty among consumers we feel that it is prudent to plan conservatively and hope to be surprised by the upside.

Turning back to the 2007 numbers, engagement had strong performance in the fourth quarter and full year. The average sales price in 2007 for an engagement ring sold on our website was just over $6,200, well above the industry average. We are pleased to see this category perform consistently well for us. All other product categories from diamond earning to pendants to wedding bands showed impressive growth for the quarter and the year. For the full year, our non-engagement jewelry sales reached over $100 million and accounted for about 32% of total revenue compared to about 30% of revenue in 2006. Our high end sales growth was strong. Sales in this category with prices over $25,000 grew greater than 50% in the fourth quarter and in fact, grew greater than 50% year-over-year in every quarter of 2007. As the fourth quarter came to a close and the first quarter started however, we began to see weakness at very high price points. We believe that the uncertain macroeconomic environment is finally having an impact on this sector of the market.

International expansion, as I stated earlier, is a key strategic initiative for our business. Q4 marked the first holiday season for our Canadian and UK websites with transactions in local currency. The response to our business in these new markets has been exceptional. International sales in the fourth quarter were $7.2 million, up over 150% from Q4 of 2006. We are excited about the expansion of our shipping capabilities to 12 new countries that we announced last week. Already with almost no marketing spend in these markets we have received multi thousand dollar orders from Japan, Australia, New Zealand, Singapore, Hong Kong, Germany and Switzerland. Our offering in these markets is limited but it is providing us with insights into these new areas and is giving us confidence in continuing to push rapidly into international markets.

I would now like to turn the call over to Diane who will provide us with an overview of where we are going in 2008.

Diane Irvine

Before I begin talking about our goals for the coming year, I want to take a moment to recognize all that Mark has accomplished as CEO in building Blue Nile’s business. Mark started Blue Nile in 1999 with just a few people, several telephones and computers, a website and a dream of creating a great business with a unique economic model and the opportunity to build a lasting brand. Mark is a true visionary who has built an amazing business, one that has redefined the consumer experience for diamonds and jewelry. Under Mark’s leadership Blue Nile invented a category, the online retailing of diamonds and jewelry and has become its undisputed leader. Mark is in many ways the quintessential customer for our products and he has created a culture at Blue Nile that obsesses about our customers and strives to create the perfect customer experience. Mark has lead us through nearly nine years of growth, through the ups and downs of the Internet from a raw start up to a highly profitable business with sales of over $300 million in 2007.

Since the day Mark offered me the opportunity to join Blue Nile in 1999 it has been an honor and privilege to work alongside him. He has built a team of talented incredible people who are passionate about what they do and committed to building a very special business for the long term. Mark has established exceptional relationships with our employees, our suppliers and business partner and our investor and he has done it all with intelligence, honestly, a sense of humor and a rare humility. I am very honored to succeed Mark as CEO and I look forward to continuing to work with him for many years. I truly believe the best is yet to come for Blue Nile.

Over the past eight years we have accomplished a tremendous amount. As we enter 2008 we have an extremely strong domestic business that is well positioned to continue to gain market share. We dominate the sale of diamond jewelry over the Internet and have become one of the country’s largest jewelers through any channel. We continue to rapidly gain share from physical retailers because we offer greater selection, exceptional value and a superior customer service. On the International front, we have a rapidly growing business with opportunities across many different geographic markets. Looking forward many years, the opportunities for us internationally rival those of the US market. We have an incredible business model and an extremely talented team. Combined, this gives us great opportunity as we move into the next several years.

While we have an unprecedented business model for the jewelry industry, as we enter 2008, the health of the economy and general consumer confidence is definitely at the forefront of our mind. As a retailer of luxury goods, we have anticipated that a slowdown in consumer spending will have an impact on our business and we have seen a softening in the current quarter as a result of the challenging macro environment. Therefore, we are very cautious in our outlook. Our focus is on establishing this business for the long term and building market share. In a period of economic uncertainty, we believe we have a great opportunity to attract customers to the exceptional products and outstanding value that we offer. In this environment we will be a very challenging competitor. Consider physical retailers of jewelry who typically have high fixed costs and run at gross margins of roughly 50%. In an environment where demand falls, this high fixed cost structure combined with the asset intensive nature of physical retail can lead to dramatic declines in profitability. Already in 2008 there have been two very significant Chapter 11 filings in jewelry retail and news of store closings from national chains.

Our model is very different. We have both the best cost structure in our industry and a capital efficiency that is unique within jewelry retail. While we are not immune to pull backs in consumer spending we believe our model allows us to weather economic downturns with continued profitability much better than any of our competition. With this as the competitive backdrop our focus in 2008 will be to continue to execute with excellence for customers, gain market share and emerge from any downturn with a stronger relative position to our competition than ever before. We will be very disciplined about running our business efficiently through this uncertain period. We will remain diligent and focused on profitable growth and free cash flow generation. Our high level objectives for the business in 2008 are: first, we will enhance the Blue Nile customer experience. We believe we deliver an unmatched customer experience at Blue Nile. Our intent is to continuously raise the bar for ourselves in this area. Over the next year we have many initiatives under the way to enhance the customer experience and ultimately increase conversion. Some of these include a comprehensive service and training initiative for our customer service team, the enhancement of our website features and functionality and a broadening of the offerings within our jewelry assortment.

We see 2008 as a time for us to capture additional market share and emerge with an even stronger competitive position. While physical store jewelers may need to cut back on service and selection to combat the economic downturn we have the ability to leverage our online platform and grow our business through a period of slower consumer spending while offering exceptional service and selection to our customers. We view this period as a tremendous opportunity to gain market share and to create value for our shareholders.

Our second objective is to focus on an efficient and lean cost structure. We have an efficient operating model that distinguishes us from our brick and mortar competitors. Our SG&A as a percentage of sales was just over 13% in 2007 compared to traditional jewelry retailer rates of 35 to 45%. We have a very efficient cost structure that doesn’t require a network of stores and high overhead costs as in physical retailer. In an uncertain economic environment it is more important than ever for us to maintain our lean cost structure. We will look at ways to improve efficiency in all areas of the business and prioritize projects that will drive the top line. Our focus on cost control is deeply ingrained into the culture of Blue Nile. That focus has been a key part of our success from the beginning of our business and it will remain with the company for the future regardless of economic environment.

Third, we will drive international growth. Expansion into new international markets will be a key initiative for 2008. As we announced last week, we now offer shipping to 12 new countries in both Europe and Asia pacific making the Blue Nile brand accessible to consumers in those markets. We believe there is great opportunity for us to capture market share in these countries where there is little, if any, online competition. The selection of diamonds in these countries today is fairly limited. Our entry into these new countries provides those consumers with access to over 60,000 high quality diamonds and dramatically expands their selection. We’ve had a very promising start with our business in Canada, the UK and Ireland and now we’re very excited about the future growth opportunities in those markets as well as the 12 new countries we began shipping to last week.

We believe 2008 is a year for Blue Nile to capture a significant share in the jewelry market both domestically and overseas. Our prospects are bright and despite the current economic headwinds we are optimistic about the long term potential for Blue Nile. I’d now like to turn the call over to Robin.

Robin Easton

Good afternoon everyone. In the fourth quarter we posted net sales of $111.9 million representing an increase of 23.3% over the fourth quarter of 2006. In Q4 total orders increased 14.9% as compared to a year ago. Our average selling price per order was $1,411 in the fourth quarter compared to $1,314 in Q4 2006. Gross profit for the quarter was $23.7 million, an increase of 25.9% year-over-year. Our gross margin for the quarter was 21.1% an improvement of 40 basis points from a year ago. Net income for the quarter was $7.5 million. Earnings per diluted share was $0.45 up 28.6% from the fourth quarter 2006.

Moving to costs, our SG&A totaled $13.6 million for the fourth quarter and included $1.7 million in stock compensation expense. As a percentage of net sales SG&A was 12.1% in Q4 compared to 11.7% in the fourth quarter a year ago. Excluding stock-based compensation expense, SG&A as a percentage of sales was 10.7% compared to 10.4% in the fourth quarter of 2006. SG&A in the quarter was impacted by additional costs associated with our expanded fulfillment center, newly established international operations as well as slightly higher marketing costs than in the fourth quarter 2006.

Operating income improved 24% in the fourth quarter to $10.1 million, representing an operating margin of 9%. Non-GAAP adjusted EBITDA which we define as earnings before interest and other income, income taxes, depreciation and amortization adjusted to exclude the effects of stock-based compensation expense increased 26.1% in the quarter to $12.4 million. This was an excellent performance for the quarter. Interest income totaled approximately $1 million for the quarter compared to $.8 million in last year’s fourth quarter. Our effective tax rate for the quarter was 33.3% compared to 35.5% a year ago. The lower tax rate is primarily due to deferred tax asset adjustments. Our effective tax rate for fiscal 2007 was 34.3% compared to 34.6% for 2006.

In respect to the balance sheet we ended the year with a strong cash balance of $122.8 million even as we repurchased $20 million of Blue Nile shares during the year. Now, let’s turn to the cash flow statement. Operating cash flow increased 17.4% during the quarter to $55.5 million. For the full year, operating cash flow increased to $41.5 million from $14.5 million. Free cash flow which we define as cash flow from operations including cash costs for taxes, tax benefits from stock compensation and changes in working capital less capital expenditures totaled $36.6 million for the year compared with $38.6 million in 2006. There are a number of items I’d like to review with respect to our free cash flow for the year. First, free cash flow for 2007 reflects the change in deferred income taxes related to the utilization of our tax net operating losses in 2006. Second, as you know, a portion of our free cash flow relates to the favorable capital dynamic in our business. While we made good progress in working capital during the year, we were disappointed with our performance in this area in Q4. Specifically, we ended the year with inventory of $20.9 million which is higher than we would have liked. We are taking steps in inventory management in order to improve our inventory position.

A very positive area that I’d like to highlight in terms of working capital performance is the significant improvement we achieved in accounts payable during the quarter with the days payable expanding by four days compared to the prior year. Lastly, our free cash flow reflects higher capital expenditures of $4.9 million for 2007 compared to $1.9 million for 2006. This increase was primarily related to the expansion of our domestic facility and the establishment of our international operation in Ireland. These are investments that we are leveraging for future growth including the recent announcement related to our expanded international offering.

During the quarter we repurchased 94,100 shares of stock for $6.5 million. For the full year 2007 we repurchased 438,755 shares of stock for $20 million. Today, in our press release we announced that our board of directors authorized an additional $100 million of stock repurchases over 24 months. This new authorization combined with our $50 million of authorization that is currently outstanding gives us the ability to opportunistically repurchase up to $150 million of Blue Nile shares over time. Since launching our stock repurchase program three years ago, we have repurchased $2.8 million shares for approximately $95 million and retired 15.7% of our outstanding shares.

I’d now like to discuss guidance for the first quarter and full year 2008. This is the first time that we have provided financial guidance for 2008. I’d like to point out that we operate on a 52/53 week fiscal calendar. Our fiscal year 2008 which will end on January 4, 2009 will include 53 weeks rather than the normal 52. The additional week will occur in our fourth quarter ending January 4, 2009.

As Mark and Diane mentioned earlier, we are very cautious in our outlook for 2008 given the uncertainty in the macro environment and the slowdown in consumer spending in the US. For the first quarter we expect net sales to be relatively flat to last year’s first quarter sales. Net income is expected to be $0.11 to $0.14 per diluted share. I’d like to provide perspective in comparing Q1 with last year’s first quarter. Q1 2007 was our highest gross quarter of the year at 34% revenue growth making it a very difficult comp. There are also a few important items to note with respect to EPS comparisons year-on-year. In Q1 2007, we reported EPS of $0.19. $0.01 of these earnings related to one time other income. Additionally, Q1 2008 is expected to have higher stock compensation expense that equates to an incremental $0.02 of EPS compared to the prior year. Lastly, the first quarter of 2008 includes higher costs year-on-year related to our newly expanded domestic fulfillment center, our international operations and higher marketing expenses.

We are being very cautious in our outlook for the year due to uncertainty given the overall economic backdrop. Our goal for the year is to grow net sales for 2008 by at least 10%. In addition, our goal is to grow non-GAAP adjusted EBITDA by at least 10% for the year. Our goal with respect to earnings per share is to achieve GAAP EPS that approximates our 2007 level. There are a few important items to note with respect to EPS comparisons for 2008 compared to last years. First, the estimated impact of stock compensation expense for 2008 is approximately $0.29 per diluted share or $0.07 higher from the impact of stock compensation expense on EPS for 2007. Second, we have assumed lower interest income on our significant cash balance as a result of lower interest rates compared to a year ago. Third, 2008 includes higher costs year-on-year related to our newly expanded domestic fulfillment center and our international operations. We expect capital expenditures for the year of approximately $2.5 million compared to $4.9 million in 2007. The effective tax rate for financial statement purposes for the first quarter and full year is expected to be approximately 35%.

Now, I’d like to turn the call back to Diane.

Diane Irvine

In summary, we’re very pleased with our Q4 results. Our plans for 2008 are to continue to build the Blue Nile brand for the long term focusing on profitable growth and free cash flow generation in a difficult macroeconomic environment. We would be happy to take your questions now.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll pause for just a moment to compile the Q&A roster. Our first question is from the line of Jim Friedland of Cowen & Company. Please go ahead.

James Friedland – Cowen & Company

First is a question on your Q1 guidance. You just noted on the guidance on revenues that you had really tough comps from Q1 last year. I was wondering if you could give us some more color on specifically what you’ve seen in the quarter to make you give guidance of flat sales? Is it Valentine’s Day where you saw a significant drop off? Is it the high end? Is it the low end? Is it all areas? Then, my second question is that you noted that you’d like to grow share in this tough environment. A couple of years ago you lowered prices, especially since marketing costs were starting to get up there and I was wondering if that’s a strategy that you would undertake in the current environment to gain share. Thanks.

Mark Vadon

On the guidance, I think we’re seeing what a lot of luxury retailers are seeing, is that consumers are behaving very differently over the last 10 weeks than they have been for quite some time. We had a weak January and things have actually picked up slightly going into February but, where we sit today, it’s pretty tough to give guidance for the full year just to be perfectly straight with you guys. What we saw in January was people pulled back. When I talked to people in the channel they’re telling me that stores are absolutely dead. We don’t know how long this continues, whether what we’re seeing is a reaction to people spending what money they were going to spend at Christmas time and then pulling back now, or if it’s something more sustained than that. So, our mindset is to give conservative guidance based on where we’re standing today and then if the situation improves, which we’re hopeful it does, we’ll continue to update. But, from a macro perspective our goal is really just to gain share. That’s all we can do. We can’t change whether or not consumers are going to come into the market to make a purchase but we can do our best to try taking those consumers when they do, and I think we’ve been doing that well for almost nine years now and regardless of what the market does we will grow faster than other people. That’s our intent and I think we’ll do that.

Our guidance is for that as well. The other anomaly we’ve seen over the last few weeks is that very high-end of the market, those price points above $25,000 that were healthy for a very long time for ourselves, as well as a lot of the other luxury players out there are all of a sudden very, very weak. I think we said in the call that high-end sales were 50% growth or above every single quarter of last year. We definitely didn’t see that in the last couple weeks of December and in January. I think the very, very high-end consumer is finally showing some vulnerability out there. The guidance we’re giving today is based on what we’ve seen so far. But if that changes we’ll update people.

On pricing our mindset is we’ll look at that month by month. We think there’s an ability to lower price in order to get more of the market, we’ll do that. But our sense isn’t that we are mispriced relative to the market or anything like that. It’s more that consumers aren’t out there. When you listen to the calls of some of our fellow jewelers what you’re hearing is that the traffic going into the stores is weak. They’re not seeing the bodies come in the front door and I think that’s the same online. We’re seeing weakness in things like the number of search impressions that are delivered and that’s not our clicks are up, that’s the number of people actually conducting searches and we’re seeing weakness in affiliate traffic. I think overall consumers are holding back right now and it doesn’t matter if we bring prices down if the people aren’t in the market. So I think we have a product where people are not going to pull back permanently, but I think we’re in a very, very kind of transitional time right now and the market is relatively weak.

Operator

Our next question is from the line of Mark Mahaney of Citigroup. Please go ahead with your question.

Mark Mahaney – Citigroup

Mark and Diane, I was wondering if you could also address what could be other issues that are affecting your revenue results or your revenue outlook, to what extent there could be any new competitive pressures in the market as a reporter saw in the Amazon press release? You mention rising marketing costs. Are you seeing again the beginnings of a spike although the searches may be down, but a spike in search engine pricing? And then finally, the issue of rising metals prices, is that at the same time crimping overall demand and I guess it doesn’t seem like it’s impacting your margin outlook, but any comments on how you navigate those headwinds if you see those as headwinds would be appreciated.

Diane Irvine

I think as Mark portrayed our thoughts on guidance that is absolutely the full story. If you look at competition I think we feel stronger than ever, from a competitive standpoint, we saw that again in the fourth quarter. So this is strictly consumer spending related and in terms of people coming to the store. I don’t think it has anything to do with competition. I think we feel stronger than ever about that position. In terms of marketing costs we do tend to see that in Q4, especially for holiday where you see more competition out there. So the prices tend to rise, but that’s not something is impacting our guidance today. Rising metal prices, you’re right. We saw dramatic increases last year and even year to date in 2008, but if you think about our product categories, the metals cost is a very small percentage of the total item. If you’re looking at a diamond ring or diamond earrings, in our case I think we’re offering the greatest value consumers can have. So I think we’re a place for them to come. If you look at our gross margins in Q4 certainly we didn’t see that we were inhibited in terms of those prices so we feel that and we factor it into our pricing over the long term. But what we’re looking at today, which is based on the weak January that we saw, has everything to do with the consumer and I think we feel today that the picture is not clear. There’s not a clear statement as to where the consumer is headed and that’s really what our thinking is about.

Mark Mahaney – Citigroup

And one quick follow up, all of that consumer weakness as far as you can tell is US. The international operations are relatively small for you, but have you seen any signs that that’s rolling over to the UK and Canada?

Diane Irvine

Our international businesses are doing great. Really we are talking about the US, Mark.

Operator

Our next question is from the line of Lorraine Maikis of Merrill Lynch. Please go ahead.

Lorraine Maikis – Merrill Lynch

Could you comment on our outlook for free cash flow for 2008? And also you did say in your guidance for the first quarter that you expect some higher year-over-year costs including marketing. Is that buying more keywords to try to drive share?

Diane Irvine

In terms of free cash flow, we don’t provide guidance there but I would say is that we expect to have good profitability this year. We think we’ll be able to manage through whatever the environment becomes. You won’t have the one-time impact that we saw a year ago from converting to being a cash taxpayer. We also have lower cap ex during the year and I think we can do an even better job in terms of our working capital management. I think we’ll have a strong number for free cash flow in 2008. In terms of marketing, we did see pricing pressure in Q4 as I mentioned which we always see during holiday. January where we saw weakness, our marketing spend on average was higher than we normally see, but I don’t think that is a trend on an ongoing basis. I think really as you look at costs on the margin thus far in the quarter, we’ve had higher marketing costs but if you look at the full year, what we’re really pointing to in terms of cost structure would be related to the renovation of our domestic fulfillment center in 07 as well as the startup of our international operations.

Mark Vadon

I think if anything if you look out over the next six or 12 months, if we do go through a period of sustained economic downturn, you’re going to see a lot of our competition pulling back. We’ve already had one large chain announce store closures. I think you’re going to see people kind of pulling in any discretionary spending and trying to control their cost structures. So I think their efforts to drive the Internet channel are not going to be a top priority within their business. We saw a little bit in 2001 of the economy pulling back and when that happened, the market for online advertising got a little bit easier. Our mindset is just that we have the strongest economic model of the jewelry players that are out there and we should be able to, and especially when you look at the Internet environment, we should be able to spend what’s appropriate to get consumers even more effectively when the market is weak.

Lorraine Maikis – Merrill Lynch

Can I just follow up with a quick question on inventory? It seemed like that was a bit higher than you were expecting coming out of holiday. What is that? Is that non-engagement jewelry and is there clearance risk there?

Diane Irvine

I think if you look at our inventory, no there is no risk there in terms of the product itself. I would say we ended up a bit higher than we would have liked. We’ll be in good shape as we go through 2008. We are talking other jewelry products. It would be setting for engagements, certainly a significant portion of our inventory at any given point in time is settings for diamond rings because we also want to be able to monetize the diamond. And then it would be other forms of jewelry. But if you look at our offering it’s really classic merchandise. So there’s nothing there that’s worrisome from that standpoint. It just ended up a bit higher than we would have liked.

Operator

Our next question is from the line of Bridget Weishaar of JP Morgan. Please go ahead.

Bridget Weishaar – JP Morgan

I know you’ve seen traffic levels down. Could you discuss what you’re seeing in terms of your conversion rates? Also have you experimented at all with prices to see what price elasticity is amongst your customers?

Mark Vadon

In Q4 we did not see traffic levels down. Traffic levels were in the mid-teens and conversion improved as well. With our 23% growth a little more than half of that was traffic and the rest was conversion. We feel like that’s a healthy combination of drivers there. On price elasticity over the years we’ve run at many different price levels trying to understand price elasticity in the market and we have a fairly price-sensitive consumer. So there is elasticity to what we’re doing here. At any given time we’re playing with pricing in individual small areas of the inventory. There’s roughly 60,000 diamonds for sale on the website and when we feel that there’s parts of the market where there’s more demand than supply, there’s parts of the market that are weak, we will raise prices there and try to get a little bit more margin. In more commoditized areas we’ll drop price and try to compete on price more. We feel like we’re maximizing where we’re at today, but that’s one where we continue to play with it. If you go back and look at our numbers a couple years ago, you saw us doing some fairly aggressive things and consumers reacting. By lowering price we drove better economics to the business. Right now our mindset is to maintain pricing on any given product line where it is today.

Operator

(Operator Instructions) Our next question is from the line of Doug Anmuth of Lehman Brothers. Please go ahead.

Doug Anmuth – Lehman Brothers$

I just want to back to the inventory issue. Diane, can you comment on where you are currently in inventory in terms of working through what you thought was a little bit high as you exited last year? What’s the urgency basically in doing that? Can you leave that and let it flow through the course of the year? And secondly what did you see in terms of the user experience in changes to user behavior from updates that you made to the site and note number?

Mark Vadon

Diane, I’ll grab the inventory and then you can do the other one. I’ll leave the fun one for you. Inventory ended probably a few million dollars higher than we would have liked. We had the inventory in stock to meet levels of demand that were growing at October, November levels. As I mentioned in the call we saw the growth rate tick down a little bit in December. That led to part of it. Where it’s also, as you see metals prices rising as they are, we are reluctant to return anything to suppliers. Normally if you’re over inventory your suppliers will help you out and take some stuff back and we don’t want to do that because we’d be returning stuff that we bought at lower prices, if that makes sense. But where we are in inventory, we have extra in things like diamond earrings and gold and platinum bands and things like that. It’s very basic product and the turn rate is still very high on those types of products. We’ll just work through that inventory as we go through Q1. It’s not a big deal. There’s also some element that we haven’t talked about, but we have the new fulfillment center in Dublin which requires inventory so as we set up a small operation there, the turn isn’t quite as fast in that operation. So you’re seeing some of the inventory going to that piece of the business as well.

Diane Irvine

In terms of the user experience, Doug, I think we’ve seen great things with our updated website. We see great results in terms of conversion. We have customers who are looking for more information, more tools in terms of doing their diamond searches and creating their customized product and I think that’s gone very, very well. And our team continues to do a great job in terms of making incremental improvements each and every day that really speak to the consumer. So that’s something we will continue to focus on this year. Especially, we look at whoever is coming to our website, we want to make it better and better for them to make their purchase and do their searches, get through that process. So I think that’s gone well but we always feel like we have room to do even better.

Operator

Our next question is from the line of Jack Murphy of William Blair. Please go ahead.

Jack Murphy – William Blair & Company

Just a couple of questions on the guidance, can you talk a little bit about what type of gross margin is embedded in the guidance, within a range, of understanding it’s not precise yet? Additionally what type of investment in terms of SG&A is embedded in the guidance for things like improving the site and international? And then finally, could you talk about if any buyback is assumed in the guidance?

Diane Irvine

In terms of gross margin, we don’t provide guidance. I’d point back to Mark’s comment that if you look product category by product category, our mindset today is that we’ll keep pricing stable there. I think we expect relative stability there. In terms of other investments, we’re not quantifying that. I think broadly it’s important to know that if you look at the past year, we’ve obviously added some people throughout our operations. We have a brand new international operation which we are growing as we’ve expanded into these new countries. In terms of the site, that’s internal, our technology team. I think on the margin we want to point out that we have a bit higher cost there, all of which positions us very well for continued growth and taking share in the future. In terms of investment, we don’t really bake into our guidance assumptions related to buybacks but clearly our mindset that is a strategic means for us to deliver value to our shareholders and we absolutely will maintain that mindset throughout.

Jack Murphy – William Blair & Company

With the $140 some odd million cash balance and cash flow generation capability is there any reason to believe you wouldn’t get back to that level of repurchase that you did more mid-2007?

Diane Irvine

I don’t want to forecast a repurchase level but you’ve seen us work opportunistically at that program. It’s absolutely our mindset that that is a program that delivers value to shareholders. We’ll always be mindful and thoughtful about that program so that we’re doing the right thing for shareholders. But that is likely our number one capital allocation strategy.

Jack Murphy – William Blair & Company

Last question, as you look at the deceleration that’s baked into the first quarter and then just 08 over 07, on the top line, could you give us a sense of are you more negative on the order growth? That would be my impression, but are you also equally as concerned about selling prices or is it more weighted toward concerns on order growth?

Mark Vadon

We don’t guide the order growth, but one thing I’ll point you to. In Q1 of 2007 we were working with Google to do an aggressive promotion on Google Checkout. I think the offering was $10 off any purchase which drives a lot of units. With a promotion not like that in this year, you probably won’t see – If you look at purely year-on-year numbers, you won’t see the type of units that we drove last year, but if you put aside those one time promotional activities that happened – I think last year we had them in Q1 and Q2 – we wouldn’t expect any deviation from the overall trend you’ve seen in the business over the years.

Diane Irvine

In terms of ticket, that’s also not something that we manage to. That’s kind of the result of what happens. Importantly with respect to guidance, as Mark talked about, we’re providing our outlook based upon what we saw in January. We have seen improvement for Valentine’s Day, but I think it’s not a trend. So I think we want to be very cautious in our outlook.

Operator

And we have time for one more question, Jennifer Bennett with JMP Securities. Please go ahead with your question.

Jennifer Bennett – JMP Securities

Quick question, could you talk a little bit about performance of engagement versus non-engagement? I guess we think of engagement as relatively recession resistant and so is it really the non-engagement diamond and other jewelry that is being challenged? My second question is with regard to the international expansion. A good part of your business is driven by referrals and word of mouth. How are you planning to drive brand awareness in these new markets?

Diane Irvine

In terms of engagement versus non-engagement, and I assume you’re referring to Q1 of 08?

Jennifer Bennett – JMP Securities

Yes.

Diane Irvine

Mark mentioned that we’ve seen a slow down at the very high end so that is impacting us, but I think more broadly if you look at this category of diamonds as being a luxury product, I think we’re just seeing a pullback on the part of the consumer. We saw great results in 2007 and in Q4 and so I have no doubt that over the long term we continue to take share and we represent a great value and place for people to come who are in the market. I think we just need to work through some of what we’re seeing in the economy. In terms of international, you’re right. Word of mouth is so powerful for us and I do think that’s what we’re seeing even in the past week, we’re doing very little marketing in those markets and I think there is demand for the Blue Nile brand and for our product so we love what we’re seeing there where I think that really is being driven off of word of mouth and awareness through referral. So we’ll begin to put some marketing dollars in those areas but I think the early results are fantastic for us there.

Mark Vadon

And just a little more on the engagement category of the question you’re asking. I do believe the engagement category is more recession proof than other parts of the market, but a couple caveats to that. One is I think you can see periods of time where people will put off the purchase and wait until they feel a little better. They won’t put it off permanently, obviously, they’re still going to go ahead and get engaged and get married, but they will put it off. The other part, within engagement there’s a piece of that market for us which we think of as upgrade rings. It’s people who’ve already been married for a significant amount of time buying the ring that they’ve always wanted and in that part of the market, it is much more of a luxury purchase as opposed to a necessity. That’s where we see, typically when we’re seeing the $50,000, the $100,000 – The other day we sold a $1 million ring. So some people are weathering the storm okay. But in that part of the market, those are typically not people who are getting engaged. They are people who are replacing an engagement ring they bought earlier in life.

On the international, within the UK and Canada we’ve got much more robust marketing programs in place there, where referral is still an important piece but we’re doing everything from search to some banner advertising. We have affiliate programs, we’re layering in an email program in those markets. In some of these newer markets we’ve never done any marketing whatsoever yet. We’re already seeing demand. The orders we’ve seen so far out of those 12 new markets range from $2,000 up to $28,000 and they’re people who are finding us and people who’ve heard about us and some of those markets, I think some of it’s coming from the [X Pack] community. It’s people who’ve become aware of us over time and are now in those markets seeding the very beginning of the referral. We saw this exact same thing in the US in 1999 and in the UK five or six years after that when we launched into that market. We’ve been very excited. Just over the last week in some of those international markets I think it’s made us realize that there’s a lot more opportunity internationally than we thought. I think that’s a big direction going forward is turning a lot of our resources to pursue that market more aggressively.

Thank you everybody for attending on our call today and we look forward to updating you next quarter. Thanks.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Blue Nile Q4 2007 Earnings Call Transcript
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