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NILE > SEC Filings for NILE > Form 10-K on 25-Feb-2014All Recent SEC Filings

Show all filings for BLUE NILE INC

Form 10-K for BLUE NILE INC


25-Feb-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the consolidated financial statements and related notes which appear elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Annual Report on Form 10-K, particularly under the heading "Item 1A. Risk Factors."

Management Overview

Blue Nile is the leading online retailer of high-quality diamonds and fine jewelry. We offer our products for sale through the Blue Nile website in over 40 countries and territories throughout the world. We believe that our extensive and unique product selection, connection with our customers through our marketing and customer service efforts, and the value we provide to our customers through our competitive pricing will result in increasing our sales and market share both domestically and internationally. Our primary focus is on growing our business by providing unparalleled quality, selection and value to consumers and delivering exceptional customer service. Our online business model allows us to avoid many of the costs that are typically incurred by physical retail stores. As a result, we are able to realize lower gross profit margins while remaining profitable and providing value to our customers through lower retail prices.

Our objective is to maximize our revenue and profitability and increase market share both domestically and internationally by offering exceptional value to our customers through a high-quality customer experience that leverages supply chain efficiencies and an efficient cost structure. We have established and will continue to refine our scalable, capital-efficient business model that enables growth with lower working capital requirements than traditional store-based jewelry retailers. We focus on optimizing the cash flow dynamics of our business by managing inventory balances along with vendor payment terms. Over the longer term, our goal is to increase revenues, profit, and cash flow by leveraging our relatively low fixed cost technology and operations infrastructure as we achieve sales increases. Our long-term financial focus is primarily on sustainable growth in free cash flow, a non-GAAP financial measure. Non-GAAP free cash flow is primarily driven by increasing our operating income and efficiently managing working capital and capital expenditures. Increases in operating income primarily result from increases in sales through our website, improvements in operating margins and the efficient management of operating costs, offset by the investments that we make in longer-term strategic initiatives.

Differentiating Factors and Value Proposition

Our innovative business model is designed to deliver exceptional value and service to customers. A significant portion of our revenues is derived through sales of engagement rings or jewelry products that feature a diamond. We have developed relationships with a large number of diamond suppliers with whom we have exclusive agreements as an online retailer. This allows us to offer our customers access to a large selection of high-quality diamonds through our website that we do not hold in inventory. In most cases, we purchase diamonds from our suppliers only as our customers place orders with us. As a result, we do not incur the significant costs that would be incurred by physical retail stores to carry high levels of diamond inventory. Our efficient operating model also provides for negative working capital benefits, since payments are received from customers within a few days of shipment of their order, but our vendor payment terms are typically in the 30-120 day range.

In addition to the working capital benefits of our model, the significant volume of diamonds that we purchase enhances our ability to buy from our suppliers at the best and lowest prices. We are able to pass these lower costs on to consumers, further increasing our value proposition.

Focus on Growth

In 2013, we focused on increasing sales through initiatives across three main categories: 1) the sale of engagement products in the U.S.; 2) the sale of non-engagement products in the U.S.; and 3) the sale of both engagement and non-engagement products in international markets.
We believe that value is one of the most important drivers of engagement sales, and the current costs of diamonds is a significant factor to our growth rate. Generally, we purchase our diamonds on a real time basis from our suppliers when a customer places an order for a specific diamond. When the cost of diamonds is relatively steady or declines, we believe that our business benefits because we are able to immediately pass those lower costs on to consumers. Diamond prices decreased year-over-year through most of 2012 before stabilizing in the fourth quarter of 2012. Diamond prices have been relatively stable since the fourth quarter of 2012 and throughout the fiscal year 2013. Regardless of diamond pricing dynamics, we will remain focused on 1) utilizing our aggressive retail pricing and supply chain capacity; 2) investing heavily in our engagement


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products; and 3) continuing to provide our customers with a compelling website experience across all devices in order to maintain our momentum, gain market share, and increase our value proposition compared to our competitors. The total addressable market for the sale of non-engagement products is much greater than that for engagement, and we believe our brand is well positioned to gain market share. To gain market share in our non-engagement category, we will
1) continue to maximize our opportunity to sell wedding bands and diamond jewelry to both new and repeat customers through refined assortment and pricing, promotion, messaging and user experience; 2) focus on quality and understandable designs to drive sales in fashion jewelry; and 3) continue to provide our customers with a compelling website experience across all devices. We have and will continue to invest in our website and customer experience. As part of our plan to accelerate growth in our international business, we extended our capabilities into markets with the highest potential for growth. We expect significant growth from international markets, both in countries where we have many years of experience, as well as emerging markets. We continue to believe that the Asia-Pacific market, specifically greater China, represents significant long-term opportunities for us. We have and will continue to increase our investments in infrastructure, fulfillment capabilities, product selection, website and mobile experience, and marketing to drive growth and gain market share in these markets. In addition, we will continue to explore strategic partnerships to better serve our customers in these markets. Investments during 2013 have increased our selling, general and administrative expenses and increased the amount of capital spend compared to last year. We believe that these investments will lead to increased growth in all categories of our business and provide higher profitability over the long-term.

Critical Accounting Policies

The preparation of our consolidated financial statements requires that we make certain estimates and judgments that affect amounts reported and disclosed in our consolidated financial statements and related notes. We base our estimates on historical experience and on other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. The following are the critical accounting policies that we believe require significant estimation and management judgment.

Revenue Recognition

We recognize revenue and the related gross profit on the date on which ownership passes from Blue Nile to our customers. For customers in the U.S., Canada, E.U., and United Arab Emirates (U.A.E), ownership passes at the time the package is received by the customer. For customers in other locations, ownership passes at the time the product is shipped. As we require customer payment prior to order shipment, any payments received prior to the transfer of ownership are not recorded as revenue. For U.S., Canadian, E.U. and U.A.E. shipments, we utilize our freight vendors' tracking information to determine when delivery has occurred, which is typically within one to three days after shipment. We also reduce revenue by a provision for returns, which is estimated based on our historical product return rates and current economic conditions. Our contracts with our suppliers generally allow us to return diamonds purchased and returned by our customers.

Stock-based Compensation

We account for stock-based compensation at fair value. We use the Black-Scholes-Merton option valuation model in determining the fair value of our stock options, which requires the input of highly subjective assumptions. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them ("expected term") and the estimated volatility of our common stock price over the expected term ("expected volatility"). Changes in these assumptions can materially affect the estimate of the fair value of employee stock options and consequently, the related amount of stock-based compensation expense recognized in the consolidated statements of operations.

We performed the following sensitivity analysis using changes in the expected term and expected volatility that could be reasonably possible in the near term. If we assumed a six-month increase or decrease in the expected term or a 500 basis point increase or decrease in expected volatility, the value of a newly granted hypothetical stock option would increase (decrease) by the following percentages:


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                       Increase    Decrease
Expected term(1)          4.8 %      (5.2 )%
Expected volatility(1)    7.3 %      (7.6 )%


____________________


(1) Sensitivity to change in assumptions was determined using the Black-Scholes-Merton valuation model compared to the following original assumptions: stock price and exercise price equal to the closing market price of Blue Nile, Inc. common stock on December 29, 2013, expected term of 4.5 years, expected volatility of 56.9%, expected dividend yield of 0% and a risk-free interest rate of 0.9%.

In addition, we estimate the expected forfeiture rate and recognize stock-based compensation expense only for grants that are expected to vest. We estimate the forfeiture rate based on historical experience. To the extent our actual forfeiture rate is different from our estimate, stock-based compensation expense is adjusted accordingly.

Results of Operations

The following table presents our historical operating results for the periods indicated as a percentage of net sales:

                                                      Year Ended       Year Ended       Year Ended
                                                     December 29,     December 30,      January 1,
                                                         2013             2012             2012
Net sales                                              100.0 %          100.0 %          100.0 %
Gross profit                                            18.6 %           18.8 %           20.7 %
Selling, general and administrative expenses            15.4 %           15.7 %           15.8 %
Operating income                                         3.2 %            3.1 %            4.9 %
Other income, net                                          - %            0.1 %            0.1 %
Income before income taxes                               3.2 %            3.2 %            5.0 %
Income tax expense                                       0.8 %            1.1 %            1.7 %
Net income                                               2.4 %            2.1 %            3.3 %

The following describes certain items set forth in our consolidated statements of operations:

Net Sales. Substantially all of our net sales consist of diamonds and fine jewelry sold via the Internet, net of estimated returns. Historically, net sales have been higher in the fourth quarter as a result of higher consumer spending during the holiday season. We expect this seasonal trend to continue in the foreseeable future.

Gross Profit. Our gross profit consists of net sales less the cost of sales. Our cost of sales includes the cost of merchandise sold to customers, inbound and outbound shipping costs, depreciation on assembly-related assets, insurance on shipments and the costs incurred to set diamonds into ring, earring and pendant settings, including labor and related facilities costs. Our gross profit has fluctuated historically and we expect it to continue to fluctuate based primarily on our product acquisition costs, product mix and pricing decisions.

Selling, General and Administrative Expenses. Our selling, general and administrative expenses consist primarily of payroll and related benefit costs for our employees, stock-based compensation, marketing costs and credit card fees. These expenses also include certain facility-related costs, and fulfillment, customer service, technology and depreciation expenses, as well as professional fees and other general corporate expenses.

Fiscal Year. Our fiscal year generally ends on the Sunday closest to December 31. Each fiscal year consists of four 13-week quarters, with one extra week added in the fourth quarter every five to six years.

The following table presents our historical operating results, including a comparison of the financial results for the periods indicated (dollars in thousands, except per share data):


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                                                                         Comparison of                 Comparison of
                                                                          Year Ended                    Year Ended
                                                                     December 29, 2013 to          December 30, 2012 to
                 Year Ended       Year Ended       Year Ended             Year Ended                    Year Ended
                December 29,     December 30,      January 1,          December 30, 2012              January 1, 2012
                    2013             2012             2012           $ Change       % Change       $ Change       % Change
Net sales      $    450,008     $    400,035     $    348,013     $    49,973         12.5  %   $    52,022         14.9  %
Cost of sales       366,357          324,977          275,881          41,380         12.7  %        49,096         17.8  %
Gross profit         83,651           75,058           72,132           8,593         11.4  %         2,926          4.1  %
Selling,
general and
administrative
expenses             69,343           62,771           55,213           6,572         10.5  %         7,558         13.7  %
Operating
income               14,308           12,287           16,919           2,021         16.4  %        (4,632 )      (27.4 )%
Other income,
net:
Interest
income, net             107              133              142             (26 )      (19.5 )%            (9 )       (6.3 )%
Other income,
net                     150              546              184            (396 )      (72.5 )%           362        196.7  %
                        257              679              326            (422 )      (62.2 )%           353        108.3  %
Income before
income taxes         14,565           12,966           17,245           1,599         12.3  %        (4,279 )      (24.8 )%
Income tax
expense               3,690            4,574            5,895            (884 )      (19.3 )%        (1,321 )      (22.4 )%
Net income     $     10,875     $      8,392     $     11,350     $     2,483         29.6  %   $    (2,958 )      (26.1 )%
Basic net
income per
share          $       0.87     $       0.64     $       0.80     $      0.23         35.9  %   $     (0.16 )      (20.0 )%
Diluted net
income per
share          $       0.85     $       0.63     $       0.77     $      0.22         34.9  %   $     (0.14 )      (18.2 )%

Comparison of Fiscal Year Ended December 29, 2013 to Fiscal Year Ended December 30, 2012

Net Sales

Net sales increased 12.5% in the fiscal year ended December 29, 2013, compared with the fiscal year ended December 30, 2012, as a result of the execution of growth initiatives across our three main categories. The total net sales increase was due to an increase in average order value, partially offset by a decrease in orders. The increase in average order value was driven by an increase in engagement orders across all price points and non-engagement orders at higher price points while the decrease in orders is due to a decrease in non-engagement orders at the lower price points.

Net sales in the U.S. increased by 11.6% to $376.8 million for the fiscal year ended December 29, 2013 compared with $337.6 million for the fiscal year ended December 30, 2012. U.S. engagement net sales increased 12.9% to $255.8 million for the fiscal year ended December 29, 2013 from $226.6 million for the fiscal year ended December 30, 2012. U.S. non-engagement net sales grew 8.9% to $121.0 million in the fiscal year ended December 29, 2013 from $111.0 million in the fiscal year ended December 30, 2012. International net sales increased 17.3% to $73.2 million for the year ended December 29, 2013, compared with $62.4 million for the year ended December 30, 2012. Internally, we monitor our international sales performance on a non-GAAP basis which eliminates the positive or negative effects that result from translating international sales into U.S. dollars ("constant exchange rate basis"). International net sales growth was negatively impacted by 2.9% due to changes in foreign exchange rates in 2013 compared with the rates in effect during 2012. Excluding the impact of changes in foreign exchange rates, international sales increased 20.2% in the year ended December 29, 2013.

Gross Profit

Gross profit increased $8.6 million or 11.4% in the fiscal year ended December 29, 2013 compared with the fiscal year ended December 30, 2012. The increase in gross profit is due to the increase in net sales. Gross profit as a percentage of net sales decreased to 18.6% in the year ended December 29, 2013 compared with 18.8% in the year ended December 30, 2012. The decrease in gross profit as a percentage of net sales (gross margin) is attributable to changes in our product mix. Our engagement products generally provide a lower gross margin than our non-engagement products. In the fiscal year ended December 29, 2013, sales of our engagement products grew faster than our non-engagement products and equaled 70.0% of our total revenue versus 69.1% in the fiscal year ended December 30, 2012.


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Costs for our products are impacted by prices for diamonds and precious metals, including gold, platinum and silver, which rise and fall based upon global supply and demand dynamics. In making retail pricing decisions, we take into account fluctuations in the pricing of diamonds and precious metals, which in turn, affect the gross margin that we realize from such products. While prices for diamonds and precious metals will continue to fluctuate based upon supply and demand, we cannot adequately predict the amount and timing of any such fluctuations. We expect that gross profit and gross margin will fluctuate in the future based on changes in product acquisition costs, particularly diamond prices, product mix and pricing decisions.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 10.5% to $69.3 million in the fiscal year ended December 29, 2013 compared with $62.8 million in the fiscal year ended December 30, 2012 due to several factors. Marketing and advertising costs increased approximately $3.2 million, primarily due to increased spending on online marketing vehicles to drive traffic to our website both domestically and internationally. Compensation and benefits expenses increased $2.0 million due to increased headcount to support order growth and key business initiatives. Payment processing fees increased approximately $1.2 million in the fiscal year ended December 29, 2013 primarily due to higher sales volumes. As a percentage of net sales, selling, general and administrative expenses were 15.4% for the year ended December 29, 2013 compared to 15.7% for the year ended December 30, 2012. The decrease in selling, general and administrative expenses as a percentage of net sales in the year ended December 29, 2013 resulted primarily from our ability to leverage our fixed cost base. We expect selling, general and administrative expenses to increase in absolute dollars in future periods as a result of our marketing efforts to drive increases in net sales, growth in our fulfillment and customer service operations to support higher sales volumes and increase in credit card processing fees and other expenses to support growth initiatives.

Other Income, Net

The decrease in other income, net in the fiscal year ended December 29, 2013 as compared with the fiscal year ended December 30, 2012 was primarily due to proceeds of approximately $0.4 million from a favorable settlement related to the De Beers anti-trust litigation in 2012.

Income Taxes

The effective income tax rate for the fiscal year ended December 29, 2013 was 25.3% as compared with 35.3% for the fiscal year ended December 30, 2012. During the fiscal year ended December 29, 2013, there was a change in accounting estimate relating to our income tax expense. We recognized an income tax benefit resulting primarily from the domestic production activities deduction related to the current and prior tax years recorded in the fiscal year ended December 29, 2013. The out-of-period impact of this deduction decreased our income tax expense and increased our net income by $1.1 million and $0.08 per diluted share for the year ended December 29, 2013.

Comparison of Fiscal Year Ended December 30, 2012 to Fiscal Year Ended January 1, 2012

Net Sales

Net sales increased 14.9% in the fiscal year ended December 30, 2012, compared with the fiscal year ended January 1, 2012, due to an increase in the number of orders shipped to customers, partially offset by a decrease in the average order value. Sales of our engagement products grew at a rate above our overall sales growth rate. Net sales in the U.S. increased by 15.6% to $337.6 million for the fiscal year ended December 30, 2012 compared with $292.1 million for the fiscal year ended January 1, 2012. U.S. engagement net sales increased 21.7% to $226.6 million for the fiscal year ended December 30, 2012 from $186.2 million for the fiscal year ended January 1, 2012. We believe that sales growth was positively impacted by a year over year decrease in diamond costs that occurred throughout most of 2012. U.S. non-engagement net sales grew 4.9% to $111.0 million in the fiscal year ended December 30, 2012 from $105.9 million in the fiscal year ended January 1, 2012. International net sales increased 11.7% to $62.4 million for the year ended December 30, 2012, compared with $55.9 million for the year ended January 1, 2012, due primarily to increased marketing efforts and expansion of our product assortment. Internally, we monitor our international sales performance on a non-GAAP basis which eliminates the positive or negative effects that result from translating international sales into U.S. dollars ("constant exchange rate basis"). International net sales growth was negatively impacted by 0.9% due to changes in foreign exchange rates in 2012 compared with the rates in effect during 2011. Excluding the impact of changes in foreign exchange rates, international sales increased 12.6% in the year ended December 30, 2012.


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Gross Profit

Gross profit increased $2.9 million or 4.1% in the fiscal year ended December 30, 2012 compared with the fiscal year ended January 1, 2012. The increase in gross profit is due to the increase in net sales. Gross profit as a percentage of net sales decreased to 18.8% in the year ended December 30, 2012 compared with 20.7% in the year ended January 1, 2012.

The decrease in gross profit as a percentage of net sales (gross margin) is attributable to changes in our product mix. Our engagement products generally provide a lower gross margin than our non-engagement products. In the fiscal year ended December 30, 2012, sales of our engagement products grew faster than our non-engagement products and equaled 69.1% of our total revenue versus 66.4% in the fiscal year ended January 1, 2012.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 13.7% to $62.8 million in the fiscal year ended December 30, 2012 compared with $55.2 million in the fiscal year ended January 1, 2012 due to several factors. Marketing and advertising costs increased approximately $4.5 million, primarily due to increased spending on online marketing vehicles, promotional activities, and other marketing activities to drive new customer acquisition and increase brand awareness. Compensation and benefits expenses increased $1.9 million due to increased headcount to support order growth, key business initiatives, and increased incentive bonus accruals. Payment processing fees increased approximately $1.3 million in the fiscal year ended December 30, 2012 primarily due to higher sales volumes. These expense increases were partially offset by a decrease of approximately $1.5 million in stock-based compensation expense. This decrease is primarily due to a lower number of options outstanding at lower option fair values in the fiscal year ended December 30, 2012. As a percentage of net sales, selling, general and administrative expenses were 15.7% for the year ended December 30, 2012 compared to 15.8% for the year ended January 1, 2012.

Other Income, Net

The increase in other income, net in the fiscal year ended December 30, 2012 as compared with the fiscal year ended January 1, 2012 was primarily due to proceeds of approximately $0.4 million from a favorable settlement related to the De Beers anti-trust litigation.

Income Taxes

The effective income tax rate for the fiscal year ended December 30, 2012 was 35.3% as compared with 34.2% for the fiscal year ended January 1, 2012. The increase is primarily attributable to tax benefits received in fiscal year ended January 1, 2012 from stock option exercises that did not recur in fiscal year 2012.

Liquidity and Capital Resources

We are primarily funded by our cash flows from operations. The significant components of our working capital are inventory and liquid assets such as cash, cash equivalents and trade accounts receivable, reduced by accounts payable and accrued expenses. Our business model provides certain beneficial working capital characteristics. While we collect cash from sales to customers within several business days of the related sale, we typically have extended payment terms with our suppliers.

Our liquidity is primarily dependent upon our net cash from operating activities. Our net cash from operating activities is sensitive to many factors, including changes in working capital and the timing and magnitude of . . .

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