Blue Nile drove sales growth of 26.9% in 2007 and delivered an operating margin of 7%, an improvement over the 6.6% in 2006. The EPS in 2007 grew 36.8% to $1.04.

The firm committed to expand its international operations and 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. The company’s international sales doubled in 2007 from the prior year from over $17 million and grew over 150% in Q4. The company is excited about the expansion of its shipping capabilities to 12 new countries. With almost no marketing spend in these markets, Blue Nile has received multi thousand dollar orders from Japan, Australia, New Zealand, Singapore, Hong Kong, Germany and Switzerland.

The company continues to perfect the Blue Nile experience for its customers. Repeat and referral continues to be the greatest source of business for Blue Nile so it is important that it exceed its customers’ expectations in every way. For the holiday season, the firm enhanced the customer experience by offering free priority overnight shipping on all orders. Additionally, the company enhanced all three of its websites in November to highlight its focus on guidance and education and to improve the usability of the sites.

The management is committed to continued disciplined cost management. For 2007, SG&A excluding stock-based compensation fell from 11.9% of sales to 11.6% of sales. The company accomplished this while opening a new operation in Dublin that is still coming up to scale. The firm continues to capitalize on the leverage in its business model and is working towards its long term goal of SG&A expense equal to 10% of net sales in our business.

For the full year, operating cash flow increased to $41.5 million from $14.5 million. Free cash flow, which is defined 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 to review with respect to the firm’s free cash flow for the year.
- Free cash flow for 2007 reflects the change in deferred income taxes related to the utilization of its tax net operating losses in 2006.
- A portion of the company’s free cash flow relates to the favorable capital dynamic in its business. While the firm made good progress in working capital during the year, it was disappointed with its performance in this area in Q4. Specifically, the company ended the year with inventory of $20.9 million, which is higher than it would have liked. The management is taking steps in inventory management in order to improve its inventory position.
- The 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 its domestic facility and the establishment of international operation in Ireland. These are investments that the company is leveraging for future growth, including the recent announcement related to its expanded international offering

For the full year 2007, Blue Nile repurchased 438,755 shares of stock for $20 million.

The engagement ring category had strong performance in the fourth quarter and full year. The average sales price in 2007 for an engagement ring sold on the firm’s website was over $6,200, well above the industry average. 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, non-engagement jewelry sales reached over $100 million and accounted for about 32% of total revenue compared to about 30% of revenue in 2006. Sales in this category with prices over $25,000 grew greater than 50% in the fourth quarter and 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, the firm began to see weakness at very high price points. The management believes that the uncertain macroeconomic environment is finally having an impact on this sector of the market.

Fiscal 2008 Outlook

The 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 the fourth quarter ending January 4, 2009. The management is very cautious in its outlook for 2008 given the uncertainty in the macro environment and the slowdown in consumer spending in the US.

For the first quarter, the firm expects net sales to be relatively flat to last year’s first quarter sales. Net income is expected to be 11 cents to 14 cents per diluted share. The Q1 of 2007 was the firm’s 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, the firm reported EPS of 19 cents. Of this, 1 cent earnings was related to one time other income. Additionally, Q1 2008 is expected to have higher stock compensation expense that equates to an incremental 2 cents of EPS compared to the prior year. Lastly, the first quarter of 2008 includes higher costs year-on-year related to the firm’s newly expanded domestic fulfillment center, international operations and higher marketing expenses.

The management is being very cautious in its outlook for fiscal 2008 due to uncertainty given the overall economic backdrop. The goal for the year is to grow net sales by at least 10%. In addition, the firm’s goal is to grow non-GAAP adjusted EBITDA by at least 10% for the year. With respect to earnings per share, the firm aims to achieve GAAP EPS that approximates 2007 level. There are a few important items to note with respect to EPS comparisons for 2008 compared to last years.
- The estimated impact of stock compensation expense for 2008 is approximately 29 cents per diluted share or 7 cents higher from the impact of stock compensation expense on EPS for 2007.
- The firm has assumed lower interest income on its significant cash balance as a result of lower interest rates compared to a year ago.
- 2008 includes higher costs year-on-year related to the newly expanded domestic fulfillment center and international operations. The firm expects 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%.

Key questions and answers from the fourth quarter fiscal 2007 earnings call conducted by Blue Nile Inc. on February 12, 2008.

James Friedland (Cowen & Company): You noted on the guidance on revenues that you had tough comps from Q1 last year. Could you comment specifically on what you’ve seen in the quarter to make you give guidance of flat sales?

Mark Vadon: We’re seeing what a lot of luxury retailers are seeing. It 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 picked up slightly going into February but, it’s tough to give guidance for the full year. 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. Our mindset is to give conservative guidance based on where we’re standing today. But, from a macro perspective, our is to gain share. 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 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.

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, all of a sudden, is very weak. The high-end sales had 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. The 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.

James Friedland (Cowen & Company): 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. Would you undertake that strategy in the current environment to gain share?

Mark Vadon: 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. It’s more that consumers aren’t out there. We’re seeing weakness in things like the number of search impressions that are delivered and that’s the number of people actually conducting searches and we’re seeing weakness in affiliate traffic. 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. We have a product where people are not going to pull back permanently, but we’re in a very transitional time right now and the market is relatively weak.

Mark Mahaney (Citigroup): Is the issue of rising metals prices crimping overall demand? Could you comment on how you navigate those headwinds if you see those as headwinds?

Diane Irvine : 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, we’re offering the greatest value consumers can have. We’re a place for them to come. If you look at our gross margins in Q4, we were not 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, has everything to do with the consumer.

Lorraine Maikis (Merrill Lynch): Could you comment on our outlook for free cash flow for 2008? 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?