UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended July 4, 2004

OR

For the transition period from           to          

Commission file number 000-50763

BLUE NILE, INC.

705 Fifth Avenue South, Suite 900
Seattle, Washington 98104
(Address of principal executive offices)

Registrant’s telephone number, including area code: (206) 336-6700

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes   (  )   No   (X)

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).   Yes   (  )   No   (X)

As of July 26, 2004, the registrant had 17,656,265 shares of common stock outstanding.

1

Cautionary Note Regarding Forward-Looking Statements

This quarterly report on Form 10-Q contains forward-looking statements that involve many risks and uncertainties. These statements relate to future events and our future performance that are based on current expectations, estimates, forecasts and projections about the industries in which we operate and the beliefs and assumptions of our management. In some cases, you can identify forward-looking statements by terms such as “would,” “could,” “may,” “will,” “should,” “expect,” “intend,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “targets,” “seek,” or “continue,” the negative of these terms or other variations of such terms. In addition, any statements that refer to projections of our future financial performance, our anticipated growth and trends in our business and other characterizations of future events or circumstances, are forward-looking statements. These statements are only predictions based upon assumptions made that are believed to be reasonable at the time, and are subject to risk and uncertainties. Therefore, actual events or results may differ materially and adversely from those expressed in any forward-looking statement. In evaluating these statements, you should specifically consider the risks described under the caption “Factors that May Affect Future Operating Results” and elsewhere in this Form 10-Q. These factors may cause our actual results to differ materially from any forward-looking statements. Except as required by law, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

2

Blue Nile, Inc.

INDEX

3

PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

BLUE NILE, INC.

The accompanying notes are an integral part of these consolidated financial statements

4

BLUE NILE, INC.

The accompanying notes are an integral part of these consolidated financial statements

5

BLUE NILE, INC.

The accompanying notes are an integral part of these consolidated financial statements

6

BLUE NILE, INC.

The accompanying notes are an integral part of these consolidated financial statements

7

BLUE NILE, INC.

Notes to Consolidated Financial Statements

Note 1. Description of the Company and Summary of Significant Accounting Policies

The Company

Blue Nile, Inc. (the “Company”) is a leading online retailer of high quality diamonds and fine jewelry. In addition to sales of diamonds, fine jewelry and watches, the Company provides guidance and support to enable customers to more effectively learn about and purchase diamonds as well as classically styled fine jewelry. The Company, a Delaware corporation, based in Seattle, Washington, was formed in March 1999. The Company maintains its primary web site at www.bluenile.com.

Change in Fiscal Year

On January 1, 2004, the Company’s fiscal year-end changed from December 31 to the Sunday closest to December 31. Each fiscal year consists of four 13-week quarters, with an extra week added onto the fourth quarter every five to six years. Because of the transition, year to date 2004 results include three additional days of operations.

Reclassifications

Certain reclassifications of prior year balances have been made for consistent presentation with the current year.

Basis of Presentation

The accompanying unaudited consolidated financial statements should be read in conjunction with the Notes to Consolidated Financial Statements contained in Amendment No. 4 of the Company’s registration statement on Form S-1, declared effective by the Securities and Exchange Commission on May 19, 2004. The same accounting policies are followed for preparing quarterly and annual financial statements. In the opinion of management, all adjustments necessary for the fair presentation of the results of operations, financial position and cash flows have been included and are of a normal, recurring nature.

Due to the seasonal nature of the retail industry, quarterly results are not necessarily indicative of the results for the full fiscal year.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Some of the more significant estimates include the allowance for sales returns, the reserve for estimated fraud losses and the deferred tax valuation reserve. Actual results could differ from those estimates.

Stock-Based Compensation

The Company accounts for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations including Financial Accounting Standards Board Interpretation No. 44, “Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25.” The Company has elected to apply the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock Based Compensation.” Had compensation cost for the Company’s stock options been determined based on the fair value of the options at the date of grant, the Company’s pro forma net income would have been as shown below (in thousands, except per share data):

8

BLUE NILE, INC.

Notes to Consolidated Financial Statements

Note 2. Inventories

Inventories are stated at cost and consist of the following (in thousands):

Note 3. Marketable Securities

The Company’s marketable securities are classified as available-for-sale as defined by Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” At July 4, 2004, marketable securities consist of U.S. government and agencies’ securities maturing in 2004. The securities are carried at fair value, which approximates cost. Interest on marketable securities is included in interest income in the consolidated statements of operations. There were no sales of marketable securities during the periods presented.

Note 4. Net Income Per Share

Basic net income per share is based on the weighted average number of common shares outstanding, excluding unvested common shares issued to employees upon early exercise of options, which are subject to repurchase by the Company. Diluted net income per share is based on the weighted average number of common shares and equivalents outstanding. Common share equivalents included in the computation represent common shares issued upon early exercise of options which are subject to repurchase rights, shares issuable upon assumed exercise of outstanding stock options, warrants and mandatorily redeemable convertible preferred stock except when the effect of their inclusion would be antidilutive.

The following tables sets forth the computation of basic and diluted net income (loss) per share (in thousands, except per share data):

9

BLUE NILE, INC.

Notes to Consolidated Financial Statements

For the quarter ended June 30, 2003, there were 2,994 preferred stock warrants and 2,517 stock option shares excluded from the computation of net income per diluted share due to their antidilutive effect. For the year to date ended June 30, 2003, there were 2,994 preferred stock warrants and 1,311 stock option shares excluded from the computation of net income per diluted share due to their antidilutive effect.

Note 5. Initial Public Offering

On May 19, 2004, the Company’s registration statement on Form S-1 was declared effective for its initial public offering, pursuant to which the Company sold 2,300,910 million shares of common stock at $20.50 per share. The Company’s common stock commenced trading on May 20, 2004. The offering closed on May 25, 2004, and, as a result, the Company received net proceeds of approximately $43.9 million (after underwriters’ discounts of $3.3 million). The Company incurred additional, estimated related expenses of approximately $1.4 million.

On April 30, 2004, the Company effected a 1 for 2.5 reverse split of its common stock and mandatorily redeemable convertible preferred stock. All shares and per share amounts and any other references to shares included in the accompanying unaudited consolidated financial statements have been adjusted to reflect this split on a retroactive basis.

Simultaneous with the closing of this offering, the Company’s 10.0 million outstanding shares of mandatorily redeemable convertible preferred stock were automatically converted into approximately 10.9 million shares of common stock.

10

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our Consolidated Financial Statements and the related notes contained elsewhere in this quarterly report on Form 10-Q. All statements in the following discussion that are not reports of historical information or descriptions of current accounting policy are forward-looking statements. Please consider our forward-looking statements in light of the factors that may affect operating results set forth herein.

Overview

Net income in the second quarter of 2004 was $1.9 million, or $0.11 per diluted share. In the second quarter of 2003, net income and net income per diluted share were $2.2 million and $0.14, respectively. There was no income tax expense in the second quarter of 2003 as a valuation allowance was recorded against deferred tax assets. Income before income taxes in the second quarter of 2004 was $2.9 million, compared to $2.2 million in the second quarter of 2003. The significant growth in sales drove the 30.4% increase in income before income taxes for the quarter.

Year to date net income and net income per diluted share for the period ended July 4, 2004 were $3.8 million and $0.22 respectively, compared to net income and net income per diluted share of $3.9 million and $0.24 for the six months ended June 30, 2003. Income before income taxes was $5.9 million for the year to date period ended July 4, 2004, compared to $3.9 million for the six months ended June 30, 2003.

Results of Operations

Comparison of Quarter Ended July 4, 2004 to Quarter Ended June 30, 2003

Net Sales

Net sales increased 28.5% to $35.0 million for the second quarter of 2004 compared to $27.3 million for the second quarter of 2003. The increase in net sales was primarily due to an increase in net sales of engagement rings and loose diamonds.

Gross Profit

Gross profit increased 29.8% to $7.9 million in the second quarter of 2004 from $6.1 million in the comparable period in 2003. The increase in gross profit was due to the increase in sales volume. Gross profit as a percentage of net sales was 22.6% and 22.4% in the quarters ended July 4, 2004 and June 30, 2003, respectively. The increase in gross profit as a percentage of net sales was primarily due to merchandise mix, with higher gross margin jewelry items making up a larger percentage of net sales in the second quarter of 2004 compared to the comparable period in 2003.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 31.4% to $5.1 million in the second quarter of 2004 from $3.9 million in the second quarter of 2003. As a percentage of net sales, selling, general and administrative expenses were 14.6% in the second quarter of 2004 compared to 14.3% in the second quarter of 2003. The increase in selling, general and administrative expenses in the second quarter of 2004 was due to several factors. Marketing expenses increased by approximately $566,000 due primarily to increased advertising costs from higher sales volume. Payroll and payroll related expenses increased approximately $190,000 resulting primarily from the addition of new employees. Legal and accounting fees increased approximately $139,000, primarily due to higher costs associated with being a public company. Insurance costs increased approximately $130,000, primarily due to higher director and officer insurance premiums as a result of becoming a public company, and credit card processing fees increased approximately $97,000 due to higher sales volumes. Additionally, in the second quarter of 2004, we recorded approximately $80,000 of stock-based compensation expense for which there was no corresponding amount in the second quarter of 2003.

Interest Income

Interest income was approximately $97,000 for the second quarter of 2004, compared to approximately $21,000 in the second quarter of 2003. The increase in interest income is primarily due to an increase in our cash and cash equivalents and marketable securities as a result of our initial public stock offering completed in May 2004, resulting in net proceeds of $42.5 million.

Income Taxes

Income tax expense was $1.1 million in the second quarter of 2004 compared to $0 in the second quarter of 2003. In the second quarter of 2004, we recognized income tax expenses at the federal statutory rate. There was no income tax expense for the comparable period in 2003 as a result of a valuation allowance against deferred tax assets.

11

Comparison of Year to Date Ended July 4, 2004 to Year to Date Ended June 30, 2003

Net Sales

Net sales increased 36.5% to $70.8 million year to date ended July 4, 2004 compared to $51.9 million in the six months ended June 30, 2003. The increase in net sales was primarily due to an increase in net sales of engagement rings and loose diamonds.

Net sales in the year to date ended July 4, 2004 were positively impacted by our transition to a 4-4-5 retail calendar on January 1, 2004 that added three days of sales compared to the six months ended June 30, 2003. Sales in the additional days contributed approximately $1.2 million to the quarter ended April 4, 2004 net sales.

Gross Profit

Gross profit increased 31.6% to $16.1 million year to date ended July 4, 2004 from $12.3 million in the comparable period in 2003. The increase in gross profit primarily resulted from increases in sales volume. Gross profit as a percentage of net sales declined to 22.8% year to date ended July 4, 2004 from 23.6% in the six months ended June 30, 2003. The decrease in gross profit as a percentage of net sales resulted primarily from retail price reductions that were instituted beginning in the second quarter of 2003. This decrease was partially offset by a change in merchandise mix. Jewelry, which has historically generated higher gross profit margin than engagement products, represented a larger percentage of our net sales in the year to date July 4, 2004 compared to the six months ended June 30, 2003.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 27.0% to $10.4 million year to date ended July 4, 2004 from $8.2 million in the six months ended June 30, 2003. Several factors contributed to the increase in selling, general and administrative expenses year to date ended July 4, 2004. Marketing expenses increased approximately $777,000 due to increased advertising costs from higher sales volume. Payroll and payroll related expenses increased approximately $493,000 resulting primarily from the addition of new employees. Legal and accounting fees increased approximately $343,000 due to higher costs associated with being a public company. Credit card processing fees increased approximately $304,000 due to higher sales volumes. Insurance costs increased approximately $152,000 primarily due to higher director and officer premiums as a result of becoming a public company. Additionally, year to date ended July 4, 2004 we recorded approximately $182,000 of stock-based compensation expense for which there was no corresponding amount in the six months ended June 30, 2003.

As a percentage of net sales, selling, general and administrative expenses were 14.7% year to date ended July 4, 2004 compared to 15.8% in the six months ended June 30, 2003. The decrease in these expenses as a percentage of net sales year to date ended July 4, 2004 resulted primarily from our ability to grow sales at a greater pace than selling, general and administrative expenses.

Interest Income

Interest income was approximately $139,000 for the year to date ended July 4, 2004, compared to approximately $55,000 in the six months ended June 30, 2003. The increase in interest income is primarily due to an increase in our cash and cash equivalents and marketable securities as a result of our initial public stock offering completed in May 2004, resulting in net proceeds of $42.5 million.

Interest Expense

Interest expense was $0 year to date ended July 4, 2004 compared to approximately $209,000 in the six months ended June 30, 2003. The decrease was due to the repayment of the outstanding balances on our notes payable and capital lease obligations in March 2003 and April 2003.

Income Taxes

Income tax expense was $2.1 million year to date ended July 4, 2004 compared to $0 in the six months ended June 30, 2003. Year to date ended July 4, 2004 we recognized income tax expenses at the federal statutory rate. In the six months ended June 30, 2003 we did not recognize income tax expense as a result of a valuation allowance against deferred tax assets.

12

Liquidity and Capital Resources

As of July 4, 2004, we had working capital of $65.4 million, including cash and cash equivalents of $52.6 million, partially offset by accounts payable of $13.8 million. We believe that our current cash and cash equivalents as well as cash flows from operations will be sufficient to continue our operations and meet our capital needs for the foreseeable future.

Net cash of $4.3 million was used for operating activities year to date July 4, 2004 compared to cash provided by operating activities of $142,000 in the six months ended June 30, 2003. Cash was provided by earnings of $3.8 million and $3.9 million year to date July 4, 2004 and the six months ended June 30, 2003, respectively. Additionally, inventory decreased by $3.5 million year to date July 4, 2004 due to the seasonal decrease in inventory of settings and jewelry from the fourth quarter of 2003. However, these amounts were offset by net payments of payables totaling $12.5 million for the year to date July 4, 2004 and $4.9 million for the six months ended June 30, 2003 due to the normal payment of vendors in the first quarter for inventory sold in the fourth quarter.

Net cash used in investing activities was $16.0 million year to date July 4, 2004 and $756,000 for the six months ended June 30, 2003. Cash used in 2004 was primarily for the purchase of marketable securities of $15.9 million. Cash used in 2003 was primarily related to capital expenditures

Net cash provided by financing activities year to date July 4, 2004 were $42.6 million resulting from the net proceeds of our initial public offering completed in May 2004. Cash used in financing activities in the six months ended June 30, 2003 was $8.8 million and was primarily related to payments of notes payable, capital leases, and a related party note payable.

Factors that May Affect Future Operating Results

You should carefully consider the risks described below and elsewhere in this report, which could materially and adversely affect our business, results of operations or financial condition. In those cases, the trading price of our common stock could decline and you may lose all or part of your investment.

Our limited operating history makes it difficult for us to accurately forecast net sales and appropriately plan our expenses.

We were formed in March 1999 and have a limited operating history. As a result, it is difficult to accurately forecast our net sales and plan our operating expenses. We base our current and future expense levels on our operating forecasts and estimates of future net sales. Net sales and operating results are difficult to forecast because they generally depend on the volume and timing of the orders we receive, which are uncertain. Some of our expenses are fixed, and, as a result, we may be unable to adjust our spending in a timely manner to compensate for any unexpected shortfall in net sales. This inability could cause our net income in a given quarter to be lower than expected.

We have incurred significant operating losses in the past and may not be able to sustain profitability in the future.

We experienced significant operating losses in each quarter from our inception in 1999 through the second quarter of 2002. As a result, our business has a limited record of profitability and may not continue to be profitable or increase in profitability. If we are unable to acquire diamonds and fine jewelry at commercially reasonable prices, if net sales decline or if our expenses otherwise exceed our expectations, we may not be able to sustain or increase profitability on a quarterly or annual basis.

As a result of our significant operating losses in prior periods, we have accrued substantial net operating loss carryforwards. If we are unsuccessful in generating sufficient net income in future periods, these assets may expire before they are utilized.

We expect our quarterly financial results to fluctuate, which may lead to volatility in our stock price.

We expect our net sales and operating results to vary significantly from quarter to quarter due to a number of factors, including changes in:

	•		demand for our products;
	•		our ability to attract visitors to our web site and convert those visitors into customers;
	•		our ability to retain existing customers or encourage repeat purchases;
	•		our ability to manage our product mix and inventory;

13

	•		consumer tastes and preferences for diamonds and fine jewelry;